1. Issue for Consideration
One of the major controversies, revolving around disallowance u/s. 14A, that has remained unresolved, is about the possibility of disallowance of an expenditure in the hands of a dealer in shares and securities, who holds such shares and securities as stock-in-trade. With the passage of time and examination of the issue by the courts, the issue has become more and more controversial.
Section 14A provides that no deduction shall be allowed in respect of an expenditure, incurred by the assessee, in relation to an income which does not form part of the total income.
A dealer in shares and securities is a person who ordinarily receives income from transfer of shares i.e., taxable under the head ‘Profits and gains of business or profession’. In addition, he receives income from dividend i.e., exempt from taxation as it does not form part of the total income under the Act. The expenditure incurred by such a person for carrying on the business of dealing in shares and securities, like any other business, is of varied nature that comprises of interest on borrowed funds to administration expenses and also depreciation.
The questions that arise for consideration in the case of a dealer in shares are – Whether any part of his expenditure could be said to have been incurred in relation to earning an exempt income? Can such an expenditure be treated as incurred in relation to earning the dividend income that is not taxable? Can a part of the expenditure at least be considered as related to earning an exempt income and therefore be disallowed? Can one apply the provision of Rule 8D for giving effect to the legislative intent expressed in section 14A? Can one contend that no expenditure is incurred at all for the purposes of earning dividend?
The Special Bench of the ITAT in the case of Daga Capital & Investment, 117ITD129 (SB)(Mum.) had held that the provisions of section 14A applied to the case of a person who was a dealer in shares. The ratio of the said decision to the extent relevant here is recently approved by a decision of the Delhi High Court, reported recently. The said decision of the court is in conflict with the decisions of the Karnataka and the Kerala High Courts. The appellate tribunals in the meanwhile have taken conflicting stands on the subject, throwing the issue wide open.
2. Maxopp Investment’s Decisions
The issue came for consideration in the case of Maxopp Investment Ltd. vs. CIT before the Delhi High Court reported in 347 ITR 272. The assessment years under consideration were A.Y. 1998-99 to A.Y. 2005-06. In the said case,the assessee company was engaged in the business of dealing in shares and securities. It held part of the shares as trading assets for the purpose of acquiring and retaining control over its group companies and the profit from sale of such shares, held as trading assets, was offered to tax as the business income. An amount of Rs. 1.61 crore was claimed as business expenditure u/s. 36(1)(iii), being interest paid on the funds borrowed from investment in shares held as trading assets. The company had a profit on sale of shares of Rs. 1,49,285/- and had received a dividend of Rs. 49,90,860/-.
The A.O. held that the interest claimed by the company was disallowable u/s. 14A. However, he restricted the disallowance to the amount of dividend. The CIT(A) and the ITAT following the Special Bench’s decision in the Daga Capital’s case (supra) upheld the action of the A.O.
In an appeal by the assesseee company to the High Court, on behalf of the company, an emphasis was laid on the expressions “incurred” and “in relation to” for contending that the word “incurred” must be taken literally in the sense that the expenditure must have actually taken place and that the expenditure must also have taken place in relation to income which did not form part of the total income. It was contended that the expression “in relation to” implied that there must be a direct and proximate connection with the subject matter and only that actual expenditure which was made directly and for the object of earning exempt income, i.e., the dividend income could be disallowed u/s. 14A. It was submitted that if the dominant and main objective of spending was not the earning of ‘exempt’ income, then the expenditure could not be disallowed u/s. 14A, provided it was otherwise allowable u/s. 15 to 59 of the said Act. It was also emphasised that the expenditure must be actual and could not be computed on the basis of some formula as stipulated under Rule 8D read with s/s. (2) & (3) of section 14A.
The Delhi High Court did not agree with the submissions of the assessee company that a narrow meaning ought to be ascribed to the expression “in relation to” appearing in section 14A as the context did not suggest that a narrow meaning ought to be given to the said expression. The court observed that the provision was inserted by virtue of the Finance Act, 2001 with retrospective effect from 1-4-1962 confirming the intention of the Parliament that it should appear in the statute book, from its inception that expenditure incurred in connection with income which did not form part of total income ought not to be allowed as a deduction; the factum of making the said provision retrospective made it clear that the Parliament wanted that it should be understood by all that from the very beginning, such expenditure was not allowable as a deduction; the Supreme Court in CIT vs. Walfort Share and Stock Brokers P Ltd: 326 ITR 1 (SC), held that the basic principle of taxation was to tax the net income, i.e., gross income minus the expenditure and on the same analogy the exemption was also in respect of net income; in other words, where the gross income would not form part of total income, it’s associated or related expenditure would also not be permitted to be debited against other taxable income.
The court noted that accepting the submission made on behalf of the assessees, then s/s. (1) would have to be read as follows:-“For the purposes of computing the total income under this Chapter, no deduction shall be allowed in respect of expenditure incurred by the assessee with the main object of earning income which does not form part of the total income under this Act.” It observed that such rereading was certainly not the purport of the said provision; the expression “in relation to”did not have any embedded object and simply meant “in connection with” or “pertaining to”; if the expenditure in question had a relation or connection with or pertained to the exempt income, it could not be allowed as a deduction even if it otherwise qualified under the other provisions of the said Act; in Walfort (supra), the Supreme Court made it very clear that the permissible deductions enumerated in sections 15 to 59 were now to be allowed only with reference to income which was brought under one of the heads of income and was chargeable to tax and that if an income like dividend income was not part of the total income, the expenditure/deduction related to such income, though of the nature specified in sections 15 to 59, could not be allowed against other income which was includible in the total income for the purpose of chargeability to tax.
In deciding that the provisions of section 14A applied in the case of receipt of dividend by a dealer in shares, against the asseessee, the Delhi High Court took note of the law prevailing before insertion of section 14A in the Act with retrospective effect, as was explained by the Supreme Court in the cases of CIT vs. Maharashtra Sugar Mills Ltd: 82 ITR 452 (SC) and Rajasthan State Warehousing Corporation vs. CIT: 242 ITR 450 (SC). The court also took note of the Memorandum explaining the provisions of section 14A and also extensively relied upon the decision of the Supreme court, delivered after introduction of section 14A, in the case of Walfort (supra) where the apex court stated that the insertion of section 14A with retrospective effect, reflected the serious attempt on the part of Parliament not to allow deduction in respect of any expenditure incurred by the assessee in relation to income, which did not form part of the total income against the taxable income. The High Court observed that the apex court in that case, clearly held that in the case of an income like dividend income which did not form part of the total income, any expenditure/deduction relatable to such (exempt or non-taxable) income, even if it was of the nature specified in sections 15 to 59 of the said Act, could not be allowed against any other income which was includible in the total income.
3. CCI Ltd’s Case
The issue recently came up for consideration of the Karnataka High Court in the case of CCI Ltd vs. JCIT reported in 250 CTR 291. In that case, the assessee company, a dealer in shares & securities, had acquired 93% of shares of Kurl-on Ltd., by availing an interest free loan with the help of a broker who had been paid an amount of Rs.28,00,000/- as brokerage. The assessee company had received a dividend of Rs.46,67,190/- which dividend was exempt from taxation. The assessee company had claimed the brokerage of Rs.28,00,000/- as deduction in computing the business income from dealing in shares & securities. The A.O. in assessing the total income of Assessment year 2007-08 treated the said brokerage expenditure as directly attributable to earning the dividend income and disallowed the same besides disallowing a part of the other business expenditure. The CIT (Appeals) confirmed the said order of the A.O. and the tribunal upheld the action of the A.O in part by directing him to prorate the said expenses over the dividend and the business income.
In an appeal to the Karnataka High Court, the assessee company raised the following question of law:“Whether the provisions of section 14A of the Act are applicable to the expenses incurred by the assessee in the course of its business merely because the assessee is also having dividend income when there was no material brought to show that the assessee had incurred expenditure for earning dividend income which is exempted from taxation?”
The assessee company contended before the High Court that the assessee had incurred an expenditure for purchasing shares and a part of such shares so purchased were sold and the income derived therefrom was offered to tax as business income and the remaining unsold shares yielded dividend; that the assessee had not incurred any expenditure to earn the said dividend income and therefore, no expenditure could be attributed to the said dividend income and the said expenditure could not be disallowed and the assessee was entitled to the benefit of deduction of the entire expenditure incurred in respect of purchase of shares.
On behalf of the Revenue,it was pointed out to the court that when shares retained by the assessee had yielded dividend, when the dividend income was exempted from payment of income tax, the expenditure incurred in acquiring that dividend also should be excluded from amount of expenditure that qualified for allowance and in that view of the matter, the orders passed by the authorities were legal and valid.
The High Court observed that when no expenditure was incurred by the assessee in earning the dividend income, no notional expenditure could be deducted from the said income; that it was not the case of the assessee retaining any shares so as to have the benefit of dividend; 63% of the shares, which were purchased, were sold and the income derived therefrom was offered to tax as business income; the remaining 37% of the shares were retained and had remained unsold with the assessee which unsold shares had yielded dividend, for which, the assessee had not incurred any expenditure at all. It further noted that though the dividend income was exempted from payment of tax, if any expenditure was incurred in earning the said income, the said expenditure also could not be deducted but in the case, when the assessee had not retained shares with the intention of earning dividend income and the dividend income was incidental to his business of sale of shares, which remained unsold by the assessee, it could not be said that the expenditure incurred in acquiring the shares had to be apportioned to the extent of dividend income and that should be disallowed from deductions.
The High Court held that the approach of the authorities, in disallowing a part of the expenditure, was not in conformity with the statutory provisions contained in section 14A of the Act. The orders were held to be not sustainable in law and were set aside.
4. Observations
Section 14A(1) stipulates that for the purposes of computing the total income under Chapter IV, no deduction shall be allowed in respect of an expenditure “incurred” by the assessee “in relation to” an income which does not form part of the total income under the Income tax Act.
The position in law in respect of the expenditure incurred for earning an income, a part of which was exempt from taxation, prior to the introduction of section 14A, was governed by the ratio of the decisions in the cases of CIT vs. Maharashtra Sugar Mills Ltd: 82 ITR 452 (SC) and Rajasthan State Warehousing Corporation vs. CIT: 242 ITR 450 (SC). It was held therein that no part of expenditure could be disallowed where the expenditure was incurred in earning an income a part of which was taxable and the balance was exempted from taxation.
The object behind the insertion of section 14A is stated in the Memorandum explaining the provisions of the Finance Bill, 2001 :-“Certain incomes are not includible while computing the total income as these are exempt under various provisions of the Act. There have been cases where deductions have been claimed in respect of such exempt income. This in effect means that the tax incentive given by way of exemptions to certain categories of income is being used to reduce also the tax payable on the nonexempt income by debiting the expenses incurred to earn the exempt income against taxable income. This is against the basic principles of taxation whereby only the net income, i.e., gross income minus the expenditure is taxed. On the same analogy, the exemption is also in respect of the net income. Expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income. It is proposed to insert a new section 14A so as to clarify the intention of the Legislature since the inception of the Income Tax Act, 1961 that no deduction shall be made in respect of any expenditure incurred by the assessee in relation to income which does not form part of the total income under the Income-tax Act.The proposed amendment will take effect retrospectively from 1st April, 1962 and will accordingly; apply in relation to the assessment year 1962-63 and subsequent assessment years.”
The law of section 14A has been sought to be explained by the Supreme Court in the case of CIT vs. Walfort Share and Stock Brokers P Ltd: 326 ITR 1 (SC),as under:-“Further, section 14 specifies five heads of income which are chargeable to tax. In order to be chargeable, an income has to be brought under one of the five heads. Sections 15 to 59 lay down the rules for computing income for the purpose of chargeability to tax under those heads. Sections 15 to 59 quantify the total income chargeable to tax. The permissible deductions enumerated in sections 15 to 59 are now to be allowed only with reference to income which is brought under one of the above heads and is chargeable to tax. If an income like dividend income is not a part of the total income, the expenditure/ deduction though of the nature specified in sections 15 to 59 but related to the income not forming part of the total income could not be allowed against other income includible in the total income for the purpose of chargeability to tax. The theory of apportionment of expenditure between taxable and non-taxable has, in principle, been now widened u/s. 14 A.”
The issue veers down to examining whether any disallowance is possible in cases where the income that is exempted from taxation is incidental to the main objective of expenditure and that the expenditure has no direct or proximate connection to the income that has been exempted from taxation. The issue is best exemplified with the case of a dealer in shares who incurs expenditure primarily for earning a taxable income from dealing in shares and received an exempt income from dividend as an incidence of his business of dealing in shares.
It is the assessee’s case that only such expenditure that can be disallowed that has been incurred directly in earning an exempt income and that an expenditure which has the distant effect of earning such an income cannot be disallowed where the income that was taxed has a proximate connection to such an expenditure. The revenue on the other hand is of the view that the language of section 14A does not provide for an exclusion, from operation of section 14A, of an expenditure which incidentally results in earning an exempt income; the provision for prorating of an expenditure under Rule 8D rather confirms that at least a part of the expenditure shall stand disallowed in all the cases; the relationship of some part of the expenditure, for earning an exempt income cannot be altogether denied.
The Income Tax Act, 1961 is replete with expressions like ‘in relation to’ and ‘relating to’, for example, sections 28, 35 and 36. While it is true that the terms carry a meaning which is wider than the one provided by the term wholly and exclusively incurred or for the purposes of, it nonetheless cannot be so wide as to include an expenditure with a remote or a distant connection to an exempt income.
Obviously for a dealer in shares, the dominant or the immediate objective is making profit on sale of shares. Earning dividend income cannot be the domi-nant objective and the dividend at the most may represent an incidental objective, unless it is held that earning dividend is also a dominant objective and there is a proximate link with such objective, the expenditure in question cannot be considered as having been incurred in relation to .
In our considered view the A.O., for a valid disallowance, should establish two important things. One that the expenditure incurred has a proximate link with the income that is exempt from taxation and the second that the purchase of shares was made with the main or dominant objective of earning an exempt income. Unless both of these facts are established by the A.O., no expenditure or part thereof should be disallowed u/s. 14A in computing the total income of a person who is a dealer in shares in respect of shares held as stock in trade.
The Kerala High Court in CIT vs. Leena Ramachandran, 339 ITR 296 held that no disallowance of interest claimed u/s. 36(1)(iii) should be made, u/s. 14A, in case of a dealer in shares who purchased shares out of the borrowed funds and held the same as stock-in-trade.
The issue has been sharply brought in focus by the decisions of the tribunal, delivered after considering the decisions of the Kerala High Court in Leena Ramachandran’s case (supra) and of the Karnataka High Court in the case of CCI Ltd. (supra) in the following cases;
In American Express Bank Ltd. ITA No. 5904 & 6022 /Mum/2000 dated 8-8- 2012, it was held that a prorated disallowance of an expenditure must be made u/s. 14A in the case of an assesseee engaged in the business of dealing in shares earning dividend income which is exempted from taxation in his hands. The tribunal distinguished the decision in Leena Ramachandran’s case (supra) by stating that the said decision rather supported the case of disallowance and the observations of the court in relation to shares held as stock-in-trade were to be treated as an obiter dicta and not the ratio decidendi which was to disallow the interest and that was upheld by the court.
In GanjamTrading Co. Pvt. Ltd. ITA No. 3724/ Mum/2005 dated 20-7-2012, the decision of the Special Bench in Daga Capital (supra) was distinguished to hold that the provisions of section 14A did not apply to the case of dealer in receipt of dividend income that was incidental to the dominant income from dealing in shares that was taxable by relying on the decision of the Karnataka High Court in CCI Ltd.’ s case (supra).
Similarly in India Advantage Securities Ltd. ITA No. 6711/Mum/2011 dated 20-7-2012, it was held that the provisions of section 14A did not apply to the case of dealer in receipt of dividend income that was incidental to the dominant income from dealing in shares that was taxable by relying on the decision of the Karnataka High Court in CCI Ltd.’ s case(supra). In this case, the decision of the tribunal in the case of American Express Bank Ltd(supra) was considered and was not followed.
Likewise, in Prakash K. Shah Securities Pvt. Ltd. ITA No. 3339/Mum/2012, the tribunal held that the provisions of section 14A did not apply to the case of dealer in receipt of dividend income that was incidental to the dominant income from dealing in shares that was taxable by relying on the decision of the Karnataka High Court in CCI Ltd.’ s case(supra).
The issue that was thought to be settled by the special bench decision has been sharply brought back in focus by the conflicting decisions discussed above. The correctness of the decision of the special bench decision was always under a scanner as was clear from the dissenting decision of Shri K.C. Singhal, the Accountant Member, in the context of the income from shares held as stock-in-trade. Even the part that held that Rule 8D was retrospective in its operation has not been accepted by the High Court in the case of Godrej & Boyce Ltd. vs. CIT, 328 ITR 081(Bom), which found the said rule to be prospective in its effect.
The Karnataka High Court in CCI’s case (supra) has relied on the intention of the dealer behind incurring the expenditure and proceeded to hold that no disallowance shall take place where the intention was clearly to earn business income by incurring an expenditure. It favoured ignoring the incidental income behind such an expenditure. This approach of the court charts out a new course by examining the proximity of the expenditure to the income and while doing so, takes into consideration the intention of the legislature stated in the memorandum to nullify the effect of the Supreme court decisions in the cases of Rajasthan Warehousing Co. and Maharashtra Sugar Millls (supra). Such an approach is desirable and is equitable and has the salutary effect of reducing the frivolous litigation in cases where the expenditure incidentally produces some exempt income. Accepting this approach also helps the revenue in avoiding an undesired expenditure on litigation in which the outcome is more likely to favour an assessee. Even the language of section 14A does seem to favour the assesssee.
The meaning of the term ‘in relation to’ can be gathered by referring to the ratio of the decision of the 11 judges bench of the Supreme court in the case of H.H.M. Madhavao Jivajirao Scindia ,Bahadur of Gwalior vs. Union of India, 1971, 1 SCC 85 wherein the court while interpreting the meaning of the term ‘relating to’ by a majority decision held that the term meant a dominant and immediate connection. A reference may also be made to Law Lexicon which states the term ‘in relation to’ requires elimination of the remote connection and indicates nearness or proximity.
The case of the revenue seems to largely hang on rule 8D that provides for the proration of an expenditure. This part of rule 8D cannot override the provisions of section 14A which does not mandate such proration at least in cases where the expenditure is not found to be incurred in relation to an exempt income. It is an accepted position in law that a rule cannot expand the scope of a legislative provision. It is true that s/s. (2) provides for determination of expenditure in accordance with Rule 8D. However, the said Rule while providing the methodology for calculation cannot extend the meaning of the term, ‘in relation to’ by including such expenditure that cannot be construed as having been incurred in relation to an exempt income.
There is one more angle to the issue that is provided by the language of clause (ii) of sub-Rule (2) of Rule 8D when it provides for a calculation with reference to the ‘value of investment’. This language again supports the case that no disallowance is envisaged in respect of shares held as stock in trade.
In cases where the dealer holds the shares as an investor for the purposes of earning dividend income, the disallowance u/s. 14A shall hold water.
