DIRECT TAX ALERT 23 March 2018 Supreme Court upholds decision of Delhi HC in Maxopp Investment, Section 14A applicable even if shares are acquired for controlling interest or held as stock-in-trade BACKGROUND Hon’ble Delhi HC in the case of Maxopp Investment1 had dismissed the ‘dominant purpose test’

wherein it held that irrespective of the fact that the intention of making investments was for gaining controlling interest in investee company and not for earning any dividend or interest income, disallowance u/s 14A is called for on the exempt income earned.

Hon’ble Punjab and Haryana HC in case of State Bank of Patiala2 held that when shares are held as stock-in-trade, the purpose of acquiring such securities was not to earn dividend or interest income, but to earn profits from trading thereon and thus entire expenditure was incurred for trading in those shares and earning business income thereon. Irrespective of whether the securities yielded any dividend or interest income, no expenditure was incurred in relation to the same and thus disallowance u/s 14A is not warranted.

1 Maxopp Investment Ltd –vs.- CIT (2012) 247 CTR 162 (Del) 2 PCIT –vs.- State Bank of Patiala (2017) 391 ITR 218 (P&H )

RULING OF THE SUPREME COURT

Facts

Case I – Maxopp Investment Ltd. Taxpayer is engaged in business of finance, investment and dealing in shares and securities.

It made investments in shares of Max India Ltd. for acquiring and retaining control over them and earned dividend income thereon. Taxpayer did not make any disallowance u/s 14A, as the dominant purpose of investment was for acquiring controlling interest and not to earn dividend income. Since no expenditure was made ‘in relation to’ earning of dividend income, the provisions of Sec. 14A would not be attracted.

The Assessing Officer (‘AO’) worked out disallowance u/s 14A by apportioning the interest expenditure on the basis of amount utilised for investment in share of Max India Ltd., however, he restricted the disallowance to the extent of exempt income earned. CIT(Appeals) upheld AO’s order.

On further appeal, the Income-tax Appellate Tribunal (‘ITAT’) tagged the Taxpayer’s hearing

with the SB hearing in case of Daga Capital Management (Private) Limited3 wherein it was held that investment in shares representing controlling interest did not amount to carrying on of business and therefore, interest expenditure incurred for acquiring shares in group companies was to be hit by provisions of Sec. 14A. The SB held that there existed dominant connection between interest paid on loan utilized for acquiring shares and earning of dividend income.

On further appeal, Hon’ble Delhi HC held that the provisions of Sec. 14A apply regardless of

the intention/motive behind making the investment. Thus, proportionate disallowance of the expenditure is maintained.

Aggrieved, the Taxpayer preferred an appeal before the Apex Court. Case II – State Bank of Patiala Taxpayer held securities as stock-in-trade and earned dividend income thereon. Shares were

purchased for trading and tax free income was only incidental to its share trading business.

AO disallowed expenditure by applying Rule 8D, however, he restricted the disallowance to the extent of exempt income. The CIT(Appeals) however disallowed the entire expenditure as per Rule 8D. On further appeal, the ITAT held that no disallowance u/s 14A can be made if shares were held as stock in trade. The ITAT relied on CBDT Circular4 which states that income arising from investment of a banking concern is attributable to business of banking under the head ‘Profits & Gains of business and profession’.

Further, Hon’ble Punjab & Haryana HC affirmed the ITAT’S view and held that the purpose of

purchase of securities was not to earn exempt income, but to earn profits from its trading and irrespective of whether those securities yielded any exempt income, no expenditure was incurred in relation to the same. Thus, no disallowance u/s 14A can be made.

The Revenue challenged this decision before the Hon’ble Apex Court.

3 ITO –vs.- Daga Capital Management (Private) Limited (2009) 312 ITR (AT) 1 4 Circular No. 18/2015 dated 02-11-2015

Ruling of the Supreme Court The Apex Court disposed off a bunch of appeals in relation to Sec. 14A by a consolidated

order. Apex Court evaluated judgements of Maxopp Investments and State Bank of Patiala and held that dominant purpose for which the investment into shares has been made may not be relevant. Even if investment was made to acquire controlling interest in investee, the fact remains that dividend income from the same is non-taxable. In view of objective of introduction of Sec. 14A as explained by Apex Court in Walfort shares & stock brokers (P) Ltd.5, proportionate expenditure related to earning of dividend income has to be disallowed.

Further, when shares are held as stock-in-trade the main purpose behind that is to earn profits from their trade. In this process, dividend income is also earned, which by virtue of section 10(34) is exempt from tax and thus triggers the applicability of Sec. 14A which is based on the theory of apportionment of expenditure between taxable and non-taxable income.

It is a quirk of fate that when the investee company declared dividend, those shares are held

by Taxpayer, though Taxpayer has to ultimately trade those shares by selling them to earn profits. Thus, the main purpose is to liquidate those shares whenever share price goes up in order to earn profits, hence, it becomes a business activity to deal in those shares. Thus, going by the facts of case in Case II, Revenue’s plea challenging aforesaid judgement was dismissed, however, law in this respect has been clarified.

The Apex Court confirmed the decision of P&H HC in Avon Cycles6 which dismissed

Taxpayer’s appeal and upheld disallowance of proportionate interest expenses considering the facts and finding recorded by lower authorities that investment is made out of mixed funds.

The Apex Court also affirmed that Rule 8D is prospective in nature.

KEY TAKEAWAYS The judgement is likely to impact Promoter Companies who are holding substantial stake in

other companies with a view to acquire controlling interest and thus would directly come under the ambit of disallowance u/s 14A.

Although the Apex Court has affirmed disallowance u/s 14A in case of shares held as stock in trade, it has not specified any method of apportionment of expenses between taxable business income and exempt dividend income. Hence, dispute on this aspect is not likely to be completely resolved.

The Apex Court’s affirmity of Rule 8D being prospective in nature, i.e., w.e.f. AY 2008-09, would help to settle the dispute forever.

5 CIT –vs.- Walfort Shares and stock brokers (P) Ltd. (2010) 326 ITR 1 (SC) 6 Avon Cycles Ltd. –vs.- CIT (ITA no. 277 of 2013 dated 20-08-2014)

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