SEMINAR ON SECTION 14A DISALLOWANCE AND DEEMED DIVIDEND

SEMINAR ON SECTION 14A DISALLOWANCE AND DEEMED DIVIDEND

Deemed Dividend-Legislative Intent The insertion of section 14A in 2001 was mainly done to make the following Supreme Court judgments non functional: i) CIT v. Maharashtra Sugar Mills Ltd. [1971] 82 ITR 452 and ii) Rajasthan State Warehousing Corporation v. CIT [2000] 242 ITR 450 wherein it was held that where there is one indivisible business giving rise to taxable income as well as exempt income, the entire expenditure incurred in relation to that business would have to be allowed even if a part of the income earned from the business is exempt from tax. Thus, Sec. 14A empowers the AO to apportion the indivisible expenditure to the tax exempt activity which was otherwise not possible in the light of the Supreme Court decisions as mentioned above.

The section was inserted vide Finance Act, 2001 with retrospective effect from 1.4.1962 as follows : 14A. 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..

Subsequently, the proviso was added by Finance Act 2002 with retrospective effect from 11.5.2001. It provides that this section shall not empower the Assessing Officer (AO) either to reassess or pass an order enhancing the assessment or reducing the refund already made or otherwise increasing the liability of the assessee for any assessment year beginning on or before 1st day of April 2001. Sub sections 2 & 3 were inserted by Finance Act 2006 w.e.f. 1.4.2007. Sub section (2) empowers the AO to determine the amount of expenditure incurred in relation to such income which does not form part of total income in accordance with the method as may be prescribed.

Insertion of Rule 8D By virtue of the powers conferred under sub section (2), Rule 8D was inserted by gazette notification dated 24.3.2008 which prescribes the method for computing the expenditure incurred in relation to the income not forming part of total income. Thus, Rule 8D was made applicable w.e.f A.Y. 2008-09 for estimating expenses relatable to exempt and income and to be disallowed u/s 14A.

Estimation of Disallowance Prior to Rule 8D Prior to A.Y. 2008-09 should be restricted to 1% of exempt income. Commissioner Of Income Tax, Kolkata-iv, Kolkata Versus M/S. Rr. Sen & Brothers (P) Ltd. GA No. 3019 of 2012 I.T.A.T. No. 243 of 2012 (Cal) After insertion of Rule 8D In accordance with Rule 8D

Analysis 14A. [(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 assesee 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 the 1st day of April, 2001.]

Sub-Section (2) provides that if an Assessing Officer is not satisfied with the correctness of the claim of the assesee in respect of such expenditure in relation to income then he shall proceed to compute the disallowance. Thus, the pre-requisite is recording of satisfaction by the assessing officer. Godrej and Boyce Mfg. Co. Ltd vs. Deputy Commissioner of Income Tax [2010] 328 ITR 0081 Maxopp Investment Ltd vs. CIT (Delhi High Court) DCIT vs. Jindal Photo Ltd (Delhi High Court) Rei Agro Ltd., Kolkata vs Department Of Income Tax I.T.A No. 1811/Kol/2012

Sub-section (1) of section 14A clearly postulates that while computing total income under Chapter VI (Computation of Total Income) no deduction shall be allowed in respect of expenditure incurred by an assessee in relation to income not forming part of the total income under the Income Tax Act, 1961. Thus, the scope of Section 14A lies embedded in these two expressions incurred and in relation to. This, implies that: (i) the expenditure should be actually incurred i.e. no notional disallowance can be made and (ii) The expenditure should be related to the exempt income.

No notional/imagined expenditure can be disallowed Maxopp Investment Ltd vs. CIT (Delhi High Court) ITA67/2009

Relatable expenditure Nexus between expenditure sought to be disallowed and exempt income has to be established in order to make disallowance in accordance with Rule 8D. CIT V/s Wallfort Share and Stock Brokers pvt. Ltd [326 ITR 1] (SC) Godrej and Boyce Mfg co. l td V/s Dy CIT [328 ITR 81] (Bom) CIT vs. Hero Cycles [323 ITR 518] (P& H) Maruti Udyog vs. DCIT 92 ITD 119 (Del) Yatish Trading Co. (P) Ltd. Vs. ACIT (2011) 50 DTR (Mum)(Trib) 158: (2011) 129 ITD 237

Rule 8D Inserted for prescribing a uniform method for computing the disallowance. Rule 8D(1) emphasizes on the requirement of recording of satisfaction and is in line with the provisions of Section 14A(2).

Rule 8D(2) (2) The expenditure in relation to income which does not form part of the total income shall be the aggregate of following amounts, namely:- (i) the amount of expenditure directly relating to income which does not form part of total income;

Rule 8D(2) (ii) in a case where the assessee has incurred expenditure by way of interest during the previous year which is not directly attributable to any particular income or receipt, an amount computed in accordance with the following formula, namely:- A x B C Where A = amount of expenditure by way of interest other than the amount of interest included in clause (i) incurred during the previous year; 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 previous 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 previous year;

Rule 8D(2) (iii) an amount equal to one-half 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 previous year."

Analysis of Rule 8D(2) (i) provides for disallowance of direct expenses such as demat charges etc. (ii) provides for disallowance of proportionate general interest expenditure. (iii) provides for disallowance of indirect expenses(0.5% of total assests)

Proportionate Interest disallowance Nexus between borrowed funds and investments has to be proved. No presumption can be made. Hero Cycles 323 ITR 518 (P&H) Winsome Textile Industries 319 ITR 204 (P&H)

Proportionate Interest disallowance If own funds are more than borrowed and mixed pool of funds is maintained the presumption is that interest-free funds were used to make investments. Woolcombers of India Ltd. v. Commissioner of Income-tax (Cal) 134 ITR 219 Reckitt & Colman of India Ltd v. Commissioner of Income-tax (Cal) 135 ITR 698 Indian Explosives Ltd v. Commissioner of Income-tax (Cal) 147 ITR 392 British Paints (India) Ltd. v. Commissioner of Income-tax (Cal) 190 ITR 196 Alkali & Chemical Corporation of India Ltd. v. Commissioner of Income-tax (Cal) 161 ITR 820

Proportionate Interest disallowance Net Interest is to be taken for computing Net Interest is positive- no interest disallowance Trade Apartment Ltd- ITAT Kolkata Morgan Stanley India Securities Private Limited- ITAT MUM Karnavati Petrochem Pvt.Ltd.- ITAT AHM

Indirect Expenses- 0.5% of Investments For computing disallowance of indirect expenses- thumb rule of 0.5% of investments is followed. However, even for this disallowance the requirement of recording specific satisfaction is to be satisfied. Godrej and Boyce Mfg co. l td V/s Dy CIT [328 ITR 81] (Bom) J. K. Investors (Bombay) Ltd. Vs. ACIT- ITA No.7858/Mum/2011 Rei Agro Ltd., Kolkata vs Department Of Income Tax I.T.A No. 1811/Kol/2012

Meaning of Average Investment for Rule 8D ITAT Kolkata has laid to rest the controversy whether Total Average Investments have to be taken or only Dividend Yielding Investments have to be taken. REI Agro Ltd vs. DCIT (ITAT Kolkata) I.T.A. No. 1331/Kol/2011

No exempt income no disallowance CIT vs. M/s.Delite Enterprises (Bombay High Court) N.B. Contrary views exist -Cheminvest Ltd vs. ITO (ITAT Delhi Special Bench)

Circular No.5 dated 11/02/2014 The CBDT has issued Circular No. 5 of 2014 dated 11.02.2014 in which it has clarified that disallowance under section 14A and Rule 8D can be made in cases where the corresponding exempt income has not been earned during the financial year. However, a circular is only binding on the Income Tax Authorities. When Supreme Court or a High Court has declared the law on the question arising for consideration, it is not be open to a Court to direct that a circular should be given effect to and not the view expressed in the decision of the Supreme Court or the High Court.

Deemed Dividend (22) "dividend" includes- (e) any payment by a company, not being a company in which the public are substantially interested, of any sum (whether as representing a part of the assets of the company or otherwise) made after the 31st day of May, 1987, by way of advance or loan to a shareholder, being a person who is the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) holding not less than ten per cent. of the voting power, or to any concern in which such shareholder is a member or a partner and in which he has a substantial interest (hereafter in this clause referred to as the said concern) or any payment by any such company on behalf, or for the individual benefit, of any such shareholder, to the extent to which the company in either case possesses accumulated profits ;

Analysis Three such situations are contemplated, being (a) any payment by way of advance or loan to a shareholder was considered as dividend paid to share- holder or (b) any payment by any such company on behalf or for the individual benefit of a shareholder was considered as dividend and (c) any payment by way of advance or loan to a concern in which such shareholder is a member or a partner and in which he has a substantial interest. Further the three situations laid out above have to be seen disjoint and not as interconnected.

It is firstly seen that the section records the term shareholder. The words "shareholder alone existed in the definition of dividend in the 1922 Act. This expression "shareholder" has been interpreted under the 1922 Act to mean a registered shareholder. Thus the expression "shareholder" found in the 1961 Act also has to be, therefore, construed as applying only to registered shareholder. The word "shareholder" is followed by the following words "being a person who is the beneficial owner of shares. Thus, the shareholder has to be registered holder as well as beneficial owner of the shares.

Further condition that the registered shareholder has also to be the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) holding not less than ten per cent of the voting power.

Accumulated Profit Only accumulated profits not the entire Reserves and Surplus and computed upto the date of payment. Rajesh P. Ved Vs ACII (ITAT, Mum) 1 ITR (Trib) 275 Smt. Meena Talukdar v. ITO, 15 TTJ 379 (Cal.)

Taking up the three situations The first to situations are straight and cover payments to shareholder or on his behalf. The third situation requires discussion: payment to any concern in which such shareholder is a member or a partner and in which he has a substantial interest (hereafter in this clause referred to as the said concern.

Conditions for attraction of the third limb of the Section (a) There must be a payment to a concern by a company. (b) A person must be a shareholder of the company being a registered holder and beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) holding not less than ten per cent. of the voting power. (c) The very same person referred to in (b) above must also be a member or a partner in the concern holding substantial interest in the concern and where the concern is a company he must be the owner of shares, not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits, carrying not less than twenty per cent. of the voting power.

If the conditions are satisfied then the payment by the company to the concern will be dividend. The question that arises is that in whose hands will it be taxed? The said section does not not spell out in specific terms as to whose hands such deemed dividend are to be taxed, whether in the hands of the " concern" or the " share-holder". The provisions are ambiguous.

Deeming fiction cannot be extended to non-shareholder Assistant Commissioner of Income-tax v. Bhaumik Colour P. Ltd. (313 ITR(AT) 147) Mum SB Commissioner Of Income Tax vs Ankitech Pvt Ltd. (Delhi H.C.) 242 CTR 129 dated 11/05/2011 Commissioner of Income-tax v. Universal Medicare Private Limited (324 ITR 263) Bom

Only Gratuitous Advances Pradip Kumar Malhotra v. Commissioner of Incometax [338 ITR 538] (Cal)

Special situations - Inter-Corporate Deposits IFB Agro Industries Ltd vs. JCIT (ITAT Kolkata) I.T.A No. 1721/Kol/2012 Bombay Oil Industries 28 SOT 383 (Bom)

Special situations - Trade Advances Trade advances which are in the nature of money transacted to give effect to a commercial transaction would not fall within the ambit of the provision of section 2(22)(e) of the Act. CIT vs. Raj Kumar, 318 ITR 462 (Delhi) CIT vs. Nagindas M. Kapadia, 177 ITR 393 (Bom) CIT vs. Ambassador Travels P. Ltd., 318 ITR 376 (Delhi), and many more

Special situations -Mere book entries Mere book entries do not constitute payment by the company CIT vs. Smt. Savithiri Sam (1998) 144 CTR (Mad) 17 : (1999) 236 ITR 1003 (Mad)