Overview

There has been substantial litigation on the issue of disallowance under section 14A of the Income-tax Act, 1961 (the Act) read with Rule 8D of the Income-tax Rules, 1962 (the Rules).

The Supreme Court (SC) in its recent decision in Maxopp Investment Ltd v. CIT [TS-5170-SC-2018-O] has ruled on the following primary issues:  

1. Whether a disallowance was warranted if the dominant purpose for investment in shares was to gain control over the investee company?

2. Whether disallowance was warranted if the shares of the investee company were held as ‘stock-in-trade’ and not as ‘investment’ since the dominant purpose was to earn business profits by trading in shares?

The Court held that the dominant purpose or motive for which investment is made, may not be relevant since dividend income is non-taxable. Prior to the introduction of section 14A, the law was that when an assessee had a composite and indivisible business having elements of both taxable and non-taxable incomes, the entire expenditure in respect of the said business was deductible and the principle of apportionment of the expenditure relating to non-taxable income did not apply. The principle was applicable only when the business was divisible. It was to find a cure to the aforesaid problem that the legislature has inserted section 14A which is based on the theory of apportionment of expenditure between taxable and non-taxable income. If expenditure is incurred for earning non-taxable income, the amount that is attributable to earning such income has to be disallowed. Hence, a disallowance will get triggered based upon the principle of apportionment of expenditure between taxable and exempt income where tax-free dividend is earned irrespective of whether shares are purchased for obtaining and retaining controlling interest (strategic investments), or for earning trading profits. This ruling will impact holding / subsidiary relationships, and banks that are holding stocks as trading assets.

The Court has made a few observations, and laid down certain principles which are briefly discussed below.

Recording of satisfaction  

The SC in para 41 of its ruling held that before applying the theory of apportionment, the Assessing Officer (AO) needs to record his satisfaction that the suo moto disallowance under section 14A, if any, made by the taxpayer was incorrect. While doing so, the nature of loan(s) taken by the taxpayer for purchasing shares or otherwise, needs to be examined.   

Further, in para 32 it held that if the expenditure has no causal connection with the exempted income then such expenditure would not be treated as related to the income and would be allowed as business expenditure.  

Can disallowance exceed exempt income?

In paras 18 and 40 of its ruling, the SC had referred to the facts in PCIT v. State Bank of Patiala [TS-5071-HC-2017(PUNJAB & HARYANA)-O] while dealing with the issue relating to shares held as stock-in-trade. In that case, the assessee had earned exempt income of Rs. 12.20 crores. The AO restricted the disallowance under section 14A to the extent of exempt income i.e. Rs. 12.20 crores. The Commissioner of Income-tax (Appeals) [CIT(A)] disallowed the entire expenditure thus enhancing the disallowance made by the AO.

The SC, in para 40 held that the view of the CIT(A) was untenable and rightly set aside by the Tribunal which was subsequently affirmed by the High Court though the theory of dominant intention was not agreed upon.

Based on the above observations, can one state that the SC appears to have agreed with the view that the disallowance cannot exceed the exempt income?        

This issue was not specifically raised for adjudication and the observations appear to be in the context of apportionment of expenditure, and do not lay down the ratio that disallowance is to be restricted up to exempt income. Further, though the assessee had raised a specific ground before the Tribunal challenging the enhancement done by the CIT(A), besides the primary issue (viz., no disallowance in respect of investments held as stock-in-trade), the Tribunal deleted the disallowance on the proposition that since the bank holds the securities as stock-in-trade, the vires of section 14A is not attracted. The Tribunal’s ruling on this aspect was later affirmed by the High Court.    

The Tribunal had not commented on the ground relating to the enhancement made by the CIT(A) as it had deleted the disallowance on a different proposition. The question as to whether disallowance can exceed the exempt income was not before the SC and therefore it did not give any finding on this issue. Moreover, as held in CIT v. Sun Engineering Works Pvt. Ltd. [TS-16-SC-1992-O], observations from a judgment have to be considered in the light of questions which were there before the Court.

Disallowance if own funds exceed investments  

A few rulings viz. CIT v. Reliance Utilities & Power Ltd. [TS-66-HC-2009(BOMBAY)-O], CIT v. HDFC Bank Ltd. [TS-6146-HC-2014(BOMBAY)-O] affirmed in CIT v. HDFC Bank Ltd. [TS-5211-HC-2016(BOMBAY)-O] have held that where the taxpayer has mixed funds (own funds and borrowings), and if its own funds are greater than advances/ investments in tax-free securities, the presumption is that the advances/ investments were made from own funds, and not from its borrowings, and disallowance of interest expenditure would not be warranted.

In para 42 of its ruling, the SC dealt with an appeal by the taxpayer against the ruling in Avon Cycles Ltd v. CIT [TS-6251-HC-2014(PUNJAB & HARYANA)-O]. In this case the issue was whether, under a mixed funds situation, interest paid on borrowed funds relating to investments in tax-free funds, could be disallowed under section 14A / Rule 8D(2)(ii) of the Rules.

The Tribunal had confirmed the disallowance of interest based upon the working made by the assessee itself. The High Court held that after examining the balance sheet of the assessee, a finding of fact had been recorded that the funds utilized being mixed funds, the interest paid by the assessee was also an interest on investments made, and in view of the factual finding, no substantial question of law arose.

The SC dismissed the appeal by the assessee stating that after applying the principle of apportionment, it did not find any merit in the appeal. Does this observation of the SC, seem to disapprove the view taken in rulings referred to earlier?

In the case of Reliance Utilities, the taxpayer had submitted before the CIT(A) that no part of the interest-bearing funds have been used for making advances. The Tribunal had recorded a finding that the taxpayer had sufficient own funds for making advances. The Court had accordingly held that if there are funds available, both interest-free and interest-bearing, then a presumption would arise that advances are out of interest-free funds if the same were sufficient to meet the advances. This presumption was established based upon the finding of fact by the CIT(A) and the Tribunal.

In the case of Avon Cycles, the AO held that in view of the large turnover and complexity in fund flow, it was difficult to identify which funds have been used for what purpose. Further, funds utilized being mixed, interest paid was also an interest on the investments made and hence disallowance of interest was to be computed as per Rule 8D(2)(ii). This was subsequently upheld by the High Court, and now the SC.

Though the assessee in Avon Cycles, had relied upon the ruling in Reliance Utilities, in its arguments, the Court distinguished the ruling only on facts, and did not dissent from the same.

Hence the principle regarding a presumption of investments being out of own funds, does not appear to have been specifically dealt with, nor adjudicated by the High Court nor the SC, in further appeal. In fact the SC , in its rulings in East India Pharmaceutical Works Ltd. v. CIT [TS-5031-SC-1997-O], and Munjal Sales Corpn v. CIT [TS-31-SC-2008-O] (para 17) had found considerable force in this principle. The ruling in East India Pharmaceutical (supra) had been relied upon by the High Court while deciding the case of Reliance Utilities, supra.

It may be noted that sub-rule (2) of Rule 8D of the Rules has been amended by the IT (Fourteenth Amendment) Rules, 2016 w.e.f. 2 June 2016. As per the amended Rule, there is no disallowance separately for interest, as was earlier provided by way of apportionment of the interest paid in the ratio of the average investments to average assets. The total disallowance will now be 1% of the annual average of the monthly averages of investments.

Computation of disallowance for shares held as stock-in-trade

The SC, in para 39 has held that the motive behind the acquisition of shares as stock-in-trade is to earn profit on trading of such shares. Income from such shares would be (taxable) trading profits and (exempt) dividend income. The ruling seems to suggest that expenditure needs to be apportioned between these two sources, though it is silent on the manner thereon.

Rule 8D(2)(ii), before its amendment by the IT (Fourteenth Amendment) Rules, 2016, provided for apportionment of interest paid in the ratio of investments yielding tax-free income to total assets. It did not provide for a computation as suggested by the SC. On the other hand, the AO has to compute the disallowance as per Rule 8D(2) if he is not satisfied with the taxpayers computation. There could be litigation on this aspect.

Investments to be considered for disallowance  

In ACIT v. Vireet Investment (P.) Ltd [TS-5879-ITAT-2017(DELHI)-O], it was held that only those investments which yielded exempt income during the year, are to be included for computing the disallowance under Rule 8D.

As this question was not raised for adjudication by the SC, the principle in Vireet Investments, supra remains undisturbed.  

Disallowance if no tax-free income is received   

The SC, in para 40 has observed that whether dividend is earned or not becomes immaterial. These observations appear to have been made in the context as to whether receipt of exempt dividend is a factor in determining whether shares held as stock-in-trade are to be excluded for the purposes of section 14A, which is apparent from the discussion which precedes the observations in para 40, and ought not to be understood as laying the proposition that no disallowance can be made if no tax-free income is received during the year.

The SC held that the principle of apportionment has to be applied between taxable and non-taxable income. The question as to whether disallowance could be made if no exempt income is received, was not specifically raised nor dealt with in the appeals before the SC. 

Conclusion

The SC has decided some important issues that have been the subject of recurring litigation. Some doubts have arisen, and some other issues need to be finally settled by the Apex Court before one can state that the sun has finally set on section 14A.