Analysis of Daga Capital Decision

S.14A which was introduced by the Finance Act, 2000, its subsequent amendment in 2007 and the Circular issued by the Hon'ble CBDT in pursuance of the provisions of S. 14A of the Income-tax Act, 1961 have led to many controversies and to add to them, the Hon'ble members of the Hon‘ble Tribunal in Special Bench decision differed, with two members taking one view and the third differing from the majority view in Daga Capital Management case. – 26 SOT 603.

Before coming to the critical analysis of Daga Capital Management decision, let us consider the law prevailing before the introduction of S. 14A and its subsequent amendment.

The Hon'ble Supreme Court in number of cases ruled that when an assessee is carrying on a business which is indivisible, but contains various activities, the entire business expenditure will be allowed by way of deduction, while computing the business income of the assessee, irrespective of the fact that some of the activities carried out by the assessee in the course of its business have generated non-taxable income, that is, unless the business is divisible, no part of the business expenditure can be disallowed on the ground that the same is attributable to the earning of non-taxable profits.

In the leading case of Rajasthan Warehousing Corporation vs. CIT reported in 242 ITR 450 (SC), the Hon'ble Supreme Court laid down the following propositions:

“(i) if the income of an assessee is derived from various heads of income, he is entitled to claim deduction permissible under the respective head, whether or not computation under each head results in taxable income;

(ii) if the income of an assessee arises any of the heads of income but from different items, e.g. different house properties or different securities etc. and income from one or more items alone is taxable whereas income from the other item is exempt under the Act, the entire permissible expenditure in earning the income from that head is deductible; and

(iii) in computing the “profits and gains of business or profession” when an assessee is carrying on business in various ventures and some among them yield taxable income and the others do not, the question of allowability of the expenditure under section 37 of the Income-tax Act, 1961, will depend on :

(a) fulfilment of requirements of that provision, namely that –

(i) the expenditure should not be in the nature of capital expenditure or personal expenses of the assessee;
(ii) it should have been laid out of expended wholly and exclusively for the purposes of the business or profession and
(iii) it should have been expended in the previous year; and

(b) on the fact whether all the ventures carried on by him constituted one indivisible business or not ;if they do the entire expenditure will be a permissible deduction, but if they do not, the principle of apportionment of the expenditure will apply, there will be no nexus between the expenditure attributable to the venture not forming an integral part of the business and the expenditure sought to be deducted as the business expenditure of the assessee”.

The Government and Legislature thought that allowance of entire expenditure, even that part of the expenditure relating to non-taxable income is allowed, as held by the Hon’ble Supreme Court, the assessee would get double advantage, the advantage of exemption in respect of non-taxable income and also deduction of expenditure relating to income under the provisions of sections 36(1)(iii) & 37(i) of the Income-tax Act, 1961. To prevent the assessee from getting this double advantage, provisions of S. 14A were brought into force by Finance Act, 2000 and later on by the Amending Act, 2007.

Now, before analysing the main provisions of S. 14A, let us quote S. 14A as it stands today:

“(1) For the purposes of computing the total income under this Chapter, no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income which does not form part of the total income under this Act.

(2) The Assessing Officer shall determine the amount of expenditure incurred in relation to such income which does not form part of the total income under this Act in accordance with such method as may be prescribed, if the Assessing Officer, having regard to the accounts of the assessee, is not satisfied with the correctness of the claim of the assessee in respect of such expenditure in relation to income which does not form part of the total income under this Act;

(3) The provisions of sub-section (2) shall also apply in relation to a case where an assessee claims that no expenditure has been incurred by him in relation to income which does not form part of the total income under this Act;

Provided that nothing contained in this section shall empower the Assessing Officer either to reassess under section 147 or pass an order enhancing the assessment or reducing a refund already made or otherwise increasing the liability of the assessee under section 154, for any assessment year beginning on or before 1st day of April 2001".

Originally, when S. 14A was introduced, sub-sections (2) and (3) were not there. They were introduced by Finance Act, 2007 operative from 1-4-2007. Before analysing sub-sections (2) and (3) of S. 14A, let us consider the provisions of sub-section (1) of S.14A without reference to sub-sections (2) and (3).

Now the first issue that arises, is as to when provisions of S. 14A(1) are applicable and particularly what was the object of introducing these provisions, as understood by the Legislature?

Now, the Memorandum explaining the provisions of the Finance Act, 2000 gives the following reason for introducing the provisions of S. 14A.

"Certain incomes are not includible while computing the total income as these are exempt under various provisions of the Act. There have been cases where deductions have been claimed in respect of such exempt income. This in effect means that the tax incentive given by way of exemptions to certain categories of income, is being used to reduce also the tax payable on the non-exempt income by debiting the expenses incurred to earn the exempt income against taxable income. This is against the basic principles of taxation whereby only net income; i.e., gross income minus the expenditure is taxed. On the same analogy, the exemption is also in respect of the net income. Expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income.

It is proposed to insert a new S. 14A so as to clarify the intention of the Legislature since the inception of the Income-tax Act, 1961 and that no deduction shall be made in respect of any expenditure incurred by the assessee relating to the income which does not form part of the total income under the Income-tax Act, 1961".

A Circular No. 11/2001 dated 23-7-2001 gives similar reasons for introducing S. 14A.

The said Memorandum and the Circular clarify that the expenditure relating to the earning of non-taxable income is not allowable in view of the provisions of S. 14A

Now, the application of S. 14A calls for the following :issues:

(1) Whether any expenditure is incurred?
(2) Whether any expenditure is incurred for earning non- taxable income?
(3) Whether there is compulsory expenditure?
(4) Whether any part of such expenditure relates to earning of non taxable income, i.e. whether the expenditure incurred is in relation to earning of non-taxable income?

Now, it is quite clear that, as explained by the above mentioned Memorandum and Circular, that provisions of S. 14A are for disallowance of expenditure incurred and that expenditure is to be disallowed, which is in relation to the earning of non-taxable income.

The heading of S. 14A says "any expenditure incurred with relation to non-taxable income”. It is clear that the section is in relation to expenditure incurred and disallowance of part of such expenditure. As such, unless there is some business expenditure which is claimed by way of deduction, the question of applying S. 14A does not arise.

For example, suppose a person for earning income, both taxable and non-taxable applies his own funds which do not bear any interest, the question of disallowing any interest on such non-interest bearing funds will not arise

Now, let us analyse the provisions of S. 14A. The section undoubtedly starts with the words "any expenditure relating to earning of non-taxable income”, which means, to apply the provisions of S. 14A the following three conditions should be fulfilled.

(i) There must be expenditure incurred.
(ii) Such expenditure must be in relation to the earning of non-taxable income.
(iii) What constitutes “in relation to" earning of non-taxable income?

Now, the facts of Daga’s case were that the assessee was a dealer in shares and held all the shares which it had acquired in the course of its business of dealing in shares as stock-in-trade. During the continuance of holding of these shares as part of stock-in-trade, the assessee received some non-taxable dividend and interest income Now, the issue before the Hon’ble Tribunal was, whether in such case there could be disallowance of any expenditure alleging that such expenditure was incurred for earning non- taxable income. The main issue before the Hon‘ble Tribunal was, what does one mean by "in relation to expenditure relating to non-taxable income”?

It appears that there was no difference of opinion as regards incurring of expenditure. The main issue was whether any expenditure incurred in the course of carrying on business by the assessee can be treated as expenditure relating to earning of non-taxable income. Rather, the short issue was as to what one means by "in relation to”.

The Hon‘ble Vice-President gave his own separate judgement, and after analysing the provisions of S. 14A in detail, he came to the conclusion that any expenditure, before it could be disallowed under the provisions of S. 14A, it has to relate to the earning of non-taxable income and in his opinion, to constitute “in relation to”, there must be a dominant and immediate connection between the expenditure and the income earned, and a remote connection which is not immediate or dominant will not fall within the provisions of S.14A(1) and, as such, when there is no immediate connection between the expenditure and the non-taxable income, provisions of S. 14A are not applicable. For coming to the conclusion that the words “ in relation to” means, the main dominant and immediate connection with, the Hon‘ble Vice-President relies on the decision of the Hon‘ble Supreme Court in the case of H.H. Maharajadhiraja Madhav Rao Jivaji Rao Scindia Scindia Bahadur of Gwalior & Ors (1971) (1 SCC 85) consisting of 11 judges. He rightly follows this decision of the Hon‘ble Supreme Court as against the other decision of the Hon'ble Supreme Court in the case of Doypack Systems Pvt. Ltd. vs. Union of India and Others [ (1988) 2 SCC 299].

Even though Doypack is a later decision, it is a decision of a bench of two judges. The Rule of construction is, if there are decisions of two benches of the Hon'ble Supreme Court, which differ, the decision of a larger bench should be followed. H.H. Maharaja’s case consisted of 11 judges as against Doypack’s which consisted of two judges.

He rightly followed the decision in Maharaja’s case for holding that the connection between the expenditure and income should be dominant and immediate, Then he goes to the issue as to how to determine the nature of the connection between the expenses incurred and the income earned by the assessee and he rightly came to the conclusion that the question would depend upon the intention and object with which the expenditure was incurred and if it was with a view to earn taxable income, it can be said that dominant and immediate connection exists between the expenditure incurred and taxable income and consequently no disallowance under section 14A can be made even where some non-taxable income is received incidentally, and if the expenses are incurred mainly with a view to earn tax free income, it can be said that dominant and immediate connection exists between the expenditure incurred and the tax free income and consequently disallowance can be made even though some taxable income may arise incidentally.

As such, as per the Hon‘ble Vice-President, one has to go to the dominant intention of the assessee for earning the income. If the dominant intention was to earn tax free income, then disallowance is called for u/s 14A, but if the dominant intention was to earn taxable income and incidentally some non-taxable income arises, no disallowance can be made u/s. 14A, as non-taxable income is incidental and there is no connection between such income and expenditure incurred.

As against that, the two members who constituted the majority, while analysing the provisions of S. 14A differ with the Hon'ble Vice-President in relation to. the meaning of the words "in relation to". According to them, even a remote connection between the non-taxable income and the expenditure incurred is sufficient to attract disallowance u/s 14A. For coming to this conclusion, they rely on the decision of the two-member bench decision of the Hon‘ble Supreme Court in Doyback’s case.

For this reason alone, the majority decision requires reconsideration because not following the binding judgment of the Hon'ble Supreme Court of the larger bench and by following the later decision of the smaller bench and that too, when smaller bench decision was delivered without referring to larger bench decision, they clearly erred and, as such, for that reason, the majority decision can be safely said to be erroneous.

Now, coming to the scope and impact of sub-sections (2) & (3) of S. 14A and Rule 8D passed in respect of the operation of the said provisions of sub-sections (2) & (3) of S. 14A, the Hon'ble Vice-President does not deal with the same as he has answered the question raised before them in the affirmative and, therefore, according to him, the question of applying the provisions of sub-sections (2) & (3) of S. 14A does not arise.

However, the majority judgment after holding that disallowance could be made u/s 14A(1), goes to consider the scope and impact of sub-sections (2) & (3) as they are of the view that S. 14A(1) cannot be read independent of sub-sections (2) & (3), and they should be read together and, therefore, the contention of the assessee that only when the case of the assessee requires disallowance u/s 14A (1), the provisions of sub-sections (2) & (3) will apply, is not acceptable.. Sub-sections (2) & (3) must be read along with sub-section (1) and, as such, once there are some expenses having some connection, however, remote it may be, with the earning of non-taxable income, disallowance may be made under sub-sections 14(2) & (3). According to these members, sub-sections (2) & (3) are procedural provisions and disallowance under sub-section (1) should be as per the provisions of sub-sections (2) & (3) and that too as per Rule 8D which prescribes the procedure for such disallowance under sub-sections (2) & (3). Then they also came to the conclusion that sub-sections (2) & (3), though introduced by Finance Act, 2007, they would be applicable to all cases, even relating to earlier years starting from A.Y. 1962-63. Here too, they ignored the fact that F.A. 2007 which introduced sub-sections (2) & (3) of S.14A itself states that they are operative from 1-4-2007. Even Rule 8D which was issued on 24-3-2008, says that it is operative from the date it is published in the Gazette.

Under these circumstances, the Hon'ble Members (majority) erred in coming to the conclusion that the provisions of sub-sections (2) & (3) and Rule 8D have retrospective effect operating from A.Y. 1962-63 onwards.

Now, the method prescribed in the Rule states that the expenditure in relation to income which does not form part of the total income shall be the aggregate of the following amounts.

a) The amount of expenditure directly relating to income which does not form part of total income.
b) In the case of interest on borrowed funds which is not directly attributable to any particular income or receipt, the amount computed in accordance with this following formula :
A x B
C
A = Amount of interest, other than the amount of interest which is directly attributable to the exempt income stated in (a) above.

B = The average of value of investment, income from which does not or shall not form part of the total income, as appearing in the balance sheet of the assessee, on the first day and the last day of the relevant accounting year.

C = The average of total assets as appearing in the balance sheet of the assessee on the first day and the last day of the accounting year. The term “Total Assets” means total assets as appearing in the balance sheet excluding the increase on account of revaluation of assets but including the decrease on account of revaluation of assets.

(c) An amount equal to ½ per cent of the average of the value of investment, income from which does not or shall not form part of the total income, as appearing in the balance sheet of the assessee, on the first day and the last day of the relevant accounting year

It may noted that the said Rule 8D instead of providing a simple and proper method for computing disallowance u/s 14A has prescribed a very irrational and inequitable method for computing such disallowance. If one computes disallowance as per Rule 8D, many expenses which have no connection with earning of the exempt income, will get disallowed.

The following instances will show how there could be disallowance under the provisions of S. 14A which have no connection with the earning of tax-free income –

(i) Interest which is directly to borrowing funds used for the purpose of earning taxable income or receipts will not be considered for disallowance of proportionate interest u/s 14A. Therefore, interest on term loan taken for purchase of Plant & Machinery, motor car loan, amount borrowed for acquiring factory or office building or any other business asset will not be considered for such disallowances.

(ii) It is not mentioned that interest which is disallowable u/s 43B or u/s 36(1)(iii) will also be excluded. But it can be assumed that only such expenditure, which is otherwise allowable in the computation of total income, will be considered for disallowance u/s 14A.

(iii) In the above formula in para 2.2(ii)(b) above, while explaining the terms “B” and “C” there is a reference to the average value of investments and total assets as per the Balance Sheet of the assessee. It is not clear as to what figures shall be adopted in the cases of non-corporate assessees, such as Individuals and HUFs who do not maintain books of account.

(iv) In Explanation to the term “B” it is stated that for considering average value of Investments, we have to consider “Investment, income from which does not or shall not form part of the total income”. This will mean that even if there is no income from some or all of the investments, the average value of these investments will enter the formula for disallowance of proportionate interest. This will mean that in some cases where there is no income from such investments and no exemption from tax is claimed on any income, proportionate interest will be disallowed. In some cases, if income from some investments is say only Rs. 1 lakh on which exemption is claimed, but disallowance of proportionate interest under the formula may work out to Rs. 2 lakhs.

(v) While explaining the term “C” it is stated that average of Total Assets as per Balance Sheet should be taken. It can be assumed that items like (a) Preliminary expenses not written off, (b) Deferred revenue expenses, (c) Deferred Tax Assets, (d) Debit balance of Profit & Loss A/c. etc. which do not represent any tangible or intangible asset, appearing in the Balance Sheet of the assessee will be excluded from Total Assets.

(vi) Similarly, current liabilities which are to be deducted from current assets in the case of the company can be added while working out amount of Total Assets.

(vii) The formula given in para 2.2(ii)(c) above, states that amount equal to ½% of the average value of investments, income from which is exempt from tax, should also be disallowed u/s 14A. This provision is not at all equitable. Such disallowance is to be made with reference to average value of such investments from which exempt income is received or not. This disallowance has no relation to either the exempt income or to the expenditure claimed by the assessee. In many cases the amount worked out may exceed the exempt income or may exceed even the total expenditure (for taxable as well as exempt income) incurred by the assessee. If we take the illustration of a closely held Investment company it is common knowledge that the administrative expenses are nominal as compared to the value of the investments. In such cases, the amount to be disallowed under the formula will far exceed the total expenses.

The validity of the new Rule 8D can be challenged on the ground that S. 14A authorises CBDT to prescribe the method for determination of expenditure incurred in relation to earning the exempt income, but the method prescribed by this Rule only determines the notional cost for holding investments which may not yield an exempt income. Such notional cost for holding the investment has no relationship with the actual expenditure incurred and claimed by the assessee. (These instances are taken from the Article by Shri P.N. Shah published in BCAJ).

Now, let us consider how far Rule 8D is valid and operative or whether it exceeds the rule-making power of the authority.

Craies on interpretation of Statute Law considers that before a rule could be considered as valid, the following conditions should be fulfilled:

(i) that they are not made, sanctioned and published in the manner prescribed by statute which authorises the making;
(ii) that they are repugnant to the laws of the country;
(iii) that they are repugnant to the statute under which they are made;
(iv) that they are uncertain;
(v) that they are unreasonable.

Now the Law Minister’s opinion of rule-making states that the following test should be applied for validity of the Rule.

The tests to be applied for considering whether the rules are within the powers of the rule-making authority under a statute are :

(1) whether the rules are reasonable and convenient for carrying the Act into full effect;
(2) whether the rules relate to matters arising under the provisions of the Act;
(3) whether they relate to matters not in the Act otherwise provided for; and
(4) whether they are consistent with the provisions of the Act.

The Hon'ble Madras High Court in the case of Second Income-tax Officer vs. Muthiah Chettiar (M.C.T.) Family Trust & Ors. reported in 102 ITR 138 has held that the Court can take into account the reasonableness of the Rule while considering the validity of the Rule.

Applying .the above tests, to consider the validity of Rule 8D, it is clear that it does not fulfil the tests laid down above, particularly of reasonableness.

S. 14A authorises CBDT to prescribe a rule to determine to what extent an expenditure is referable to the earning of tax-free income. It presupposes two things that an expenditure should be incurred and it should be attributable to non-taxable earning. As such, if the rule applies to cases where no expenditure is incurred or as per the rule if the expenditure attributed to the earning of non-taxable income is more than the total expenditure itself for earning business income, it goes without saying that the rule goes beyond its rule-making power.

On this ground the validity rule can certainly be challenged in the higher court. Unfortunately, this issue as regards the validity of the rule is not considered by the Special Bench decision. However, this issue can be taken up when the appeal is filed against the said order or in any other matter where Rule 8D is applied.

The Hon‘ble Members, while coming to the conclusion that sub-sections (2) & (3) of S. 14A and Rule 8D are operative from the inception of 1961 Act, relied on the recent Hon‘ble Supreme Court judgement in CIT vs. Gold Coin Health Food P. Ltd. reported in 304 ITR 308. Relying on the said judgement, the Hon‘ble Members opined that these provisions are clarificatory and also procedural. Therefore, they should have retrospective operation. With utmost respect I may state that reliance on Gold Coin‘s case was clearly unjustified. First of all, the case before the Hon‘ble Supreme Court and the present case are not at all comparable.

The Hon’ble Supreme Court in that case was dealing with an existing Expl. 4 to S. 271 which provides that it is by way of explanation. This Explanation was added with a view to clarify that out of the two possible views of operation of this Explanation, the view of the Department that it is operative since inception, the Hon‘ble Supreme Court held, was preferable to the other view that it is not clarificatory and it is operative only from the date it was brought into force. For this purpose, they relied on the Wanchoo Committee’s report as well as on the Circular issued as back as in 1975 in respect of the operation of the said Explanation. As such, in respect of the highly debatable and debated issue relating to the operation of the said Explanation, the Hon‘ble Supreme Court came to the conclusion that it has retrospective operation.

As against that, in our case in respect of the operation of S. 14A, there was no prior debate as regards its operation which required any clarification. There were no two views in respect of the operation of S. 14A. The Act amending S. 14A to provide a procedure for disallowance u/s 14A, by introducing sub-sections (2) & (3), clearly provides that it is operative from 1-4-2007. Both the Memorandums explaining these provisions as well as the Circular issued in respect of the same, clearly provide that they are operative from 1-4-2007. Rule 8D also provides that it is operative from the date it is published in the gazzettee. There is nothing in these provisions or Rule 8D, which would support the view that they were issued to clarify the existing position. Obviously, when there are no existing provisions, the question of clarifying the position does not arise.

As regards the emphasis that sub-sections (2) & (3) of S. 14A are procedural in nature and they should have an impact on all pending matters in respect of assessments from the inception of the Income-tax Act, 1961 itself, it must be noted that the machinery provisions could also be substantive and considering the nature of sub-sections (2) & (3) of S. 14A, they are clearly substantive provisions. It may also be noted that unless it is provided or by necessary implication, a Rule cannot have retrospective operation. S. 295 (4 ) which recognises this well known position in law, provides as under:

“The power to make rules conferred by this section shall include the power to give retrospective effect, from a date not earlier than the date of commencement of this Act to the rules or any of them and, unless the contrary is permitted (whether expressly or by necessary implication), no retrospective effect shall be given to any rule so as to prejudicially affect the interests of assessee”.

As Rule 8D itself provides that it is operative from the date of the Rule and there is nothing in the Rule to show that by implication, it has retrospective operation.

Another issue that has to be taken into account is that S. 14A provides that only when the Income-tax Officer is not satisfied by the determination by the assessee of the expenditure in relation to the earning of non-taxable income, then only the Officer can reject such determination of the expenditure and he may reject the book results and determine such expenditure as per the rules prescribed. As such, before invoking the provisions of Rule 8D, the Officer has to give a finding as to why he considers that the determination of the expenditure relating to non-taxable income as done by the assessee is not proper and only when he comes to such decision that such determination is not proper, he may reject the book results relating to the same and determine the expenditure referable to the earning of non-taxable income as per rule 8D. It is obvious that before he could reject the determination as per the books, he must hear the assessee. Unfortunately, this aspect has also not been considered by the Special Bench.

Another fact that must be pointed out is that there is a third member decision of the Delhi Bench reported in 107 ITD 267 – Wimco Seedlings Ltd. vs. Dy Commissioner of Income-tax (Asst) Special Range, Moradabad, which had held that the Revenue not only has to show that some expenditure was actually incurred, but also to show its relationship with earning of income which is not taxable. The said decision was cited before the Hon'ble Tribunal but majority judgment does not deal with the said decision and in law a Third Member decision is as good as the Full Bench and, therefore, the Bench was bound to follow it. Reference may be made to the following decisions:

(i) 151 ITR 584 (Del) – P.C. Puri vs. CIT (Delhi)
(ii) 100 ITD 285 – Dy. Comm. of Income-tax vs. Oman International Bank SAOG.

The majority decision in Daga Capital Management (P) Ltd. case, for all these reasons is erroneous. Therefore, it should be challenged as such in the higher Courts.

Article by Mr. Vijay H. Patil, advocate