Section 14A of the Income-tax Act read with Rule 8D of Income-tax Rules which provide for disallowance of expenditure incurred in relation to income which does not form part of the total income, had been subject matter of a number of controversies. The issues had finally travelled up to the Supreme Court. The Supreme Court has settled many important issues in regard to application of provisions of section 14A read with Rule 8D of Income-tax Rules vide three judgments delivered in the recent past in the case of Godrej & Boyce Manufacturing Co. Ltd. v. Dy. CIT & Anr. (2017) 394 ITR 449 (SC); Commissioner of Income-tax v. Essar Teleholdings Ltd. (2018) 401 ITR 445 (SC) and Maxopp Investment Ltd. v. Commissioner of Income Tax (2018) 402 ITR 640 (SC). The issues which now stand settled by the Hon’ble Supreme Court are discussed hereunder:
1. The expenditure should be actually incurred
In the decision in the case of Godrej & Boyce (supra) (para 36), the Hon’ble Court has observed that “what cannot be denied is that the requirement for attracting the provisions of Section 14A(1) of the Act is proof of the fact that the expenditure sought to be disallowed/deducted had actually been incurred in earning the dividend income. Again in the judgment of Maxopp Investment (supra) vide para 32, the Hon’ble Court has held that “if an expenditure incurred has no casual connection with the exempted income, then such an expenditure would obviously be treated as not related to the income that is exempted from tax, and such, expenditure would be allowed as business expenditure. To put it differently, such expenditure would then be considered as incurred in respect of other income which is to be treated as part of the total income.” Accordingly, the first condition to apply provisions of section 14A of the Act is that the assessee must have incurred expenditure which can be said to be related to exempt income.
2. Rule 8D was prospective w.e.f. A.Y. 2008-09
Vide judgment in the case of Essar Teleholdings Ltd. (supra), the Hon’ble Court settled the issue that Rule 8D was prospective and could not be applied to assessment years up to A.Y. 2007-08. Accordingly, in respect of assessment year up to 2007-08, the disallowance could be made by the Assessing Officer in his best judgment.
3. In order to apply Rule 8D satisfaction is to be recorded
The Hon’ble Supreme Court in the case of Godrej & Boyce vide para 37 held that “whether such determination is to be made on application of the formula prescribed under Rule 8D or in the best judgment of the Assessing Officer, what the law postulates is the requirement of a satisfaction in the Assessing Officer that having regard to the accounts of the assessee, as placed before him, it is not possible to generate the requisite satisfaction with regard to the correctness of the claim of the assessee. It is only thereafter that the provisions of Section 14A(2) and (3) read with Rule 8D of the Rules or a best judgment determination, as earlier prevailing, would become applicable.” Again in the case of Maxopp Investment, the Hon’ble Court vide para 41 held that “having regard to the language of Section 14A(2) of the Act, read with Rule 8D of the Rules, we also make it clear that before applying the theory of apportionment, the AO needs to record satisfaction that having regard to the kind of the assessee, suo motu disallowance under Section 14A was not correct. It will be in those cases where the assessee in his return has himself apportioned but the AO was not accepting the said apportionment. In that eventuality, it will have to record its satisfaction to this effect. Further, while recording such a satisfaction, nature of loan taken by the assessee for purchasing the shares/making the investment in shares is to be examined by the AO.”
4. No disallowance on account of interest expense if borrowed funds have not been used for investments
The Court vide para 38 of the judgment in the case of Godrej & Boyce held that in the absence of any basis disclosed by the Assessing Officer establishing a reasonable nexus between the expenditure to be disallowed and dividend income received and also in the absence of any basis that any part of the borrowings of the assessee had been diverted to earn tax free income despite the availability of surplus or interest free funds available disallowance cannot be made. The Hon’ble Court in the judgment of Maxopp Investment also vide para 41 while holding that recording of satisfaction is necessary, it has specifically been observed that “further, while recording such a satisfaction, nature of loan taken by the assessee for purchasing the shares / making the investment in shares is to be examined by the AO.”
5. Interest expenditure on loans taken for specific business purpose is not to be considered for the purpose of apportionment
The Hon’ble Supreme Court in the case of Godrej & Boyce was considering the circumstances wherein it has been held in earlier years that no disallowance was to be made since the borrowed funds had not been used for the purpose of investments. In assessment year under consideration there was no increase in the amount of investments. In the circumstances view was taken that the expenditure under reference was not related to earning of dividend income and the assessee was entitled to exemption of full amount of dividend income. In the case of Maxopp Investment the Hon’ble Supreme Court in para 42 has discussed the decision of Punjab & Haryana High Court in the case of Avon Cycles Ltd., Ludhiana. It has been stated that the assessee had paid total interest of ₹ 2.92 lakh out of which interest paid on term loan raised for specific purpose totals to ₹ 1.70 crore and balance interest paid by the assessee was ₹ 1.21 crore. In view of provisions of Rule 8D(2)(ii) of Income-tax Rules, the Tribunal had upheld the disallowance of ₹ 10,49,851/- which was determined with reference to interest of ₹ 1.21 crore only after excluding interest on loans raised for specific purpose. High Court had dismissed the appeal filed against the order of ITAT observing that after examining the Balance Sheet of the assessee and finding of fact, there was no question of law. The Hon’ble Supreme Court also after going through the record and applying the principle of apportionment has dismissed the appeal. What is important to be noted is that the apportionment as per Rule 8D(2)(ii) of Income-tax Rules had been made and upheld only with reference to balance interest of ₹ 1.21 crore. The position that amount of disallowance of ₹ 10,49,851/- was determined with reference to interest expenditure of ₹ 1.21 crore is quite clear on the basis of relevant order of ITAT, Chandigarh Bench, which was the subject matter before the High Court and the Supreme Court in ITA No.1143/Chd/2011 dated 17-1-2013. As per the facts average amount of investments was ₹ 18.685 crore and average of total assets was ₹ 215.34 crores and on that basis proportionate disallowance out of total expenditure of ₹ 1.21 crore related to the average investment worked out to ₹ 10,49,851/-.
Accordingly, it is stated that any expenditure incurred which is relatable to specific loans taken for business activities is to be excluded for the purpose of determining the proportionate disallowance on account of interest as per Rule 8D(2)(ii) of Income-tax Rules.
6. In case own funds are more than the investments no disallowance on account of interest is to be made
The Hon’ble Supreme Court in the case of Godrej & Boyce has specifically taken note of the fact in that case investments were only of ₹ 125.54 crore whereas own funds of the company were of ₹ 280.64 crore which was interest free funds in the form of share capital and reserves. In the circumstances it was held by the Supreme Court that the fact that any part of the borrowings of the assessee had been diverted to earn tax free income despite the availability of surplus or interest free funds available remains unproved by any material whatsoever. Therefore, no disallowance for interest was to be made.
7. Position accepted in earlier years need to be followed in subsequent years
The Hon’ble Court also held in the case of Godrej & Boyce that though the principle of res judicata would not apply to assessment proceedings under the Act, the need for consistency and certainty and existence of strong and compelling reason for a departure from a settled position has to be spelt out. In this case since position had been examined and accepted by the Tribunal in earlier years the Hon’ble Court held that different view could not be taken.
8. Disallowance is to be restricted to exempt income
In the case of Maxopp Investment, the Hon’ble Court had taken note of the facts of the case vide para 5 wherein amount of disallowance u/s. 14A was determined at ₹ 67.74 lakh but the Assessing Officer had restricted the same to the amount of dividend income received and claimed as exempt of ₹ 49.90 lakh. Again while recording the facts of the case of State Bank of Patiala, the Hon’ble Court has noted the fact that the Assessing Officer had restricted the disallowance to the amount of exempt income after applying the formula contained in Rule 8D. CIT(A), however, had issued the notice of enhancement and disallowed the entire expenditure claimed by the assessee instead of restricting the disallowance to the amount of exempt income as done by the Assessing Officer. ITAT and the High Court had deleted the total disallowance. The Hon’ble Supreme Court vide para 40 has again specifically taken note of the fact that while passing the assessment order the Assessing Officer had restricted the disallowance to the amount which was claimed as exempt income. CIT(A) had disallowed the entire amount of expenditure. Hon’ble Court held “that the view of the CIT(A) was clearly untenable and rightly set aside by the ITAT. Therefore, on facts, the Punjab & Haryana High Court has arrived at a correct conclusion by affirming the view of the ITAT, though we are not subscribing to the theory of dominant intention applied by the High Court”.
Accordingly, the issue stands approved by the Supreme Court that disallowance is to be restricted to the amount of exempt income.
9. Dominant purpose of investment is irrelevant
The Hon’ble Supreme Court in the case of Maxopp Investment after detailed discussion has held that “we are of the opinion that the dominant purpose for which the investment into shares is made by an assessee may not be relevant. No doubt, the assessee like Maxopp Investment Limited may have made the investment in order to gain control of the investee company. However, that does not appear to be a relevant factor in determining the issue at hand. Fact remains that such dividend income is not-taxable. In this scenario, if expenditure is incurred on earning the dividend income, that much of the expenditure which is attributable to the dividend income has to be disallowed and cannot be treated as business expenditure. Keeping this objective behind Section 14A of the Act in mind, the said provision has to be interpreted, particularly, the word ‘in relation to the income’ that does not form part of total income.” Similarly, in the case of State Bank of Patiala wherein shares had been held as stock-in-trade the Hon’ble Court vide para 38 has disagreed with the judgment of Punjab & Haryana High Court observing that “at the same time, we do not agree with the test of dominant intention applied by Punjab & Haryana High Court, which we have already discarded.”
10. The basis on which disallowance is to be determined in the case of shares held as stock-in-trade
The Hon’ble Supreme Court in the case of Maxopp Investment after holding that dominant intention of holding the shares as stock-in-trade is not relevant vide para 38 specifically noted that having held so, “The question is as to on what basis those cases are to be decided where shares of other companies are purchased by the assessee as ‘stock-in-trade’ and not as investment. We proceed to discuss this aspect hereinafter.” Thereafter, the Hon’ble Supreme Court vide para 39 has held that “where shares are held as stock-in-trade, the main purpose is to trade in those shares and earn profits therefrom. However, we are not concerned with those profits which would naturally be treated as ‘income’ under the head ‘profits and gains from business and profession’. What happens is that, in the process, when the shares are held as ‘stock-in-trade’, certain dividend is also earned, though incidentally, which is also an income. However, by virtue of Section 10(34) of the Act, this dividend income is not to be included in the total income and is exempt from tax. This triggers the applicability of Section 14A of the Act which is based on the theory of apportionment of expenditure between taxable and non-taxable income as held in Walfort Share and Stock Brokers P Ltd. case. Therefore, to that extent, depending upon the facts of each case, the expenditure incurred in acquiring those shares will have to be apportioned”. (Emphasis supplied). Accordingly, the Hon’ble Supreme Court has held that in such cases “depending upon the facts of each case, the expenditure incurred in acquiring those shares will have to be apportioned”. In other words, the Supreme Court has appreciated the factual position that in a case where shares are held as stock-in-trade, dividend may be received or may not be received or may be received at a small portion of shareholding and, therefore, formula provided in Rule 8D may not be suitable. Hence, disallowance is to be determined on apportionment basis considering the facts of each case. Further, vide para 40 of the judgment the Hon’ble Court has approved the disallowance to the extent of exempt income, as was made in that case.
In conclusion it is stated that all the major issues which have been subject matter of controversy have been settled by the Hon’ble Supreme Court. In order to set the controversy at rest CBDT should issue a circular directing all the Assessing Officers to determine the disallowance as per section 14A read with Rule 8D of Income-tax Rules in accordance with law settled by the Hon’ble Supreme Court.