The Finance Act, 2001 inserted section 14A in the Income-tax Act, 1961 with retrospective effect from 01 April, 1962. Section 14A provides that expenditure incurred in relation to exempt income shall not be allowed as a deduction while computing total income. The Memorandum to the Finance Bill, 2001, explained the said provision as follows:

"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 non-exempt 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".

The Finance Act, 2006 further amended the section (with effect from 01 April, 2007) to provide in cases where the assessing officer is not satisfied with the correctness of the disallowance claim made by the assessee, the amount of disallowance shall be computed in accordance with the prescribed methodology. The Central Board of Direct Taxes has inserted Rule 8D in the Income-tax Rules, 1962 to prescribe the methodology for computing the deduction.

Section 14A and Rule 8D have been the subject matter of several tax litigations. In several cases, tax officials have not accepted the disallowance amount computed by the assesse and have sought to compute the amount of disallowance by following the methodology prescribed under Rule 8D, including in situations where the assessee claimed that no expenditure was incurred to earn any exempt income.

The Delhi Bench of the ITAT, in the case of Cheminvest Ltd. v. ITO [TS-54-ITAT-2009(DEL)-O], held that disallowance under section 14A has to be made even if the assessee has not earned any exempt income during the assessment year. However, on appeal by the assessee, the Delhi High Court reversed the ITAT ruling and held that no disallowance under section 14A can be made in a year in which no exempt income has been earned or received by the assessee. It further held that section 14A does not apply to shares bought for strategic purposes.

The CBDT vide its Circular no 5/2014 dated 11 February, 2014 clarified that the purpose of introducing section 14A is that the expenditure relatable to earning of exempt income have to be considered for disallowance, irrespective of whether any such income has been earned during the financial year or not. However, the Delhi High Court in the case of IL & FS Energy Development Company Limited  [TS-5745-HC-2017(Delhi)-O] held that the CBDT circular no 5/2014 dated 11 February, 2014 cannot override the express provisions of section 14A read with rule 8D. Several other Courts have held similar views.

Similarly, in several instances, assessees argued that dividend, although exempt in the hands of the shareholder, has been taxed by way of dividend distribution tax in the hands of the company. However, the Supreme Court (SC), in the case of Godrej & Boyce Manufacturing Company Ltd. v. DCIT  [TS-5110-SC-2017-O] held that the fact that dividend income is subject to dividend distribution tax in the hands of the company is not a relevant circumstance to allow expenditure in the hands of the shareholder, and as such dividend does not form part of the total income, the expenditure relating to such income would be disallowed under section 14A.

Another issue involving protracted litigation was whether 14A disallowance can be made for strategic investments made by assessees. For various commercial reasons, companies may decide to create subsidiaries for carrying on businesses that may or may not be similar to the business of the assessee. In such instances, usually the assessee treats the said investment as a capital asset, as the investment is not made to earn income through trading in those securities.

In such situations, the assessee would take a view that the main purpose for investing in shares was to gain control over the investee company and not to earn exempt income. Accordingly, no disallowance should be warranted under section 14A. However, the tax authorities would reject this stand on the premise that section 14A nowhere contemplates that the purpose of the investment is to be considered. As long as there is exempt income, disallowance under section 14A can be made.

The SC considered this issue in its ruling in the case of Maxopp Investments Limited [TS-5170-SC-2018-O]. The SC observed the following:

a. If an expenditure incurred has no casual connection with the exempt income, the same would not be considered as related to exempt income and would be allowable as a business expense;

b. The dominant purpose for which shares were held was not relevant for applicability of section 14A. As long as an exempt income was earned, the expenditure incurred as attributable to earning such exempt income, has to be disallowed under section 14A.

c. The SC agreed with the view of the Delhi HC that the intent behind the insertion of section 14A retrospectively was to incorporate the principle of apportionment of expenses between exempt income and taxable income. This was to ensure that the assessee does not take double benefit by reducing the expenses incurred towards the exempt income against the taxable income and availing the exemption on non-taxable income.

d. The SC accepted the distinction between "investment" and "stock-in-trade" noted by the CBDT Circular relied upon by the Punjab & Haryana HC in the case of State Bank of Patiala [TS-5071-HC-2017(Punjab & Haryana)-O]. However, the SC disregarded the dominant purpose test for section 14A.

e. Confirmed the view taken by the Tribunal and the Punjab & Haryana HC of restricting the disallowance to the quantum of exempt income;

f. The SC held that irrespective of the objective of investment in shares (when the shares are held as stock-in-trade with a view to earn trading profits or as investment representing controlling interest) and the assessee earned an incidental exempt dividend income, section 14A was triggered, which was based on the theory of apportionment of expenditure between taxable and exempt income.

g. The SC held that before applying the theory of apportionment, the assessing officer needs to record satisfaction that the suo moto disallowance made by the assessee was incorrect. While recording such satisfaction, the assessing officer must also examine the nature of the loan taken by the assessee for purchasing the shares/ making the investment.

With the above SC ruling, the ambiguities around the applicability of section 14A in the hands of investors, who held shares either to acquire/ retain controlling interest in other entities or as stock in trade, has been put to rest. However, it is important to note that the Finance Act, 2016 introduced section 115BBDA to tax dividends. As per the provisions of the amended section 115BBDA, the dividend received by the specified assessees in excess of INR 10 lakhs is taxable in the hands of the shareholders. With this amended section, dividends earned by individuals and firms are taxable, whereas for companies, it continues to be exempt. A question arises as to whether the form of the entity would impact the tax computation. Further, with effect from 01 April 2018, long-term capital gains tax on which STT has been paid are also brought under the purview of tax and the exemption has been withdrawn. In such a case, whether assessees can claim investments in listed shares to earn taxable income, and that dividend is merely incidental to ownership, and hence, no disallowance is warranted under section 14A. One will have to wait for the Courts to discuss and rule on the same.

The views expressed in this article are personal. This article includes inputs from Akshay Shenoy, Director M&A Tax PwC India, Manish Gupta, Manager, M&A Tax PwC India and Samyak Shah, Associate, M&A Tax PwC India.