Baroda Cpe Study circle 30 th August, 2011

CA. RAHUL PARIKH 1

BARODA CPE STUDY CIRCLE 30 th AUGUST, 2011

ISSUES ON SECTION 14A

CA. RAHUL PARIKH

HISTORY OF SECTION 14A

The Net Income Principle

Any Income earned during any year, must always be taxed on a net basis i.e. Gross Income minus the expenditure incurred for earning such income.

Conversely, another principle emerges

That any expenditure which was incurred to earn an income which was exempted on a gross basis would automatically be non-deductible.

Basic

Principles

of

Taxation

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Supreme Court held otherwise in:

Indian Bank Ltd. 56 ITR 77 Maharashtra Sugar Mills Ltd. 82 ITR 452 Rajasthan Sate Warehousing Corp Ltd. 242 ITR 450

The Supreme Court held:

1) Where a business consisted of two parts, one which generated taxable income and the second which generated exempted income and if the business by itself was indivisible

2) Then, Entire expenditure which is incurred wholly for the purpose of business would be deductible, even if part of such expenditure could reasonably be apportioned to the exempt income

Section 14A

History

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To over- r ide the s a id pos iti on, Se cti on 1 4A int roduced by F inance A ct , 2 001 wi th ret rospecti ve effec t f rom 1/4 /19 61.

Section 14A read as under:

For the purposes of computing the total

income under this Chapter, no deduction shall

be allowed in respect of expenditure incurred

by the tax payer in relation to income which

does not form part of the total income under

this Act.

Section

14A (1)

Section 14A

History

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Prov iso to S ecti on 14A introduc ed by F inance A c t , 200 2

Proviso provided that Assessing Officers shall not be entitled to reassess under Section 147 or rectify any order Section 154 in order enhance the income on account of Section 14A for any assessment year prior to 1st April, 2001.

Proviso introduced in order to mitigate hardship caused to Assessees, whose settled cases were reopened on account of retrospective nature of Section 14A

Proviso however did not cover assessments which had not achieved finality on account of appeals or any other pending proceedings.

Proviso

to

Section

14A

Section 14A

History

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S u b - s e c ti o n ( 2 ) a n d ( 3 ) t o S e c ti o n 1 4 A i n t r o d u c e d b y F i n a n c e A c t , 2 0 0 6 w i t h e ff e c t f r o m AY 2 0 0 7 - 0 8 ,

The sub-sections read as under:

(2) The Assessing Officer shall determine the amount of expenditure incurred in relation to such income which does not form part of the total income under this Act in accordance with such method as may be prescribed, 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 this Act.

(3) The provisions of sub-section (2) shall also apply in relation to a case where an assessee claims that no expenditure has been incurred by him relation to income which does not form part of the total income under this Act.

Section 14A

Sub-Section

(2) & (3)

Section 14A

History

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B a s i s o f D i s a l l o w a n c e u n d e r S e c ti o n 1 4 A , w h e n n o m e t h o d p r e s c r i b e d

Since, no methods were prescribed upto 24th March, 2008, ad-hocism in disallowance continued.

In Dhanlaxmi Bank Ltd. 2 SOT 625, Cochin Tribunal held that since method of working out disallowance of the expenditure is not prescribed, no disallowance is permissible

A contrary view has been taken by Bombay High Court in Godrej & Boyce Manufacturing Company Ltd. 234 CTR 1, where it was held

a) Even in absence of sub section (2) and (3), the AO was not precluded from making apportionment and eventual disallowance u/s 14A. In fact, such apportionment would be necessary to give effect to the substantive provisions of sub-section (1) of Section 14A.

b) In absence of sub section (2) and (3) or prior to Rule 8D, the AO is entitled to make a disallowance u/s 14A any reasonable method.

Section 14A

History

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I n t r o d u c ti o n o f R u l e 8 D

Introduced on 24th March, 2008

Rule 8D essentially provided the AO with a 3 part formula to determine disallowance under Section 14A, where he is satisfied that the required expenditure has not been disallowed under Section 14A by the Assessee suo-moto in his Return of Income

Rule

8D

Section 14A

History

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Method prescr ibed under Rule 8D

The disallowance under Section 14A shall be the aggregate of following 3 parts:

1) Any Expenditure which is directly related to an exempt income

2) Interest, which is not directly attributable to any particular income or receipt, calculated by the following formula: A * (B/C), where

A = Interest other interest included in (1) above

B = Average of Opening and Closing Investments, which are source of exempted Income

C = Average of Opening and Closing Total Assets.

3) 0.5% of Average of Opening and Closing Investments

Rule 8D

Method

Section 14A

History

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Appl icabi l i ty – Retrospective or Prospective ?

Mumbai Tribunal in Daga Capital Management Pvt. Ltd. 26 SOT 603 held the applicability of Rule 8D to be retrospective as Rule 8D was purely procedural in nature.

Bombay High Court over-ruled Mumbai Tribunal in Godrej & Boyce Manufacturing Company Ltd. 234 CTR 1 and clarified that Rule 8D would only have prospective effect from AY 2008-09.

Rule 8D

Applicability

Rule 8D Issues

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When can Rule 8D by invoked by AO ?

The AO cannot straight away resort to Rule 8D Sub-Section 2 of Section 14A and Rule 8D(1), both require

the AO to first consider the books of accounts of the taxpayer before resorting to Rule 8D.

The AO must arrive at an objective satisfaction that the Assessee’s claim is incorrect.

Bombay High in Godrej & Boyce Manufacturing Company Ltd. 234 CTR 1 has held that for objective satisfaction, following would be required from the AO:

a) Notice by the AO to the Assessee to present his facts and justify his claim

b) Recording of his reasons for arriving at a conclusion that the Assessee’s claim is not justified

Rule 8D

Applicability

Rule 8D Issues

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Which Interest is e l ig ib le for d isal lowance?

Interest which is directly attributable to borrowed funds used for the purpose of earning taxable income or receipt is out of the purview of Rule 8D.

For the purpose of computing proportionate disallowance of Interest under Rule 8D, only interest which is not attributable to any particular income or receipt is to be included

Interest which is already disallowed u/s 43B or 36(1)(iii) cannot be again disallowed u/s 14A.

Rule 8D

Applicability

Rule 8D Issues

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Computation of Average Investments

Only investments, which are source of exempted income to be considered for Part 2 and Part 3 of Rule 8D method.

Method fails in following two circumstances:

1) Opening and Closing values of Investments are Nil, though there is holding through the year

2) Where investments are treated as Stock in trade

A ground can be taken that in view of the judgment of the Supreme Court in B. C. Sriniwas Shetty 128 ITR 284, that once the computation mechanism fails, so does the charging section and hence disallowance u/s 14A is not possible

Rule 8D

Applicability

Rule 8D Issues

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Computation of Average Total Assets

Total Assets refers to value of all Assets reflected in the Balance Sheet and hence would not include any of the following:

a) Preliminary Expenses or Deferred Revenue Expenses not written off

b) Deferred Tax Assets

c) Debit Balance of Profit & Loss Account

Whether Current Assets to be included in Total Assets are Net Current Assets or Gross Current Assets ? Logic would dictate that since words used are Total Assets, Gross Current Assets would be included.

Rule 8D

Applicability

Rule 8D Issues

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I s d isal lowance u/s 14A poss ib le, where there is no exempt income ?

Mumbai Tribunal in Lafarge India Holding (P) Ltd. Taxcorp (ITAT) 17086 held that if no dividend income is earned during the year, there can be no disallowance under Section 14A

Chennai Tribunal in Siva Industries & Holdings Ltd. (ITA no. 2148 / Mds / 2010) also similarly held that for the applicability of sec.14A there must be

(1) income which is taxable under the Act for the relevant assessment year and

(2) there should also be income which does not form part of the total income under the Act during the relevant assessment year.If either one is absent, then sec. 14A(1) has no applicability.

Decisions in

favour of

Assessee

Section 14A

issues

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CA. RAHUL PARIKH

I s d isal lowance u/s 14A poss ib le, where there is no exempt income ?

Delhi Tribunal in Cheminvest Ltd. 317 ITR 86 and Everplus Securities and Finance Ltd. 285 ITR 112 has held that as long as expenditure is incurred on a source of exempt income, whether income is earned or not earned is not material, such expenditure ought to be disallowed.

The Delhi Tribunal has drawn its conclusions from a converse principle drawn from the Supreme Courts’ landmark judgment in Rajendra Prasad Moody 115 ITR 522. In Rajendra Prasad Moody, the Supreme Court held that interest on monies borrowed for purchase of shares was allowable as deduction u/s 57(iii) irrespective of whether or not there is any yield of dividend from such shares.

Decisions

against

Assessee

Section 14A

issues

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Owned Funds v/s Borrowed Funds?

Can an Assessee claim that investments have been made entirely from Owned Funds, which are non-interest bearing and hence no disallowance u/s 14A is justified ?

Is mere presence of Owned Funds in excess of Investments on the Balance Sheet enough or does a direct nexus between investments and interest free funds needs to be proved ? On whom does the onus of proof lie ?

Principle laid out by Supreme Court in Munjal Sales Corporation 298 ITR 298 can be of important consideration:

Where the opening balance of profits of the firm exceeds the loans given to sister concerns, then it is presumed that the said loans are given out of its own funds.

Issues

involved

Section 14A

issues

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Delhi Tribunal in Maruti Udyog Ltd. 92 ITD 119 had held that where sufficient own funds of the assessee were available for making investment, it cannot be assumed that any part of investment producing the tax free income must have been from borrowed funds unless there is evidence to show that any specific investment has been made from borrowed funds.

The Mumbai Tribunal in Faze Three Exports Ltd. v. Add. CIT (ITA no. 7701/Mum/2004 (AY 2001-02) and 4677/Mum/2005 (AY 2002-03) relying on the decision of the Hon. Supreme Court in Munjal Sales Corporation v. CIT 298 ITR 298 (SC) 2008 had held that no disallowance u/s 14A was justified when sufficient interest free funds were available to cover the investments in equity shares.

Decisions in

favour of

Assessee

Section 14A

issues

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The Bombay High Court in Reliance Utilities and Power Ltd. 313 ITR 340 held that If there be interest free funds available to an assessee sufficient to meet its investments and at the same time the assessee had raised a loan it can be presumed that the investments were from the interest free funds available.

The Bombay High Court has drawn the above conclusion based on the Supreme Court judgment in East India Pharmaceutical Works 224 ITR 627.

Decisions in

favour of

Assessee

Section 14A

issues

19

CA. RAHUL PARIKH


Mumbai Tribunal in Daga Capital Management Pvt. Ltd. 26 SOT 603 held that all disallowances u/s 14A ought to be strictly computed as per Rule 8D irrespective of the fact that whether interest free funds are available or not.

The Bombay High Court in Godrej & Boyce Manufacturing Company Ltd. 234 CTR 1 held that

1) The judgment in Reliance Utilities shows that there were interest free owned funds available and not merely reserves.

2) The real enquiry is whether there are interest free funds available on the assets side and in the absence of sufficient proof of available interest free funds, no such presumption can be drawn. Moreover, it has been urged that after the introduction of Section 14A(1), no such presumption can in any event be drawn, since Parliament expressly requires apportionment.

Decisions

against

Assessee

Section 14A

issues

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Punjab and Haryana High Court in Hero Cycles Ltd. 323 ITR 518, held that:

a) If the investment in the shares is out of the non-interest bearing funds, disallowance u/s. 14A of the Act is not sustainable;

b) The contention of the revenue that directly or indirectly some expenditure is always incurred which must be disallowed u/s. 14A of the Act cannot be accepted;

c) Disallowance u/s. 14A of the Act requires a finding of incurring of expenditure. If it is found that for earning exempt income, no expenditure has been incurred, disallowance u/s. 14A of the Act cannot stand;

d) The contention of the revenue that even if the assessee has made investments in shares out of its own funds, the said own funds are merged with the borrowed funds in a common kitty and, therefore, disallowance u/s. 14A of the Act can be made is also not justified.

Some more

Recent

Decisions in

favour of

Assesseee

Section 14A

issues

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CA. RAHUL PARIKH


The Mumbai Tribunal in Godrej Industries Ltd. (ITA no. 1090 / Mum / 09) held that the Assessee had sufficient own funds in the form of own capital and reserve to make the investments. The Tribunal also considered the Fund Flow Statement presented to observe that the Assessee had generated sufficient funds from its own operations to make investments and thus disallowance u/s 14A is not justifiable.

The Mumbai Tribunal in Godrej Agrovet Ltd. (ITA no. 1629 /Mum/09) accepted the assessee’s plea that since it was maintaining a separate current account with a bank for parking its surplus funds and had only used the same for the purpose of making investments, no disallowance ought to be made under Section 14A.

Some more

Recent

Decisions in

favour of

Assesseee

Section 14A

issues

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The Supreme Court in Walfort Share and Stock Pvt. Ltd. 326 ITR 1 has held that for attracting the provisions of Section 14A, there has to be a proximate cause for disallowance which is its relationship with the tax exempt income. Hence, even if the tax payer has interest bearing borrowed funds, for disallowing the interest expenditure under Section 14A, the AO has to establish the relationship of the expenditure with the exempt income. In absence of it, no disallowance can be made under Section 14A.

This judgment, firmly puts the onus of proving the nexus between interest bearing borrowed funds and investments on the AO, before he can invoke Section 14A.

Some more

Recent

Decisions in

favour of

Assesseee

Section 14A

issues

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CA. RAHUL PARIKH

14A appl icabi l i ty v iz Shares held as Stock in Trade ?

Can disallowance u/s 14A be attracted in cases, where trading in equity shares is a business activity and dividend income is merely incidental ?

Mumbai Tribunal in Mukund Global Finance Ltd. v. DCIT held that Interest on borrowed funds invested in trading of Shares and kept as Stock in Trade deserves to be allowed as revenue expenditure and no disallowance under Section 14A would be justified even though exempt dividend income is earned from shares held as stock in trade.

Kerala High Court in Smt. Leena Ramchandrani ITA no. 1784 of 2009 has held that interest on borrowed funds utilized for acquisition of shares held as stock in trade would be eligible for deduction u/s 36(1)(iii).

Decisions in

favour of

Assesseee

Section 14A

issues

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Mumbai Tribunal in Daga Capital Management Pvt. Ltd. 26 SOT 603, where the Special Bench of Mumbai Tribunal while considering a similar question held that Sub-section (1) of Section 14A provides in unequivocal terms for not allowing deduction in respect of expenditure incurred by the assessee in relation to exempt income….. There is hardly anything to infer, that the legislature intended to immune the expenditure in relation to incidental exempt income from the operation of Section 14A. There is no exception for not considering any income which is not exempt from tax, bet it main or incidental.

Decisions

against

Assesseee

Section 14A

issues

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Bombay High Court in Godrej & Boyce Manufacturing Company Ltd. 234 CTR 1, while dealing with a similar question held that Dividend income being exempt under section 10(33), the expenditure incurred in relation to earning such income cannot be allowed under Section 14A, whether the shares are held as investments or as stock in trade will not have any impact on applicability of Section 14A so long as dividend income which does not form part of the total income under the Act is earned from the shares

Decisions

against

Assesseee

Section 14A

issues

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14A appl icabi l i ty v iz Share in Profits of a F i rm

The Mumbai Trbunal in Hitesh D. Gajaria ITA No. 993/Mum/2007 (AY 2003-04) held that

share in profits of the Firm is exempt from tax u/s 10(2A) not in the absolute sense. It is only to avoid double taxation, once in the hands of the firm and secondly in the hands of the partner. Therefore, we find that the provisions of Section 14A would not apply to the assessee / partner and it is not necessary for the Assessing Authority to disallow the proportionate expenditure form the claim of the Assessee. Section 14A is not applicable in the case.

Decision in

favour of

Assesseee

Section 14A

issues

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14A appl icabi l i ty v iz Share in Profits of a F i rm

The Mumbai Trbunal in Dharamsingh M. Popat, the Tribunal held that

Firm pays tax on its profits in its own capacity and not on behalf of the parthers. The tax so paid is not available as credit to the partners. Further, partner’s share in such profits is exempt from tax and hence would be regarded as tax free income in the hands of the partner even though the firm has paid tax thereon.

Decision

against

Assesseee

Section 14A

issues

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Penalty on disal lowance u/s 14A

The Supreme Court in Reliance Petroproducts (P) Ltd. 230 CTR 320, while considering the issue of penalty on account of disallowance u/s 14A held that

The argument of the revenue that submitting an incorrect claim for expenditure would amount to giving inaccurate particulars of such income is not correct. By no stretch of imagination can the making of an incorrect claim in law tantamount to furnishing inaccurate particulars. ……If the contention of the Revenue is accepted then in case of every Return where the claim made is not accepted by the AO for any reason, the tax payer will invite penalty u/s 271(1)(c).

Decision in

favour of

Assessee

Section 14A

issues

29

CA. RAHUL PARIKH

Penalty on disal lowance u/s 14A

Delhi Tribunal in the case of Nalwa Investments Ltd. ITA no. 3805 / Del /2010 held thatThe section, as it existed at the time of filing the return, does contain a provision for disallowance of expenditure which is related to non-taxable income. Therefore, it is expected of any assessee to attempt at segregating expenditure which is related to such a claim. No attempt has been made in this behalf. However, it is also a fact that such segregation is beset with lot of problems as the issue has finally been laid to rest by introduction of Rule 8D in the Income-tax Rules in the year 2008. The assessee did not have benefit of this rule when it filed the return of income. Therefore, even in absence of any attempt on the part of the assessee, it can be said that questions of disallowance and its quantification are quite disputable and can lead to bona fide difference in opinion between the assessee and the authorities. In such a situation, the levy of penalty will not be justified.

Decision in

favour of

Assessee

Section 14A

issues

30

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SUMMARY

The law on Section14A can still be considered as a young law.

Most of the judicial precedents available pertain to a period

prior to introduction of Rule 8D. Even amongst these, there

are severe contradictions and no clear view is possible. One

needs to carefully evaluate one’s own facts, the quantum of

disallowance involved and the risk one is willing to take and

thereafter decide the ground to be taken.

Section 14A

issues

31

The law on Section14A can still be considered as a

young law. Most of the judicial precedents available pertain

to a period prior to introduction of Rule 8D. Even amongst

these, there are severe contradictions and no clear view is

possible. One needs to carefully evaluate one’s own facts,

the quantum of disallowance involved and the risk one

needs to take and thereafter decide the ground to be taken.

THANK YOU

Documents

Baroda Cpe Study circle 30 th August, 2011