A significant change proposed in the current Union Budget relates to the disallowance of deduction of interest expenditure incurred on borrowings used for earning dividend income or income from units of mutual funds. The proposal seeks to amend Section 93(2) of the Income-tax Act, 2025, and is intended to come into effect from 1 April 2026.
1. Earlier Legal Position
Historically, dividend income was entirely exempt from tax in the hands of shareholders. However, after the abolition of the Dividend Distribution Tax (DDT) regime, dividend income became taxable directly in the hands of shareholders under the head “Income from Other Sources.”
Under the earlier provisions and the amendments introduced in 2021, interest expenditure incurred on borrowings taken for the purpose of investing in shares or mutual fund units was allowed as a deduction under Section 57(i). However, such deduction was restricted to a maximum of 20% of the dividend income.
In practical terms, if an investor had borrowed funds to purchase shares or mutual fund units and paid interest on such borrowings, the interest expense could be deducted from the dividend income to the extent of 20% of the total dividend income while computing taxable income.
2. Proposed Amendment – What is New?
The proposed amendment seeks to provide that no deduction whatsoever shall be allowed in respect of interest expenditure incurred on borrowings used for earning dividend income or income from mutual fund units.
In other words, even if an investor has borrowed funds for investment in shares or mutual funds and has incurred interest expenditure on such borrowings, such interest will not be deductible from the dividend income in any manner.
Thus, dividend income will be taxed in full, without allowing any deduction towards interest cost incurred for earning such income.
3. Rationale and Implications
From the Government’s perspective, certain investors were undertaking large-scale leveraged investments and claiming deduction of interest expenses to reduce their taxable income. Such practices resulted in tax arbitrage and erosion of the tax base, thereby causing revenue loss to the Government.
The complete withdrawal of interest deduction on dividend and mutual fund income is therefore intended to simplify the tax system and augment tax revenues.
However, from the perspective of investors, the measure may appear stringent and somewhat inequitable. In business activities, interest expenditure on borrowed funds is generally allowed as a deductible expense. In contrast, in the case of personal investments, such deduction is now proposed to be denied entirely.
Another area requiring clarity is whether this restriction will apply uniformly to all entities such as Hindu Undivided Families (HUFs), trusts, and Limited Liability Partnerships (LLPs).
A fundamental principle of taxation is that tax should be levied on real income. If expenses incurred for earning income are not allowed as deductions, the taxation effectively shifts from net income to gross income, which may contradict the underlying concept of real income.
The Supreme Court of India has, in several decisions, emphasized that where there is a direct nexus between expenditure and income, denial of deduction may not be justified. Therefore, if the interest expense is directly attributable to earning dividend income, complete disallowance could potentially be viewed as inconsistent with the “Real Income Theory.”
4. Advantages of the Proposed Change
(1) Simplification of the Tax System
The earlier framework involving the 20% cap, verification of interest claims, and examination of nexus between borrowing and investment created administrative complexity. The proposed change eliminates these complications.
(2) Control over Aggressive Tax Planning
High Net Worth Individuals (HNIs) often utilized leveraged investment strategies to minimize tax liability. The amendment is expected to curb such aggressive tax planning practices.
(3) Increased Government Revenue
By disallowing interest deductions, the taxable base increases, leading to higher tax collections.
(4) Reduction in Speculative Leveraged Investments
The measure may discourage excessive borrowing for speculative investment in equity markets, thereby promoting more prudent financial behavior.
5. Disadvantages of the Proposed Change
(1) Perceived Double Tax Impact
Tax will be payable on the entire dividend income without considering the interest cost incurred for earning such income, which may appear economically unfair.
Example:
Dividend income: ₹10,00,000
Interest expenditure: ₹8,00,000
Earlier: Deduction allowed up to 20% → taxable income could be reduced.
Now: Entire ₹10,00,000 becomes taxable, even though the actual net income is only ₹2,00,000.
(2) Adverse Impact on Investors
Middle-class investors who occasionally invest through borrowed funds or structured investments may face higher tax liability.
(3) Potential Impact on the Mutual Fund Industry
Leveraged investment strategies may decline, which could indirectly affect certain segments of the investment industry.
(4) Inconsistency between Business and Personal Investments
Interest expenditure remains deductible in business operations but is disallowed in personal investment activities, creating an apparent inconsistency in tax treatment.
6. Practical Issues and Limitations
(1) Determination of Purpose of Borrowing
If a single loan is used partly for business purposes and partly for investment purposes, determining the exact allocation of interest may become contentious.
(2) Treatment in Capital Gains Cases
If borrowed funds are used to purchase shares that are later sold and result in capital gains, whether interest expenditure will be considered while computing capital gains remains unclear.
(3) Applicability to Various Entities
Clarification is required regarding whether the restriction will apply uniformly to HUFs, trusts, LLPs, and other entities.
7. Judicial Perspective
Indian courts, including the Supreme Court, have repeatedly emphasized that:
- Where there exists a direct nexus between expenditure and income, deduction should ordinarily be allowed.
- Taxation should be based on real income rather than notional or gross income.
Therefore, a complete prohibition on interest deduction, particularly where the borrowing is directly linked to dividend income, may raise questions from the standpoint of the Real Income Doctrine.
8. Making the Law More Complicated
The Finance Ministry is simplifying the provisions of the income-tax law. However, in the present context, the amendment appears to make the law more complex rather than simpler.
Under the proposed provision, interest on loans taken for personal investment in shares or mutual funds will not be allowed as a deduction, whereas interest on borrowings used for business purposes will continue to be allowed as a deductible expenditure. Since the restriction applies only to personal investments and not to business borrowings, the allowability of deduction will now depend upon the nature and purpose of the borrowing and the investment made therefrom.
This distinction introduces additional complexity into the law. Tax authorities will be required to examine whether the borrowing was taken for business purposes or personal investment, and in many cases, funds may be utilized partly for both purposes. Such situations will inevitably lead to interpretational issues, disputes, and administrative difficulties in determining the correct tax treatment.
Consequently, instead of simplifying the law, the amendment may actually increase compliance burdens and litigation, as the determination of the purpose and utilization of borrowed funds becomes a critical factor in deciding the allowability of interest expenditure.
9. Was a More Balanced Approach Possible?
Instead of a complete prohibition, a more balanced approach could have been adopted, such as:
- Reducing the deduction limit from 20% to 10%, or
- Allowing deduction based on actual net income, or
- Restricting deduction only in cases involving large or leveraged borrowings.
A complete ban may therefore appear to be an excessively stringent measure.
10. Possible Balanced Alternatives
Some practical alternatives could include:
- Allowing deduction of interest expenditure up to a limited percentage of dividend income.
- Providing relief for small investors.
- Restricting deductions only where borrowings exceed a specified threshold.
11. Conclusion
The proposal to completely disallow deduction of interest on borrowings used for earning dividend and mutual fund income may help the Government simplify the tax regime and increase revenue collection. However, from the standpoint of investors, the measure may appear harsh and somewhat inequitable.
The fundamental principle of taxation is that tax should be levied on real net income. If expenses incurred to earn income are not allowed as deductions, taxation effectively shifts from net income to gross income, which may raise conceptual and practical concerns.
Therefore, while the amendment is not entirely unjustified, it might have been implemented in a more balanced and pragmatic manner, ensuring both revenue protection for the Government and fairness for taxpayers.
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