Loss on dividend stripping transactions cannot be disallowed for years prior to introduction of specific anti-avoidance provisions

Citation : CIT Vs M/s. Walfort Share & Stock Brokers P. Ltd

(Civil Appeal No. 4927 of 2010 arising out of S.L.P. (C) No. 19422 of 2009)

Court: Supreme Court

S. 94(7) was inserted prospectively w.e.f. 1.4.2002 to disallow dividend stripping losses. If the argument of the Revenue that even transactions prior to s. 94(7) can be disallowed is accepted, it will render s. 94(7) redundant and also lead to anomalous results.

Backdrop

Ø Finance Act, 2001 inserted sub-section (7) of section 94 in the Income-tax Act, 1961 (the ITA), with effect from Financial Year (F.Y.) 2001-02, to introduce anti-avoidance provision with respect to dividend stripping transactions. As per the said provision, loss incurred on purchase and sale of securities / units undertaken within the specified period shall be disallowed to the extent of dividend received on such securities / units.

Ø Also, section 14A was introduced by Finance Act 2001 with retrospective effect from F.Y. 1961-62, disallowing any expenditure incurred for earning exempt income.

In this regard, recently the Supreme Court (SC) has examined the issue of loss arising from dividend stripping transaction for years prior to the introduction of the anti-avoidance provision of section 94(7) of the ITA.

Facts

Ø The taxpayer was a member of the Bombay Stock Exchange and earned income from share trading and brokerage. During F.Y. 1999- 2000, the taxpayer purchased units of a Mutual Fund on the record date and earned dividend on the same. As a result of dividend payout, the Net Asset Value of the Mutual Fund stood reduced by that amount.

Ø The taxpayer claimed the dividend received as exempt from tax under the ITA and also claimed the loss incurred on sale of the units as business loss.

Ø The Assessing Officer and the Commissioner of Income-tax (Appeals) rejected the claim of the taxpayer and disallowed the entire loss on the ground that a dividend stripping transaction was not a business transaction but primarily entered into for the purpose of tax avoidance. The so-called loss was an artificial loss created by a pre-designed set of transactions.

Ø On appeal by the taxpayer, the Tribunal upheld the claim of the taxpayer which was confirmed by the High Court. The Revenue filed a Special Leave Petition with the SC.

Issue before the SC:- Whether the loss arising in the course of a dividend stripping transaction prior to introduction of anti-avoidance provision was dis allowable on the ground that such loss was artificial as the dividend stripping transaction was not a business transaction?

Observations and Ruling of SC

Ø The taxpayer received the sale-price as well as dividend. The fact that the dividend received is tax-free is the position recognized under the ITA and use of such provisions cannot be called an “abuse of law”.

Ø Even assuming that the transaction was pre- planned, there was nothing to impeach the genuineness of the transaction. The SC placed reliance on its earlier decision of Azadi Bachao Andolan [2003] 263 ITR 706, where it was held that a citizen is free to carry on its business within the four corners of the law.

Ø Mere tax planning, without any motive to evade taxes through color able devices was not frowned upon even in the case of McDowell & Co. [1985] 154 ITR 148 Accordingly, the losses pertaining to exempt income cannot be disallowed prior to introduction of section 94(7).

Ø As per the provisions of section 94(7), only losses to the extent of dividend received are disallowed. Losses over and above the dividend are allowable even after section 94(7). This shows that Parliament has not treated the dividend stripping transaction as sham or bogus.

Ø The alternative argument of the Revenue that the loss constitutes “expenditure incurred” for earning dividend (a tax-free income) and was liable for dis allowance under section 14A was also not upheld. For attracting section 14A, there has to be a proximate cause for dis allowance, which has relationship with the tax exempt income. This was absent in the present case.

Ø The contention of the Revenue that dividend represented return of investment and hence was liable to be reduced from the cost of acquisition was dismissed on the ground that Accounting Standard 13 provides that interest / dividends received on investments are generally regarded as return on investment and not return of investment.

Ø The cost of acquisition of a security, which includes the price paid for interest / dividend accrued thereon, would be in the nature of capital outlay and it cannot be set-off as expenditure against income accruing on those securities. Reliance in this regard was placed on the decision of the SC in case of Vijaya Bank Vs. Additional Commissioner of Income Tax([1991] 187 ITR 541).

Ø Accordingly, loss arising from dividend stripping transaction taking place prior to F.Y. 2001-02 was allowed.

Key takeaways

Ø The SC ruling confirms that the loss incurred in dividend stripping transactions cannot be disallowed for years prior to the introduction of specific anti-avoidance provisions of the ITA.

Ø The SC has reiterated that a genuine transaction undertaken by the taxpayer to obtain a tax advantage cannot be disregarded and treated as abuse of law if it is within the provisions of the ITA.