This Article summarizes recent decisions Bombay and Kerala High Courts on the issue of disallowance of expenditure incurred in relation to exempt income by way of dividend on shares.

The first ruling is of the Bombay HC in the case of Godrej & Boyce Mfg. Co. Ltd. (Taxpayer) v. DCIT in which it held that (a) The provisions of Section 14A (Section) of the Income Tax Law (ITL) are applicable to dividend income which is exempt in the hands of the shareholder even though such dividend suffers Dividend Distribution Tax (DDT) in the hands of the company. (b) The Section applies where there is proximate relationship between the expenditure and the exempt income. (c) The Section has inbuilt safeguard by way of a requirement of objective satisfaction of the Tax Authority regarding the incorrectness of the taxpayer’s claim before the methodology, prescribed under the Section, can be invoked. (d) The provisions of Sections 14A(2) and 14A(3) (procedural provisions) and Rule 8D, providing for normative methodology of computation of disallowance, are constitutionally valid. (e) The procedural provisions and Rule 8D are prospective in nature and apply from tax year 2007¬08 onwards.

The second ruling is of the Kerala HC in the case of CIT v. Leena Ramachandran (Taxpayerl) in which it held that interest expenditure incurred on acquisition of shares held as investment is covered within the scope of the Section and not allowable as deduction in view of the mandate of the Section.


The Finance Act, 2001 inserted the Section in the ITL, with retrospective effect from 1 April 1962 i.e., from the date of inception of the current ITL. The Section provides that for the purposes of computing total income under Chapter IV of the ITL, no deduction shall be allowed in respect of expenditure incurred by a taxpayer, in relation to the exempt income.

The Finance Act, 2006 further amended the Section with effect from 1 April 2007 to include the procedural provisions providing that the amount of disallowance will be computed as per a prescribed methodology where the Tax Authority is not satisfied with the claim of the taxpayer or where the taxpayer claims that no expenditure has been incurred by him in relation to exempt income. The Central Board of Direct Taxes (CBDT) prescribed the methodology by Rule 8D which was inserted in the Income Tax Rules with effect from 24 March 2008.

Rule 8D prescribes computation of disallowance under three limbs viz. (a) Direct expenditure. (b) Indirect interest expenditure computed on pro rata basis in proportion of average value of investments to the total assets. (c) 0.5% of the average value of investments.

In the case of Daga Capital Management Pvt. Ltd. & Others  [117 ITD 169 (Mum)] (Daga), the Special Bench (SB) of the Mumbai Income Tax Appellate Tribunal (ITAT) held that the procedural provisions and Rule 8D were clarificatory in nature and applied them with retrospective effect from the date of insertion of the Section in the ITL i.e., 1 April 1962.

Bombay High Court ruling

Facts of the case

The Taxpayer is a company holding certain investments in shares of Indian companies including group companies which were promoted by the Taxpayerl. The investments were held since many years. Further, 95% of the shares held were bonus shares for which no cost was incurred.

For tax year 2001-02, the Taxpayer received dividend income of INR 343M. The Taxpayer claimed exemption with reference to the entire dividend income of INR 343M.

For the year under reference, the Taxpayer incurred interest expenditure of INR 517M and administrative expenditure of INR 1898M. The Taxpayer contended that no part of this expenditure was incurred for earning dividend income. For this purpose, the Taxpayer relied on the following factual parameters:

Liabilities INR (in M)
Capital and free reserves 2806
Others including interest bearing loans 6575
Total 9381
Investment in Shares 1255
Other assets 8126
Total 9381

The Tax Authority disallowed interest expenditure of INR 69M worked out on pro rata basis between the investment in shares and the total assets by invoking the Section.

The first appellate authority deleted the disallowance by placing reliance upon orders of the ITAT for earlier years where the ITAT had held that no expenditure could be notionally attributed to the earning of dividend income.

On further appeal to the ITAT by the Tax Authority, the ITAT remitted the matter back to the Tax Authority to decide the issue in the light of the SB Ruling.

The Taxpayer appealed further to the HC.

Contentions of the Taxpayer

The dividend income cannot be regarded as exempt income since it suffers DDT, which is payable by the company distributing the dividend. The exemption for dividend income in the hands of shareholder is only to obviate double taxation of same stream of income. The Section applies only to such income which is fully exempt from taxation in the hands of any person (e.g. agricultural income).

The procedural provisions and Rule 8D are not retrospective and have no application to the tax  year under reference viz., 2001-02. They are substantive provisions and cannot be regarded as clarificatory in nature.

Rule 8D does not represent an accepted or well-settled method for determining expenditure incurred in relation to exempt income. It provides for uniform method to be applied in a like manner to all the taxpayers who may not be similarly situated. It is arbitrary and unreasonable, making it violative of the procedural provisions as well as Article 14 of the Constitution which provides for right to equality before the law and equal protection of laws within the territory of India.

A literal interpretation of the Section with Rule 8D in the context of dividend income gives rise to unintended consequences resulting in disallowance of expenditure disproportionate to the quantum of dividend income.

Contentions of the Tax Authority

The Section and Rule 8D apply to dividend income, since dividend income which has suffered DDT is exempt from tax in the hands of the shareholder.

The procedural provisions and Rule 8D merely lay down the machinery for quantification of the expenditure which is disallowable as per the Section. Therefore, they are clarificatory in nature and apply from the same date from which the Section was inserted in the ITL.

Rule 8D is in conformity with the principles of the Section and provides a rational, fair and reasonable method for computing the quantum of expenditure attributable to exempt income.

Merely because the application of Rule 8D creates hardship in some individual cases does not militate against its validity and constitutionality.

Ruling of the HC

On applicability of this Section to dividend income

The Section was introduced to overcome a series of Supreme Court (SC) rulings which held that where the taxpayer has an indivisible business, giving rise to both exempt and taxable incomes, the expenditure incurred in such indivisible business cannot be apportioned between the two types of incomes. As held by  the SC in the case of CIT v. Walfort Share and Stock Pvt. Ltd., [2010-TIOL-47-SC-IT]  it widens the scope of apportionment of expenditure between the exempt income and taxable income.

Dividend income which has suffered DDT falls directly within the scope of income which does not form part of total income and is covered by the Section.

DDT paid by the company is on its own behalf and not as an agent of the shareholders. It is an additional tax levied on that portion of the profits of the company which is distributed to the shareholders. It is not a tax levied on dividends received by a shareholder.

On scope of the Section

For disallowance under the Section, there must be a proximate relationship between the expenditure and the income which does not form part of the total income. Once the proximate relationship is established, the disallowance has to be effected.

Rule 8D cannot be invoked mechanically by the Tax Authority. The procedural provisions require the satisfaction of the Tax Authority having regard to the accounts of the taxpayer that the claim made by the taxpayer is not correct. Such satisfaction must be an objective satisfaction arrived at in good faith and on relevant consideration of all facts and circumstances. Also, the Tax Authority must record reasons for non-satisfaction with the claim of the taxpayer.

Even in absence of the procedural provisions and Rule 8D, the Tax Authority should follow a ‘reasonable’ method of apportionment of expenditure consistent with what the circumstances of the case would warrant.

The Section is framed on well-settled principle of taxation to tax the net income that is to say, gross income minus the expenditure. Hence, the literal interpretation of the Section does not result in any absurdity.

On constitutional validity or procedural provisions and Rule 8D

The procedural provisions and Rule 8D were introduced in the wake of considerable disputes between the Tax Authority and the taxpayers on the quantum of disallowance.

The legislature has provided for adequate safeguard within the Section before the Tax Authority can invoke Rule 8D.

The choice of prescribing a particular method is left to the wisdom of the legislature. The court will not interfere to substitute its own view merely because another method appears to be more suitable or hardship is created in individual cases. So long as the method has nexus with the object sought to be achieved and is not prima facie capricious, perverse or irrational, it cannot be held to be unconstitutional. The method provided by Rule 8D has adequate justification and, hence, is constitutionally valid.

On retrospective application of procedural provisions and Rule RD

While the Section was inserted with retrospective effect, the procedural provisions are specifically made applicable from tax year 2006-07 and Rule 8D has been inserted with effect from 24 March 2008. They were introduced to resolve disputes between the Tax Authority and the taxpayers and, hence, they are not clarificatory in nature.

The ITL provides that CBDT does not have power to make rules with retrospective effect which prejudicially affect the interests of the taxpayers.

It is a settled principle that the law prevailing on the first day of April immediately following the tax year is applicable for the relevant tax year. Rule 8D notified on 24 March 2008 applies with effect from tax year 2007-08 onwards. For earlier years, the Tax Authority has to apply a reasonable method for quantifying the expenditure

Kerala High Court ruling

Facts of the case

The Taxpayer2 is an individual running a proprietory business of trading in goods. Over a period of 10 years, she acquired 90% of share capital of a leasing company.

The Taxpayer2 made the acquisition of shares of the leasing company with borrowed funds. Interest expenditure incurred for the tax year under reference on such borrowings was INR 1.75M. The Taxpayer2 earned dividend income of INR 0.3 M on those shares for the tax year under reference.

The Tax Authority disallowed the deduction of interest expenditure by invoking the Section which was sustained by the first appellate authority.

On further appeal by the Taxpayer2, the Tribunal partially reduced the disallowance to INR 0.2M.

The Tax Authority appealed further to the HC.

Contentions of tne Taxpayer

The interest expenditure was incurred to acquire controlling interest in the leasing company in which the Taxpayer2 had deep interest since the leasing company was leasing only those goods which it bought from the Taxpayer2. The financial stability of the leasing company was, thus, critical for her own business.

The ITL specifically grants deduction for interest paid in respect of capital borrowed for the purposes of the business of the taxpayer.

Reliance was placed on the SC ruling in the case of S. A. Builders vs. CIT [288 ITR 1] in which the SC advocated the test of commercial expediency for grant of deduction in respect of interest expenditure and held that where the holding company has deep interest in the business of its subsidiaries, interest cost on borrowed funds used for advancing interest-free loans to subsidiaries is allowable as deduction.

 Contentions of the Tax Authority

The borrowed funds were admittedly used only for the purpose of acquiring shares of the leasing company.

Except for dividend, the Taxpayer2 derived no other benefit from the investment made in the leasing company.

The dividend income being exempt from tax, the interest expenditure is not allowable as deduction in view of the mandate of the Section.

Ruling of the HC

The HC ruled in favor of the Tax Authority and held that the whole of the interest expenditure of INR 1.75M was disallowable under the Section for the following reasons:

The facts on record bear out that the Taxpayer2 had received only dividend income from the investment in shares and no other benefit was derived from the leasing company in respect of the business carried on by the Taxpayer2.

The dividend income is exempt from tax and, hence, in terms of the Section, any expenditure incurred for earning such income is not allowable as deduction.

The Taxpayer held the shares as an investment. If the shares are held as stock-in¬trade, the Taxpayer2 would be entitled to deduction of the interest expenditure incurred on acquisition of such shares in terms of the specific provisions of the ITL.

The test of commercial expediency laid down in the SC ruling of S. A. Builders is not applicable in the facts of the present case since there was no nexus between the business of Taxpayer2 and the holding of shares in the leasing company.


In view of the Bombay HC ruling, it will be significant for the taxpayers to justify the quantification of the disallowable expenditure by robust documentation and sound principles of apportionment. Where the Tax Authority is not satisfied with the taxpayer’s claim, it will need to follow the directions of the Bombay HC of giving reasonable opportunity to the taxpayer and making disallowance only after taking into account all the relevant facts and circumstances and recording reasons for its non-satisfaction.

The Kerala HC ruling confirms that where the shares are held as stock-in-trade, interest expenditure is allowable as per the specific provisions of the ITL.

In both the above referred rulings, the shares were held as capital asset by the taxpayers. Both the rulings were not concerned with a situation where the shares are held as stock-in-trade by the taxpayers which give rise to both taxable income by way of trading profit and exempt income by way of dividend. In the case of Daga, the SB has upheld the applicability of the Section even in case of stock-in trade and the taxpayer’s appeal against this ruling is presently pending before the Bombay HC.

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September 2021