SECTION 14A- some important aspects not yet considered by courts. Some suggested contentions / questions for appeal

[CA DEV KUMAR KOTHARI]

Section 14A was inserted  in relation to income not taxed in any manner :

S.14A was inserted to avoid deduction of expenses, where tax exemptions were allowed in respect of some type of incomes which did not form part of gross total income as well as total income under income-tax Act and such incomes were not taxed by any other alternate method of tax on income.

In other words income was not at all taxable.

Section 14A  was inserted  to overcome rulings in three judgments namely:

1. Commissioner of Income-Tax, Bombay City I Versus Maharashtra Sugar Mills Limited 1971 (8) TMI 14 - SUPREME Court relating to  agricultural income, which cannot be taxed under the Income-tax Act or any other enactment of the central Government to levy tax on agricultural income. This is because tax on agricultural income can be imposed only by concerned State Government, as per Constitution of India.
2. Commissioner Of Income-Tax, Madras Versus Indian Bank Limited 1964 (10) TMI 14 - SUPREME Court- relating to tax free bonds – interest income was altogether exempt and was not taxed under any other system of tax on income.
3.  Rajasthan State Warehousing Corporation Versus Commissioner of Income-Tax 2000 (2) TMI 5 - SUPREME Court relating to total exemption from income –tax of eligible incomes.   In this cases also the income was  exempted u/s 10 and was not taxed under any other scheme of tax on income. 

Therefore, it is clear that S.14A was inserted to overcome situations where income was altogether exempt and not taxed under any other scheme of taxation.

Exempted vis a vis taxable income :

From same investment one can derive taxable income and exempted income. In ground reality we find that probability and scope of earning taxable income is much higher than probability and scope of earning tax free income. For example:

Nature of income in hands of recipient	Taxable income	Exempted income	Remarks
By partner from firm	Remuneration, Interest on capital and current account. Commission, guarantee commission, rent, any other income.	Only share in profit of firm, when firm has paid tax is exempted in hands of partner.	From same investment taxable income are earned which have more probability than earning tax free income. The ratio of exempted income will also be very low.
Investment in securities	Short-term capital gains, Trading gains, Arbitrage gains, Security lending gains. Remuneration received from companies as director/ employee etc. Any other gains from same company in which investment is made by holding shares.	Dividend, when dividend distribution tax has been paid by company or Mutual Fund. Long-term capital gains, when STT has been levied.	DO

Therefore, we find that any investment is not made only for earning exempted income. If an opportunity is available to realized gains, one will prefer to book profit instead of waiting to get an exempted income by increasing holding period.

Language used in S.14A:

Provision of section 14A.

In sub-section words used are as follows:

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.

unquote

2. The  expression “… in relation to income which does not form part of the total income under this Act.”

 is used in other sub-sections of section 14A and relevant Rules also.

In the Income-tax Act   the phrase ‘total income’ is used in relation to chargeable income that is the base on which tax is imposed. The income-tax is imposed by annual Finance tax Act.  The Finance Tax prescribes rates for tax on income imposed under different methods and schemes.

Crucial wordings and aspects about S.14A:

We find two sets of wordings in the sub-section (1) these are given in first column and in second column significance is discussed:

Words used	Significance
total income under this Chapter,	This expression is used in relation to total income of assessee which is computed as per provisions of the Chapter IV that is Sections 14- 59.
which does not form part of the total income under this Act.	Here ‘total income under this Act’ means any income on which tax is not imposed under the entire Act whether directly or indirectly.
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	The AO can determine disallowable expenditure only when any ‘income does not form part of total income under the Act’ and not merely when any income is not included in total income of assessee under the Chapter.

From above analysis it is clear that S.14A will apply only to such incomes which are not chargeable at all under the Act. If it was intended only in relation to the assessee whose income is to be computed, then similar expression could have been used that is ‘which does not form part of total income under this chapter or ‘which does not form part of total income of assessee’ instead of words ‘which does not form part of the total income under this Act.

The Income tax Act is a self-contained and integrated code. As per scheme of the Act, some incomes are taxable in hands of the recipient of income whereas some incomes are taxable in hands of person who pays or distribute income.

When a tax is finally collected at distribution stage, then the income in respect of which such tax is collected is nothing but a taxable income on which income- tax is collected on income.

Tax paid by way of tax on income of firm, dividend distributed by companies and mutual funds, and Security Transaction Tax (STT) are tax finally collected, that is when tax is not provisionally collected, or when it is not in nature of advance tax  like tax deducted or collected on behalf of recipient of income, for which credit or refund can be claimed. These tax are not allowed in hands of payer and payee both. So these are income-tax, finally collected.

 Therefore, all such income on which tax is imposed indirectly are income which form part of total income under  the Income-tax Act  for the purpose of levy of tax on income. It cannot be said that such income do not form part of total income under this Act to which S. 14A apply.

Decided cases:

As per understanding of author on reading of various important judgments on Section 14A, author observe that the above aspect of two different expressions used in S.14A has not been argued by counsels and has not been considered by Courts. These arguments must be forcefully placed before authorities and courts. In case Tribunal has held S.14A applicable, in appeal before High Court, substantial  questions of law can be drafted on the following lines in suitable manner:

Suggested questions	Reasoning
Whether, on correct interpretation of S.14A of the Income-tax act, 1961, honourable Tribunal was correct and justified in holding that S. 14A is applicable ignoring two different expressions used in S.14A namely (i) “computing the total income under this Chapter “and (ii  …”in relation to income which does not form part of the total income under this Act”?	The language in first phrase in S.14A that is (i) is in relation to computation of income of assessee under Chapter IV. There can be exclusion of income in this computation but the same income can be included in chargeable income in other provisions e.g. S.115JB, 115O, 115R and provisions for Security Transaction Tax (STT). The language used in second phrase is  much wider and includes any income which is chargeable by way of  income-tax or a tax in lieu of income-tax .  ‘Total income under this Act ’ ,  therein means income chargeable to tax  in any manner and not necessarily in hands of assessee. LTCG with security transaction tax ( STT) may be exempted under Chapter IV computation, but it is taxable u/s 115JB in case of companies. Dividend Distribution Tax (DDT) and Security Transaction Tax  (STT) are in nature of income-tax imposed in lieu of income-tax in hands  of shareholder. The exemption allowed to shareholder/ investor is  only because DDT and STT are imposed and not in other situation. It can be said that S.14A will be applicable only in cases of income which is not taxed in any direct or indirect manner under any scheme of taxation e.g. S. 115JB, S 115O, S. 115R , tax paid by firms, and simplified  tax on  transactions in securities, by way of imposing STT. Only income like agricultural income, which cannot be taxed by the Central Government and tax on tax free bonds, PF, PPF etc. are incomes in respect of which S.14A can be invoked.
Whether, on correct interpretation of S.14A,  honourable Tribunal was correct and justified in holding that S.14A will be applicable even though the income by way of dividend and long-term capital gains are taxed under simplified scheme of  imposition and collection of  income-tax, and substantial tax was collected  under such scheme of taxation?	Exemption for dividend is allowed only when DDT is paid. When DDT is not paid dividend is taxable in hands of shareholder (e.g. in case of deemed dividend, and dividend by co-operative societies and also in period when DDT was not in force). Long-term capital gains are exempted only when STT is paid , at the time of transfer of security, and not when STT is not paid. For example, in case of off market transactions in any shares whether listed or not STT is not paid and gains are not exempt but taxable.
Whether, on correct interpretation of S.14A, honourable Tribunal was correct and justified in holding that S.14A will be applicable even though from the same portfolio, substantial taxable income was also derived, and probabilities of earning taxable income are very high and probability of earning exempted income are very low and tax exemption is also un-certain, as government can change scheme of taxation any time?	When a portfolio can result into taxable income and exempted income both, it cannot be assumed that  expenses have been incurred for earning exempted income. In any case entire expenses cannot be said to have been incurred for earning exempted income, ignoring the fact that taxable income has also been derived from the same portfolio. Therefore, a substantial portion of interest is attributable to taxable incomes.
Whether, the honourable Tribunal was wrong in ignoring the provisions of S. 115JB, under which exempted income by way of long-term capital gains , subjected to security transaction tax, are taxable, hence such  long-term capital gains also form part of total income under the IT Act, hence S.14A cannot be invoked?	LTCG with STT may not be included in income while computing normal income of assessee company but it forms part of book profit and is subject to income –tax u/s 115JB. This is applicable only in case of companies.
Whether, Tribunal was justified in confirming disallowance of interest expenditure, ignoring the fact that from the same portfolio substantial taxable incomes were earned, and earning of exempted income is very low, uncertain and less probable than earning of taxable income?
Whether , Tribunal was right in ignoring the fact and related documents that earning by way of dividend is very low ( around 1.5 - 2 %) and so no one really invest in shares just to earn exempted income and assessee also did not used borrowed capital only for earning exempted income?	The assumption that investment in shares is made to earn dividend is wrong.