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In Maxopp Investment Ltd v\/s CIT<\/a><\/em> 402 ITR 640 (SC), the Supreme Court has laid down important law on the interpretation of section 14A and Rule 8D. Advocate Vipul Joshi has conducted a detailed study of the judgement in juxtaposition with the earlier judgements of the apex court in Godrej & Boyce Mfg. Co. Ltd v\/s DCIT<\/a><\/em> 394 ITR 449 (SC)] and CIT v\/s. Essar Teleholdings Ltd<\/a><\/em> 401 ITR 445 (SC) and explained its precise implications<\/strong><\/p>\n THE DECISION IN CASE OF MAXOPP INVESTMENT LTD.<\/u><\/strong> <\/p>\n <\/em>The decision delivered by the Supreme Court in the case of Maxopp Investment Ltd. &Ors. v\/s. CIT –<\/a> [(2018) 402 ITR 640 (SC)]<\/strong> completes trilogy of the judgments on core issues relating to section 14A of the Income – tax Act, 1961 [“the Act”]; the first one being the case of Godrej & Boyce Mfg. Co. Ltd. v\/s. DCIT –<\/a> [(2017) 394 ITR 449 (SC)]<\/strong> and the second being the case of CIT v\/s. Essar Teleholdings Ltd. –<\/a> [(2018) 401 ITR 445 (SC)]<\/strong>. While the issue in the case of Godrej was applicability of section 14A vis – a – vis the dividend income which has already suffered dividend distribution tax in terms of section 115-O and 115-R,the issue in the case of Essar was prospective \/retrospective operation of Rule 8D. The issue involved in the case of Maxopp was applicability of section 14A vis– a – vis shares held as strategic investments \/ shares held as stock in trade. The discussion in this article is confined to the issues arising from the decision in the case of Maxopp Investment Ltd. [“Maxopp”].<\/em><\/p>\n It is one of the fundamental principles of law on precedent that a decision has to be understood and analyzed on the basis of the facts and the specific issues that were before the court, on the basis of which arguments from both the sides proceeded. A slight variation in these factors can prevent the case from being a binding precedent for a subsequent case having different factual and arguments matrix that are relevant on the issue. Further, it is also important to appreciate a decision in the backdrop of the legal precedents and the legislative history. Therefore, since this decision in case of Maxopp has very far reaching effects and repercussions, it becomes imperative to revisit the entire issue afresh, with the legislative history and legal precedents connected therein – albeit at the cost of breaching the limitation oflength of this article – so as provide assistance to understand and appreciate the ratio and impact of this judgment in true perspective. For the very same reason – limitation of length of article– the discussion is divided into three parts, the first part devoted to tracing the legislative history and legal precedents prior to insertion of section 14A as well as legislative intention behind introduction of section 14A, the second part devoted to legal precedents post insertion of section 14A, including the decision of Maxopp, and the third part containing analysis and comments.<\/p>\n PART ONE<\/strong><\/p>\n PRE SECTION 14A P<\/strong>OSIT<\/strong>ION<\/strong><\/p>\n Essentially, the focal point of the entire controversy is the issue of allowance \/ disallowance of the expenditure incurred in connection with earning of tax free income. To analyze the issue, one has to, necessarily, go to the very genesis of the provisions of section 14A of the Income – tax Act, 1961 [“the Act”] due to the very nature of the issue. The entire controversy has arisen due to the words “in relation to” as used in section 14A while stipulating that ‘… … no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to<\/u><\/strong> income which does not form part of the total income under this Act.”<\/em><\/p>\n Now, the phrase “in relation to” is not defined in the Act, nor there is much judicial precedent on this phrase so far as the income tax law is concerned. Therefore, the same is to be interpreted keeping in view:<\/p>\n I. The background and the prior position in law<\/p>\n II. The legislative history<\/p>\n III. The legislative intention \/ The mischief sought to be remedied<\/p>\n IV. The legal precedents on the issue post insertion<\/p>\n V. The relevant principles of interpretation of statute <\/p>\n I. THE BACKGROUND AND THE PRIOR POSITION<\/u><\/strong><\/p>\n It is very essential to analyze the background and the prior position in order to appreciate the legislative intention behind brining an amendment 40 years after enactment of the Act; that too, giving retrospective effect of 40 years. It may also be essential to understand the mischief that was sought to be addressed \/ avoided by the legislature while bringing section 14A. The analysis is also important in order to appreciate whether, with one stroke of pen, is it that the legislature intended to overrule all judicial precedents on all aspects concerning this issue that stood test for more than half a century so as to make them totally redundant; or is it that the intention was to affect only certain specific fact situations.<\/p>\n Now, this can be best analysedby summarizing some of the propositions laid down by catena of legal precedents on the aspect of allowability of a deduction, which is otherwise eligible under the Act, vis– a –vis generation of tax free income, arising out of itdirectly or incidentally. Some of them are analyzed hereunder, which are, by no means, exhaustive to the issue. <\/p>\n<\/p>\n A. GENERAL<\/u><\/p>\n 1. Proposition: If a tax free security is capable of producing [taxable] profit and loss, no part of the cost can be disallowed on the reasoning that the same was incurred for producing tax – free interest income arising therefrom.<\/em><\/p>\n In one of the pioneering judgments on this aspect, A Three Judges Bench of the Supreme Court, in the case of CIT v\/s. Indian Bank Limited – [(1965) 56 ITR 77 (SC)],<\/em><\/strong> was concerned with a case of a banking company that had invested large sum in tax free government securities out of interest bearing funds. The securities were treated by the assessee as its stock – in – trade; the profit \/ loss arising out of which was computed under the head “business”. The contention of the Department was that a part of the interest expenses was disallowable as the securities generated tax free interest income, on the basis of the general principle that no expenditure can be allowed as a deduction from the profits of a business unless the part of the business to which the expenditure is attributable is capable of producing income or profits liable to be taxed under the Act. In other words, it was contended that if a part of profits of a business is not taxable, no expenditure incurred for the purpose of earning those profits can be allowed as deduction. Otherwise, it was contended, it would amount to double benefit to the assessee<\/u>. It was argued that if a particular income has no taxable quality, it also loses quality for qualifying for expenditure allowable u\/s. 10 of Indian Income-tax Act, 1922 [parimateria<\/em> with section 28 \/ 29 of the Act].The Three Judges Bench, at the very threshold, rejected the stand of the Department on the preliminary ground that even if the stand of the Department was to be accepted, such stand did not assist the revenue in that case as it was not controverted that the profits and losses accruing from the sale and purchase of such securities had been included in the assessment [that is, taxed]. Therefore, as the tax – free securities were capable of producing [taxable] profits and losses, the Apex Court held that the appeal of the Department must fail on this ground alone. {These observations are quite significant in the present context.}<\/p>\n 2. Proposition: Allowability of business expenditure is not dependent upon producing taxable or non – taxable income. The fact that the income arising from a part of that business is not exigible to tax under the Act is not a relevant criteria.<\/em><\/p>\n (i) In the above referred case of Indian Bank Limited, the Apex Court, after holding as above, proceeded to adjudicate this second proposition as under: <\/p>\n “We must look at section 10 (2) and deduct all the allowances permissible to him. In allowing a deduction which is permissible the question arises: Do we look behind the expenditure and see whether it has the quality of directly or indirectly producing taxable income? The answer must be in the negative for two reasons: First, Parliament has not directed us to undertake this enquiry. There are no words in section 10 (2) to that effect. On the other hand, indications are to the contrary. In section 10 (2) (xv), what Parliament requires to be ascertained is whether the expenditure has been laid out or expended wholly and exclusively for the purpose of the business. <\/em><\/p>\n The legislature stops short at directing that it be ascertained what was the purpose of the expenditure. If the answer is that it is for the purpose of the business, Parliament is not concerned to find out whether the expenditure has produced or will produce taxable income. <\/em><\/p>\n Secondly, the reason may well be that Parliament assumes that most types of expenditure which are laid out wholly and exclusively for the purpose of business would directly or indirectly produce taxable income, and it is not worth the administrative effort involved to go further and trace the expenditure to some taxable income.<\/u><\/em><\/p>\n Therefore, it seems to us that there is nothing in the language of section 10 from which it can be fairly implied that an expenditure or allowance falling within the section must fulfill some other condition before it can be allowed.” <\/em><\/p>\n<\/p>\n The Apex Court followed the ratio laid down in the case of Hughes v\/s. Bank of New Zealand – [(1938) 6 ITR 636 (SC)]<\/em><\/strong> and reproduced the following observations of Greene L. J., which may be relevant for the present purpose:<\/p>\n "when the statute says that interest is to be exempt, I am quite unable to read it as meaning that in giving effect to that exemption by implication, some repercussion is to take place on a different provision of the Act altogether…… I can find nothing in the statute which requires this interest to be treated, so to speak, as a trade within a trade. This is really what the Crown contend, that in some way this interest which is to be brought into account as an item of receipt is to be taken out of it with some apportioned expenses appropriated to it as though it were a trade by itself."<\/em><\/p>\n The Court held that there is no general principle that if a part of the income of a business is tax free, expenditure incurred for the purpose of earning this income is outside the purview of section 10 of Income – tax Act, 1922.<\/p>\n (ii) In an interesting case before the Full Bench of the Madras High Court, {S. A. S. S. ChellappaChettiar v\/s. CIT –[(1937) 5 ITR 97 (Madras) (FB)]}<\/em><\/strong>, most part of the interest bearing funds of the assessee – money lender stood invested in agriculture land that was received by the assessee from his constituent towards repayment of loan that was given in course of his money lending business. The assessee managed and cultivated the agriculture land and earned tax free agriculture income. The contention of the Department was on the same line as above. The Income Tax Officer disallowed 4\/5th of the interest expenditure on the ground that 4\/5th of borrowed money had been invested in such agriculture land that generated tax free income. The officer also disallowed 50% of establishment expenses. The High Court, very pertinently, observed that the cultivation was merely a necessary incident of his involuntary possession which came to him because as a money – lender he had lent money to a borrower who could not repay his money. <\/p>\n The High Court held that if money is originally borrowed for the purpose of business, it is immaterial whether, later on, tax free income gets generated in course of the business activity as a necessary incident and the assessee is not to be deprived of the advantages conferred by exemptions such as section 10 (2) (iii) [parimateria<\/em> with section 36 (1) (iii) of the Act] because the capital benefiting therefrom by means of permissible deductions happens to produce a non – taxable income. The High Court also made a very interesting observation, which is very relevant for post section 14A scenario. The Court observed that if the Department’s contention was to be accepted, the assessee would have been better off if he had not taken this land from the debtor and, therefore, unable to realize anything in cash as, in such a situation as he would then be able to at least get (full) benefit of deduction of interest under section 10 (2) (iii). <\/p>\n {Post section 14A \/ Rule 8D, there have been numerous cases where the disallowance under section 14A comes to a figure many times more than the dividend income itself; in many cases more than even the entire expenses, compelling the assessee to lament about the dividend income being tax free or about at all receiving such dividend (tax free)! Recent amendments in Rule 8D do not mitigate such situations completely and satisfactorily.}<\/em> <\/p>\n This decision was approved by the Apex Court in the case of Indian Bank [discussed earlier] and Maharashtra Sugar [discussed later].<\/p>\n (iii) The above proposition was applied by the Bombay High court in the case of CIT v\/s. Industrial Investment Trust Co. Ltd. –[(1968) 67 ITR 436 (Bom)],<\/em><\/strong> where the business of the assessee was a single activity, which did not have two distinct or different businesses: one yielding a tax – free profit and the other a profit which was subject to tax, and the expenses were incurred for the carrying on of such single business, which produced income partly of one kind and partly of another. The Court granted the benefit of deduction to the assessee, rejecting the argument of the department that otherwise the assessee would get double advantage.<\/p>\n (iv) In the case of CIT v\/s. Maharashtra Sugar Mills Ltd. – [(1971) 82 ITR 452 (SC)]<\/em><\/strong>, the Supreme Court was concerned with the case of the assessee, a company, which was having extensive land on which it was growing sugar – cane which was used for manufacturing sugar in its factory. Both the businesses were, admittedly, indivisible. The issue was disallowance of a part of managing agency commission which, according to the Department, was incurred in respect of the tax free agriculture activity of growing sugar – cane. The Apex Court found no basis for the same, by observing as under:<\/p>\n “This contention proceeds on the basis that only expenditure incurred in respect of a business activity giving rise to income, profit or gains taxable under the Act can be given deduction to and not otherwise. We see no basis for this contention.To find out whether the deduction claimed is permissible under the Act or not, all that we have to do is to examine the relevant provisions of the Act. Equitable considerations are wholly out of place in construing the provisions of a taxing statute. We have to take the provisions of the statute as they stand. If the amount claimed is permissible under the Act then the same has to be deducted from the gross profit. If it is not permissible under the Act, it has to be rejected.<\/u>As mentioned earlier, it is not disputed that the cultivation of sugar-cane and the manufacture of sugar constituted one single and indivisible business. Section 10 (2) says that profits under section 10 (1) in respect of a business should be computed after deducting the allowances mentioned therein. One of the allowances allowed is that mentioned in section 10 (2) (xv) which says that any expenditure laid out or expended wholly an exclusively for the purpose of such business shall be deducted as an allowance. The mandate of section 10 (2) (xv) is plain and unambiguous.Undoubtedly, the allowance claimed in this case was laid out or expended for the purpose of the business carried on by the assessee. The fact that the income arising from a part of that business is not exigible to tax under the Act is not a relevant circumstance.<\/u>” <\/em><\/p>\n (v) The above principle was followed by the Apex Court, even after 30 years, in the celebrated case of Rajasthan State Warehousing Corporation v\/s. CIT – [(2000) 242 ITR 450 (SC)]<\/em><\/strong>. This decision is very significant as it is this decision that was sought to be nullified by introducing section 14A. This was a case where the assessee, a State Government Corporation, derived income from various sources, which included income from warehousing that was exempt u\/s. 10 (29) of the Act. The A.O. disallowed business expenses allocable to non – taxable income. Allowing the appeal of the assessee, the Court laid down the following principles: <\/p>\n “(i) if income of an assessee is derived from various heads of income, he is entitled to claim deduction admissible under the respective head whether or not computation under each head results in taxable income;<\/em><\/p>\n (ii) if income of an assessee arises under any of the heads of income but from different items, e.g., different house properties or different securities, etc., and income from one or more items alone is taxable whereas income from the other item is exempt under the Act, the entire permissible expenditure in earning the income from that head is deductible; and<\/em><\/p>\n (iii) in computing "profits and gains of business or profession" when an assessee is carrying on business in various ventures and some among them yield taxable income and the others do not, the question of allowability of the expenditure under section 37 of the Act will depend on:(a)fulfillment of requirements of that provision noted above; and(b)on the facts whether all the ventures carried on by him constituted one indivisible business or not; if they do, the entire expenditure will be a permissible deduction but if they do not, the principle of apportionment of the expenditure will apply because there will be no nexus between the expenditure attributable to the venture not forming an integral part of the business and the expenditure sought to be deducted as the business expenditure of the assessee.”<\/em><\/p>\n It is significant to note that even the Department conceded this legal position. <\/p>\n (vi) However, if, in a given case, the assessee is not able to prove that the various activities carried on by the assessee [generating taxable as well as non – taxable income] constitute one single integrated activity or that such activities do not represent distinct business, then the ratio of Maharashtra Sugar Mills cannot be applied. In such a case, the common expenses, like head office expenses, can be apportioned among such different activities on a reasonable basis. B. CASES CONCERNING ALLOCATION OF EXPENSES WITH RESPECT TO EARNING OF INTEREST FREE INCOME \/ DIVIDEND FROM SHARES & SECURITIES<\/u> <\/p>\n Even on this aspect, the law was quite well settled, which will be evident from analysis of few cases as hereunder; the contents of which are very much self – explanatory. <\/p>\n 1. General<\/u><\/p>\n (i) For the purpose of section 57 (iii), there should be some nexus between the expenditure and the earning of the income. …… The interest (on fixed deposits) accrues sui generis<\/em>. The interest is payable by the bank whether it is claimed or not and whether there is any establishment or not. <\/p>\n Normally, there was no necessity for spending anything separately for earning the interest. While rejecting the assessee’s claim of administrative expenses, the Court made very pertinent observations as follows: {Consider this proposition in light of the present position, where now there is a system of direct credit of dividend to the account of the shareholder.}<\/em><\/p>\n (ii) There is a difference between an expense relatable to acquisition of share<\/u> and an expense relatable to dividend<\/u> being earned upon such shares. An expense may be a former but not necessarily the latter as well.<\/p>\n CIT v\/s. General Insurance Corporation of <\/strong>India<\/strong> – [(2002) 254 ITR 203 (Bom)]<\/strong><\/p>\n {The Department accepted this ratio and did not agitate this ground while preferring appeal against this judgement before Supreme Court on another ground.} <\/strong><\/p>\n {This ratio goes to the very root of the issue, as this subtle distinction is now completely lost sight of.}<\/p>\n 2. Cases concerning 80M<\/u><\/p>\n [Section 80M, as existed upto 31.03.2003, essentially, provided for deduction in respect of certain inter – corporate dividends. In other words, dividends derived by companies from domestic companies were taxed on concessional basis. One of the contentious issues was whether the exemption of dividend income was on gross basis or net basis and, if on net basis, how to allocate \/ apportion expenses to be deducted against such dividend income.]<\/p>\n (i) For the purpose of computing the amount of dividend to be exempted u\/s. 80M, only expenditure that are actually incurred for earning dividend income are to be deducted. There is no scope for allocation of notional or estimated expenditure or application of rule of proportionality with respect to the expenses (including the interest) alleged to have been incurred for the purpose of earning such dividend income. <\/p>\n CIT v\/s. Central Bank of <\/strong>India<\/strong> – [(2003) 264 ITR 522 (Bom)]<\/strong>.The appeal of the Department dismissed by Supreme Court in CIT v\/s. Central Bank of <\/strong>India<\/strong> – [(2015) 373 ITR 524 (SC)]<\/strong>.}<\/p>\n CIT v\/s. United Collieries Ltd. – [(1993) 203 ITR 857 (<\/strong>Cal<\/strong>)]<\/strong><\/p>\n CIT v\/s. Modern Terry Towels Ltd. – [(2013) 357 ITR 750 (Bom)]<\/strong><\/p>\n CIT v\/s. Reliance Industries Ltd. – [(2017) 86 taxmann.com 24 (Bom)]<\/strong><\/p>\n (ii) “The question may still arise as to whether any notional expenditure can be taken into consideration for the purpose of deduction while calculating the income from dividend or only expenditure actually incurred by an assessee can be taken into consideration while calculating the deduction claimed under section 80M. In our considered opinion, there lies a distinction between what we call notional expenditure and actual expenditure.<\/u> If it is proved to be a case of actual expenditure incurred by an assessee while earning \/ depositing the dividend, then certainly the amount actually incurred by way of expenditure has got to be deducted in accordance with the procedure prescribed under the Act. But when there is nothing on record to show that any expenditure is incurred by an assessee while earning \/ depositing the dividend, then it is difficult for us to hold that some hypothetical and \/ or notional expenditure can be made a basis for deduction. In other words, we have not been able to notice any provision which may entitle the taxing authorities to work out by way of expenditure any notional figure for the purpose of section 80M though, in fact, it has not been so incurred by an assessee while encashing the dividend.” <\/em><\/p>\n State Bank of <\/strong>Indore<\/strong> v\/s. CIT – [(2005) 275 ITR 23 (MP)]<\/strong><\/p>\n {A case where CIT (A) itself had deleted the disallowance vis – a – vis interest, which was accepted by the Department. The appeal of the assessee was vis –a – vis 10% disallowance towards collection charges.} <\/p>\n (iii)The Special Bench of the Tribunal in the case of Punjab State Industrial Ltd. v\/s. DCIT – [(2006) 102 ITD 1 (Chd) (SB)]<\/strong>, laid down certain propositions with respect to dividend income vis – a – vis section 80M of the Act, after exhaustively dealing with the issue. Some of them, so far as relevant for the present article, are:<\/p>\n “(iv) That actual expenditure incurred is to be taken into consideration. There is no question of taking expenditure on estimate or presumption basis while computing dividend income or while allowing deduction under section 80M.<\/em><\/p>\n (v) That where shares are acquired out of borrowed funds, on which dividend is received, deduction of interest paid can be allowed under section 57 provided loan was taken for making and earning dividend income. There is no question of deduction of any amount paid as interest, to which provisions of section 36 (1) (iii) are applicable, while computing deduction under section 80M.”<\/em><\/p>\n 3. Cases concerning shares acquired for the purpose other than to earn dividend; for example, to acquire controlling interest, etc.<\/u><\/em><\/p>\n If the ultimate motive of the assessee for acquiring shares of a company is to obtain controlling interest in that company, it cannot be said that the immediate purpose of acquisition of shares was to earn income from dividends. Consequently, the interest expenses incurred on the monies borrowed for acquisition of the shares cannot be reduced from the dividend income for section 57 (iii).<\/p>\n (i) CIT v\/s. Amritaben R. Shah – [(1999) 238 ITR 777 (Bom)] <\/strong><\/p>\n (ii) CIT v\/s. Jardine Henderson Ltd. – [(1994) 210 ITR 981 (<\/strong>Cal<\/strong>)]<\/strong> Refer also: SatishBalaMalhotra v\/s. CIT – [(2017) 391 ITR 256 (P&H)]<\/strong><\/p>\n C. CASES CONCERNING SHARES HELD AS STOCK – IN – TRADE<\/u><\/p>\n (i) There is a marked and subtle distinction between an investor in share and a dealer in share. More particularly, an investor’s intention is to earn dividend income while a dealer’s intention is to earn business profit. Therefore, if an individual invests in shares for the purpose of earning dividend, he is not carrying on the business and vice – versa. (ii) In case of a dealer in shares, since purchase and sale of the shares generate taxable profit \/ loss, as long as such shares are capable of producing taxable profit, no part of expenditure can be disallowed on the plea that the dividend thereon is tax free. (iii) Dividend accruing on the shares held as stock – in – trade, as trading assets, retains the same character as business income. (iv) ‘In view of the law as laid down by the Supreme Court it appears to us that the expenditure in the instant case has been shown to be referable to the business activity carried on by the assessee and must be allowable under the head “Business income”. ….. We had occasion to consider a similar question in Income – tax Reference Nos. 365, 369 and 367 of 1971 (Commissioner of Income – tax v\/s. Birds Investment (Anniversary Investment Agency)), where we held that where the assessee was holding shares as its circulating capital and it was not possible to ascertain if any shares were held solely for the purpose of earning dividends, there was no justification for apportioning the expenditure incurred by the assessee against income arising under two separate heads i.e., business and dividend.<\/u>”<\/em><\/p>\n CIT v\/s. New India Investment Corporation Ltd. – [(1978) 113 ITR 778 (<\/strong>Cal<\/strong>)]<\/strong> – Followed in CIT v\/s. Enemour Investments Ltd. – [(1994) 72 Taxman 370 (Cal)], CIT v\/s. Carolina Investments Ltd. – [(1996) 87 Taxman 238 (Cal)]<\/strong>–by holding that no apportionment is required vis – a – vis section 80M in case of a dealer in shares, “because in the type of cases like the one before us, the dividend income as such cannot have any outgoing so the question of reducing the gross dividend to net dividend does not at all arise”<\/em>. Further, “Apportionment will only arise in the case where two or more types of business and expenditure have been incurred. In the absence of any particular expenditure incurred question of apportionment will not arise<\/u>.”<\/em><\/p>\n (v) “The mere fact that income by way of dividend has accrued and that the expenditure incurred is in some manner or other related to the accrual of the dividend income is not sufficient. If this aspect is kept in view and the facts of the case are looked at, it becomes abundantly clear that the object of the assessee in incurring the expenditure was not to earn income by way of dividends. <\/em><\/p>\n The borrowing of the assessee by way of overdraft from the bank was not for the purposes of acquiring shares with the object of earning dividends on those shares, but the object of the borrowing was to purchase shares for the purposes of the assessee’s business, namely, buying and selling of shares and securities with a view to earning profits. The object of the borrowing thus was not for making or earning dividend income. ………The dividend received by the assessee from these shares and the interest paid by the assessee to the bank on the loan borrowed by it formed part of its normal business transactions, which as we have already stated is trading in shares and securities. These being the findings, it is not possible to agree with the Tribunal that the interest paid by the assessee to the bank on its borrowing was an expenditure incurred solely for the purposes of making or earning dividend income within the meaning of sub-section (2) of section 12.<\/em>{parimateria with section 57}<\/p>\n Here the assessee firm is a dealer in shares. It is not a firm doing business of investing money in shares. The borrowings were not with the object of purchase of shares by way of investment with a view to earning dividend thereon. The object with which the borrowings were made was for the purposes of carrying on its business activities of purchasing and selling shares and securities. The accrual of the dividend income had only been incidental in the course of the business.”<\/em> {Interestingly, while rejecting \/ objecting the claim of the assessee, it was the Department’s case that in case of dealers in shares, no expense can be attributable to the dividend income, as the same was purely incidental.}<\/p>\n (vi) “Where a shareholder receives dividend in respect of the shares held by him, the dividend is received because of the fact of his holding the shares. When an assessee deals in shares and buys them in order to sell them, his main activity is the purchase and sale of shares. It may no doubt be true that the possibility of earning substantial dividend from the shares is one of the circumstances which a dealer in shares takes into account. But his business really consists of purchase and sale of shares. He does not purchase shares with a view to get dividend, but the object of purchasing his shares is to earn profit by the sale of those shares. Earning of dividend is thus merely the incidental result of the main activity of the purchase of shares.<\/u>”<\/em><\/p>\n [According to the Revenue in this case, the dividend income accrued to the assessee effortlessly and automatically by reason of his being owner of the shares in question and he could not, therefore, be said to have exerted himself for earning the said income. The Hon’ble Court accepted the stand and held that the dividend income was immediately derived from the ownership of the shares and not from any personal exertion.] Followed in: CIT v\/s. RamdasLallubhai – [(1981) 130 ITR 150 (Bom)] – <\/strong>Rejecting the argument of the assessee that the receipt of dividend income was integral part of the business activity of the assessee which consisted of purchase and selling of shares. <\/p>\n Followed in:DeviduttDhurmal Bajaj v\/s. CIT – [(1981) 131 ITR 16 (Bom)]<\/strong><\/p>\n All these decisions involved interpretation of the term “earned income” within the meaning of erstwhile section 2 (47) (iii) of the Finance Act, 1962, which entitled an assessee certain relief if the income was “earned income”. The assessees claimed such relief on the ground that the dividends were earned by the assessees because of their personal exertion and, consequently, were their “earned income”. In the latter case, the Tribunal took the view that the dividend income was generated from mere ownership of shares and not from any activity on the part of the shareholders, “who having bought the share can sit back”<\/em>. The High Court followed the decision of Bombay High Court in case of CIT v\/s. D. G. Goenka–[(1981) 129 ITR 260 (Bom)]<\/em>, and observed as under:<\/p>\n “It is only after the dividend is properly declared that the amount so received by the assessee can be said to be dividend income. It may be that at the time of purchasing or selling of the shares, the assessee may be making an estimate of the expected dividend income while determining either the purchase or the sale price. But, at that stage, no income arises in the form of dividend and, therefore, the argument that dividend income results from personal exertion put in at the time of either acquisition or sale of shares and must, therefore, qualify for being described as "earned income" cannot be accepted.<\/u>”<\/em><\/p>\n (vii) In case of an assessee carrying on business of shares, the expenditure incurred on account of brokerage, share transfer expenses and interest evidently do not fall under either of the two clauses of section 57. “There is nothing to show that any part of it was incurred for earning dividend income”<\/em>. That being so, it is not allowable as a deduction in the computation of dividend income. The Income Tax officer, therefore, had no power to bifurcate the same on pro rata basis and deduct a part of it from the dividend income. “If the ITO was of the opinion that the whole of the expenditure claimed by the assessee was not allowable as a deduction in computation of business income, he could have said so and restricted the deduction to an amount which is permissible deduction. But deducting a part of it from dividend income without any material to show that it falls under either of the two clauses of section 57, is not tenable in law.<\/em>”<\/em> (viii) “In the case of a dealer in shares, as in the present case, the dividend retains the character of business income though assessed under section 56. The interest on the borrowings is paid for the purpose of business and therefore, allowable under section 36 (1) (iii). The interest paid is not expenditure laid out or expended wholly or exclusively for the purpose of earning the dividend as required under section 57 (iii) and therefore, should not be reduced under section 57 from the dividend income.”<\/em> {A case of a dealer in shares, where the A.O. had computed exemption u\/s. 80M on net basis, after deducting interest component in accordance with the provision of section 56,57, and 58 of the Act. The High Court distinguished the ratio laid down in Distributors (Baroda) P. Ltd. v\/s. UOI – [(1985) 155 ITR 120 (SC)], on the reasoning that that case was limited to the question whether deduction under section 80M was available with respect to the gross or net amount of dividend in a case where the assessee was an investment company and not a trader dealing in shares.}<\/p>\n (ix) In case of dealers, unlike investors, shares are not purchased with the object of earning any dividend. Unless evidence is brought on record that purchase at price cum – dividend, it cannot be said that any part of consideration included cost of dividend. Contract of sale is relevant. <\/p>\n Intention of parties must provide, expressly or impliedly, that consideration is paid either for specified goods to be transferred or services to be rendered or both. If there is no such contract, then no part of the consideration can be attributed to any other element, which is incidental to the performance of the contract. Merely because something passes alongwith subject matter intended under the contract would not mean that any part of the consideration is related to that element. <\/p>\n Nothing can be inferred on suspicion. Where shares are purchased without intention of purchasing dividend element, then the entire dividend received should be considered as income and no cost can be attributed to such dividend. In such cases, burden is on revenue. D. In fact, there are many cases concerning allowability of expenditure when dividend was taxable u\/s. 56 of the Act[Income from Other Sources], where the Courts adopted the test of intention \/ object \/ motive behind incurring such expenditure while adjudicating the issue of allowability or otherwise of such expenditure. Two of such judgements, randomly selected, are: II. THE LEGISLATIVE HISTORY<\/u><\/strong><\/p>\n <\/strong>There was no such provision, prior to introduction of section 14A, concerning disallowance of expenditure vis– a – vis tax free income or for such apportionment of business expenses. The nearest provision, perhaps, was the erstwhile section 20 of the Act, which was in existence till 31.03.1989.Interestingly, section 20, which fell under the erstwhile head “Interest on Securities” provided for allowing deduction,frominterest income on securities held by a banking company being taxed under this separate head, of common expenses in proportion of receipt from interest on securities to gross receipts by such banking company.Normally, such interest income is a part of business income of a banking company, with common administrative and other expenses that are fully allowable under various sections under the head “Profits and gains of business”, like sections 30, 31, 36 and 37. It was only that since, only for the tax purpose, such interest income was to be taxed under a separate head of income – while rest of the operational income continuing to be taxed under the head “Profits and gains of business” – with all expenses to earn both types of income being common and otherwise allowable under the above referred sections, that a need arose to allocate a portion of such common expensestowards such interest income so that the results are not distorted. As such, this was an enabling provision, to enable banks to reduce their income on securities by the expenses related thereto and not a restricting section putting bar or restriction on allowability of any expense. It will be of relevance if two of the decisions concerning section 20 are briefly discussed.<\/p>\n 1.<\/strong> Citibank N.A. v\/s. CIT – [(2003) 262 ITR 47 (Bom)]<\/strong><\/p>\n In this case, the Department sought to apply the cap \/ restriction of section 40A (5) to such allocated expense under section 20 as well. The Bombay High Court rejected this contention on the ground that “section 40A cannot be read into section 20 merely because section 20(1)(i) refers to appointment of common expenditure allowable, inter alia, under sections 36 and 37.”<\/em><\/p>\n 2. CIT v\/s. Central Bank of <\/strong>India<\/strong> – [(2003) 264 ITR 522 (Bom)]<\/strong><\/p>\n In this case, the Bombay High Court rejected the action of the Department in importing the ‘Rule of Proportionate expenditure’ contemplated by section 20 into section 80M of the Act, by holding that such rule of section 20 is based on estimation of expenses, whereas the exemption \/ deduction under section 80M is allowable on dividend after taking into account only actual expenditure incurred for the purpose of earning such dividend income.<\/p>\n SUMMATION OF PRE SECTION 14A <\/u><\/strong>LEG<\/u><\/strong>AL POSITION <\/u><\/strong><\/p>\n Keeping in mind the legislative intention behind introducing section 14A and the mischief that was sought to be avoided, upon analysis of the judgments that were rendered prior to introduction of section 14A, the following position emerge:<\/p>\n 1. In computing “profits and gains of business or profession”, when an assessee is carrying on business in various ventures and some among them yield taxable income and the other do not, if all the ventures constitute one indivisible business, the entire expenditure, if otherwise fulfill requirements of allowability as deduction under normal provisions of the Act, will be permissible deduction. 2. To put it differently, an expense, for this purpose, could be categorized into three types:<\/p>\n (i) An expense which is clearly and identifiably incurred in relation to earning tax free income:<\/u><\/p>\n There was, and also is, no dispute about the proposition that such expense was, and is, never allowable as deduction, with or without section 14A.<\/p>\n (ii) An expense which is incurred in relation to earning taxable income:<\/u><\/p>\n There was, and also is, no dispute about the proposition that such expense is fully allowable, with or without section 14A, if it otherwise fulfills the conditions of the respective provisions under which the deduction is claimed. This is even if a tax free income got generated purely incidentally in the process.<\/p>\n (iii) An expense which is, admittedly and as a matter of fact,<\/em> incurred in relation to earning tax free income, but arising from indivisible businesses [generating taxable and tax free income] and it is not possible to clearly identify \/ quantify such expense separately<\/u><\/p>\n The only dispute, if at all, was with respect to this type of expense. As per the ratio of the Supreme Court in case of Rajasthan State Warehousing Corpn., the assessee would be allowed deduction of this third type of expense as well, in absence of any legislative provision to disallow a part of it. In other words, the dispute was only with respect to a case where, admittedly<\/u>, (i) there was a specific and identified exercise \/ business to earn tax free income and (ii) some expenses were incurred for earning such tax free income and (iii)the businesses (generating tax free income and taxable income) wereindivisible.<\/p>\n 3. It should be reiterated that there was no dispute about the first two types of expenses. Neither section 14A affects the judicial precedents on the type of expenses referred to at (i) and (ii) in the preceding para nor was that the legislative intent. The insertion of section 14Awas brought vide Finance Act, 2001 in the wake of the decisions concerning the situation at (iii). As per the legislative intention itself, section 14A was introduced only to overcome the decisions concerning the situation at (iii). Therefore, at the most, it can be said that the section seeks to nullify the ratio laid down by the Supreme Court in the case of Rajasthan State Warehousing Corporation. A very crucial aspect to be appreciated is that in both the cases of Maharashtra Sugar Mills and Rajasthan State Warehousing, the assessees were undertaking, admittedly and undisputedly<\/strong> identifiable, planned and organized activity specifically to earn income, which was exempt from tax, alongwith other activities generating taxable income and, again, admittedly<\/strong>, certain expenses were incurred for these activities. This is in contrast with a case where an assessee merely happens to earn tax free income, like dividend, only incidentally and not as a part of any organized business activity specifically carried on to earn such tax free income. In other words, where, admittedly,<\/u><\/strong>some specific exercise \/ business is undertaken to earn tax free income and, again, admittedly, some expenditure has been incurred for earning such tax free income, that such expenditure, or a portion thereof, is now sought to be disallowed, even if it is not possible to identify \/ correlate such expenses precisely or directly.However, if there is only one business (say, in case of a share dealer) and that is carried on only to earn taxable income then the ratio of the judgment in the case of Rajasthan Warehousing or Maharashtra Sugar does not get attracted..<\/p>\n 4. Further, almost all Courts looked into the object \/ intention behind incurring a particular expenditure vis – a – vis earning of tax free income, like dividend, interest, etc., while ultimately rejecting disallowance made on apportionment basis. Conversely, the Courts looked into primary object \/ intent also for rejecting a claim of deduction, more specifically, in terms of section 57 (iii) of the Act. Accordingly, while on one hand it was held that no disallowance out of business expenses was called for in cases of shares& securities held as trading assets \/ business assets just because a tax free interest \/ dividend income happened to get generated; on the other hand, expenditure was held to be not allowable \/ allocable against dividend income, where shares were acquired for controlling purpose, on the ground that the intention was not to earn dividend income. <\/p>\n 5. Importantly, while taxing dividend income under the head “Income from other sources”, in fact, it was the Department which used to refuse such assessees deduction of various expenses on the ground that the dividend income is earned effortlessly and no specific expense can be attributable to it.<\/p>\n 6. Even assuming dividend income is to be given exemption on net basis, it could be reduced, if at all and at the most, only by actual expenses incurred. There is no scope for any assumed or notional expense to be apportioned.<\/p>\n 7. From the above analysis of the position prior to insertion of section 14A, at least one aspect that definitely emerges is that the ‘theory of apportionment’ was not<\/strong> inherent, much less widely and commonly method, in the matter of allowing business deductions vis – a – vis earning to tax free income. Far from it, there was consensus of opinion against that. The rule of apportionment was confined to very few specific and selected area, like section 20, that too, as a matter of allowance and not disallowance.<\/p>\n III. THE LEGISLATIVE INT<\/u><\/strong>ENTI<\/u><\/strong>ONFOR INTRODUCING SECTION 14A<\/u><\/strong><\/p>\n 1. The only indicator of the legislative intention is the Memorandum explaining the introduction of section 14A, as found in Finance Bill, 2001 and the circular issued thereafter, being Circular No. 14 of 2001, both of which contain, more or less, same language and intent. A bare perusal of both would reveal that what is intended to be covered by section 14A are only those expenses that are “incurred to earn<\/strong> the exempt income …..”<\/u><\/em>. The phraseology used in this regard is near, and somewhat akin, to the language used in section 57 (iii) of the Act, which phraseology has been held to be narrower than ‘for the purpose of’<\/em> as found in section 37 of the Act, by catena of decisions. This similarity is for the obvious reason that section 14A seeks to take back \/ disallow what would have been otherwise allowable, if the dividend was taxable. Dividend was taxable u\/s. 56 and the only deductions allowable were as enumerated in section 57, which section, it has been held in many cases, has narrower scope. As such, the legal precedents concerning dividend income vis – a – vis section 57 would be of relevance, especially when the phrase “in relation to” is not defined in the Act. <\/p>\n 2. In fact, the last part of the circular is very significant in as much as it says that: “Expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income.”<\/u><\/em>. <\/p>\n As such, it is clearly stated in the circular itself that the expenses which are relatable to earning taxable income are to be allowed, as per the legislative intent itself. As such, section 14A affects, and is intended to affect, only the third type of expense, as illustrated above. This is also accepted by the Department, being in consonance with the ratio laid down by the Apex Court in Walfort’s case. In fact, this is also accepted by the Supreme Court in both the cases, that is, Walfort and Maxopp.<\/p>\n This is of immense significance, as will be discussed in Part Three.<\/p>\n PART TWO<\/strong><\/p>\n POST SECTION 14A POSITION<\/strong><\/p>\n LEGAL PRECEDENTS ON THE ISSUE<\/u><\/strong><\/p>\n There have been many decisions of the Tribunal and high courts and also of the Apex Court on various aspects of section 14A that may be relevant for this article; many of which are in favour of the proposition that:<\/p>\n – Section 14A being a disabling section, the onus \/ burden is on the Department, which is also very heavy, to prove that some expenditure is incurred in relation to<\/em> a tax free income.<\/p>\n – Nexus, connection and relationship between the expenditure and earning of the tax free income should be clearly established. There is no room for any assumption or presumption.<\/p>\n – In case of stock – in – trade, dividend is merely incidental to the holding of, and trading in, shares for a particular period when the dividend is declared. The intention is to earn profit in share trading and not to earn dividend. Thus, the provisions of section 14A cannot be invoked. <\/p>\n – In case of shares held as strategic investments, the same are acquired and held purely as a part of strategic business decision affecting a group as a whole, not with the intention of earning dividend. Therefore, section 14A does not get attracted in such cases as well.<\/p>\n Since, in view of the Apex Court decision in Maxopp’s case, at least the last two propositions are regarded as no longer correct, the decisions pertaining to those issues are not analyzed for the sake of brevity. However, only few decisions are discussed, before adverting to the decision of Maxopp.<\/p>\n 1. DECISION IN CASE OF MAXOPP (TRIBUNAL) TAGGED ALONGWITH DAGA CAPITAL<\/u><\/strong><\/p>\n (i) The origin of this entire controversy can be traced to the famous decision in case of ITO v\/s. Daga Capital Management Ltd. – [(2008) 312 ITR (AT) 1 (Mum) (SB)]<\/em><\/strong>, rendered by Special Bench of the Income Tax Appellate Tribunal, Mumbai, with which the appeal of Maxopp was also tagged and heard. Interestingly, the issue before the Special Bench can be summarized by the very – and the only<\/u><\/em><\/strong>– question that was referred to the Special Bench, which is as follows:<\/p>\n “Whether, in the facts and the circumstances of the case and in law, the provisions of section 14A of the Income tax Act, 1961, are applicable with respect of dividend income earned by the assessee engaged in the business of dealing in shares and securities, on the shares held as stock in trade and when earning of such dividend income is, therefore, incidental to trading in shares?”<\/em><\/p>\n
\n [ON SECTION 14A]<\/u><\/strong>
\n –<\/em><\/strong> An Analysis
\n –<\/em>VIPUL B. JOSHI<\/strong>
\n ADVOCATE<\/strong>
\n {Note: The underline and the bold font, whenever used, are for emphasis purpose only}<\/em><\/p>\n
\n {Ref: Waterfall Estates Ltd. v\/s. CIT – [(1996) 219 ITR 563 (SC)]}<\/strong><\/p>\n
\n “<\/em>The requirement under section 57(iii) that the expenditure should have been incurred ‘for the purpose of making or earning such income’ shows that the object<\/u> of spending or the end or aim or the intention<\/u> of such spending was for earning the interest income.”<\/em>
\n Vijayalakshmi Sugar Mills Ltd. v\/s. CIT – [(1991)191 ITR 641 (SC)]<\/strong><\/p>\n
\n [Dividend merely an incidental benefit]<\/strong><\/p>\n
\n Bengal & Assam Investors Ltd. v\/s. CIT – [(1966) 59 ITR 547 (SC)]<\/strong><\/p>\n
\n {Ref: CIT v\/s. Indian Bank Ltd. – [(1965) 56 ITR 77 (SC)]} <\/strong><\/p>\n
\n Western States Trading Co. v\/s. CIT – [(1971) 80 ITR 21 (SC)] <\/strong><\/p>\n
\n –Followed in CIT v\/s. Devenport& Co. Pvt. Ltd. – [(1986) 158 ITR 348 (<\/strong>Cal<\/strong>)<\/strong>].
\n –Followed in CIT v\/s. Anniversary Investments Agencies Ltd. – [(1989) 175 ITR 199 (Cal)]<\/strong>, where the Court observed: “There is no dispute that the assessee was doing investment business and holding of stock and shares par took of the nature of circulating capital. It was not possible to distinguish shares held solely for the purpose of earning dividend and to determine the borrowings made for the purpose of acquiring such shares and the interest paid thereon. It was not possible to attribute any particular item of expenditure for having been incurred solely for the purpose of earning dividend income. The shares being held as circulating capital for the business, the expenditure including the interest, has to be allowed as deduction in computing the business profits. In the premises, there is no question of allocation of such expenses between business income and dividend income.<\/u>”<\/em><\/p>\n
\n CIT v\/s. Jagmohandas J. Kapadia– [(1966) 61 ITR 663 (Bom)]<\/strong><\/p>\n
\n CIT v\/s. D. G. Goenka–[(1981) 129 ITR 260 (Bom)] <\/strong><\/p>\n
\n CIT v\/s. Mahendra S. Shah – [(1993) 203 ITR 178 (Bom)] <\/strong><\/p>\n
\n CIT v\/s. Emrald Co. Ltd. – [(2006) 284 ITR 586 (Bom)] <\/strong><\/p>\n
\n Smt. Rekha Bharat Chheda v\/s. <\/strong>ACIT<\/strong> – [(2007) 107 ITD 245 (Mum)] <\/strong>
\n {A case decided in the context of section 10 (33)}<\/p>\n
\n Sarabhai Sons (P) Ltd. v\/s. CIT – [(1993) 201 ITR 464 (Guj)] – Test of dominant purpose
\n CIT v\/s. Smt. Swapna Roy – [(2011) 331 ITR 367 (All)]<\/p>\n
\n {Ref: Rajasthan State Warehousing Corp. v\/s. CIT – [(2000) 242 ITR 450 (SC)]}<\/em> <\/p>\n