No Proportionate Disallowance When Dividend Investments Made From Own Funds: Madras HC

CIT Vs Karur Vysya Bank Ltd. (Madras High Court)

Summary: Madras High Court dismissed seven departmental appeals concerning Karur Vysya Bank for AYs 1994-95, 1996-97, 1997-98 and 1998-99, deciding the substantial questions of law in favour of the assessee. On deduction under Section 80M, the Court accepted that the deduction is ordinarily computed on net dividend income, following Distributors (Baroda) Pvt. Ltd. v. Union of India. However, the assessee had sufficient surplus/own funds to make the investments yielding dividend income. Applying South Indian Bank Ltd. v. Commissioner of Income-tax, the Court held that no proportionate expenditure could be disallowed or estimated where investments were not made from interest-bearing funds.

On bad debts under Sections 36(1)(vii) and 36(1)(viia), the Court followed Catholic Syrian Bank Ltd. v. Commissioner of Income-tax, under which the deductions for actual write-off of bad debts and provision for bad and doubtful debts of rural branches operate distinctly. The relevant questions were consequently answered against the Revenue.

On interest paid on purchase of securities held as stock-in-trade, the Court followed the assessee’s own case and the applicable precedent to hold that expenditure incurred in relation to Government securities treated as stock-in-trade constituted revenue expenditure. The issue concerning proportionate expenditure attributable to tax-free bonds was also answered for the assessee following South Indian Bank Ltd.

For AY 1994-95, the Court held that securities held by the bank constituted stock-in-trade. It also relied upon CBDT Circular No.18 of 2015 dated 02.11.2015, which recognises that investments made by banking concerns form part of banking business. Broken-period interest was held deductible as revenue expenditure, following the assessee’s earlier case and American Express International Banking Corporation v. CIT. All substantial questions were thus answered in favour of Karur Vysya Bank and adverse to the Revenue, and the departmental appeals were dismissed without costs.

Cases Discussed

• Commissioner of Income-Tax vs United General Trust Ltd. (200 ITR 488) (Supreme Court) — Relied upon by the Assessing Authority while deducting proportionate expenditure, including management expenses, in computing deduction under Section 80M.
• Distributors (Baroda) P. Ltd. vs Union of India and others, 155 ITR 120 (Supreme Court) — Followed for the settled principle that deduction under Section 80M is computed with reference to dividend income forming part of gross total income and not the gross dividend received.
• Income Tax Officer v Daga Capital Management Pvt. Ltd. (2009) 312 ITR (AT) 1 (Mumbai) (SB) — Relied upon by the Tribunal for holding that Rule 8D provided a formula for computation of expenses retrospectively and for remitting the issue to the Assessing Authority.
• South Indian Bank Ltd. v. Commissioner of Income-tax [2021] 130 taxmann.com 178 (Supreme Court) — Applied where the assessee had sufficient own funds exceeding investments yielding exempt income; proportionate disallowance was held unwarranted.
• Catholic Syrian Bank Ltd. v. Commissioner of Income-tax, 343 ITR 270 (Supreme Court) — Followed for the distinct and independent operation of deductions for bad debts actually written off and provisions for bad and doubtful debts relating to rural advances.
• Karur Vysya Bank v. Commissioner of Income Tax, TCA.No.509 of 2011 (Madras High Court) — Followed on interest paid on securities held by the bank as stock-in-trade.
• Commissioner of Income-tax v. HDFC Bank Ltd., 173 taxmann.com 580 — Followed in the assessee’s own case on treatment of Government securities as stock-in-trade and related expenditure.
• CIT Vs Nawanshahar Central Cooperative Bank Ltd. [2007] 160 TAXMAN 48 (Supreme Court) — Referred to in CBDT Circular No.18/2015 for the principle that investments made by a banking concern form part of its banking business.
• American Express International Banking Corporation v. CIT, 258 ITR 601 (Bombay High Court) — Followed for allowing broken-period interest as revenue expenditure where securities were held as stock-in-trade.

FULL TEXT OF THE JUDGMENT OF MADRAS HIGH COURT

This is a batch of seven departmental appeals relating to assessment years (AY) 1994-95, 1996-97, 1997-98 and 1998-99 and we have heard Mr.V.Mahalingam, learned Senior Standing Counsel for the revenue/appellant and Mr.R.Vijayaraghavan, learned counsel for Mr.Subbaraya Aiyar, learned counsel for the assessee/respondent.

2. The assessee/respondent is a scheduled bank and several issues arise for resolution in the context of the Income Tax Act, 1961 (in short ‘Act’) in these appeals. The substantial questions of law arising for consideration have been admitted on various dates. Since some questions overlap, we decide each question of law indicating alongside the assessment years and Tax Case (appeal) numbers in which that issue arises for consideration.

3. Substantial question of law arising in TC(A).Nos.290 of 2010 (A.Y.1996-97), 291 of 2010 (A.Y.1997-98) and 292 of 2010 (A.Y.1998-99) and admitted on 28.06.2010:

Whether on the facts and in the circumstances of the case, the Income Tax Appellate Tribunal was right in holding that the deduction u/s 80M should be worked out applying Rule 80D read with Section 14A without appreciating that it was not applicable for the dividend income for the Assessment Year under consideration, instead of upholding the Assessing Officer’s action in working out the expenditure to be deducted on the basis of the Supreme Court’s decision in 200 ITR 478?

4. The Assessing Authority, while considering the grant of deduction under Section 80M of the Act, proceeded on net basis, in granting deduction of expenditure proportionate to the total income. The total income determined as taxable was a sum of Rs.63.22 Crores (approx.), and dividend received from Corporate Companies was Rs.37,06,331/-. Relief under Section 80M was allowed on net income and proportionate expenses relating to dividend income was disallowed.

5. The Assessing Authority relied on the judgment of the Supreme Court in the case of Commissioner of Income-Tax vs United General Trust Ltd¹ and in deducting proportionate expenses and taking into account management expenses as well. As the proportionate expenditure was of a sum of Rs.31,35,470/-, the deduction was computed using the following formula, and the relevant portion of the assessment order reads thus:

‘3706331
————— X 1770524044 = Rs.31,35,471
2092875007

The balance of net income from dividend Rs.5,70,860.
60% thereon works out to Rs.3,42,516. This will be
allowed as deduction u/s 80M.

6. In first appeal, the assessee assailed the aforesaid restriction, being of the view that no expenditure ought to have been deducted at all. The Commissioner of Income Tax (Appeals) (in short, CIT(A)) takes a tangential view. While accepting the position that it would not be proportionate expenses that would have to be disallowed, he estimates the expenditure at 2% of the dividend. The findings of the CIT(A) are as follows:

12.3. I have carefully considered the submissions thus made by the appellant. This issue too has been discussed at length in the appellate order for the assessment year 1990-91. It has been held in the said order that the stand taken by the Assessing Officer that deduction u/s 80M could be allowed only in respect of the net dividend is correct. In the case of Distributors (Baroda) P. Ltd. vs Union of India and others, 155 ITR 120, the Hon’ble Supreme Court had categorically held that the deduction required to be allowed under the provisions of section 80M(1) had to be calculated with reference to the amount of dividend computed in accordance with the provisions of the Act and forming part of the gross total income, and not with reference to the full amount of dividends received by an assessee. Therefore, there is no scope for any debate that deduction u/s 80M will have to be computed only with reference to net dividends and not the gross. The appellant’s argument that in the case of Commissioner of Income-tax vs Union General Trust Ltd. 200 ITR 488, only managerial expenses had been held to be netted from the gross dividends is not correct. The only issue before the Hon’ble Court in the above case was whether any portion of the managerial expenses could be attributed to dividends and accordingly could be deducted from the gross dividends in order to arrive at the net dividends. The court did not have any occasion to look into the other expenses. It was only in this context that the Hon’ble Court had ruled on the deductibility of managerial expenses alone.

12.4. In view of the foregoing, I would hold that the Assessing Officer was perfectly justified in considering disallowance of expenses with reference to the dividends claimed for deduction u/s 80M. However, the moot question is how much of the expenses could be said to have been incurred by the appellant for earning the dividends. Only such expenditure as could be related to the dividends on the ground of having been wholly and exclusively laid out could be disallowed u/s 57(iii). Earlier on, while dealing with the subject of proportionate disallowance of expenses relatable to interest on tax-free securities, it has been seen that the appellant had substantial interest-free funds at its disposal and, therefore, no part of the interest-bearing borrowals could be said to have been used for making investments in shares. In the circumstances, no financial expenditures could be attributed to the dividends claimed u/s 80M. Coming to the managerial expenses, I find merit in the appellant’s submission that as the dividend warrants involved were negligible in number and the vouchers transacted were also very few, the managerial expenses attributable would also be negligible. However, as the appellant itself has offered the attributable expenses to be taken at 2% of the dividends, which offer must be regarded as reasonable, the attributable expenses are hereby directed to be taken at 2% of the dividends. The Assessing Officer shall recompute the deduction admissible to the appellant u/s 80M accordingly.

7. As against the aforesaid conclusion of the CIT(A), cross appeals were filed by both the assessee as well as the revenue before the Income Tax Appellate Tribunal. The Tribunal relying on the decision of the Special Bench of the Income Tax Appellate Tribunal, Bombay in Income Tax Officer v Daga Capital Management Pvt. Ltd.², held that Rule 8D provided for a formula for computation of expenses retrospectively, and remitted the matter to the file of the Assessing Authority with a direction to follow the decision of the Special Bench and decide the matter in accordance with law.

8. Both the assessee and the revenue had filed Tax Case (Appeals) before this Court. The assessee’s appeals were numbered as T.C.(A) Nos.509 to 511 of 2010 and by order dated 08.02.2022, the matter stood remanded to the Assessing Officer in light of the judgment of the Supreme Court in South Indian Bank Ltd. v. Commissioner of Income-tax³. Unfortunately, the revenue appeals were not heard along with the assessee’s appeals.

9. The Assessing Authority took the matter up and passed consequential orders on 29.06.2022. Applying the judgment of the Supreme Court in South Indian Bank Ltd⁴, he accepted the claim of the assessee and the discussion reads as follows:

‘It was claimed that the exempted investment held in shares and MF as on 31/03/1996 was Rs.20.86 Cr, from out of total investments of Rs.407 Crores which constitute 5.12% of total investments. The bank was having own funds by way of equity capital of Rs.89 crores and demand deposit of Rs.272 crores. Therefore, equity and demand deposits was more than the investment in exempted investments. Hence, no disallowance is warranted on proportionate expenses on earning exempted income as held by Hon’ble Supreme Court verdicts in South Indian Bank case and requested to delete the addition made. Out of the total disallowance of Rs.22,23,799/-, already an amount of Rs.21,79,323/- was given relief in the giving effect order. Hence, the balance of Rs.44,476/- is to be allowed.’

10. The grant of relief as sought for by the assessee under order dated 29.06.2022 has attained finality and no proceedings for either revision or re-assessment have been initiated by the Department. Technically, therefore, the present appeals are infructuous as the connected revenue appeals have been dismissed as withdrawn on 21.08.2025 on the ground of low tax effect.

11. As far as Section 80M is concerned, the position that deduction is to be computed on net basis only is settled by the judgment of the Supreme Court in the case of Distributors (Baroda) Pvt. Ltd vs Union Of India⁵. This is also clear from the scheme of Chapter VIA of the Income Tax Act 1961. Section 80A provides for computation of relief under various provisions in Chapter VIA based on the computation of total income, wherein the assessee is to reduce such expenditure that has a direct nexus to the earning of the income on which deduction is granted.

12. However, in the present case, the financials of the assessee reveal sufficient surplus funds for making of investments leading to the earning of dividends. The question of restriction of the dividend would thus not arise seeing as the investment has been made, not out of interest bearing funds, but from out of assessee’s own funds.

13. In light of the categoric finding of the assessing authority relating to the sufficiency/adequacy of surplus funds in the assessee’s hands, there is no justification for any disallowance, and in such circumstances, it is not open to the Department to estimate such expenditure. This question is hence answered in favour of the assessee.

14. Substantial question of law arising in TCA.Nos.291 & 292 of 2010 (A.Ys.1997-98 and 1998-99) and admitted on 28.06.2010:

Whether on the facts and in the circumstances of the case, the Income Tax Appellate Tribunal was right in allowing the claim of bad debts without applying the proviso under Section 36(1)(vii) and without appreciating that the provision was a composite one composed of a percentage of total income and a percentage of aggregate advances of Rural Branches of the Bank?

15. Both learned counsel agree that the above issue has been answered against the revenue and in favour of the assessee by a judgment of the Supreme Court in Catholic Syrian Bank Ltd. v. Commissioner of Income-tax⁶. The operative portion of the judgment reads as follows:

S.H.Kapadia, CJI. – I have gone through the judgment of my esteemed brother Swatanter Kumar, J. and I agree with the conclusions contained therein. However, I would like to give my own reasons.

The question for our consideration is – whether on the facts and circumstances of the case, the assessee(s) is eligible for deduction of the bad and doubtful debts actually written off in view of section 36(1)(vii) which limits the deduction allowable under the proviso to the excess over the credit balance made under clause (viia) of Section 36(1) of Income Tax Act, 1961 (“ITA” for short)?

2. Under Section 36(1)(vii) of the ITA 1961, the tax payer carrying on business is entitled to a deduction, in the computation of taxable profits, of the amount of any debt which is established to have become a bad debt during the previous year, subject to certain conditions. However, a mere provision for bad and doubtful debt(s) is not allowed as a deduction in the computation of taxable profits. In order to promote rural banking and in order to assist the scheduled commercial banks in making adequate provisions from their current profits to provide for risks in relation to their rural advances, the Finance Act, inserted clause (viia) in sub-section (1) of Section 36 to provide for a deduction, in the computation of taxable profits of all scheduled commercial banks, in respect of provisions made by them for bad and doubtful debt(s) relating to advances made by their rural branches. The deduction is limited to a specified percentage of the aggregate average advances made by the rural branches computed in the manner prescribed by the IT Rules, 1962.

Thus, the provisions of clause (viia) of Section 36(1) relating to the deduction on account of the provision for bad and doubtful debt(s) is distinct and independent of the provisions of Section 36(1)(vii) relating to allowance of the bad debt(s). In other words, the scheduled commercial banks would continue to get the full benefit of the write off of the irrecoverable debt(s) under Section 36(1)(vii) in addition to the benefit of deduction for the provision made for bad and doubtful debt(s) under Section 36(1)(viia). A reading of the Circulars issued by CBDT indicates that normally a deduction for bad debt(s) can be allowed only if the debt is written off in the books as bad debt(s). No deduction is allowable in respect of a mere provision for bad and doubtful debt(s). But in the case of rural advances, a deduction would be allowed even in respect of a mere provision without insisting on an actual write off.

However, this may result in double allowance in the sense that in respect of same rural advance the bank may get allowance on the basis of clause (viia) and also on the basis of actual write off under clause (vii). This situation is taken care of by the proviso to clause (vii) which limits the allowance on the basis of the actual write off to the excess, if any, of the write off over the amount standing to the credit of the account created under clause (viia). However, the Revenue disputes the position that the proviso to clause (vii) refers only to rural advances. It says that there are no such words in the proviso which indicates that the proviso apply only to rural advances. We find no merit in the objection raised by the Revenue. Firstly, CBDT itself has recognized the position that a bank would be entitled to both the deduction, one under clause (vii) on the basis of actual write off and another, on the basis of clause (viia) in respect of a mere provision. Further, to prevent double deduction, the proviso to clause (vii) was inserted which says that in respect of bad debt(s) arising out of rural advances, the deduction on account of actual write off would be limited to the excess of the amount written off over the amount of the provision allowed under clause (viia). Thus, the proviso to clause (vii) stood introduced in order to protect the Revenue. It would be meaningless to invoke the said proviso where there is no threat of double deduction. In case of rural advances, which are covered by the provisions of clause (viia), there would be no such double deduction. The proviso limits its application to the case of a bank to which clause (viia) applies. Clause (viia) applies only to rural advances. This has been explained by the Circulars issued by CBDT. Thus, the proviso indicates that it is limited in its application to bad debt(s) arising out of rural advances of a bank. It follows that if the amount of bad debt(s) actually written off in the accounts of the bank represents only debt(s) arising out of urban advances, the allowance thereof in the assessment is not affected, controlled or limited in any way by the proviso to clause (vii).

3. Accordingly, the above question is answered in the affirmative, i.e., in favour of the assessee(s). For the above reasons, I agree that the appeals filed by the assessees stand allowed and the appeals filed by the Revenue stand dismissed with no order as to costs.

This question of law is answered in the affirmative and in favour of the assessee.

16. Substantial question arising in TCA.Nos.293, 294 & 295 of 2010 (AY 1996-97, 1997-98, 1998-99) and admitted on 16.08.2010:

Whether on the facts and in the circumstances of the case, the Income Tax Appellate Tribunal was right in holding that the interest paid on purchase of securities amounting to [as follows] should be allowed as deduction on the ground that the assessee bank held the securities as stock-in-trade?

A.Y. 1996-97 : Rs.10,47,58,473/-
A.Y. 1997-98 : Rs. 4,60,73,298/-
A.Y. 1998-99 : Rs. 37,79,675/-

17. The above question has been answered in favour of the assessee in its own case in, Karur Vysya Bank v. Commissioner of Income Tax⁷ following the ratio of the judgment in the case of Commissioner of Income-tax v. HDFC Bank Ltd⁸. The operative portion of the judgment reads as follows:

‘4.The next question of law is as to “whether the Tribunal was right in law in holding that the interest paid on charge of investment is allowable as revenue expenditure disregarding the principle that the interest paid on charge of investments categorized as ‘permanent’ are to be treated as capital expenditure and not as revenue expenditure”. As far this question of law is concerned, the main contention raised by various parties in respect of the Government securities held by the banks are to be treated as stock-in-trade, came up for consideration before this Court and this Court in the decision reported in (2005) 273 ITR 510 (Mad) (supra), by following the decision of the Hon’ble Supreme Court reported in (1999) 156 CTR (SC) 380 : (1999) 240 ITR 355 (SC) (supra), held that those Government securities, which are held by the bank are all stock-in-trade, the security will not be of permanent nature, not a capital expenditure and whatever expenditure incurred in the purchase and the subsequent realisation will all be treated as revenue expenditure. That broad principle on the nature of Government securities has been held to be stock-in-trade and the question now arises in this case is whether the interest paid on charge of investments is allowable as revenue expenditure disregarding the principle that the interest paid on charge of investments categorised as ‘permanent’ is to be treated as capital expenditure and not as revenue expenditure. The Department’s contention that the interest paid on charges of investments cannot be treated as revenue expenditure is not now available when the very Government securities itself is treated to be stock-in-trade as per the decision of this Court. Whatever expenses incurred or interest paid therein on such shares was only revenue expenditure and not a capital expenditure in nature and the Tribunal by following the decision of this Court reported in (2005) 273 ITR 510 (Mad) (supra) and by following the Hon’ble Supreme Court decision reported in (1999) 156 CTR (SC) 380 : (1999) 240 ITR 355 (SC) (supra) has arrived at the conclusion that the interest paid will not be a capital expenditure and only a revenue expenditure. Hence, we hold that the Tribunal’s finding is legal, valid and correct. Therefore, this question is also answered against the Revenue and in favour of the assessee following the above decisions of this Court and the Hon’ble Supreme Court.’

Accordingly, this substantial question is answered in favour of the assessee.

18. Substantial question arising in TCA.Nos.293, 294 & 295 of 2010 (AY 1996-97, 1997-98, 1998-99) and admitted on 16.08.2010:

Whether on the facts and in the circumstances of the case, the Income Tax Appellate Tribunal was right in not dealing with the disallowance of a sum of [as follows] as proportionate expenditure related to tax-free bonds deleted by the Commissioner of Income Tax (Appeals)?

A.Y. 1996-97 :Rs.2,24,38,091/-
A.Y. 1997-98 :Rs.3,35,46,751/-
A.Y. 1998-99 :Rs.7,38,81,028/-

19. As both parties agree that this question is to be answered in favour of the assessee in light of the judgment in South Indian Bank Ltd⁹, this question is answered in favour of the assessee.

20. Substantial question of law arising in TCA.No.663 of 2010 (A.Y.1994-95) and admitted on 30.08.2010:

1. Whether or not the securities held by the assessee bank are stock in trade or capital outlay?

2. Whether the interest paid on the purchase of securities by the assessee bank for the broken period is entitled for deduction or not?

3. Whether it is gross or net dividend/income that is liable for deduction under Section 80M?

21. Adverting to Question No.1, while the assessee states that it is consistently holding the securities purchased by it as stock-in-trade, the Department has taken a contra view that the interest on purchases is to be added to the cost. The Tribunal has answered this issue following the decision in the assessee’s own case in Commissioner of Income Tax v. Karur Vysya Bank Ltd¹⁰.

22. We have also dealt with the same question at paragraphs 16 and 17 above and concluded in favour of the assessee. In addition, CBDT Circular No.18 of 2015, dated 02.11.2015 also supports the case of the assessee, and reads as follows:

‘……….

Subject: Interest from Non-SLR securities of Banks – reg.

It has been brought to the notice of the Board that in the case of Banks, field officers are taking a view that, “expenses relatable to investment in non-SLR securities need to be disallowed u/s 57(i) of the Act as interest on non-SLR securities is income from other sources.”

2. Clause (id) of sub-section (1) of Section 56 of the Act provides that income by way of interest on securities shall be chargeable to income-tax under the head “Income from Other Sources”, if, the income is not chargeable to income-tax under the head “Profits and Gains of Business and Profession”.

3. The matter has been examined in light of the judicial decisions on this issue. In the case of CIT Vs Nawanshahar Central Cooperative Bank Ltd. [2007] 160TAXMAN 48(SC), the Apex Court held that the investments made by a banking concern are part of the business of banking. Therefore, the income arising from such investments is attributable to the business of banking falling under the head “Profits and Gains of Business and Profession”.

3.2 Even though the abovementioned decision was in the context of co-operative societies / Banks claiming deduction under section 80P (2)(a)(i) of the Act, the principle is equally applicable to all banks/commercial banks, to which Banking Regulation Act, 1949 applies.

4. In the light of the Supreme Court’s decision in the matter, the issue is well settled. Accordingly, the Board has decided that no appeals may henceforth be filed on this ground by the officers of the Department and appeals already filed, if any, on this ground before Courts/Tribunals may be withdrawn/ not pressed upon. This may be brought to the notice of all concerned.’

23. Question No. 2 relating to the treatment of broken period interest is to answered in favour of the assessee in light of the judgement of the decision dated 01.02.2017 of this Court in TC(A). Nos. 82 to 828 of 2008 in the assessee’s own case, the relevant portion of which reads as under:

“5. The following question of law, though raised, has not been admitted :-

“Whether, on the facts and in the circumstances of the case, the Income-tax Appellate Tribunal is right, in law, in holding that the broken period interest is to be treated as revenue expenditure?”

6. Both parties would agree that the question is a substantial question of law that merits consideration. Accordingly, we admit the same. The finding of fact is to the effect that securities are held as stock-in-trade and that the income from sale therefrom is offered to tax as revenue. In the light of the admitted facts as seen from the order of the authorities, the expenditure incurred by the assessee towards broken period is liable to be allowed as revenue expenditure. There is no infirmity in the order of the Tribunal in this regard.

7. The question stands answered in favour of the assessee, following the judgment of the Bombay High Court in American Express International Banking Corporation v. CIT (258 ITR 601). The appeals are dismissed. No costs.”

24. Question No.3 relating to deduction under Section 80M is covered in favour of the assessee in light of the judgement in South Indian Bank Ltd.¹¹. In light of the discussion supra, these questions are answered in favour of the assessee and adverse to the revenue.

25. These Tax Case (Appeals) are dismissed. No costs. Connected miscellaneous petition is closed.

Notes:

¹ (200 ITR 488)

² (2009) 312 ITR (AT) 1 (Mumbai)(SB)

³ [2021] 130 taxmann.com 178(SC)

⁴ Foot Note Supra (3)

⁵ (155 ITR 120)

⁶ (343 ITR 270)

⁷ (TCA.No.509 of 2011)

⁸ (173 taxmann.com 580)

⁹ Foot Note Supra (3)

¹⁰ (273 ITR 510)

¹¹ Foot Note Supra (3)