Supreme Court (SC) Ruling – Whether the expenditure incurred (including interest paid on funds borrowed), while purchasing the shares/ stocks of a company for the purpose of gaining control over the investee company or as 'stock-in-trade' (i.e. as a business activity) and not as investment to earn dividends, can be treated as expenditure ‘in relation to income i.e. dividend income, which does not form part of the total income?
Maxopp Investment Ltd. vs. CIT, New Delhi with Others
[Civil Appeal Nos. 104-109 of 2015]/  91 taxmann.com 154 (SC)
Facts of the case:
Maxopp Investment Ltd., the appellant, is engaged, in the business of finance, investment and dealing in shares and securities. The appellant holds shares/securities in two portfolios:
a) as investment on capital account; and,
b) as trading assets for the purpose of acquiring and retaining control over investee group companies, particularly Max India Ltd., a widely held quoted public limited company
The profit/ loss arising on sale of shares/ securities held as ‘investment’ is returned as income under the head ‘capital gains’, whereas any profit/ loss arising on sale of shares/ securities held as ‘trading assets’ (i.e. held with the intention of acquiring, exercising and retaining control over the investee group companies) has been regularly offered and assessed to tax as business income under the head ‘profits and gains of business or profession’.
The appellant filed return of income for the AY 2002-03, declaring income of INR 78,90,430. The appellant being consistent with the treatment regularly followed, did not disallow the interest expenditure to the extent relatable to investment in shares of Max India Limited, yielding tax free dividend income. According to the appellant, the dominant purpose/ intention of investment in shares of Max India Ltd was to acquire/ exercise and retain control and not earn dividend income. The dividend income of INR 49,90,860 earned on shares of Max India Ltd was only incidental to the holding of such shares.
The Assessing Officer (AO) worked out a disallowance under Section 14A of the Income-tax Act, 1961 (the Act) by apportioning the total interest expenditure in the ratio of investment in shares of Max India Ltd. (on which dividend was received) to the total amount of unsecured loan. The AO, however, restricted disallowance under Section 14A to the amount of dividend received of INR 49,90,860 and claimed exempt income.
The Commissioner of Income-tax (Appeals) [CIT(A)] upheld the order of the AO. Thus, the appellant carried the matter in further appeal to the Income-tax Appellate Tribunal (ITAT). In view of the conflicting decisions of various Benches by the ITAT, with respect to the interpretation of Section 14A of the Act, a Special Bench was constituted in the case of ITO v. Daga Capital Management (Private) Ltd. [312 ITR (AT) 1]. The appeal of the appellant was also tagged and heard by the aforesaid Special Bench.
The Special Bench held that the investment in shares representing controlling interest did not amount to carrying on of business and, therefore, interest expenditure incurred for acquiring shares in group companies was hit by the provisions of Section 14A of the Act. The appellant preferred appeal to the High Court, under Section 260A of the Act, against the aforesaid order of the Special Bench.
The Hon’ble Delhi High Court also held that the expression ‘in relation to’ appearing in Section 14A of the Act is synonymous with ‘in connection with’ or ‘pertaining to’, and, that the provisions of Section 14A apply regardless of the intention/ motive behind making the investment. Thus, the Court maintained a proportionate disallowance of the expenditure incurred by the appellant.
Contentions of the appellant before the Hon’ble SC:
Key Observations / conclusions of the Hon’ble SC:
1. Delhi High Court ruling in the case of appellant  347 ITR 272 (Delhi) (expenditure incurred (including interest paid on funds borrowed) in respect of investment in shares of operating companies for acquiring and retaining a controlling interest)
However, where the business was divisible, the principle of apportionment of the expenditure was applicable and the expenditure apportioned to the ‘exempt’ income or income not exigible to tax, was not allowable as a deduction
In the case of an income like dividend income, which does not form part of the total income, any expenditure/ deduction relatable to such (exempt or non-taxable) income, even if it is of the nature specified in Sections 15 to 59 of the Act, it cannot be allowed against any other income which is included in the total income
2. Punjab and Haryana High Court ruling in the case of PCIT v. State Bank of Patiala  391 ITR 218 (Exempt income in the form of dividend was earned by the Bank from securities held by it as its stock in trade)
3. Aspect 1: Shares are held as investment in the investee company for the purpose of having controlling interest
4. Aspect 2: Shares are held as ‘stock-in-trade’ and not as ‘investment’, particularly, by the banks
5. For appeals pertaining to period prior to introduction of Rule 8D, the Hon’ble SC held that Rule 8D is prospective in nature and could not have been made applicable in respect of the assessment years prior to 2007 when the said Rule was inserted. The said view has been upheld by the decision of the Hon’ble SC in the case of CIT, Mumbai v. M/s. Essar Teleholdings Ltd. (Civil Appeal No. 2165 of 2012) wherein the said Rule is held to be prospective in nature
The decision of the SC reiterates the principle as laid down by various High Courts and Supreme Courts, that the principle behind enacting Section 14A in the Act, is to disallow any expenditure incurred ‘in relation to the income which does not form part of the total income under this Act’.
The SC held that in determining the disallowance, what is to be considered in law is not the intention or the dominant intention while making the purchase of such investment, which results in earning non-taxable income. It is only to the extent of not considering the intention or dominant intention that the SC has held, that one would need to consider the law, and disallow such expenditure in relation to such non-taxable income.
However, one would need to keep in mind certain extremely critical observations of the SC, which are important in determining the law as regards ‘what is the expenditure that is in relation to the income which does not form part of the total income’.
The SC states that, only that expenditure which has been incurred in relation to non-taxable income has to be disallowed. If an expenditure incurred has no ‘principal connection’ with the exempted income, then such an expenditure would clearly be treated as not ‘in relation to the income which does not form part of the total income’ and thus, such expenditure would be allowed as business expenditure.
The SC further observed that the action of the AO in the case of State Bank of Patiala (supra), by restricting the disallowance of expenditure to the amount which was claimed as exempt income, by applying Section 14A r.w. Rule 8D was reasonable.