The issue before the Hon’ble Supreme Court (SC) was whether section 14A of the Income-tax Act, 1961 (the Act) enables the Department to make disallowance on expenditure incurred for earning tax-free income, where the assessee does not maintain separate accounts for the investments and other expenditure incurred for earning the tax-free income
Facts of the case:
– South Indian Bank Limited and other banks, are scheduled banks (assessee banks). In the course of their business, they engage in the business of investments in bonds, securities and shares, resulting in interest and dividend income which are exempt / tax-free.
– The assessee banks being in the business of banking had not maintained separate accounts for the investments made in bonds, securities and shares from which the tax-free income is earned so that disallowances could be limited to the actual expenditure incurred by them. The assessee banks had borrowed funds as well as own funds and the own funds exceeded the borrowed funds.
– The Assessing Officer (‘AO’) in the absence of separate accounts for investment which earned tax-free income opined that it was not possible to determine the actual expenditure including overheads and other administrative expenditure incurred for earning exempt income. Hence, the AO made proportionate disallowance of interest attributable to the funds invested to earn tax-free income by referring to the average cost of deposit for the relevant year.
– The Commissioner of Income-Tax (Appeals) [‘the CIT (A)’] had concurred with the view taken by the AO. In assessee’s appeal against CIT(A)’s order, the Income-tax Appellate Tribunal (‘ITAT’) considered the absence of separate identifiable funds used by the assessee for making investments in tax-free bonds and shares. However, the ITAT found that assessee has indivisible business and considering the nature of business, the investments made in tax-free bonds and in shares would be in nature of stock-in-trade.
– The ITAT also noticed that the assessee banks had surplus funds and reserves from which investments can be made. Accordingly, it accepted the assessee’s case that investments were not made out of interest or cost-bearing funds alone. Consequently, the ITAT held that disallowance under section 14A is not warranted, in absence of clear identity of funds.
– The decision of the ITAT was reversed by the Hon’ble High Court (‘the HC’) by accepting the contentions advanced by the Revenue in their appeal and accordingly the assessee banks went before the Apex Court, the Hon’ble Supreme Court (‘the SC’), to challenge the High Court’s decision which was against the assessee.
Key observations and decision of the Hon’ble Supreme Court:
– The Hon’ble SC held that “in a situation where the assessee has mixed fund (made up partly of interest-free funds and partly of interest-bearing funds) and payment is made out of that mixed fund, the investment must be considered to have been made out of the interest-free fund. In respect of payment made out of mixed fund, it is the assessee who has such right of appropriation and also the right to assert from what part of the fund a particular investment is made and it may not be permissible for the Revenue to make an estimation of a proportionate figure.”
– The SC relied on its earlier decision in the case of Commissioner of Income Tax v. Reliance Industries Ltd (2019) 410 ITR 466 SC, wherein the SC held that where there is a finding of fact that interest-free funds available to the assessee were sufficient to meet its investment, it will be presumed that investments were made from such interest-free funds.
– The SC also referred to the decision of below High Courts:
– The SC based on the principles enunciated in the above judgments, states that “the disallowance would be legally impermissible for the investment made by the assessees in bonds/shares using interest-free funds, under section 14A of the Act. In other words, if investments in securities is made out of common funds and the assessee has available, non-interest-bearing funds larger than the investments made in tax-free securities then in such cases, disallowance under section 14A cannot be made.”
– The Revenue relied on the ruling of SA Builders v. CIT (2007) 1 SCC 781. The SC distinguished the said ruling on facts and stated that the issue in SA Builders is pending before the larger Bench in Tulip Star Hotels and has no bearing for the present matter.
– The SC held that the assessee has the obligation to provide full material disclosures at the time of filing of the Income-Tax Return, however, there is no corresponding legal obligation upon the assessee to maintain separate accounts for different types of funds held by it.
In absence of any statutory provision which compels the assessee to maintain separate accounts for different types of funds, the Revenue’s reliance on Honda Siel Power Products Ltd. v. DCIT (2012) 12 SCC 762/ (2012) 340 ITR 53 (Delhi) would have no application to support its contention against the assessee.
– The SC noted another important judgment dealing with section 14A disallowance, namely, Godrej and Boyce Manufacturing Company Ltd. V. DCIT (2017) 81 taxmann.com 111 (SC). The relevant portion of the judgment reads as follow: “36…what cannot be denied is that the requirement for attracting the provisions of section 14A (1) of the Act is proof of the fact that the expenditure sought to be disallowed/deducted had actually been incurred in earning the dividend income…”
– The SC observed that the Revenue did not contend that the assessee-banks held the securities for maintaining the Statutory Liquidity Ratio (SLR), as mentioned in the CBDT Circular no. 18 of 2015 dated 02.11.2015. In view of this position, when there was no finding that the investments of the assessee are of the related category, tax implication would not arise against the assessee from the said Circular.
– Based on the above, the SC concluded that the proportionate disallowance of interest was not warranted under section 14A for investments which yield tax-free dividend and interest to assessee-banks in those situations where, interest-free own funds available with the assessee, which exceeded their investments. Hence, the SC agreed with the view taken by the ITAT favouring the assessees.
– The above conclusion was reached by the SC because nexus had not been established between expenditure disallowed and earning of exempt income. The Revenue had failed to substantiate its argument that assessee was required to maintain separate accounts. The Revenues reliance on Honda Siel (Supra) to project such an obligation on the assessee, was negated. The Revenue had also failed to refer to any statutory provision which obligated the assessee to maintain separate accounts which might justify proportionate disallowance.
– Further, after referring to quote of Adam Smith in his seminal work – The Wealth of Nations, the SC has made following observations:
In the light of the discussions, the issue framed in the appeals was answered against the Revenue and in favour of the assessee banks.
– This is a welcome ruling. However, the dividend distribution tax regime has been abolished and hence, the dividend earned is now taxable in the hands of shareholders. Therefore, section 14A of the Act would not now be applicable on the dividend income earned. This Ruling will be beneficial to all the pending litigation as it has been held that where own funds are in excess of borrowed funds, then the presumption in law would be that the taxpayer has investments which have been made out of own funds and hence no disallowance can be made under section 14A.
– ‘To put it another way, in respect of payment made out of mixed fund, it is the assessee who has such right of appropriation and also the right to assert from what part of the fund a particular investment is made and it may not be permissible for the Revenue to make an estimation of a proportionate figure’, these words of the SC bring out the fundamental principles of interpretation of tax laws that there is no presumption in tax laws and nothing can be implied.
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