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TMI Blog2010 (8) TMI 77X X X X Extracts X X X X X X X X Extracts X X X X ..... in relation to such income which does not form part of the total income in accordance with the method that may be prescribed by the Rules made under the Act if the Assessing Officer is not satisfied with the correctness of the claim of the assessee, having regard to the accounts of the assessee. By subsection (3), the provisions of subsection (2) are also to apply to a situation in which the assessee claims that no expenditure has been incurred in relation to income which does not form part of the total income under the Act. Section 14A was introduced by an amendment to the Finance Act of 2001 with retrospective effect from 1 April 1962. Subsections (2) and (3) were inserted by the Finance Act of 2006 with effect from 1 April 2007. Rule 8D of the Income Tax Rules prescribes the method for determining the expenditure incurred in relation to income which does not form part of the total income, where the Assessing Officer is not satisfied with the claim of the assessee. Rule 8D was notified in the Official Gazette of 24 March 2008. By Section 10(33) - as it stood during Assessment Year 2002-03 income by way of dividend referred to in Section 115O was not to be included in computing th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... directing Respondent No.1 to apply Rule 8D of the Rules for computing the amount of disallowance under Section 14A of the Act." The assessee has, in addition, filed a Petition under Article 226 of the Constitution in order to challenge the constitutional validity of the provisions of Section 14A and of Rule 8D. Notice was issued to the Attorney General of India. Rule shall issue on the petition. In view of the importance of the question involved, Counsel for the Assessee and the Additional Solicitor General of India have agreed to the final disposal of the appeal and the Petition at this stage. 4. Broadly speaking, the submissions which have been urged on behalf of the assessee can be classified under the following heads: (i) Section 14A cannot be invoked in respect of dividend income from shares and mutual fund income for the reason that for the provision to be attracted, income must be exempt from tax or must be tax free which it has been urged, is not the case; (ii) Even if a literal interpretation of Section 14A suggests that the provision applies because income from dividends and mutual funds is not to be included while computing the total income under Section 10(33), a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... in the common pool of funds, it was difficult to ascertain whether investments had been made out of internal accruals or from borrowed funds. The Assessing Officer was of the view that if the assessee had not made investments in these securities, it would not have been required to borrow funds to that extent and consequently, the interest burden could have been reduced. On this basis, the Assessing Officer concluded that a part of the interest payment pertained to funds utilized for the purpose of investment in shares. The interest charged to the profit and loss account of Rs. 51.71 crores was bifurcated in the proportion between investments attributable to dividend receipts (Rs. 125.54 crores) to the total assets of the assessee (Rs. 938.11 crores). On this basis, the interest attributable to dividend receipts was computed at Rs. 6.92 crores which was disallowed. 7, In appeal, the assessee admitted that the exemption under Section 10(33) was to be allowed only on net dividend income. The assessee, however, contended that it was not permissible to notionally ascribe expenses to the earning of dividend income when in actual fact no expenses were incurred. The shares, according to t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ning agricultural income was permitted in its entirety as a deduction from taxable income and in the latter case, expenditure was allowed, even though relatable to exempt warehousing income as well as the taxable interest and other income; (ii) Dividend income and income from mutual funds cannot be regarded as exempt income. Tax on dividends declared, distributed or paid by the Company is imposed under Section 115O and similar is the position of mutual funds under Section 115R. Hence, when Section 10(33) provides that such income shall not be included as income of the shareholder/Unit holder, it does not mean that this is exempt income or income which is not charged to tax; (iii) Applying Heydon's rule of interpreting statutes and considering the object of inserting Section 14A, the phrase "does not form part of the total income" should be read as equivalent to exempt income; (iv) Dividend from shares or income from units of mutual funds are not exempt income as they are charged to tax under Sections 115O and 115R on the declaration of the dividend by a Company or, as the case may be, the distribution of income by a mutual fund. Tax is charged on such independent streams of inc ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... . 12. A Division Bench of this Court presided over by Chief Justice M.C.Chagla, in the Broach Cooperative Bank Ltd. vs. Commissioner of Income Tax{(1949) Vol.II B.L.R. 718}, upheld the application of the principle of apportionment by the Tribunal. While construing the first proviso to Section 8 of the Income Tax Act, 1922, the Division Bench held that it applied only to securities which are not tax free and, therefore, the only right of the assessee was to claim deduction with regard to interest on monies borrowed by him where he utilized those monies in investing them in securities on which he has got to pay tax, but if the assessee used money borrowed by him in investment of tax free securities, he could not claim a deduction given to him under the first proviso. 13. In order to consider the merits of the submissions which have been urged on behalf of the assessee, it would be necessary to advert to the background underlying the enactment of Section 14A. 14. In C.I.T. vs. Indian Bank Limited,{AIR 1965 SC 1473} the assessee, carried on the business of banking and the interest received on its investment in Government securities was exempt from income tax. The assessee claimed a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s of the assessee and the fact that the income arising from a part of the business was not assessable to tax was held not to be a relevant circumstance. 16. In Waterfall Estate Ltd. vs. C.I.T.,{(1996) 8 SCC 509} a finding of fact was entered by the Tribunal that the coffee curing works and estate of the assessee constituted separate and distinct activities. On this basis, the Supreme Court held that the decision in Maharashtra Sugar was distinguishable. 17. In a subsequent decision in Rajasthan State Warehousing Corporation vs. C.I.T.{2000 (109) Taxman 145}, a disallowance was effected by the Assessing Officer of such part of the expenditure which was allocable to exempt warehousing income. The Tribunal and the High Court confirmed the disallowance. Allowing the appeal, the Supreme Court held as follows: "(i) if income of an assessee is derived from various heads of income, he is entitled to claim deduction permissible under the respective head, whether or not computation under each head results in taxable income; (ii) if income of an assessee arises under any of the heads of income but from different items, e.g. different house properties or different securities, etc., and i ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the total income as these are exempt under various provisions of the Act. There have been cases where deductions have been claimed in respect of such exempt income. This in effect means that the tax incentive given by way of exemptions to certain categories of income is being used to reduce also the tax payable on the nonexempt income by debiting the expenses incurred to earn the exempt income against taxable income. This is against the basic principles of taxation whereby only the net income, i.e., gross income minus the expenditure is taxed. On the same analogy, the exemption is also in respect of the net income. Expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income. It is proposed to insert a new section 14A so as to clarify the intention of the Legislature since the inception of the Income Tax Act, 1961, that no deduction shall be made in respect of any expenditure incurred by the assessee in relation to income which does not form part of the total income under the Income Tax Act. The proposed amendment will take effect retrospectively from 1st April, 1962 and will accordingly, apply in relation to the assessment year 1962- ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... al income under the Act. Section 14A, has the effect of broadening or widening the earlier position. The consequence of the insertion of Section 14A has been dealt with in a judgment of the Supreme Court in C.I.T. vs. Walfort Share and Stock Private Limited, delivered on 6 July 2010.{Civil Appeal 4927 of 2010}. In Walfort, the assessee who was a member of the Stock Exchange, purchased units of a Mutual Fund on 24 March 2000 upon which it became entitled to a dividend of Rs.1.82 crores. As a result of a payout of the dividend, the NAV of the mutual fund which was Rs.17.23 per unit on 24 March 2000, stood reduced to Rs.13.23 per unit on 27 March 2000. The assessee in the return claimed a deduction of Rs.1.82 crores as exempt from tax under Section 10(33) but also claimed a set off of the loss incurred on the sale of the units. This was disallowed by the Assessing Officer on the ground that the transaction was in the nature of dividend stripping. The disallowance was deleted by the Tribunal whose decision was confirmed by the High Court. The main issue before the Supreme Court was whether the loss on the sale of the units could be considered as expenditure in relation to earning divid ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... hat the provisions of Section 14A were construed in Walfort to evince the Parliamentary intent 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 under the Act against taxable income. Section 14A is clarificatory of the position that expenses can be allowed only to the extent that they are relatable to the earning of taxable income. Only those expenses which are in respect of the earning of taxable income can be allowed. That Section 14A broadens the theory of apportionment of expenditure between taxable and non-taxable income is evident from the following observations of the Supreme Court: "The theory of apportionment of expenditures between taxable and non-taxable has, in principle, been now widened under Section 14A. Reading Section 14 in juxtaposition with Sections 15 to 59, it is clear that the words "expenditure incurred" in Section 14A refers to expenditure on rent, taxes, salaries, interest etc. in respect of which allowances are provided for (see Sections 30 to 37)." On facts, the Supreme Court held that an expenditure is a payout which relates to disbursement. A pay back to th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... under Section 14A. Income which does not form part of the total income is broadly adverted to as exempt income as an abbreviated appellation. Insertion of Subsections (2) and (3) to Section 14A: 25. Subsections (2) and (3) of Section 14A were inserted by an amendment brought about by the Finance Act of 2006 with effect from 1 April 2007. Subsections (2) and (3) provide as follows: "14A(2) 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 in accordance with such method as may be prescribed, if the Assessing Officer, having regard to the accounts of the assessee, is not satisfied with the correctness of the claim of the assessee in respect of such expenditure in relation to income which does not form part of the total income under this Act. (3) The provisions of subsection (2) shall also apply in relation to a case where an assessee claims that no expenditure has been incurred by him in relation to income which does not form part of the total income under this Act: Provided that nothing contained in this section shall empower the Assessing Officer either to reassess ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d be no warrant for taking recourse to the method prescribed by the rules. For, it is only in the event of the Assessing Officer not being so satisfied that recourse to the prescribed method is mandated by law. Sub section (3) of Section 14A provides for the application of sub section (2) also to a situation where the assessee claims that no expenditure has been incurred by him in relation to income which does not form part of the total income under the Act. Under the proviso, it has been stipulated that nothing in the section will empower the Assessing Officer, for an Assessment Year beginning on or before 1 April 2001 either to reassess under Section 147 or pass an order enhancing the assessment or reducing the refund already made or otherwise increasing the liability of the assessee under Section 154. 26. The circumstances in which the provisions of sub sections (2) and (3) were introduced by an amendment have been adverted to in a circular of the CBDT dated 28 December 2006.{Circular 14 of 2006}. The circular notes that in the existing provisions of Section 14A no method for computing the expenditure incurred in relation to income which does not form part of the total income ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... or paid as dividends and no further credit therefor shall be claimed by the company or by any other person in respect of the amount of tax so paid. (5) No deduction under any other provision of this Act shall be allowed to the company or a shareholder in respect of the amount which has been charged to tax under subsection (1) or the tax thereon." Subsection (1) of Section 115O begins with a non obstante provision and stipulates that any amount declared, distributed or paid by a company by way of dividends shall be charged to additional income tax: 'Additional' because this is in addition to income tax chargeable in respect of the total income of the domestic company. The total income of a domestic company is chargeable to income tax under the Act. In addition, any amount declared, distributed or paid by such company by way of dividends is subjected to additional income tax at the stipulated rate. The charge under sub section (1) of Section 115O is on a component of the profits of the domestic company representing an amount declared, distributed or paid by way of dividend. 29. The plain meaning of Section 14A is that no deduction can be allowed in respect of expenditure ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ious year of a person who is the recipient. This is defined to include all income, from whatsoever sources derived, which is received or deemed to be received or which accrues or is deemed to have accrued in India or which accrues or arises outside India during the previous year. Section 10 defines those categories of income which shall not be included in computing the total income of the previous year of any person. Income tax is a tax on income in the hands of the assessee. Hence, when Section 14A disallows expenditure incurred by the assessee in relation to income which does not form part of the total income, it would include categories of income such as dividend from shares and income from mutual fund which under Section 10 are not to be included in the total income. Since dividend income and income from mutual funds are not included in the total income of the assessee, no deduction of expenditure is permissible under Section 14A(1). Subsection (5) of Section 115O stipulates that no deduction under any other provisions of the Act shall be allowed to the Company or to a shareholder in respect of the amount which has been charged to tax under subsection (1) or the tax thereon. 3 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... companies. Thus, by inserting Section 115O, additional income-tax is levied on the amount of profits declared, distributed or paid as dividend and by inserting Section 10(33) it is made clear that the dividends referred to in Section 115O would be exempt from tax. 36. In Purushottamdas Thakurdas vs. C.I.T.{(1963) 48 ITR 206} the Supreme Court construed the provisions of Section 16(2) and Section 49B of the Indian Income Tax Act, 1922. Subsection (2) of Section 16 provided that any dividend shall be deemed to be income of the year in which it is paid regardless of the question as to when the profits out of which the dividend is paid were earned. By a deeming fiction introduced by Section 49B, when a dividend was paid to a shareholder by a Company which was assessed to tax, the income tax in respect of such dividend was deemed to have been paid by the shareholder himself. The Supreme Court observed that the position as a matter of general law was as follows: "In general law, the Company is chargeable to tax on its profits as a distinct taxable entity and it paid tax in discharge of its own liabilities and not on behalf of or as an agent for its shareholders".{At pages 213 & 214 of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he Circular states that the Finance Act of 1997, therefore, introduced a new system of collecting tax on profits distributed by the Company by way of dividend, which was to be in addition to the income tax chargeable in respect of the total income of the Company. 39. The circular issued by the CBDT as a matter of fact clearly establishes that prior to the introduction of Section 115O of the Finance Act of 1997, corporate dividends were taxed in the hands of shareholders as income from other sources. This provision was abolished by the introduction of Section 115O. Under subsection (1) of Section 115O, an additional income tax was imposed on profits distributed by a Company by way of dividend and a new clause, clause 33 was inserted in Section 10 to exempt dividend income in the hands of the shareholder. 40. We have also been fortified in the conclusion which we have drawn, by the judgment of the Supreme Court in Walfort (supra). The Supreme Court has in the following observation expressly held that since dividend income does not form part of the total income, the expenditure that is incurred in the earning of such income cannot be allowed even though it is of a nature specified i ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... me which does not form part of the total income under the Act. Dividend income does not form part of the total income under the Act by virtue of the provisions of Section 10(33). Consequently, it is impossible to accede to the submission that Section 14A should be confined only to those categories of income, such as agricultural income, where the income is exempt in the hands of any person. The judgment of the Privy Council in C.I.T. vs. Rameshwar Singh,{(1935) 3 ITR 305}, is of no relevance to the issue involved in this case. While construing the provisions of the Income Tax Act, 1922, the Privy Council observed that agricultural income is excluded altogether from the scope of the Act whatsoever or by whomsoever it may be received. This would have no bearing on the construction to be placed on the provisions of Section 14A. A Summation of our conclusions on the interpretation of the provisions: 43. In order to conclude the discussion on this aspect of the case, we would proceed to recapitulate our conclusions. (i) Section 14A was enacted by Parliament in order to overcome the judgments of the Supreme Court in the case of Indian Bank, Maharashtra Sugar and Rajasthan Warehousing ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... pportion the expenditure and to disallow the expenditure incurred by the assessee in relation to income which does not form part of the total income under the Act. The Assessing Officer would have to follow a reasonable method of apportioning the expenditure consistent with what the circumstances of the case would warrant and having regard to all the relevant facts and circumstances; (vii) Consequent upon the insertion of subsection (2), the disputes which had arisen between tax payers and the Revenue on the method of determining the expenditure to be disallowed, have been given a quietus by adopting a uniform method of determination; (viii) Subsection (2) of Section 14A does not enable the Assessing Officer to apply the method prescribed by Rule 8D without determining in the first instance the correctness of the claim of the assessee, having regard to the accounts of the assessee. Subsection (2) of Section 14A mandates that it is only when having regard to the accounts of the assessee, the Assessing Officer is not satisfied with the correctness of the claim of the assessee in respect of expenditure incurred in relation to income which does not form part of the total income und ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... profits as dividend is liable to pay tax on the total income inclusive of the amount of profits distributed as dividend. By inserting Section 115O, the legislature has imposed additional income-tax on the amount of profits distributed as dividend. Thus, tax as well as additional income-tax are taxes levied on the profits of a domestic company. From the fact that the additional income-tax is levied only on profits declared, distributed, or paid as dividend, it cannot be said that the additional income-tax is not a tax on the profits of the domestic company but a tax on dividend. (c) Where profits of a Company are distributed as dividend, those profits are taxed in the hands of the Company and dividends are taxed in the hands of the shareholders because the character of the income in the hands of a Company and in the hands of a shareholder is totally different. Profits in the hands of a company would be business income, whereas, the said amounts when distributed as dividend, would constitute dividend income in the hands of the shareholders. In such a case, the liability on the Company is on profits of business income, where as the tax liability on the shareholder would be on the di ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Section 115O is the additional tax on profits distributed as dividend and not a tax on dividends, because dividends received are exempt under Section 10(33). (xii) The general principle of law is that a Company is chargeable to tax on its profits as distinct taxable entity and has to pay tax in discharge of its own liability and not on behalf of or as an agent of its shareholders. This position of the general law is recognized and incorporated in Section 115O and is not overridden by the statutory provision; (xiii) Income from dividend and similarly, income from mutual funds do not form part of the total income under Section 10(33). The expenditure incurred in relation to earning such income cannot be allowed under Section 14A; (xiv) In order to determine the quantum of the disallowance, there must be a proximate relationship between the expenditure and the income which does not form part of the total income. Once such a proximate relationship exists, the disallowance has to be effected. All expenditure incurred in the earning of income which does not form part of the total income has to be disallowed subject to compliance with the test adopted by the Supreme Court in Walfor ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ion to the shareholders; (ii) The assumption that in effect, it is the shareholder who bears the tax under Section 115O(1) since the shareholder has forgone the assumed higher dividend; (iii) An assumption that the payment of tax under Section 115O(1) is on behalf of the shareholder. On these assumptions, the conclusion is sought to be drawn by the assessee that the shareholder will suffer twice, namely, by the assumed payment of tax on his behalf under Section 115O(1) and by the disallowance on expenditure claimed under Section 14A. We are in agreement with the submission which has been urged on behalf of the Union Government that the contention that the literal interpretation of Section 14A would lead to an absurd consequence is erroneous. As the Supreme Court observed in Walfort, Section 14A represents a serious attempt on the part of Parliament to ensure that the tax incentive to certain incomes should not be used to reduce the tax payable on non-taxable income by debiting expenses incurred to earn non-taxable income against the taxable income. In other words, what Section 14A effectuates is that a shareholder should not get the benefit both of an exemption under Section 10(33) ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... = the average of value of investment, income from which does not or shall not form part of the total income, as appearing in the balance sheet of the assessee, on the first day and the last day of the previous year; C = the average of total assets as appearing in the balance sheet of the assessee, on the first day and the last day of the previous year; (iii) an amount equal to onehalf per cent of the average of the value of investment, income from which does not or shall not form part of the total income, as appearing in the balance sheet of the assessee, on the first day and the last day of the previous year." Section 14A(2) and (3): 47. On behalf of the assessee, it has been submitted that (i) The very idea that there can be a uniform rule for determining the expenditure relating to the earning of tax free income is arbitrary and violative of Article 14. Every industry, it has been urged, has its own peculiar background and one cannot equate a manufacturing industry with a service industry or an entity dealing in investment or in shares. Every asset has its peculiar situation. Subsection (2) of Section 14A by providing for a uniform method of applicability, is alleged to t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... omputing the quantum of expenditure attributable to tax exempt income. The provision presents a reasonable solution to assess a complex accounting and tax problem and the underlying rationale has been explained in the affidavit in reply; (iv) The fact that Rule 8D adopts a uniform method as a means of computation does not make it arbitrary or unreasonable: (a) The method will be adopted only if the Assessing Officer is not satisfied of the correctness of the claim of the assessee, having regard to the accounts of the assessee; (b) The adoption of standard rates or percentages to compute figures of income or expenditure are not abhorrent to tax legislation; (v) An estimate can be made so long as it is not arbitrary and has a nexus with the facts discovered. Even if the Court believes that it is not a best estimate or the most appropriate method, it cannot be struck down since in the realm of constitutional validity, the Court is not concerned with mathematical or scientific exactitude of the method; (vi) Rule 8D only provides a machinery or method to measure and attribute expenditure that is relatable to tax exempt income. On the contrary, if expenditure utilized towards earning tax ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ding direct expenditure and expenditure on power, fuel etc.), the disallowance under the prorata method as followed in Rule 8D(2)(ii) would be Rs.82 crores. However, under the 0.5% measure provided by Rule 8D(2)(iii) the disallowance is Rs.1.57 crores. Hence, the present measure is in fact, more favourable to the assessee and cannot under any circumstances be said to be unconstitutional; (x) Hence, the intention of Section 14A is clearly to disallow all expenses relating to the non-taxable income, and to curb the practice of claiming allowances for expenditures on exempt income. All that is required is to show that there is a 'proximate cause' between the expenditure incurred and the exempt income. A 'proximate cause' connotes a relationship between the expense and the exempt income (Walfort supra). So understood, even indirect expenses may have a proximate cause to the exempt income, and the same must hence be disallowed. For example, if the staff employed in an office partake in both manufacturing and dividend business, that proportion of the staff (indirect) expenses incurred in relation to the dividend business will be disallowed. However, if the assessee does n ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... obvious reasons, meticulously scrutinize the impact of its burden on different persons or interests. Where there is more than one method of assessing tax and the Legislature selects one out of them, the Court will not be justified to strike down the law on the ground that the Legislature should have adopted another method which, in the opinion of the Court, is more reasonable, unless it is convinced that the method adopted is capricious, fanciful, arbitrary or clearly unjust." Advantages or disadvantages to individual assesses are "accidental and inevitable and are inherent in every taxing statute as it has to draw a line somewhere and some cases necessarily fall on the other side of the line."{at para 10 page 597}. 53. In Ganga Sugar Corporation Ltd. v. State of Utter Pradesh{(1980) 1 SCC 223}, the Supreme Court recorded a caution which must be observed by the Court in dealing with challenges to the constitutional validity of taxing statues: "Practical considerations of the Administration, traditional practices in the trade, other economic pros and cons enter the verdict but, after a judicial generosity is extended to the legislative wisdom, if there is writ on the statute pe ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ere is writ on the statute perversity, madness in the method or gross disparity, judicial credibility may snap and the measure may meet with its funeral". 56. These principles must guide the determination by this Court on the constitutional challenge to sub sections (2) and (3) of Section 14A and to Rule 8D. A fundamental basis of the challenge addressed before the Court is the prescription of a uniform method for determining the disallowance of expenditure incurred in relation to income which does not form a part of the total income under the Act. The challenge is that the law and the subordinate legislation operate in situations which are unequal by prescribing a uniform method to assessees who are not similarly situated. The challenge is to the treatment of unequals equally. 57. Now in dealing with the challenge it is necessary to advert to the position that sub section (2) of Section 14A prescribes a uniform method for determining the amount of expenditure incurred in relation to income which does not form part of the total income only in a situation where the Assessing Officer, having regard to the accounts of the assessee is not satisfied with the correctness of the claim o ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ing Officer "Courts will not readily defer to the conclusiveness of an executive authority's opinion as to the existence of a matter of law or fact upon which the validity of the exercise of the power is predicated". (M.A. Rasheed v. The State of Kerala{AIR 1974 SC 2249. (at para 7 page 2252)}. A decision by the Assessing Officer has to be arrived at in good faith on relevant considerations. The Assessing Officer must furnish to the assessee a reasonable opportunity to show cause on the correctness of the claim made by him. In the event that the Assessing Officer is not satisfied with the correctness of the claim made by the assessee, he must record reasons for his conclusion. These safeguards which are implicit in the requirements of fairness and fair procedure under Article 14 must be observed by the Assessing Officer when he arrives at his satisfaction under sub section (2) of Section 14A. As we shall note shortly hereafter, sub rule (1) of Rule 8D has also incorporated the essential requirements of sub section (2) of Section 14A before the Assessing Officer proceeds to apply the method prescribed under sub rule (2). 59. The charge of the assessee that there is an inherent ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ssees and the department in regard to the method to be adopted in computing the expenditure relatable to the earning of non-taxable income. In this background, if the legislature considered it appropriate to prescribe a particular method that legislative choice cannot be held to be arbitrary or oppressive. Thirdly, sub sections (2) and (3) and the proviso to Section 14A contain sufficient safeguards that would ensure a reasonable exercise of power. Apart from the safeguards to which a reference has been made earlier, the proviso stipulates that nothing contained in the Section shall empower the Assessing Officer to reassess under Section 147; or enhance the assessment or reduce the refund already made; or otherwise increase the liability of the assessee under Section 154, for any assessment year beginning on or before 1 April 2001. 60. In the affidavit in reply that has been filed on behalf of the Revenue an explanation has been provided of the rationale underlying Rule 8D. In the written submissions which have been filed by the Additional Solicitor General it has been stated, with reference to Rule 8D(2)(ii) that since funds are fungible, it would be difficult to allocate the act ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ng the disallowance of expenditure attributable to the earning of non-taxable income and it is not one out of several well accepted or well settled modes of computation. Hence, it was submitted that the present case is distinguishable from the situation which arose before the Supreme Court in Commissioner of Wealth Tax v. Sharvan Kumar Swarup and Sons{(1994) 210 ITR 886}. Further, reliance was placed on Section 295(4) which specifically provides that no retrospective effect could be given to a rule so as to prejudicially affect the interest of the assessee. Sub sections (2) and (3) were inserted into Section 14A by the Finance Act of 2006 with effect from 1 April 2007. Rule 8D was inserted by the Income Tax Act (Fifth Amendment) Rules 2008 which were published in the Gazette on 24 March 2008. The rules specifically provide that they shall come into force from the date of their publication in the Official Gazette. These provisions, it was urged, cannot be applied to Assessment Year 2002-03 which is under consideration as it is the law prevalent on the first day of April of an assessment year that would have to be applied. In any event where different dates are provided for the enfor ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... legislature has plenary power to legislate both prospectively and retrospectively. Therefore whether an amending provision is to operate with prospective or retrospective effect has to be determined on the language and ambit of the statutory provision. Amendments which are clarificatory or declaratory of the position in law, as the legislature intended it always to be, are regarded as being retrospective. Hence, when the legislature steps in by amending the law to set right an incorrect judicial interpretation, an inference can be drawn that the amendment was intended to be retrospective. An amendment which is inserted to remedy unintended consequences and to make a provision workable or which supplies an obvious omission and is required to be read into a section to give it reasonable interpretation has been treated as retrospective in operation. 64. These principles emerge from the precedent on the subject: (i) In Income Tax Officer v. M.C.Ponnoose{(1970) 75 ITR 174}, the Supreme Court dealt with a case where Section 2(44) containing the definition of the expression 'Tax Recovery Officer' was substituted by the Finance Act of 1963 and it was provided that the new defin ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... lthough the payment did not fall in the relevant previous year. This was because the sales tax collected pertained to the last quarter of the relevant accounting year and could be paid only in the next quarter which fell in the next accounting year. Hence, though the sales tax had been paid by an assessee within the statutory period prescribed and prior to the filing of the income tax return, the assessee was unwittingly prevented from claiming a deduction. This was not intended by Section 43B. An amendment was made by the Finance Act of 1987 by the insertion of the first proviso. The Supreme Court held that the amendment was curative in nature and hence, the proviso which was inserted by the Finance Act of 1987 should be given retrospective effect from the date of the inception of Section 43B. The Supreme Court held that the first proviso was remedial in nature, designed to eliminate unintended consequences which may cause undue hardship to an assessee and which made the provision unworkable or unjust in a specific situation: "A proviso which is inserted to remedy unintended consequences and to make the provision workable, a proviso which supplies an obvious omission in the sect ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e open market on the valuation date. Under Rule 1BB the value of a house used for residential purposes was to be determined in a particular manner. The issue before the Supreme Court was whether this rule was a provision of substantive law, not expressly applicable to valuation for earlier years and therefore only prospective or whether it was merely procedural and would apply to all pending cases. The Supreme Court held that Rule 1BB "merely provides a choice amongst well known and well settled modes of valuation". Chief Justice M.N. Venkatachaliah speaking for the Court held that even in the absence of Rule 1BB there would have been no legal impediment to adopt the mode of valuation embodied in Rule 1BB by adopting the method of capitalization of income on a number of years' purchase value. The rule, held the Supreme Court, was intended to impart uniformity in valuations and to avoid vagaries and disparities resulting from the application of different modes of valuation in different cases where the nature of the property is similar. Rule 1BB was held to be "essentially a rule of evidence as to the choice of one of the well accepted methods of valuation in respect of certain k ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Gauhati High Court held that the explanation of 1983 was given effect from 1 April 1979 and would therefore not apply to assessment years prior thereto. By the Finance Bill of 1999 a new explanation was substituted with effect from 1 April 2000 which declared that income of the nature referred to in the clause payable for service rendered in India and the rest period or leave period which is preceded and succeeded by services rendered in India and forms part of the service contract shall be regarded as income earned in India. The Supreme Court held that given the legislative history of Section 9(1)(ii) it was only to be assumed that the explanation was deliberately introduced with effect from 1 April 2000 and was therefore intended to apply prospectively. The Supreme Court adverted to three circumstances: firstly, the departmental understanding of the effect of the 1999 amendment as contained in a circular of the Central Board of Direct Taxes afforded a reasonable construction thereof and there was no reason why the Supreme Court should not adopt it. Secondly, the cardinal principle of tax law is that the law to be applied is that in force in the relevant assessment year unless ot ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Supreme Court held that the definition of the expression 'income' in Section 2(24) is inclusive and includes losses. The Finance Act had merely intended to make what was otherwise implied, explicit. Since the expression 'income' had been held by the Supreme Court to include losses, consequently where in a case on account of addition of concealed income the loss returned stands reduced, a penalty would be leviable even prior to 1 April 2003 if the final assessed income is the loss. The amendment was therefore regarded as being clarificatory in nature. 65. The following principles guide in determining as to whether an amendment is prospective or retrospective: (i) In determining as to whether an amendment is to take effect prospectively or with retrospective effect, the date from which the amendment is made operative does not conclusively decide the question. The Court has to examine the scheme of the statute prior to the amendment and subsequent to the amendment to determine whether an amendment is clarificatory or substantive; (ii) An amendment which is clarificatory is regarded as being retrospective in nature and would date back to the original statutory prov ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Gazette. This by itself is not conclusive. Secondly, prior to the insertion of Section 14A by the Finance Act of 2001 the Supreme Court had held in its decisions in Indian Bank, Maharashtra Sugars and Rajasthan State Warehousing Corporation (supra) that in the case of a composite and indivisible business which resulted in taxable and non-taxable income, it was impermissible for the Assessing Officer to apportion the expenditure incurred in relation to such business as between the earning of taxable and non-taxable income. Sub section (1) of Section 14A was inserted with retrospective effect from 1 April 1962 to overcome the decisions of the Supreme Court. At the same time, as has been noticed by the Supreme Court in its decision in Wolfort, the theory of apportionment of expenditure between taxable and non-taxable income has, in principle, been now widened under Section 14A. Reading Section 14 in juxtaposition with Sections 15 to 59, it has been observed that the words "expenditure incurred" in Section 14A refer to expenditure on rent, tax, salary, interest etc. in respect of which allowances are provided for. Thirdly, sub sections (2) and (3) were introduced by a legislative amend ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... as argued before us that the fact that Rule 8D is not in that sense an embodiment of a "well known and well settled mode" or a "well accepted method" is no indicator in regard to its reasonableness. We have upheld the contention of the Union of India that Rule 8D is reasonable in its nature. That, however, is not dispositive of the question as to whether the rule can be regarded as prospective or retrospective in nature. In determining as to whether a rule in a piece of subordinate legislation is to be regarded as prospective or retrospective, an important aspect that has been emphasized by the Supreme Court in the aforesaid decision is as to whether the rule embodies what is essentially a well known, a well settled or well accepted method. As a matter of fact in the present case there can be no doubt about the position that Rule 8D has essentially put into place an artificial method of estimating the expenditure that can be regarded as being relatable to income that does not form part of the total income under the Act. The learned Additional Solicitor General has both in the course of the oral arguments as well as in the written submissions emphasized before the Court that if the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... have to be disallowed on the ground that it was incurred in relation to the earning of income which does not form part of the total income under the Act. Undoubtedly in determining what would constitute a reasonable method for effecting the disallowance, the Assessing Officer would have to give due regard to all the facts and circumstances of the case. The change which is brought about by the insertion of sub sections (2) and (3) into Section 14A by the Finance Act of 2006 with effect from 1 April 2007 is that in a situation where the Assessing Officer is not satisfied with the correctness of the claim of the assessee in regard to the expenditure incurred by it in relation to the non-taxable income, the Assessing Officer would have to follow the method which is prescribed by the rules. The rules were notified to come into force on 24 March 2008. It is a trite principle of law that the law which would apply to an assessment year is the law prevailing on the first day of April. Consequently, Rule 8D which has been notified on 24 March 2008 would apply with effect from Assessment Year 2008-09. The rule consequently cannot have application in respect of Assessment Year 2002-03 which is ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... al for Assessment Year 1998-99 would show that the Tribunal held that no nexus between the investments made by the assessee in dividend earning shares and borrowings by the assessee has been established. This order was followed for Assessment Years 1999-00 and 2001-02. Counsel appearing on behalf of the assessee submitted that as against its investments in income yielding shares / units of mutual funds of Rs.125.54 Crores on 31 March 2002, the assessee had a share capital of Rs.6.55 Crores and reserves and surplus of Rs.274.09 Crores aggregating to Rs.280.64 Crores. The inference which is sought to be drawn on behalf of the assessee by counsel is that the investments were made by the assessee out of its own funds. Moreover, it has been submitted that the investment which stood at Rs.127.20 Crores was reduced as on 31 March 2002 to Rs.125.54 Crores and there was a decrease in the investment during the previous year under consideration. Counsel placed reliance on the judgment of the Supreme Court in Radhasoami Satsang v. Commissioner of Income Tax{(1992) 193 ITR 321 (SC)} to urge that though strictly speaking res judicata does not apply to income tax proceedings each assessment year ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ugh different assessment years has been found as a fact one way or the other and parties have allowed that position to be sustained by not challenging that order, it would not be appropriate to allow the position to be changed in a subsequent year, in the absence of any material change justifying the Revenue to take a different view of the matter. Moreover, in the concluding part of the judgment the Supreme Court has held that this decision "is confined to the facts of the case and may not be treated as an authority on aspects which have been decided for general application"{46at page 329}. The decision of the Supreme Court in Munjal Sales Corporation (Supra) turned purely on the facts of the case. The Supreme Court noted that the opening balance as on 1 April 1994 was Rs.1.91 Crores whereas the loan given to a sister concern was a small amount of Rs.5 lacs. The profits earned by the assessee during the relevant year were held to be sufficient to cover the loan of Rs.5 lacs. In the decision of the Division Bench of this Court in Reliance Utilities (supra) the Division Bench has held that "if there be interest free funds available to an assessee sufficient to meet its investments an ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... at the Tribunal failed to consider the applicability of Section 14A in its proper perspective, for assessment year 2001-2002 would not bar the Tribunal from considering disallowance under Section 14A in assessment year 2002-2003. c) The decisions reported in Sridev Enterprises(supra), Munjal Sales Corporation (supra) and Radhasoami Satsang (supra) holding that there must be consistency and definiteness in the approach of the revenue would not apply to the facts of the present case, because of the material change introduced by Section 14A by way of statutory disallowance in certain cases. Therefore, the decisions of the Tribunal in the earlier years would have no relevance in considering disallowance in assessment year 2002-2003 in the light of Section 14A of the Act. 73. For the reasons which we have indicated, we have come to the conclusion that under Section 14A(1) it is for the Assessing Officer to determine as to whether the assessee had incurred any expenditure in relation to the earning of income which does not form part of the total income under the Act and if so to quantify the extent of the disallowance. The Assessing Officer would have to arrive at his determination af ..... X X X X Extracts X X X X X X X X Extracts X X X X
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