EY Tax Alert. Executive summary

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1 16 March 2018 EY Tax Alert Supreme Court rules on disallowance of expenditure in relation to exempt dividend income from shares held as strategic investment and stock-intrade Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your Ernst & Young advisor. Executive summary This Tax Alert summarizes a ruling of the Supreme Court (SC) dated 12 February 2018 in the case of Maxopp Investment Ltd. [1] (Taxpayer) on the issue of disallowance of expenditure incurred in relation to exempt income by way of dividend on shares held as trading assets and stock-in-trade under Section 14A (Section) of the Indian Tax Laws (ITL). The SC held that while construing the scope of the phrase in relation to employed in the Section, the dominant purpose for which the investment in shares is made by the Taxpayer is not relevant. Even if the dominant purpose of investing in shares is not to earn exempt dividend income, but to have controlling interest over the investee company or to earn profit from trading in shares, it will not preclude the applicability of the Section. The fact remains that dividend received is exempt from tax. The Section statutorily incorporates the principle of apportionment of expenses between exempt income and taxable income. Keeping this object of the Section in mind, if expenditure is incurred on earning dividend income, pro rata expenditure attributable to the dividend income has to be disallowed under the Section. [1] [(2018) 91 taxmann.com 154 (SC)]

2 Page 2 Nevertheless, the computation of disallowance will depend upon the facts of each case. In case of taxpayer holding shares as stock in trade where dividend is earned incidentally or by quirk of fate, the disallowance can be NIL. In all cases, before applying the theory of apportionment, the Tax Authority needs to record satisfaction that, having regard to the facts of the case, suo moto disallowance made by the Taxpayer is not correct. While recording such satisfaction, the Tax Authority has to examine the nature of loan taken by the Taxpayer for purchasing/making investment in the shares. Background The Finance Act, 2001 inserted the Section, 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 provide that the amount of disallowance shall be computed as per the 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 it in relation to exempt income. The Central Board of Direct Taxes (CBDT) [2] prescribed the methodology by Rule 8D which was inserted in the Income Tax Rules, with effect from 24 March For the relevant tax year under consideration, 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 [3]. Since the enactment of the Section, there have been various controversies/issues surrounding interpretation of the Section, resulting in significant tax litigation. [2] The apex administrative direct tax authority in India [3] Notification No. 43/2016 dated 2 June 2016 partially substituted then existing Rule 8D and provides for a new method for computation of disallowance of expenditure which, in addition to the amount of expenditure directly relating to exempt income, shall include an amount equal to 1% of annual average of monthly averages of the opening and closing balance of the value of investment, which gives rise or may give rise to exempt income. However, the total amount of disallowance shall be restricted to total expenditure claimed by the taxpayer. Refer EY Tax Alert dated 8 June 2016, CBDT notifies new method for computation of expenditure incurred for earning exempt income In the recent past, the SC has settled the following controversies on the scope of the Section: In the case of Godrej & Boyce Manufacturing Company Ltd. v. DCIT [4], the SC held that the mere fact that dividend suffers dividend distribution tax in the hands of the company before reaching the shareholders as exempt income, does not preclude the applicability of the Section. In the case of CIT v. Essar Teleholdings Ltd. [5], the SC held that while the Section is inserted with retrospective effect, Rule 8D, inserted with effect from 24 March 2008, has prospective effect and cannot be applied to tax years prior to tax year Another issue where there is divergence of judicial views is whether any disallowance is required in relation to expenditure incurred to earn exempt dividend income from shares held as stock-in-trade and not as investment. Facts of the case There were two types of Taxpayers before the SC. In the case of the first Taxpayer, it held the shares as trading assets acquired with the intention of retaining controlling interest over the investee company. In the second case, the Taxpayer (being a bank) held the shares as stock-in-trade for the purposes of purchase and sale in the ordinary course of banking business to earn trading profit. Both Taxpayers earned exempt dividend income from such shares. Both Taxpayers claimed that the dominant purpose of investing in shares was not to earn dividend income and, hence, did not offer any disallowance under the Section. The Tax Authority, in both the cases, made pro rata disallowance of interest expenditure, but restricted the disallowance to the quantum of exempt dividend income. In the case of the first Taxpayer, the disallowance was upheld by the First Appellate Authority, the Income Tax Appellate Tribunal (Tribunal) and the Delhi High Court (Delhi HC). The Tribunal held that investment in shares, representing controlling interest, did not amount to carrying on of business (it would normally be on capital account and not a trading asset) and, therefore, interest expenditure incurred on acquisition of shares of group companies was disallowable under the Section. The Delhi HC [6] held that the phrase in relation to used in the Section means in connection with or pertaining to and, hence, needs to be construed widely. The Section would apply regardless of the intention/motive behind the investment. [4] [(2017) 394 ITR 449 (SC)] [5] [(2018) 90 taxmann.com 2 (SC)] [6] Maxopp Investment Ltd. v. CIT [(2012) 347 ITR 272 (Del)]

3 Page 3 In the case of the second Taxpayer, the First Appellate Authority enhanced the disallowance up to the full amount, as per Rule 8D. However, the Tribunal and the Punjab & Haryana HC (P&H HC) [7] ruled in the Taxpayer s favor and deleted the disallowance. The P&H HC held that the purpose of the purchase of shares was not to earn exempt dividend income, but to earn trading profits. The term investment employed in Rule 8D does not include stock-in-trade. Since the Section and Rule 8D constitute an integrated code, the Section also cannot be read to include stock-in-trade. In view of the conflicting HC rulings, the respective losing parties appealed to the SC. Issue before the SC Whether disallowance under the Section is attracted in a case where exempt dividend income is earned from shares held as trading assets or stock-in-trade where the predominant intent of investing in shares is not to earn exempt dividend income, but to either retain controlling interest over the investee company or to earn profit from trading in shares. SC s ruling On applicability of the Section to exempt dividend income on shares held as trading assets The SC affirmed the view of the Delhi HC and held that if dividend income received is exempt, the disallowance under the Section is triggered in all cases, even where the investment in shares is not with the main object of earning dividend income. It adopted the following reasoning for its conclusion: As per the Section, expenditure incurred in relation to exempt income is not allowed as deduction. If an expenditure incurred has no casual connection with the exempt income, such that it cannot be treated as related to the exempt income, then such an expenditure would be allowed as business expenditure. There is no judicial divergence on this aspect. Controversy arises on interpretation to be given to the words in relation to in a scenario where exempt dividend income is earned, but the dominant purpose of investing in shares is not to earn exempt dividend (dominant purpose test). The Section was introduced against the backdrop of SC rulings which had held that, where a 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. Such expenditure has to be fully allowed as deduction. The Legislature perceived this as resulting in a double benefit to taxpayers, which reduced the tax payable on the non-exempt income by debiting the expenses incurred to earn the exempt income against taxable income. As held by the SC in the case of CIT v. Walfort Share and Stock Pvt. Ltd. [8], the Section incorporates the principle of apportionment of expenditure between exempt income and taxable income. Keeping in mind the above object of the Section, if expenditure is incurred on earning the dividend income, pro rata expenditure attributable to the dividend income has to be disallowed. The dominant purpose test is not relevant to trigger the Section. The dominant purpose for which the investment is made by the Taxpayer is not relevant. The fact remains that dividend received is exempt from tax. On applicability of the Section to dividend income on shares held as stock-in-trade In the context of shares held as stock-in-trade and not as investment, particularly by banks, the SC, on facts, affirmed the P&H HC ruling and held that disallowance under the Section ought to be NIL in case of acquiring shares held as stock-in-trade where in addition to gain on trading, dividend income is also earned incidentally or by quirk of fate. The SC held as under: In the case of CIT v. Nawanshahar Central Cooperative Bank Ltd. [9] the SC held that investments in approved securities statutorily made by a banking company are part of the banking business and, thus, income arising from such investments is taxable as business income, and not as income from other sources. Pursuant to this ruling, the CBDT clarified vide Circular No. 18 of 2015 dated 2 November 2015 (Circular) that although the ruling is in the context of profit-linked tax holiday deduction for a cooperative bank, the principle laid down in the ruling is equally applicable to all banks. The P&H HC held that the Circular carves out a distinction between stock-in-trade and investment and provides that if the motive behind purchase and sale of shares is to earn profit, then the same would be treated as trading profit and if the object is to derive income by way of dividend, then the profit would be said to have accrued from the investment. The SC agreed with the P&H HC ruling on such distinction between stock-in-trade and investment. However, it disagreed with the application of the dominant purpose test by the P&H HC to determine trigger of disallowance under the Section. [8] [(2010) 326 ITR 1 (SC)] [7] Pr. CIT v. State Bank of Patiala [(2017) 391 ITR 218 (P&H)] [9] [(2007) 160 Taxman 48 (SC)]

4 Page 4 In the context of shares held as stock-in-trade, if certain dividend income is earned, though incidentally, the Section would trigger, which is based on the theory of apportionment of expenditure between taxable and exempt income and, if the section is triggered, depending upon the facts of each case, the pro rata expenditure incurred in acquiring those shares is to be apportioned. In the facts of the case, the Tax Authority had computed disallowance by applying the principle of apportionment and restricted it to quantum of exempt income. However, the First Appellate Authority had enhanced the disallowance. This is considered by the SC to be untenable. The conclusions of the Tribunal and the P&H HC were considered to be right in deleting the entire disallowance made by the First Appellate Authority although they were perceived to have erred in applying the theory of dominant intention. Thus, the SC endorsed the final conclusion of the Tribunal and the P&H HC of nil disallowance in the facts of the case where shares were held as stock-in-trade. The SC drew distinction between shares held as stockin-trade and shares held to retain controlling interest. In case of stock-in-trade, it becomes a business activity of the Taxpayer to deal in those shares as a business proposition and whether dividend is earned or not becomes immaterial. In fact, receipt of dividend would be a quirk of fate that when the investee company declared dividend, those shares are held by the Taxpayer. But in case of taxpayers who hold shares to retain control over the investee company, whenever dividend is declared by the investee company, it would necessarily be received by the taxpayer alone. Even at the time of investing into those shares, such taxpayer knows that it may generate dividend income as against the taxpayer who holds shares as stock-in-trade whose main purpose is to liquidate those shares whenever the share price goes up in order to earn profits. On the Tax Authority s obligation to record satisfaction Comments Prior to the present SC ruling, there was divergence of judicial views on the applicability of the Section to shares held as trading assets or stock-in-trade where expenditure is not incurred with the main object of earning exempt dividend income. The present SC ruling resolves the controversy in favor of the Tax Authority by disregarding the dominant intention test and confirming the applicability of the Section even to shares held as trading assets. However, in case of shares held as stockin-trade, the SC has ruled in favor of the Taxpayer by confirming that disallowance would be NIL where the Taxpayer earns profits by trading in shares and dividend income is earned incidentally or by quirk of fate. In view of this SC ruling, it is imperative for taxpayers to consider the disallowance even where shares are held to retain controlling interest and 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 would need to follow the directions of the SC of recording reasons for non-satisfaction and making further disallowance only after taking into account all the relevant facts and circumstances. The SC held that before applying the theory of apportionment, the Tax Authority needs to record satisfaction that suo moto disallowance made by the Taxpayer under the Section was incorrect. While recording such satisfaction, the Tax Authority also needs to examine the nature of loan taken by the Taxpayer for making investment in shares.

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