2011 (11) TMI 30 - HC - Income Tax

Provisions of Section 14A read with Rule 8D - whether interest paid on funds borrowed for investing in shares of operating companies for acquiring and retaining a controlling interest therein is allowable under section 36(1)(iii) and is not hit by section 14A of the Income tax Act, 1961. - retrospective applicability of the sub-sections (2) & (3) of the said section 14A and of the said Rule 8D to the assessment years in question which range from 1998-99 to 2005-06. - Held that - the amount of expenditure in relation to exempt income has two aspects (a) direct and (b) indirect. The direct expenditure is straightaway taken into account by virtue of clause (i) of sub-rule (2) of Rule 8D. The indirect expenditure, where it is by way of interest, is computed through the principle of apportionment, as indicated above. And, in cases where the indirect expenditure is not by way of interest, a rule of thumb figure of one half percent of the average value of the investment, income from which does not or shall not form part of the total income, is taken. The provisions of subsections (2) and (3) of Section 14A would be workable only with effect from the date of introduction of Rule 8D. This is so because prior to that date, there was no prescribed method and sub-sections (2) and (3) of Section 14A remained unworkable. - Rule 8D would operate prospectively. Even for the pre-Rule 8D period, whenever the issue of section 14A arises before an Assessing Officer, he has, first of all, to ascertain the correctness of the claim of the assessee in respect of the expenditure incurred in relation to income which does not form part of the total income under the said Act. - In case, the assessing officer is not, on the basis of objective criteria and after giving the assessee a reasonable opportunity, satisfied with the correctness of the claim of the assessee, he shall have to reject the claim and state the reasons for doing so. Having done so, the assessing officer will have to determine the amount of expenditure incurred in relation to income which does not form part of the total income under the said Act. He is required to do so on the basis of a reasonable and acceptable method of apportionment.

Issues Involved:
1. Whether expenditure (including interest paid on funds borrowed) for investment in shares of operating companies for acquiring and retaining a controlling interest is hit by section 14A of the Income Tax Act, 1961.
2. Whether the provisions of sub-section (2) and sub-section (3) of section 14A inserted by the Finance Act, 2006 with effect from 01/04/2007, apply retrospectively to all pending proceedings.
3. Whether Rule 8D inserted by the Income-tax (Fifth Amendment) Rules, 2008 with effect from 24/03/2008 is procedural in nature and hence applies retrospectively to all pending proceedings.

Detailed Analysis:

Issue 1: Applicability of Section 14A to Expenditure for Acquiring Controlling Interest
The court examined whether the interest paid on funds borrowed for investing in shares of operating companies to acquire and retain a controlling interest is allowable under section 36(1)(iii) and is not hit by section 14A. The assessees argued that the intention behind acquiring such shares was not to earn dividend but to acquire and retain a controlling interest, making the dividend income incidental. Therefore, they contended that the interest paid on the borrowed funds should be allowable as business expenditure.

However, the court emphasized that section 14A was introduced to ensure that no deduction shall be allowed in respect of expenditure incurred in relation to income which does not form part of the total income under the Act. The court rejected the narrow interpretation of "in relation to" suggested by the assessees and held that if the expenditure has a relation or connection with or pertains to exempt income, it cannot be allowed as a deduction. The court concluded that the expenditure incurred in relation to exempt income is not allowable, even if it otherwise qualifies under the other provisions of the Act.

Issue 2: Retrospective Applicability of Sub-sections (2) and (3) of Section 14A
The court analyzed whether sub-sections (2) and (3) of section 14A, introduced by the Finance Act, 2006 with effect from 01/04/2007, apply retrospectively. The court noted that these sub-sections were introduced prospectively and were intended to apply from the assessment year 2007-08 onwards. The court referred to the Notes on Clauses of the Finance Bill, 2006, and the CBDT Circular No.14/2006, which clearly indicated that the amendments would apply from the assessment year 2007-08 and subsequent years.

The court held that sub-sections (2) and (3) of section 14A are prospective and do not apply retrospectively. Therefore, these provisions cannot be applied to assessment years prior to 2007-08.

Issue 3: Retrospective Applicability of Rule 8D
The court examined whether Rule 8D, introduced by the Income-tax (Fifth Amendment) Rules, 2008 with effect from 24/03/2008, applies retrospectively. The court observed that the Central Board of Direct Taxes (CBDT) did not make Rule 8D retrospective and explicitly stated that the rules would come into force from the date of their publication in the Official Gazette.

The court agreed with the assessees' contention that Rule 8D is prospective and cannot be regarded as being retrospective. The court also referred to the decision of the Bombay High Court in Godrej and Boyce Mfg. Co. Ltd v. DCIT, which held that Rule 8D has prospective effect and applies from the assessment year 2008-09 onwards.

Conclusion:
1. Question 1: Answered in the affirmative. Expenditure incurred in relation to income which does not form part of the total income is not allowable as a deduction under section 14A.
2. Question 2: Answered in the negative. Sub-sections (2) and (3) of section 14A apply prospectively from the assessment year 2007-08 onwards.
3. Question 3: Answered in the negative. Rule 8D applies prospectively from the date of its introduction (24/03/2008) and does not apply to assessment years prior to 2008-09.

Disposition of Appeals:

Assessees' Appeals:
The appeals filed by the assessees were restored to the respective files of the concerned Assessing Officers with the direction to re-compute the disallowance in accordance with the steps outlined in paragraph 42 of the judgment, without applying Rule 8D for assessment years prior to 2008-09.

Revenue's Appeals:
The appeals filed by the revenue were disposed of with directions to the Assessing Officers to follow the steps outlined in paragraph 42 of the judgment, without applying Rule 8D for assessment years prior to 2008-09. The specific appeals and their outcomes were detailed in the judgment.

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