1. Whether expenditure (including interest paid on funds borrowed) in respect of investment in shares of operating companies for acquiring and retaining a controlling interest therein is hit by section 14A of the Income tax Act, 1961 inasmuch as the dividend received on such shares does not form part of the total income? Held-Yes

2. Whether the provisions of sub-section (2) and sub-section (3) of section 14A inserted by the Finance Act, 2006 with effect from 01/04/2007, would apply retrospectively to all pending proceedings? Held-No

3. Whether Rule 8D inserted by the Income -tax (Fifth Amendment) Rules, 2008 with effect from 24/03/2008 was procedural in nature and hence would apply retrospectively to all pending proceedings? Held-No

Case Details:
ITA-687/2009
Maxopp Investment Ltd. (Appellant) vs. Commissioner of Income Tax (Respondent)
Date: 18-11-2011

Facts of the Case:
The assessee company is in the business of finance, investment and of dealing in shares and securities. The assessee held shares and securities, partly as investments on the "capital account" and partly as "trading assets" for the purpose of acquiring and retaining control over its group companies, primarily Max India Ltd. As per the assessee, any profit resulting on the sale of shares held as trading assets was duly offered to tax as business income of the assessee. During the previous year relevant to the assessment year 2002-03, the assessee incurred total interest expenditure of Rs. 1,61,21,168/-, which was claimed as business expenditure under section 36(1)(iii) of the Income Tax Act, 1961 (hereinafter referred to as "the said act"). According to the assessee, the expenditure claimed was not hit by section 14A of the said act, on the ground that although borrowed funds were partly utilised for investment in shares held as trading assets, such investment was made with the intention to acquire and retain a controlling interest in the aforesaid company and that the receipt of dividend thereon was merely incidental.

During the Assessment Year, the assessee had received dividend income of Rs. 4990860/- on the shares of Max India Ltd, held by the assessee as "trading assets". The assessing officer, invoking section 14A apportioned the said interest expenditure in the ratio of investment in shares of Max India Ltd, on which dividend was received, to the principal amount of unsecured loans, which worked out to Rs. 67,74,175/-. However, the assessing officer restricted the disallowance under section 14A of the said act to Rs. 49,90,860/-, being the amount of dividend received.

Excerpts from the Judgment:
14. Thus, prior to the introduction of section 14A in the said Act, 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 the 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. However, where the business was divisible, the principle of apportionment of the expenditure was applicable and the expenditure apportioned to the ‘exempt’ income or income not exigible to tax, was not allowable as a deduction.

Objective behind insertion of section 14A

15. The object behind the insertion of section 14A in the said Act is apparent from the Memorandum explaining the provisions of the Finance Bill 2001 which is to the following effect:-

"Certain incomes are not includable 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.

It is proposed to insert a new section 14A so as to clarify the intention of the Legislature since the inception of the Income - tax Act, 1961, that no deduction shall be made in respect of any expenditure incurred by the assessee in relation to income which does not form part of the total income under the Income-tax Act.

The proposed amendment will take effect retrospectively from April 1, 1962 and will accordingly, apply in relation to the assessment year 1962-63 and subsequent assessment years."

16. As observed by the Supreme Court in the case of CIT v. Walfort Share and Stock Brokers P Ltd: 326 ITR 1 (SC), the insertion of section 14 A with retrospective effect reflects the serious attempt on the part of Parliament not to allow deduction in respect of any expenditure incurred by the assessee in relation to income, which does not form part of the total income under the said act against the taxable income. The Supreme Court further observed as under:-

".. In other words, section 14 A clarifies that expenses incurred can be allowed only to the extent that they are relatable to the earning of taxable income. In many cases the nature of expenses incurred by the assessee may be relatable partly to the exempt income and partly to the taxable income. In the absence of section 14A, the expenditure incurred in respect of exempt income was being claimed against taxable income. The mandate of section 14A is clear. It desires to curb the practice to claim deduction of expenses incurred in relation to exempt income against taxable income and at the same time avail of the tax incentive by way of an exemption of exempt income without making any apportionment of expenses incurred in relation to exempt income…”

“..Expenses allowed can only be in respect of earning taxable income. This is the purport of section 14A. In section 14A, the first phrase is "for the purposes of computing the total income under this Chapter" which makes it clear that various heads of income as prescribed in the Chapter IV would fall within section 14A. The next phrase is, "in relation to income which does not form part of total income under the Act". It means that if an income does not form part of total income, then the related expenditure is outside the ambit of the applicability of section14A..”

(Emphasis supplied)

17. The Supreme Court also clearly held that in the case of an income like dividend income which does not form part of the total income, any expenditure/deduction relatable to such (exempt or non-taxable) income, even if it is of the nature specified in sections 15 to 59 of the said Act, cannot be allowed against any other income which is includable in the total income. The exact words used by the Supreme Court are as under:-

"Further, section 14 specifies five heads of income which are chargeable to tax. In order to be chargeable, an income has to be brought under one of the five heads. Sections 15 to 59 lay down the rules for computing income for the purpose of chargeability to tax under those heads. Sections 15 to 59 quantify the total income chargeable to tax. The permissible deductions enumerated in sections 15 to 59 are now to be allowed only with reference to income which is brought under one of the above heads and is chargeable to tax. If an income like dividend income is not a part of the total income, the expenditure/deduction though of the nature specified in sections 15 to 59 but related to the income not forming part of the total income could not be allowed against other income includable in the total income for the purpose of chargeability to tax. The theory of apportionment of expenditure between taxable and non-taxable has, in principle, been now widened under section 14 A."

(emphasis supplied)

25. We are of the view that the expression "in relation to" appearing in Section 14 A of the said act cannot be ascribed a narrow or constricted meaning. If we were to accept the submission made on behalf of the assessees then sub-section (1) would have to be read as follows:-

"For the purposes of computing the total income under this Chapter, no deduction shall be allowed in respect of expenditure incurred by the assessee with the main object of earning income which does not form part of the total income under this Act.”

That is certainly not the purport of the said provision. The expression “in relation to” does not have any embedded object. It simply means “in connection with” or “pertaining to”. If the expenditure in question has a relation or connection with or pertains to exempt income, it cannot be allowed as a deduction even if it otherwise qualifies under the other provisions of the said Act. In Walfort (supra), the Supreme Court made it very clear that the permissible deductions enumerated in sections 15 to 59 are now to be allowed only with reference to income which is brought under one of the heads of income and is chargeable to tax. The Supreme Court further clarified that if an income like dividend income is not part of the total income, the expenditure/deduction related to such income, though of the nature specified in sections 15 to 59, cannot be allowed against other income which is includable in the total income for the purpose of chargeability to tax.

Scope of sub-sections (2) and (3) of Section 14A
29. Sub-section (2) of Section 14 A of the said Act provides the manner in which the Assessing Officer is to determine the amount of expenditure incurred in relation to income which does not form part of the total income. However, if we examine the provision carefully, we would find that the Assessing Officer is required to determine the amount of such expenditure only if the Assessing Officer, having regard to the accounts of the assessee, is not satisfied with the correctness of the claim of the assessee in respect of such expenditure in relation to income which does not form part of the total income under the said Act. In other words, the requirement of the Assessing Officer embarking upon a determination of the amount of expenditure incurred in relation to exempt income would be triggered only if the Assessing Officer returns a finding that he is not satisfied with the correctness of the claim of the assessee in respect of such expenditure. Therefore, the condition precedent for the Assessing Officer entering upon a determination of the amount of the expenditure incurred in relation to exempt income is that the Assessing Officer must record that he is not satisfied with the correctness of the claim of the assessee in respect of such expenditure. Sub-section (3) is nothing but an offshoot of sub-section (2) of Section 14A. Sub-section (3) applies to cases where the assessee claims that no expenditure has been incurred in relation to income which does not form part of the total income under the said Act. In other words, sub-section (2) deals with cases where the assessee specifies a positive amount of expenditure in relation to income which does not form part of the total income under the said Act and sub-section (3) applies to cases where the assessee asserts that no expenditure had been incurred in relation to exempt income. In both cases, the Assessing Officer, if satisfied with the correctness of the claim of the assessee in respect of such expenditure or no expenditure, as the case may be, cannot embark upon a determination of the amount of expenditure in accordance with any prescribed method, as mentioned in sub-section (2) of Section 14A of the said Act. It is only if the Assessing Officer is not satisfied with the correctness of the claim of the assessee, in both cases, that the Assessing Officer gets jurisdiction to determine the amount of expenditure incurred in relation to such income which does not form part of the total income under the said Act in accordance with the prescribed method. The prescribed method being the method stipulated in Rule 8D of the said Rules. While rejecting the claim of the assessee with regard to the expenditure or no expenditure, as the case may be, in relation to exempt income, the Assessing Officer would have to indicate cogent reasons for the same.

Rule 8D
31. It is, therefore, clear that determination of the amount of expenditure in relation to exempt income under Rule 8D would only come into play when the Assessing Officer rejects the claim of the assessee in this regard. If one examines sub-rule (2) of Rule 8D, we find that the method for determining the expenditure in relation to exempt income has three components. The first component being the amount of expenditure directly relating to income which does not form part of the total income. The second component being computed on the basis of the formula given therein in a case where the assessee incurs expenditure by way of interest which is not directly attributable to any particular income or receipt. The formula essentially apportions the amount of expenditure by way of interest [other than the amount of interest included in clause (i)] incurred during the previous year in the ratio of the average value of investment, income from which does not or shall not form part of the total income, to the average of the total assets of the assessee. The third component is an artificial figure – one half percent of the average value of the investment, income from which does not or shall not form part of the total income, as appearing in the balance sheets of the assessee, on the first day and the last day of the previous year. It is the aggregate of these three components which would constitute the expenditure in relation to exempt income and it is this amount of expenditure which would be disallowed under Section 14A of the said Act. It is, therefore, clear that in terms of the said Rule, the amount of expenditure in relation to exempt income has two aspects – (a) direct and (b) indirect. The direct expenditure is straightaway taken into account by virtue of clause (i) of sub-rule (2) of Rule 8D. The indirect expenditure, where it is by way of interest, is computed through the principle of apportionment, as indicated above. And, in cases where the indirect expenditure is not by way of interest, a rule of thumb figure of one half percent of the average value of the investment, income from which does not or shall not form part of the total income, is taken.

Do sub-sections (2) and (3) of Section 14A and Rule 8D apply retrospectively ?
35. We are of the view that Rule 8D would operate prospectively. ………….. It is, therefore, clear that Rule 8D, which was introduced by virtue of the Notification No.45/2008 dated 24.03.2008, was prospective in operation and cannot be regarded as being retrospective. We may also point out that we have had the benefit of the decision of the Bombay High Court in Godrej and Boyce Mfg. Co. Ltd v DCIT: (2010) 328 ITR 81 (Bom), wherein it has, inter alia, been held that the provisions of Rule 8D of the said Rules has prospective effect and shall apply with effect from assessment year 2008-09 onwards.

40. From the above discussion, it is clear that, in effect, the provisions of subsections (2) and (3) of Section 14A would be workable only with effect from the date of introduction of Rule 8D. This is so because prior to that date, there was no prescribed method and sub-sections (2) and (3) of Section 14A remained unworkable

How is Section 14A to be worked for the period prior to the introduction of Rule 8D?
So, even for the pre-Rule8D period, whenever the issue of section 14A arises before an Assessing Officer, he has, first of all, to ascertain the correctness of the claim of the assessee………… he shall have to reject the claim and state the reasons for doing so. Having done so, the assessing officer will have to determine the amount of expenditure incurred in relation to income which does not form part of the total income under the said Act. He is required to do so on the basis of a reasonable and acceptable method of apportionment.

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