EY Tax Alert. Executive summary. Supreme Court upholds disallowance of expenditure incurred in relation to exempt dividend income.

Transcription

1 9 May 2017 EY Tax Alert Supreme Court upholds disallowance of expenditure incurred in relation to exempt dividend income Executive summary 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 EY advisor. This Tax Alert summarizes a recent Supreme Court (SC) ruling in the case of Godrej and Boyce Manufacturing Co. Ltd. [1] (Taxpayer) where the issue before the SC was whether the disallowance under Section (s.) 14A of the Indian Tax Laws (ITL) would apply on expenditure incurred for earning exempt dividend income on which Dividend Distribution Tax (DDT) is paid by the dividend paying company. The SC held that, on principles, s.14a disallowance applies to dividend income since it is exempt from tax in the hands of shareholder although it suffers DDT in the hands of dividend paying company. Furthermore, this position emerges from a plain and literal reading of s.14a which is consistent with the scheme of the ITL and the legislative object of introduction of this provision. However, the SC also held that the disallowance is triggered only if there is proof that the expenditure sought to be disallowed has actually been incurred in earning exempt dividend income. Before applying s.14a, the Tax Authority should be satisfied that having regard to the accounts of the taxpayer, the taxpayer s claim is not correct. In the facts of the present case, the Tax Authority had failed to establish a reasonable nexus between interest expenditure sought to be disallowed and exempt dividend income. Moreover, the Tax Authority had accepted in earlier years litigation that the investments yielding exempt income were not made from borrowed funds. There being no change in the facts or law in the current year, the SC held that the Tax Authority was not justified in departing from a settled position of earlier years. [1] [TS-176-SC-2017]

2 Background The Finance Act, 2001 inserted s.14a 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 ITL exempts dividend income received by a shareholder, if the domestic company paying the dividend income is liable to pay DDT at the time of declaration, distribution or payment thereof under a specific provision of the ITL. Similar exemption applies to income received from mutual funds. Facts in the Taxpayer s case The Finance Act, 2006 further amended s.14a with effect from 1 April 2007 to provide 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 it in relation to exempt income (procedural provisions). 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 Rule 8D [2], as applicable to the year under reference, prescribed 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 and (c) 0.5% of the average value of investments. The Special Bench (SB) of the Mumbai Tribunal in the case of Daga Capital Management Pvt. Ltd. & Others [3] held that the procedural provisions and Rule 8D were clarificatory in nature and applied with retrospective effect from the date of insertion of s.14a in the ITL i.e. 1 April [2] Rule 8D has been amended w.e.f. 2 June 2016 and prescribes disallowance under two limbs viz. (a) Direct expenditure (b) 1% of the average value of investments and further that, the disallowance under both the limbs shall not exceed the total expenditure claimed by the taxpayer. [3] [117 ITD 169 (Mum)] Refer EY Tax Alert Special Bench of the Mumbai Tribunal rules on disallowance of expense incurred in relation to exempt income dated 23 October 2008 The Taxpayer is engaged in the business of manufacture of steel furniture, security equipment, typewriters, electrical equipment and other related products. It held investments in shares of Indian companies which also included group companies promoted by the Taxpayer. The investments were held since many years in the past. It also held investments in mutual funds. The Taxpayer earned exempt dividend income from these investments. More than 98% of exempt dividend income was from group companies. For the tax years , and , the Tax Authority disallowed pro-rata interest expenditure as being relatable to exempt dividend income. The Taxpayer s contention was that the investments were made from interestfree funds in the form of share capital and reserves; no part of borrowed funds were used for making investments. The First Appellate Authority accepted this contention and deleted interest disallowance on the ground that the Tax Authority had failed to establish nexus between borrowed funds and investments yielding exempt income. On further appeals by the Tax Authority, the Tribunal confirmed non-applicability of s.14a which was accepted by the Tax Authority and not appealed further to the Bombay High Court. The tax year involved in the present case is where facts were identical to earlier years. The Tax Authority disallowed pro-rata interest expenditure as in earlier years.

3 The First Appellate Authority deleted the disallowance of interest expenditure by placing reliance upon favorable orders of the Tribunal for earlier years where the Tribunal had held that no expenditure could be notionally attributed to the earning of dividend income. The Tax Authority appealed to the Tribunal. By this time, the SB ruled that procedural provisions and Rule 8D have retrospective application. Hence, the Tribunal remanded the matter back to the Tax Authority to decide the issue in the light of SB ruling. On the Taxpayer s appeal against Tribunal ruling, the Bombay HC held [4] that (a) the provisions of s.14a are applicable to dividend income which is exempt in the hands of the shareholder even though such dividend suffers DDT in the hands of the company (b) s.14a applies where there is proximate relationship between the expenditure and the exempt income and (c) the procedural provisions and Rule 8D are prospective in nature and apply from tax year onwards. Both the Taxpayer and the Tax Authority filed further appeals before the SC. The Taxpayer s appeal was against the Bombay HC s ruling on applicability of s.14a to dividend income and disallowance made by the Tax Authority in the facts of its case. The Tax Authority s appeal was against Bombay HC s ruling that the procedural provisions and Rule 8D are prospective in nature and apply from tax year onwards. Issues before the SC Irrespective of factual position and findings in the Taxpayer s case, whether s.14a disallowance applies to exempt dividend income in respect of which company/mutual fund is liable to pay DDT? Irrespective of legal position of applicability of s.14a to dividend income, whether any disallowance was attracted in the Taxpayer s case where the Tax Authority had accepted non-applicability of s.14a in earlier years? Contentions of the Taxpayer S.14A applies only when the income is tax-free; non-taxable and there is no incidence of tax per se. Dividend on shares is subjected to DDT under a specific provision of the ITL. As tax is already paid in the form of DDT by the company paying the dividend, s.14a should not apply since the income is really not tax-free. The fact that tax on dividend is paid by company as DDT and not by the shareholder is not relevant. Same principle applies for mutual fund income where mutual fund is liable to pay income distribution tax. The exemption applies to dividend received from domestic company which is liable to DDT and not to dividends received from foreign companies where no DDT is paid. This shows that domestic dividend is really not tax-free. In the present case, the SC was concerned with the Taxpayer s appeal alone. The SC clarified that the Tax Authority s appeal on retrospective application of Rule 8D is presently pending and the SC has not adjudicated on that issue. [4] [(2010)[328 ITR 81](Bom)] Refer EY Tax Alert - Bombay and Kerala High Courts rule on disallowance of expenditure incurred in relation to exempt income dated 13 August The exemption for dividend income and payment of DDT constitute a composite scheme for taxation of dividend. The dividend is taxed in the hands of the company distributing the dividend and, consequently, is not included in the total income of the shareholder. This scheme was withdrawn for one year in tax year and again reintroduced from tax year which shows that the provisions form an integrated code. The mere fact that the dividend income is not to be included in the total income of a taxpayer would not attract the provisions

4 of s.14a, since the cardinal test is whether the dividend income is tax-free or not. For this purpose, it is not relevant who bears or who pays the tax. A literal interpretation of s.14a to dividend income leads to manifest absurdity of disallowance of expense despite payment of DDT. This is contrary to the legislative intent and must be avoided. Reliance was placed on the earlier SC judgement in the case of K.P.Varghese v. ITO [5] (K. P. Varghese ruling). DDT is an additional tax payable on the profits of a company and no credit of such additional tax is available either to the company or to the shareholder. Furthermore, the DDT provision specifically precludes any deduction in the hands of shareholder or the company in respect of dividend which is subjected to DDT. The liability to pay DDT is on the dividend paying company. The dividend income is exempt in the hands of the shareholder and, hence, the expenditure incurred by shareholder for earning dividend income cannot be allowed. DDT is not a tax on profits earned by the company since DDT is payable only on dividend declared, distributed or paid by the company which may be from current year s or earlier years profits. DDT is payable even if the company is not liable to income-tax under regular provisions. Contentions of the Tax Authority The insertion of s.14a was to specifically offset several judicial pronouncements which, prior to insertion of s.14a, held that in case of a taxpayer earning income which is both includible and nonincludible in the total income, the entire expenses would be permissible as deduction, including, expenses pertaining to income not includible in the total income. The scheme of the ITL is very clear. Dividend income if it is liable to tax needs to be computed on net basis after allowing the deductions permitted by the ITL. Consequently, if dividend income is exempt, the exemption needs to be computed on net basis. S.14A reiterates this fundamental principle that expenses are allowable only to the extent they have nexus to earning of taxable income. Reliance was placed on the earlier SC ruling in the case of CIT v. Walfort Share & Stock Brokers P. Ltd. [6] (Walfort ruling) for this proposition. [5] [(1981)[131 ITR 597](SC)] [6] [(2010)[326 ITR 1](SC)] The withholding tax provisions of the ITL exclude dividend income on which DDT has been paid. This supports that DDT cannot assume the character of tax paid on the dividend income by the shareholder. SC ruling The SC ruled in Tax Authority s favor on the first issue pertaining to applicability of s.14a to exempt dividend income but on the facts of the Taxpayer s case, it held that no disallowance was attracted having regard to the consistent findings in earlier years accepted by the Tax Authority. Applicability of s.14a to exempt dividend income The object behind the introduction of s.14a was to deny the claim of allowance of expenditure incurred towards earning exempt income in a situation where a taxpayer has both exempt and nonexempt income. The deduction of expenses incurred on exempt dividend income cannot be allowed on the ground that DDT has been paid by the dividend paying company. The exempt dividend income is not a part of the total income of the taxpayer. A plain reading of s. 14A would go to show that the income must not be includible in the total income of the taxpayer. Once the said condition is satisfied, the expenditure incurred in earning the said income cannot be allowed to be deducted. On a plain and literal reading, s.14a does not envisage a situation where deduction of expenses can be

5 allowed in the hands of shareholder merely because tax on exempt dividend income has been paid by way of DDT by the company. A plain and literal reading of S.14A does not give rise to any absurdity. S.14A is consistent with the object/purpose of the ITL for levy of tax. It is well-settled that where the words of the statute are clear and unambiguous, no other principle of interpretation other than literal interpretation can be applied [7]. K. P. Varghese ruling is distinguishable since, in that case, application of literal reading of the provision led to manifest an absurdity whereby a tax burden was imposed on the taxpayer despite honestly honouring his contractual obligation. The scheme of the ITL is that dividend which is subjected to DDT is not included in total income of shareholder. S.14A stands clearly attracted in such situation. Dividend exemption and DDT was withdrawn in tax year Dividend became taxable in hands of the shareholder in that year and consequently, the shareholder was also entitled to claim deduction of expenses. Dividend exemption and DDT was reintroduced from tax year onwards. Consequently, the position is reversed. DDT provision makes it clear that neither the dividend paying company nor the shareholder can claim any deduction in respect of dividend income. [7] Reliance for this proposition placed on earlier SC rulings in the cases of CIT v. Calcutta Knitwears [(2014)[6 SCC](SC)] and CIT v. Tara Agencies [(2007)[292 ITR 444](SC)] as also popular observations of Rowlatt, J in the English ruling of Cape Brandy Syndicate v. IRC (1921)[1 KB 64] to the effect that.in a taxing statute one has to look at what is clearly said. There is no room for any intendment. There is no equity about a tax. There is no presumption as to a tax. Nothing is to be read in, nothing is to be implied. One can only look fairly on the language used. The Walfort ruling also makes it clear that expenses can be allowed only if it is in respect of earning taxable income. S.14A disallows expenditure incurred to earn exempt income and prevents it from being deducted against other taxable income. Whether disallowance was attracted in the Taxpayer s facts It is true that procedural provisions to compute disallowance were inserted by Finance Act Prior to such insertion, the Tax Authority was required to compute disallowance on best judgement basis. But irrespective of the methodology of computation of disallowance, it cannot be denied that s.14a requires proof of the fact that expenditure if it is to be disallowed was actually incurred in earning exempt dividend income. Before applying s.14a, the Tax Authority should be satisfied that having regard to accounts of the taxpayer, the taxpayer s claim is not correct. In the facts of present case, the Tax Authority had failed to establish a reasonable nexus between interest expenditure sought to be disallowed and exempt dividend income. The Tax Authority had failed to establish that any part of borrowed funds were diverted to make investments, despite availability of interest-free funds in the form of share capital and reserves. Moreover, the Tax Authority had accepted in earlier years litigation that investments yielding exempt income were not made from borrowed funds. There being no change in facts or law in the current year, the Tax Authority was not justified in departing from the settled position for earlier years in absence of strong and compelling reasons. Reliance was placed on earlier SC ruling in the case of Radhasoami Satsang v. CIT [8] which held that although it is true that [8] [(1992)[193 ITR 321](SC)]

6 every tax year is an independent unit of assessment but where a fundamental aspect permeating through different tax years has been accepted by both the parties, it would not be appropriate to change the position in subsequent year. Comments The present SC ruling is a landmark ruling which settles the principles on contentious issue of application of s.14a to exempt dividend income which is subject to DDT. Incidentally, the Income Tax Simplification Committee set up by the Government of India had recommended in its first report published in 2016 that the tax provisions should be designed on the basis of economic taxation and expenditure incurred in connection with earning dividend income, which is subjected to DDT, should not suffer any disallowance. The present SC ruling reaffirms the legal basis for application of s.14a to exempt dividend income by holding that the fact that such income is subjected to DDT in hands of the company is not a relevant circumstance to allow deduction of expense in hands of shareholder. However, it also reaffirms the consistent rulings of several High Courts that prerequisite for application of s.14a are (a) finding by the Tax Authority that expenditure is actually incurred in earning dividend income and (b) recording of satisfaction, based on accounts of taxpayer, regarding incorrectness of taxpayer s claim for lower or NIL disallowance.

7 Our offices Ahmedabad 2nd floor, Shivalik Ishaan Near C.N. Vidhyalaya Ambawadi Ahmedabad Tel: Fax: Bengaluru 6th, 12th & 13th floor UB City, Canberra Block No.24 Vittal Mallya Road Bengaluru Tel: Fax: Ground Floor, A wing Divyasree Chambers # 11, O Shaughnessy Road Langford Gardens Bengaluru Tel: Fax: Chandigarh 1st Floor, SCO: Sector 9-C, Madhya Marg Chandigarh Tel: Fax: Chennai Tidel Park, 6th & 7th Floor A Block (Module 601, ) No.4, Rajiv Gandhi Salai Taramani, Chennai Tel: Fax: Delhi NCR Golf View Corporate Tower B Sector 42, Sector Road Gurgaon Tel: Fax: rd & 6th Floor, Worldmark-1 IGI Airport Hospitality District Aerocity, New Delhi Tel: Fax Hyderabad Oval Office, 18, ilabs Centre Hitech City, Madhapur Hyderabad Tel: Fax: Jamshedpur 1st Floor, Shantiniketan Building Holding No. 1, SB Shop Area Bistupur, Jamshedpur Tel: BSNL: Kochi 9th Floor, ABAD Nucleus NH-49, Maradu PO Kochi Tel: Fax: Kolkata 22 Camac Street 3rd Floor, Block C Kolkata Tel: Fax: Mumbai 14th Floor, The Ruby 29 Senapati Bapat Marg Dadar (W), Mumbai Tel: Fax: th Floor, Block B-2 Nirlon Knowledge Park Off. Western Express Highway Goregaon (E) Mumbai Tel: Fax: Pune C-401, 4th floor Panchshil Tech Park Yerwada (Near Don Bosco School) Pune Tel: Fax: Ernst & Young LLP EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization and may refer to one or more of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Ernst & Young LLP is one of the Indian client serving member firms of EYGM Limited. For more information about our organization, please visit Ernst & Young LLP is a Limited Liability Partnership, registered under the Limited Liability Partnership Act, 2008 in India, having its registered office at 22 Camac Street, 3rd Floor, Block C, Kolkata Ernst & Young LLP. Published in India. All Rights Reserved. ED None This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither Ernst & Young LLP nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor. 4th & 5th Floor, Plot No 2B Tower 2, Sector 126 NOIDA Gautam Budh Nagar, U.P. Tel: Fax: EY refers to global organization, and/or one or more of the independent member firms of Ernst & Young Global Limited Join India Tax Insights from EY on