2011 (11) TMI 267 - HC - Income Tax

Expenditure in relation to income which does not form part of Total Income - Held That - First of all, AO 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. Even where the assessee claims that no expenditure has been incuured in relation to income which does not form part of total income the assessing officer will have to verify the correcteness of such claim. In case the assessing officer is satisfied with the claim of the assessee with regard to the expenditure or no expenditure as the case may be the assessing officer is to accept the claim of the assessee insofar as the quantum of disallowance under section 14A is concerned. In such eventuality the assessing officer cannot embark upon a determination of the amount of expenditure for the purposes of section14A(1). 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. Applicability of Section 14A of the Income Tax Act, 1961, to interest paid on borrowed funds for investing in shares for acquiring and retaining controlling interest.
2. Retrospective applicability of sub-sections (2) and (3) of Section 14A.
3. Retrospective applicability of Rule 8D of the Income Tax Rules, 1962.

Issue-wise Detailed Analysis:

1. Applicability of Section 14A to Interest Paid on Borrowed Funds:

The primary issue was 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 not hit by Section 14A of the Income Tax Act, 1961. The court held that the expression "in relation to" in Section 14A should be given a broad interpretation. It means "in connection with" or "pertaining to". Therefore, any expenditure incurred in connection with income which does not form part of the total income, such as dividend income, cannot be allowed as a deduction. The court rejected the argument that the expenditure must have a dominant and immediate connection with the exempt income. The court concluded that the expenditure incurred on borrowed funds for acquiring shares to retain controlling interest is hit by Section 14A, as the dividend received on such shares does not form part of the total income.

2. Retrospective Applicability of Sub-sections (2) and (3) of Section 14A:

The court examined whether sub-sections (2) and (3) of Section 14A, introduced by the Finance Act, 2006, with effect from 01/04/2007, would apply retrospectively. The court held that sub-sections (2) and (3) of Section 14A are prospective in nature. They were introduced with effect from 01/04/2007 and apply from the assessment year 2007-08 onwards. The court referred to the Notes on Clauses of the Finance Bill, 2006, and the Memorandum explaining the provisions in the Finance Bill, 2006, which clearly indicated that the amendments would apply from the assessment year 2007-08 and subsequent years.

3. Retrospective Applicability of Rule 8D:

The court also considered whether Rule 8D, introduced by the Income-tax (Fifth Amendment) Rules, 2008, with effect from 24/03/2008, was procedural in nature and hence would apply retrospectively. The court held that Rule 8D is prospective in operation and cannot be regarded as being retrospective. The court noted that the Central Board of Direct Taxes (CBDT) had the power to make rules with retrospective effect but did not do so for Rule 8D. The court referred to the Bombay High Court's decision 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 and Directions:

The court concluded that for the assessment years prior to the introduction of Rule 8D, the Assessing Officer must first ascertain the correctness of the claim of the assessee regarding the expenditure incurred in relation to exempt income. If the Assessing Officer is not satisfied with the claim, he must determine the amount of such expenditure based on a reasonable and acceptable method of apportionment. The court set aside the Tribunal's orders to the extent they directed re-computation of disallowance under Rule 8D for the assessment years prior to 2008-09 and restored the matters to the respective files of the Assessing Officers to follow the steps outlined by the court.

Disposition of Appeals:

Assessees' Appeals:
The appeals filed by the assessees were disposed of by directing the Assessing Officers to follow the steps outlined by the court in paragraph 42 of the judgment.

Revenue's Appeals:
The appeals filed by the revenue were disposed of by setting aside the Tribunal's judgments and orders to the extent they deleted or partially deleted the disallowance under Section 14A and restoring the matters to the files of the Assessing Officers to follow the steps outlined by the court in paragraph 42 of the judgment.

← Previous Next →