Wednesday, February 18, 2009

A Way around Daga Capital?

An earlier post had discussed a decision of a Special Bench of the Mumbai Income Tax Appellate Tribunal (ITAT) in Daga Capital [26 SOT 603], highlighting its far-reaching implications on expenditures incurred ‘in relation to’ the earning of tax-free income under the Income Tax Act (Act). The Special Bench, following the Supreme Court decision in Doypack Systems [(1988) 2 SCC 299], held that the phrase ‘in relation to’ includes both direct and indirect connection, thus significantly widening its scope. However, one other aspect of the decision, which was only touched on earlier, has now proved to be of possibly greater significance.

Along with the discussion of the phrase ‘in relation to’, another issue that arose in Daga Capital was whether the computation provisions in section 14A are retrospective. This issue is significant due to the scheme and legislative evolution of the provision. Section 14A was originally introduced by the Finance Act 2001, with retrospective effect from 1st April, 1962. In its original form, the provision merely provided that expenditure incurred in relation to tax-free income shall not be deductible. However, there was no provision for the mode in which such relatable expenditure was to be determined. This computation provision was introduced by the Finance Act, 2006, without explicit retrospective effect. Thus, one of the issues that arose in Daga Capital was whether these computation provisions under section 14A were retrospective. The Court, relying on a recent decision of the Apex Court in Gold Coin Health Foods Ltd. [304 ITR 308 (SC)], held that these provisions merely gave effect to section 14A(1), which was explicitly retrospective. Thus, these provisions being procedural, were held to be retrospective.

While this seems to be a straightforward and unsurprising result in law, the practical effects of the decision have led to more than a fair share of debate and discomfiture. This is because of the actual content of the computation provisions. Section 14(A)(2) provides that if the Assessing Officer (AO) ‘is not satisfied’ with the assessee’s claim as to the amount of expenditure relatable to exempt income, he shall determine the amount of expenditure ‘in accordance with such method as may be prescribed’. This prescribed method in provided in Rule 8D of the Income Tax Rules, according to which the amount of expenditure disallowed is proportionate to the amount of tax-free investments made, irrespective of the source of the investment. Thus, the mode of computation uses the proportion of the investment vis-a-vis the total assets of the company, to determine what proportion of the total expenditure should be disallowed. Further, section 14A(3) provides that this mode of computation applies also when the assessee claims that no expenditure has been incurred by him in earning the tax-free income. An archetypical case would be when an enterprise has sufficient reserves of interest-free funds to make a tax-free investment. In such a case, there is no question of there being any expenditure in relation to earning tax-free income, since the funds invested in the earning of the income have been internally provided. In such a case, ideally, there should be no disallowance of deductions for expenditures that may have been incurred in other activities of the business. Prior to the decision in Daga Capital, there were a few decisions, specifically in the context of section 14A, stating that the burden was on the Revenue to show the link between the expenditure incurred and the tax-free income earned. However, after the broad interpretation of the provision and the retrospective application of the computation provisions vide Daga Capital, the position seems to have undergone a change. This means that even if an enterprise has not, in fact, borrowed for the purposes of making tax-free investment, but borrowed for other purposes, it still would be denied deductions to the extent worked out by Rule 8D.

On the text of the provision, there was only one way left out of the situation. Section 14A(2) provides that Rule 8D should be applied only when the Assessing Officer ‘is not satisfied’ with the claim of expenditure made by the assessee. However, given that this is a requirement of mere subjective satisfaction, prima facie it does not seem to have any significant implications. However, a recent decision of the Bombay High Court in CIT v. Reliance Utilities & Power [221 CTR (Bom) 435] has possibly provided a way out of the labyrinth. The decision concerns section 36(1)(iii) of the Act, which allows for deducting the amount of interest paid on capital borrowed for the purposes of business. The inquiry necessitated to determine the amount of interest (expenditure) deductible is similar to that under section 14A, i.e. the link between the expenditure incurred and the use of the funds has to be established. In this context, the High Court held that the existence of interest-free funds sufficient to meet the capital requirement would create a presumption against the possibility that the moneys were borrowed for the purposes of the business. Admittedly, at first sight, the fact that this decision is not on section 14A, and is based on a differently worded provision, takes away from its relevance in the context of Daga Capital. However, its significance lies in the fact that Daga Capital is silent on the precise effect of the retrospectivity of section 14A(2) & (3), since on facts there, the expenditure was clearly for the investment, the question was only whether the income had a sufficient nexus to the expenditure. Also, it does not throw light on the level and type of satisfaction of the Assessing Officer to be established before the mode of computation laid down in Rule 8D may be used. The decision in Reliance, especially given that it has been made in a relatively broad fashion [i.e. not specifically restricted to section 36(1)(ii)] makes possible an assertion that although the AO may use the computation provided in Rule 8D, he can do so only on satisfactorily rebutting a presumption against the use of borrowed funds for earning tax-free income, when sufficient interest-free funds are available. Thus, until such time as the ghost of Daga Capital is laid to rest in the High Court or even higher, this may be a source of much-needed respite to assessees.

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