While section 14A of the Income-tax Act, 1961 (IT Act) provides for disallowance of expenditure incurred to earn exempt income, Rule 8D of the Income-tax Rules, 1962 (IT Rules) contains methodology for computing the disallowance under section 14A.
Recently, the Supreme Court1 had an occasion to examine whether disallowance under section 14A of the IT Act is called for when the investment is made from mix funds (consisting of both borrowed as well as own funds). We, at BDO in India, have summarised the ruling of the Supreme Court and provided our comments on the impact of this decision hereunder.
FACTS OF THE CASE
The taxpayer, a scheduled bank, had made investments in bonds, securities and shares resulting in interest and dividend income which were exempt / tax free. The taxpayer, being in the business of banking, did not maintain separate accounts for the investments made in bonds, securities, and shares wherefrom the tax-free income was earned. The taxpayer had borrowed funds as well as own funds. The own funds exceeded the borrowed funds. The Tax Officer opined that in the absence of separate accounts, it was not possible to determine the actual expenditure including overheads and other administrative expenditure incurred for earning the exempt income. Hence, the Tax Officer made proportionate disallowance of interest attributable to the funds invested to earn tax free income by referring to the average cost of deposit for the relevant year. While the First Appellate Authority affirmed the Tax Officer’s order, the Tax Tribunal granted relief to the taxpayer. The Hon’ble High Court denied the relief granted by the Tax Tribunal. Hence, the taxpayer filed an appeal in the Supreme Court.
The Apex Court held that if investments in securities are made out of common / mix funds and the taxpayer has available non-interest-bearing funds which are more than the investments made in tax- free securities, then in such cases, it is the taxpayer who has the right of appropriation and also the right to assert from what part of the fund a particular investment is made. In such cases, it may not be permissible for the Revenue to make estimation of a proportionate figure. Hence, a disallowance under Section 14A cannot be made. It relied on its earlier decision in case of Reliance Industries Ltd2 wherein it had been held that since interest free funds available to taxpayer were sufficient to meet its investment it will be presumed that investments were made from such interest free funds. The Apex Court also referred to the decision of various High Court3. Further, it also distinguished on facts its earlier ruling in case of SA Builders4. While granting relief to the taxpayer, the Supreme Court made following observations:
- The taxpayer has the obligation to provide full material disclosure at the time of filing of the Income Tax Return but there is no corresponding legal obligation upon the taxpayer to maintain separate accounts for different types of funds held by it.
- In absence of any statutory provision which compels the taxpayer to maintain separate accounts for different types of funds, the judgment cited by the Revenue will have no application to support the Revenue’s contention against the taxpayer.
- The Revenue Authority has not contended that the taxpayer held the securities for maintaining the Statutory Liquidity Ratio (SLR), as mentioned in the circular5. In view of this position, when there is no finding that the investments of the taxpayer are of the related category, tax implication would not arise against the taxpayer from the said circular.
Further, after referring to quote of Adam Smith in his seminal work – The Wealth of Nations, the Apex Court has made following observations:
- In taxation regime, there is no room for presumption, and nothing can be taken to be implied. The tax an individual or a corporate is required to pay, is a matter of planning for a taxpayer and the Government should endeavour to keep it convenient and simple to achieve maximisation of compliance.
- Just as the Government does not wish for avoidance of tax equally it is the responsibility of the regime to design a tax system for which a subject can budget and plan. If proper balance is achieved between these, unnecessary litigation can be avoided without compromising on generation of revenue.
This is a welcome ruling. With the abolition of the DDT regime, the dividends are now taxable in the hands of shareholders. Hence, section 14A of the IT Act should not be applicable on the dividends. However, this Ruling will be beneficial to all the pending litigation as it has held that where the own fund is in excess of borrowed fund, the taxpayer can contend that investments have been made out of own funds.
Further, dividends will now be taxable in the hands of the shareholders under “income from other sources” against which only interest expenditure up to a maximum of 20% of the gross dividend would be deductible. In such cases, where investments have been made out of mixed funds, the taxpayer may apply the theory of beneficial allocation for claim of interest against such dividend income.
1South Indian Bank Ltd. vs CIT, Civil Appeal No. 9606 of 2011 (Supreme Court)
2CIT(LTU) vs. Reliance Industries Ltd 410 ITR 466 (SC)
3HDFC Bank Ltd vs DCIT 383 ITR 529 (Bom. HC)
Pr. CIT vs Bombay Dyeing and Mfg. Co. Ltd. (ITA No. 1225 of 2015)(Bom HC)
CIT vs Suzlon Energy Ltd 354 ITR 630 (Guj. HC)
CIT vs Microlabs Ltd 383 ITR 490 (Kar. HC)
CIT vs Max India Ltd 388 ITR 81 (P&H HC)
41 SCC 781 (Supreme Court)
5Circular No. 18 of 2015 dated 2 November 2015