Supreme Court: Disallowance relying on section 14A of IT Act cannot make on expenditure incurred for earning tax-free income

South Indian Bank Ltd. Vs Commissioner of Income Tax; Civil Appeal 9606 of 2011; Supreme Court of India ; 09.09.2021

The Hon’ble Supreme Court of India, in the present Civil Appeal considered the question of law involving interpretation of Section 14A of the Income Tax Act. That whether Section 14A, enables the Department to make disallowance on expenditure incurred for earning tax free income in cases where assessees like the present appellant, do not maintain separate accounts for the investments and other expenditures incurred for earning the tax-free income.

Facts:

The assessees are scheduled banks and in course of their banking business, they also engage in the business of investments in bonds, securities and shares which earn the assessees, interests from such securities and bonds as also dividend income on investments in shares of companies and from units of UTI etc. which are tax free.

In Section 14, the various incomes are classified under Salaries, Income from house property, Profit & Gains of business or profession, Capital Gains & Income from other sources. The Section 14A relates to expenditure incurred in relation to income which are not includable in Total Income and which are exempted from tax. No taxes are therefore levied on such exempted income. The Section 14A had been incorporated in the Income Tax Act to ensure that expenditure incurred in generating such tax exempted income is not allowed as a deduction while calculating total income for the concerned assessee.

At outset it is clarified that none of the assessee banks amongst the appellants, maintained separate accounts for the investments made in bonds, securities and shares wherefrom the tax-free income is earned so that disallowances could be limited to the actual expenditure incurred by the assessee. In other words, the expenditure incurred towards interest paid on funds borrowed such as deposits utilized for investments in securities, bonds and shares which yielded the tax-free income, cannot conveniently be related to a separate account, maintained for the purpose. The situation is same so far as overheads and other administrative expenditure of the assessee.

In absence of separate accounts for investment which earned tax free income, the Assessing Officer made proportionate disallowance of interest attributable to the funds invested to earn tax free income. The assessees in these appeals had earned substantial tax-free income by way of interest from tax free bonds and dividend income which also is tax free. Substantial expenditure is incurred for earning tax free income. Since actual expenditure figures are not available for making disallowance under Section 14A, the Assessing Officer worked out proportionate disallowance by referring to the average cost of deposit for the relevant year.

Contention of the Appellants:

The investments made in bonds and shares should be considered to have been made out of interest free funds which were substantially more than the investment made and therefore the interest paid by the assessee on its deposits and other borrowings, should not be considered to be expenditure incurred in relation to tax free income on bonds and shares and as a corollary, there should be no disallowance under Section 14A of the Act.

Observations by Court:

• The sub-Section (2) and (3) in section 14 A were introduced to the main section by the Finance Act, 2006 with effect from 01.04.2007.
• The contention on behalf of the assessee was rejected by the CIT(A) as also by the High Court primarily on the ground that the assessee had not kept their interest free funds in separate account and as such had purchased the bonds/shares from mixed account. This is how a proportionate amount of the interest paid on the borrowings/deposits, was considered to have been incurred to earn the tax-free income on bonds/shares and such proportionate amount was disallowed applying Section 14A of the Act.
• The disallowance would be legally impermissible for the investment made by the assessees in bonds/shares using interest free funds, under Section 14A of the Act. In other words, if investments in securities is made out of common funds and the assessee has available, non-interest-bearing funds larger than the investments made in tax- free securities then in such cases, disallowance under Section 14A cannot be made.
• In HDFC Bank Ltd. Vs. Deputy Commissioner of Income Tax (2016) 383 ITR 529 (Bom) / 2016 SCC Online Bom 1109, the assessee was a Scheduled Bank and the issue therein also pertained to disallowance under Section 14A. In this case, the Bombay High Court even while remanding the case back to Tribunal for adjudicating afresh observed (relying on its own previous judgment in same assessee’s case for a different Assessment Year) that, if assessee possesses sufficient interest free funds as against investment in tax free securities then, there is a presumption that investment which has been made in tax free securities, has come out of interest free funds available with assessee. In such situation Section 14A of the Act would not be applicable.
• By the same logic, the disallowance would be legally impermissible for the investment made by the assessees in bonds/shares using interest free funds, under Section 14A of the Act.
• The bench referred to observations made by Justice Sikri in Maxopp Investment Ltd. v. CIT……..the same are reproduced herein:

“3…………. The purpose behind Section 14-A of the Act, by not permitting deduction of the expenditure incurred in relation to income, which does not form part of total income, is to ensure that the assessee does not get double benefit. Once a particular income itself is not to be included in the total income and is exempted from tax, there is no reasonable basis for giving benefit of deduction of the expenditure incurred in earning such an income……..
…41. In the first instance, it needs to be recognised that as per Section 14-A(1) of the Act, deduction of that expenditure is not to be allowed which has been incurred by the assessee in relation to income which does not form part of the total income under this Act”. Axiomatically, it is that expenditure alone which has been incurred in relation to the income which is includible in total income that has to be disallowed. If an expenditure incurred has no causal connection with the exempted income, then such an expenditure would obviously be treated as not related to the income that is exempted from tax, and such expenditure would be allowed as business expenditure. To put it differently, such expenditure would then be considered as incurred in respect of other income which is to be treated as part of the total income….
…50. It is to be kept in mind that in those cases 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. In fact, it would be a quirk of fate that when the investee company declared dividend, those shares are held by the assessee, though the assessee has to ultimately trade those shares by selling them to earn profits. The situation here is, therefore, different from the case like Maxopp Investment Ltd. [Maxopp Investment Ltd. v. CIT, 2011 SCC OnLine Del 4855 : (2012) 347 ITR 272] where the assessee would continue to hold those shares as it wants to retain control over the investee company. In that case, whenever dividend is declared by the investee company that would necessarily be earned by the assessee and the assessee alone. Therefore, even at the time of investing into those shares, the assessee knows that it may generate dividend income as well and as and when such dividend income is generated that would be earned by the assessee. In contrast, where the shares are held as stockin-trade, this may not be necessarily a situation. The main purpose is to liquidate those shares whenever the share price goes up in order to earn profits……….
..51….It will be in those cases where the assessee in his return has himself apportioned but the AO was not accepting the said apportionment. In that eventuality, it will have to record its satisfaction to this effect.………….”

• Central Board of Direct Taxes (CBDT) had issued the Circular no. 18 of 2015 dated 02.11.2015, which had analyzed and then explained that all shares and securities held by a bank which are not bought to maintain Statutory Liquidity Ratio (SLR) are its stock-in-trade and not investments and income arising out of those is attributable, to business of banking. Shares and securities held by a bank are stock in trade, and all income received on such shares and securities must be considered to be business income. That is why Section 14A would not be attracted to such income.
• The Revenue does not contend that the Assessee Banks had held the securities for maintaining the Statutory Liquidity Ratio (SLR), as mentioned in the circular. In view of this position, when there is no finding that the investments of the Assessee are of the related category, tax implication would not arise against the appellants, from the said circular.
• From the aforesaid discussion it can be concluded that the proportionate disallowance of interest is not warranted, under Section 14A of Income Tax Act for investments made in tax free bonds/ securities which yield tax free dividend and interest to Assessee Banks in those situations where, interest free own funds available with the Assessee, exceeded their investments. With this conclusion, the bench unhesitatingly agreed with the view taken by the learned ITAT favouring the assessees.
• The above conclusion is reached because nexus has not been established between expenditure disallowed and earning of exempt income. The respondents as earlier noted, have failed to substantiate their argument that assessee was required to maintain separate accounts. The learned counsel for the revenue has failed to refer to any statutory provision which obligate the assessee to maintain separate accounts which might justify proportionate disallowance.

Held:

In view of the forgoing discussion, the issue framed in these appeals was answered against the Revenue and in favour of the assessee. The appeals by the Assessees were accordingly allowed. The department cannot make disallowance relying on section 14 A of the Act on expenditure incurred for earning tax free income in cases where assessees do not maintain separate accounts for the investments and other expenditures incurred for earning the tax-free income.