Saturday, November 14, 2009

Yet Another Controversy over Section 14A

Earlier posts here had discussed the decision of a Special Bench of the Bombay ITAT in Daga Capital and the possible inequities that could result from its interpretation of section 14A. The most significant one was that expenditure could be disallowed even if no nexus was established between the expenditure and tax-free investment income. To quote from an earlier post explaining the inequity,

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.

Two decisions of the ITAT had sought to alleviate the inequity of the position, by creating a presumption in favour of the assessee in certain cases or by holding that the extent of disallowance cannot be increased on an application of Rule 8D.

However, the Punjab and Haryana High Court in CIT v. Hero Cycles has finally done that which the Tribunal could not do due to rules of precedent- it has held that notwithstanding the application of Rule 8D, the establishment of a nexus between the expenditure incurred and the tax-free income has to be established by the Revenue. On facts, one of the units of the assessee had incurred interest expenditure, and the assessee as a whole had earned some tax free dividend income. The Revenue sought to connect these two together, and apply Rule 8D to disallow the expenditure. However, the CIT(A) found on facts that the interest expenditure had been set off elsewhere, and the dividend income was earned from the investment of tax free money. Based on this finding of fact, the CIT(A) upheld the assessee’s contention.

This decision was appealed against by the revenue to the High Court. Relying on its August 2009 decision in CIT v. Winsom Textile Industries Ltd., the Court affirmed the order of the CIT(A), opining that “[d]isallowance under Section 14A requires finding of incurring of expenditure where it is found that for earning exempted income no expenditure has been incurred, disallowance under Section 14A cannot stand”. While the decision doesn’t seem remarkable in itself, given the concerns expressed after Daga Capital, it serves as an assurance to assessees incurring expenditure and earning tax-free income through different parts of their business.

However, another twist to the issue is provided by the recent order of a Third Member of the Ahmedabad ITAT in Kanel Oil v. JCIT. Discussing the hierarchy between a Special Bench decision and the decision of a non-jurisdictional High Court, the Third Member held that the High Court would override only if there was no other conflicting High Court decision on the issue, and if the High Court decision was not per incuriam. On facts there, the Third member held that the High Court had ignored certain statutory provisions, rendering it per incuriam. On this basis, he held that the Special Bench decision would override the High Court. The merits of this decision, and the competence of a lower court to determine whether the decision of a higher court is per incuriam can be the subject of much independent debate. However, what is relevant here is to note that if Kanel Oil is to be followed, the position may be unsettled even after Hero Cycles. The computation scheme under Rule 8D(2)(ii) and (iii) specifically provides for disallowance even if there no nexus between the expenditure and the income. On this basis, it may be possible to argue that Hero Cycles ignores the text of Rule 8D, and being the decision of a non-jurisdictional High Court, need not be followed in Bombay, where Daga Capital’s Special Bench order would continue to hold fort.

In sum, Hero Cycles seemed to have provided a certain panacea to assessees concerned about the precise scope of Rule 8D and the decision in Daga Capital. However, the degree of relief afforded has been lessened by the uncertain implications of Kanel Oil.

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