The Hindu Business Line : A harsh ruling for share dealers

Finance Act, 2001, introduced Section 14A in the Income-Tax Act 1961, providing for disallowance of expenditure in relation to income which does not form part of total taxable income. The Section has already generated enough controversies. The Haryana High Court upheld disallowance of expenditure on staff in the case of a business which was earning substantial agricultural income (302 ITR 218).

In respect of inter-corporate investments, interest is taxable but not dividend income. According to the Revenue, even the interest will have to be taxed under ‘other sources’. Apportionment of expenditure will have to be considered.

The CBDT (Central Board of Direct Taxes) provided quantitative guidelines in Notification No.45/2008 dated March 24, 2008. Income Tax (Fifth Amendment) Rules, 2009 brought in Rule 8D prescribing the method for determining the amount of expenditure in relation to income not includable in total income.

There is no difficulty in applying Section 14A where dividends are earned by investors for whom it is not business income. But problems arise in applying the Section in the case of traders in shares. Here, dividend income is part of business income though it may be assessed by virtue of special provisions of the law under ‘other sources’. Should the expenditure incurred in share trading be disallowed merely because the income is assessed as dividend?

Daga Capital case

Daga Capital Management (P) Ltd was engaged in the business of dealing of shares. The company derived dividend income of Rs 1,78,163. This was exempt under Section 10(33) of the Act. It claimed expenditure by way of interest amounting to Rs 9,58,325 on borrowed funds. There was also other expenditure relating to trading in shares and securities. The company declared a net loss of Rs 12,87,780.

The assessing officer (AO) invoked Section 14A. The company objected, pointing out that its business was to purchase and sell shares and securities and not make any investment in shares on long-term basis. The entire sales were always offered to tax as revenue receipts in the earlier years.

The intention had always been to hold the shares as stock-in-trade. Dividend income was only a by-product of the trading activity and, therefore, there was no relation between the expenditure by way of interest and the exempted income.

The AO overruled the objection. Applying Section 14A, he disallowed the claim for deduction of interest of Rs 9,58,325. A Special Bench of the Income-Tax Appellate Tribunal (ITAT) considered the matter in detail (in Appeal Nos 8057 of 2003 and 2048 of 2005 — assessment years 2001-02 and 2002-03 in October, 2008).

The Special Bench ruled by a majority of two to one that Section 14A is a special provision which deals with disallowance of expenditures incurred by assessees in relation to income which does not form part of total income under the Act.

In view of the specific provision under Section 14A, expenses falling under any head or Section which are otherwise deductible as business expenditure or under any other respective heads, would call for disallowance to the extent to which those expenses have been incurred in relation to income exempt from tax.

For purposes of Section 14A, what is relevant is to work out expenditure in relation to exempt income and not to examine whether expenditure incurred by the assessee has resulted in exempt income or taxable income.

Section 14A uses the expression ‘in relation to’. These words encompass not only direct but also indirect expenditure which has any relation to exempt income and, therefore, all direct and indirect expenses are disallowable under Section 14A, which have any relation with income not chargeable to tax under the Act.

Section 14A would be applicable even where shares are held as stock-in-trade. Even expenditure in relation to incidentally exempt income is not immune from the Section. Consequently the Section would be applicable with respect to dividend income earned by the company, engaged in the business of dealing in shares and securities on shares held as stock-in-trade even when earning of such dividend income was incidental to trading and shares.

Legislature’s intent

The AO is bound to adopt Rule 8D for making disallowance under Section14A, where he is not satisfied with the correctness of the claim of the assessee in respect of such an expenditure. The legislature has used the expression ‘in relation to’ and not ‘directly relatable to’ or wholly and exclusively ‘for the purposes of’.

This clarifies the intention of giving a wider meaning and bringing into its sweep not only direct but also indirect expenditure in relation to the exempt income for purposes of disallowance under Section 14A.

The Special Bench found no merit in the company’s submission that Section 14A would be applicable only when the shares are held as an investment and not as stock-in-trade. It referred to Rule 8D to (2)(ii) which talks of the ‘value of investments’ and not the assets ‘held as investment’.

The Special Bench order disallowing expenditure incurred in share trading business will definitely affect dealers in shares. The matter is already before the Bombay High Court.

(The author is a former Chief Commissioner of Income-Tax. blfeedback@thehindu.co.in)

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