History

Section 14A of the Income-tax Act, 1961 (‘Act’) was introduced by the Finance Act 2001 with retrospective effect from 1 April 1962, to provide for disallowance of expenditure incurred/ deemed to have been incurred in relation to earning of income not chargeable to tax in India.

This concept was logical and necessary as if an income was not charged to tax, then as corollary the expenditure incurred to earn such tax free income should also not be allowed as deduction as the same would tantamount to double taxation. It would be unjust to allow deduction of this expenditure against the other taxable income.

Further, Rule 8D under the Income-tax Rules, 1962 was introduced with retrospective effect from 01^st April 2001, to provide a reasonable basis to compute a deeming amount of deduction/ expense which may be incurred on earning such exempt income.  

Controversies

This Section has been subject matter of judicial interpretations on umpteen occasions. It has been on the watch list of the tax department since its introduction in the year 2001.

The major controversies, among others, were in the area of:

a. Establishment of nexus between the exempt income and related expenditure;

b. Disallowance where no exempt income is earned during the relevant assessment year;

c. Restriction of disallowance to dividend income;

d. No disallowance where owned funds are more than borrowed funds;

e. Retrospective application of Rule 8D; and

f. Investment in subsidiaries is for acquiring controlling interest/ strategic investment.

High Courts on various occasions [TS-173-HC-2011(CALCUTTA)-O], [TS-5824-HC-2008(BOMBAY)-O] and [TS-5531-HC-2013(MADRAS)-O] have held that exempt income received from strategic investment made for retaining/ having a controlling stake should not be considered for computing the disallowance under Section 14A of the Act as the dominant purpose for making such investment is not earning ‘divided income which is exempt from tax in India’.

Decision of the Supreme Court

Recently, the Supreme Court (‘SC’) decided on applicability of Section 14A of the Act, in the case of Maxopp Investment Ltd vs. CIT  [TS-5170-SC-2018-O] wherein it has held that any strategic investment should be considered while computing the disallowance under the disallowance made under Section 14A of the Act, however, shares held as ‘stock in trade’ should not be considered while computing the disallowance under Section 14A of the Act as any exempt dividend income earned from such investment is ‘quirk of fate’.

In arriving at the decision, the SC, amongst others, held that:

a. Dominant purpose test or intention behind investing into shares is irrelevant for computing the disallowance under Section 14A of the Act;

b. Investments made to retain controlling interest in group companies (ie, strategic investments) are to be considered while computing the disallowance under Section 14A of the Act;

c. Where any dividend income arises from shares held by the tax payer as ‘stock in trade’, then such investment into shares should not be considered for disallowance under Section 14A of the Act; and

d. No disallowance is to be made where there is no exempt income.

Dichotomy in the decision of the Supreme Court

The SC has held that dominant purpose test is irrelevant for application of Section 14A of the Act and strategic investments are to be considered for disallowance under Section 14A of the Act. However, in the same very decision the SC ruled that the shares held as ‘stock in trade’ should not be considered for Section 14A disallowance. The rationale which though is not explicitly stated in the decision clearly brings out the dichotomy in the decision, as explained below:

It is surprising to note that the SC on one hand has clearly ruled on that ‘dominant purpose test’ is not relevant but has ruled in favour on the issue of shares to be held as ‘stock in trade’, which is nothing but based on the dominant purpose test.

The rationale which isn’t explicitly spelt out is that the investment in shares which are held as stock in trade are for the purpose of earning appreciation in value and the same would be sold off by the investor the moment the value appreciates. Incidentally, while holding such shares as ‘stock in trade’, it is only ‘quirk of fate’ that dividend income may arise to the assessee.  Therefore, where there is any dividend income arising to the tax payer, he would NOT be subject to the provisions of Section 14A of the Act as the intention was not to earn such dividend. This argument did not work in favour of ‘strategic investment’, even where the intention was NOT to earn dividend income.

The above dichotomy needs be cleared as on independent reading of the decision the rationale to treat ‘strategic investment’ and ‘shares held as stock in trade’ differently does not come out at all.

Application of Section 14A of the Act to Subsidiary / Wholly Owned Subsidiary

In this dynamic world, 50:50 Joint Venture (‘JV’) company, incorporating subsidiaries, Wholly Owned Subsidiary (‘WOS’) are driven by commercial/ business consideration. They are in fact mode of doing business by the company itself and certainly not a mere investment.

The legislature has on various occasion provided benefits from taxation, reduced the rigors of taxation to subsidiaries/ WOS. Some of the pertinent examples are as follows:

a. Section 115-O of the Act provides for payment of additional income tax (‘DDT’) on the amount of dividend distributed by an Indian company at the effective rate of 20%. DDT was levied twice once where the dividend was distributed by subsidiary/ WOS to its parent company, and again when such dividend was further declared by the Parent company. The legislature acknowledged this double taxation and the hardship which was being caused by this. In order to remove the hardship, an amendment was introduced to Section 115-O of the Act to allow a parent company to set off the dividend received from its subsidiary company against dividend distributed by the parent company, provided that the dividend received has suffered DDT.

b. Section 47(iv)/ (v) of the Act provides that transfer of any asset from a holding company to its subsidiary and vice versa, would not be subject to capital gain tax.

c. The definition of company in which public are substantially interested extend to its subsidiaries also.

The above clearly manifest that WOS/ subsidiaries are ‘extensions’ of the parent company itself. Whilst, optically, parent company are allotted shares of WOS/ subsidiaries they cannot be regarded as investment. These WOS/ subsidiaries look upon their parent company for infusion of funds for their business requirements. The parent company on many occasions borrows the money to provide to its WOS/ subsidiaries.

In view of the classic business relation between parent company and its WOS/ subsidiaries, 50:50 JV company, they should be regarded as a part/ extension of the parent company and not a classical investment made to earn dividend income, and accordingly, no disallowance under Section 14A of the Act be applied. Legislation amendment to this effect would be a good step towards acknowledging and appreciating the business reality and avoiding unnecessary litigation.

(Shrenik Suchanti, Senior Tax Professional, EY also contributed to this article)