SC rejects dominant purpose test for exclusion of strategic investments in calculation of disallowance u/s 14A - Maxopp Investment Ltd.

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]/ [2018] 91 154 (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:

  • The holding of investment in group companies representing controlling interest, amounts to carrying on business, as held in the various cases
  • As per Section 56 of the Act, the dividend income is assessable under the head ‘income from other sources’. Where dividend is earned on shares held as stock-in-trade/ shares purchased for acquiring/ retaining and controlling interest, dividend income is in the nature of business income
  • Interest paid on loans borrowed for acquiring shares representing controlling interest in the investee company is allowable as business expenditure in terms of Section 36(1)(iii) of the Act, as the same is for the purpose of business and/or profession and not for earning dividend
  • Conversely, interest paid on funds borrowed for investment in shares representing controlling interest does not represent expenditure incurred for earning dividend income and is not allowable under Section 57(iii) of the Act (prior to introduction of Section 14A)

Key Observations / conclusions of the Hon’ble SC:

1.   Delhi High Court ruling in the case of appellant [2012] 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)

  • The law prior to the introduction of Section 14A was that, when an assessee had a composite and indivisible business which had elements of both taxable and non-taxable income, the entire expenditure in respect of the said business was deductible and in such a case, the principle of apportionment of the expenditure relating to the non-taxable income did not apply.

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

  • The object behind the insertion of Section 14A reflects the serious attempt on the part of Parliament not to allow deduction in respect of any expenditure incurred by the assessee in relation to income, which does not form part of the total income

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

  • The term ‘expenditure incurred’ as appearing in Section 14A(1) of the Act means incurring of actual expenditure and not some imagined expenditure. The ‘actual’ expenditure that is in contemplation under Section 14A(1) of the said Act is the ‘actual’ expenditure in relation to or in connection with or pertaining to exempt income. Hence, if no expenditure is incurred in relation to the exempt income, no disallowance can be made under Section 14A of the Act.

2.   Punjab and Haryana High Court ruling in the case of PCIT v. State Bank of Patiala [2017] 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)

  • The High Court accepted that the assessee was engaged in the purchase and sale of shares/ securities as a trader with the object of earning profit and not with a view to earn interest or dividend. The assessee did not have an investment portfolio and the dividend and interest earned was from the securities that constituted the assessee’s stock-in-trade
  • The above contention was supported by the CBDT Circular No.18, dated 2 November 2015. The High Court observed 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. Further, if the object is to derive income by way of dividend then the profit would be said to have accrued from the investment. The assessee may have two portfolios, namely, investment portfolio and a trading portfolio. In the case of the former, the securities are to be treated as capital assets and in the latter as trading assets
  • Reference was made to the judgments of various Supreme Courts and High Courts:
    o    CIT v. Nawanshahar Central Co-operative Bank Ltd. [2007] 289 ITR 6 (SC)
    o    CIT v. Walfort Share and Stock Brokers P Ltd 326 ITR 1 (SC)
    o    CCI Ltd. v. JCIT, Udupi [2012] 206 Taxman 563 (Kar)
    o    CIT v. G.K.K. Capital Markets (P.) Ltd. [2017] 392 ITR 196 (Cal)
    o    Dhanuka and Sons v. CIT [2011]339 ITR 319 (Cal)

3.   Aspect 1: Shares are held as investment in the investee company for the purpose of having controlling interest

  • The dominant purpose for which the investment is made by the appellant into shares may not be relevant. Thus, the appellant making the investment in order to gain control of the investee company is not a relevant factor 
  • If expenditure is incurred on earning the dividend income, that much of the expenditure which is attributable to the dividend income has to be disallowed and cannot be treated as business expenditure
  • The principle of apportionment of expenses as ingrained in Section 14A of the Act is important and for the said principle, reliance is placed on the judgment of the Walfort Share and Stock Brokers P Ltd (supra) 
  • The Hon’ble Supreme Court relied on the decision of the Hon’ble Delhi High Court in the case of the appellant and held that the Legislature has not only inserted Section 14A by the Finance (Amendment) Act, 2001 but also made it retrospective, i.e., 1962 when the Act itself came into force. The legislative intent and objective behind the insertion of Section 14A was also expressed in the Memorandum explaining the provisions of the Finance Bill, 2001
  • The Hon’ble Supreme Court accepted the view taken by the Delhi High Court in the appellant’s case, and did not accept the dominant purpose theory as laid down by the State Bank of Patiala (supra). 
  • Thus, based on the above reasoning, the Hon’ble SC dismissed the appeals of the appellant as well as similar cases, where shares were purchased by the appellant to have controlling interest in the investee companies 

4.    Aspect 2: Shares are held as ‘stock-in-trade’ and not as ‘investment’, particularly, by the banks

  • Circular No. 18/2015 dated November 02, 2015 issued by CBDT clarifies that the investments made by a banking concern are part of the business or banking and thus, the income arising from such investments is attributable to business of banking falling under the head ‘profits and gains of business and profession’
  • The SC held that the Hon’ble Punjab and Haryana High Court in the case of State Bank of Patiala is correct on the issue when it carves out a distinction between ‘stock-in-trade’ and ‘investment’. However, the SC did not agree to the test of dominant intention as applied by the Punjab and Haryana High Court
  • The applicability of Section 14A is triggered in cases when shares are held as stock-in-trade and the main purpose is to trade in those shares and earn profits. This so, as certain dividend income is incidentally earned. However, by the provisions of Section 10(34) of the Act, dividend income is not included in the total income and is exempt from tax. Hence, the expenditure incurred in acquiring those shares will have to be apportioned, based on the facts of each case, between taxable and non-taxable income as held in the case of Walfort Share and Stock Brokers P Ltd. (supra)
  • Where shares are held as 'stock-in-trade', it becomes a business activity of the assessee to deal in those shares as a business proposition. Whether dividend is earned or not becomes immaterial. The earning of dividend income is therefore, incidental to the trading of securities and is thus, distinguishable from the activity of investment, which results in acquiring a controlling interest in the investee company
  • As per the provisions of Section 14A(2) of the Act, read with Rule 8D of the Income-tax Rules, 1962 (the Rules), before applying the theory of apportionment, the AO needs to record his satisfaction, that having regard to the kind of the assessee, suo moto disallowance under Section 14A is incorrect. The AO in such cases, would need to record his satisfaction as to why the disallowance made by the assessee is not correct in facts and in law. Further, nature of loan taken by the assessee for purchasing the shares/making the investment in shares is to be examined by the AO

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


Our Comments:

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.

17 Mar 2018