Only that expenditure which is “in relation to” earning dividends can be disallowed
While computing the profit and gains from business or profession, there are certain expenditures which are disallowed. This means that the income tax department does not allow the benefit of such expenditures and the assesses are required to pay taxes on such expenditures by adding it back to the net profits. Let us refer to the case of Maxopp Investment Ltd. v. CIT (2018), which was mainly concerned with the disallowance of dividend received on investment.
Facts of the Case:
- The company was engaged in the business of finance, investment and dealing in shares and securities.
- The assessee held shares in two portfolios; as investment on capital account and as trading assets for the purpose of acquiring and retaining control over investee group companies, particularly Max India Ltd., a widely held quoted public limited company.
- Any profit/loss arising on sale of shares held as ‘investment’ was returned as income under the head ‘capital gains’, whereas profit/loss arising on sale of shares held as ‘trading assets’ (i.e. held, inter alia, with the intention of acquiring, exercising and retaining control over investee group companies) was regularly offered and assessed to tax as business income under the head ‘profits and gains of business or profession’.
- Consistent with the aforesaid treatment regularly followed, the assessee filed return declaring income of Rs.78,90,430.
- No part of the interest expenditure of Rs.1,16,21,168 debited to the profit and loss account, to the extent relatable to investment in shares of Max India Limited, yielding tax free dividend income, was considered disallowable under Section 14A on the ground that shares in the said company were acquired for the purposes of retaining controlling interest and not with the motive of earning dividend.
- According to the assessee, the dominant intention of investment in shares of Max India Ltd. was acquiring/retaining controlling interest therein and not earning dividend and, therefore, dividend of Rs.49,90,860 earned on shares of Max India Ltd. during the relevant previous year was only incidental to the holding of such shares.
- The Assessing Officer (AO), while passing the assessment order, under Section 143(3) worked out disallowance under Section 14A at Rs. 67,74,175 by apportioning the interest expenditure of Rs. 1,16,21,168 in the ratio of investment in shares of Max India Ltd. (on which dividend was received) to the total amount of unsecured loan.
- The AO, however, restricted disallowance under that Section to Rs. 49,90,860 being the amount of dividend received and claimed exempt.
Proceedings of Appellate Authorities
- In appeal, the CIT(A) upheld the order of the AO. assessee herein carried the matter in further appeal to the ITAT.
- The Special Bench of ITAT held that there existed dominant connection between interest paid on loan utilized for acquiring the aforesaid shares and earning of dividend income.
- Consequently, the provisions of Section 14A of the Act were held to be attracted on the facts of the case.
Proceedings of the High Court (HC)
- Against the aforesaid order of the Special Bench, Assessee preferred appeal to the High Court.
- The Delhi High Court held that the expression ‘in relation to’ appearing in Section 14A of the Act was synonymous with ‘in connection with’ or ‘pertaining to’, and, that the provisions of that Section applied regardless of the intention/motive behind making the investment.
- As a consequence, proportionate disallowance of the expenditure incurred by the assessee was maintained.
- Against the order of the HC, Assessee appealed to the Supreme Court.
Issue raised before the Supreme Court (SC)
- The question arose under varied circumstances where the shares were purchased of a company for the purpose of gaining control over the said company or as ‘stock-in-trade’.
- However, incidentally income was also generated in the form of dividends as well.
- On this basis, the assessee contended that the dominant intention for purchasing the share was not to earn dividends income but control of the business in the company in which shares were invested or for the purpose of trading in the shares as a business activity etc.
- In this backdrop, the issue was as to whether the expenditure incurred can be treated as expenditure ‘in relation to income’ i.e. dividend income which does not form part of the total income.
- To put it differently, was the dominant or main object would be a relevant consideration in determining as to whether expenditure incurred is ‘in relation to’ the dividend income.
- Though in some other cases, there were little difference in fact situation.
- However, all these cases pertained to dividend income, whether it was for the purpose of investment in order to retain controlling interest in a company or in group of companies or the dominant purpose was to have it as stock-in-trade.
Observations by the Supreme Court (SC) on the nature of the dispute
- SC observed that as per section 14A(1) of the Act, deduction of that expenditure was not to be allowed which was incurred by the assessee “in relation to income which does not form part of the total income under this Act”.
- It was that expenditure alone which was incurred in relation to the income which was includible in total income that was disallowed.
- If an expenditure incurred had no causal connection with the exempted income, then such an expenditure would obviously be treated as not related to the income that was exempted from tax, and such expenditure would be allowed as business expenditure.
- The entire dispute was, what interpretation is to be given to the words ‘in relation to’ in the given scenario, viz. where the dividend income on the shares is earned, though the dominant purpose for subscribing in those shares of the investee company was not to earn dividend.
- SC had two scenarios in these sets of appeals.
- In one group of cases the main purpose for investing in shares was to gain control over the investee company.
- Other cases were those where the shares of investee company were held by the assessee as stock-in-trade (i.e. as a business activity) and not as investment to earn dividends.
- In this context, it was to be examined as to whether the expenditure was incurred, in respective scenarios, in relation to the dividend income or not.
Observations of the SC on the dominant purpose
- SC was of the opinion that the dominant purpose for which the investment into shares was 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 did not appear to be a relevant factor in determining the issue at hand.
- Fact remained that such dividend income was non-taxable.
- In this scenario, if expenditure was incurred on earning the dividend income, that much of the expenditure which was attributable to the dividend income had to be disallowed and could not be treated as business expenditure.
- Keeping this objective behind Section14A in mind, the said provision had to be interpreted, particularly, the word ‘in relation to the income’ that did not form part of total income.
- SC affirmed the observation of HC that prior to introduction of Section 14A, the law was that when an assessee had a composite and indivisible business which had elements of both taxable and non-taxable income, the entire expenditure in respect of said business was deductible and, in such a case, the principle of apportionment of the expenditure relating to the non-taxable income did not apply.
- The principle of apportionment was made available only where the business was divisible.
- It was to find a cure to the aforesaid problem that the Legislature had not only inserted Section 14A by the Finance (Amendment) Act, 2001 but also made it retrospective, i.e., 1962 when the Income Tax Act itself came into force.
- The aforesaid intent was expressed loudly and clearly in the Memorandum explaining the provisions of the Finance Bill, 2001.
- SC, thus was not inclined to accept the dominant purpose theory.
Observations of the SC on what happened when the shares were held as ‘stock-in-trade’ and not as ‘investment’?
- The question was as to on what basis cases were to be decided where the shares of other companies were purchased as ‘stock-in-trade’ and not as ‘investment’.
- SC observed that where shares were held as stock-in-trade, the main purpose was to trade in those shares and earn profits therefrom.
- Those profits which would naturally be treated as ‘income’ under the head ‘profits and gains from business and profession’.
- However, in the process, when the shares were held as ‘stock-in-trade’, certain dividend was also earned, though incidentally, which was also an income.
- However, by virtue of Section 10 (34) of the Act, this dividend income was not to be included in the total income and is exempt from tax.
- As per the SC this triggers the applicability of Section 14A which was based on the theory of apportionment of expenditure between taxable and non-taxable income.
- Therefore, to that extent, depending upon the facts of each case, the expenditure incurred in acquiring those shares would have to be apportioned.
- Confirming the AO’s action of restricting the disallowance to exempt income the Court held that the view of the CIT(A) was clearly untenable and rightly set aside by the ITAT.
- Having regard to the language of Section 14A(2) read with Rule 8D, SC made it clear that before applying the theory of apportionment, the AO had to record satisfaction that having regard to the kind of the assessee, suo moto disallowance under Section 14A was not correct.
- It would be in those cases where the assessee in his return had himself apportioned but the AO was not accepting the said apportionment.
- In that eventuality, it would 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 had to be examined by the AO.
In conclusion SC held that, the argument that Section 14A & Rule 8D will not apply if the “dominant intention” of the assessee was not to earn dividends but to gain control of the company or to hold as stock-in-trade is not acceptable. Section 14A applies irrespective of whether the shares are held to gain control or not.
However, where the shares are held as stock-in-trade, the expenditure incurred for earning business profits will have to be apportioned and allowed as a deduction. Only that expenditure which is “in relation to” earning dividends can be disallowed u/s 14A & Rule 8D. Further disallowance cannot be more that exempt income.
In case where the assessee has made suo moto disallowance, the AO has to record proper satisfaction on why the claim of the assessee as to the quantum of suo moto disallowance is not correct