Friday, August 13, 2010

Bombay High Court Upholds Section 14A and Rule 8D - Part II

In a previous post, the outline of the propositions in Godrej & Boyce v. DCIT was provided, followed by a discussion of the first issue before the Court. The other two issues, and the Court’s conclusions are discussed below.

Section 14A(2) and (3) and Rule 8D are Constitutionally valid

The next question posed by the case was whether the discretion granted to the AO by section 14A(2) and (3) and Rule 8D falls foul of Article 14 of the Constitution. Under section 14A(2), the Assessing Officer, if not satisfied with the correctness of the assessee’s claim, may determine the amount of expenditure incurred in relation to such income. Such determination is to be done in accordance with the method prescribed under the Income Tax Rules, i.e., Rule 8D. Section 14A(3) is a clarificatory provision that even if an assessee claims that no expenditure has been incurred in relation to the income, it shall not curtail the AO’s powers under sub-section (2). Rule 8D reads-

(1) Where the Assessing Officer, having regard to the accounts of the assessee of a previous year, is not satisfied with:

(a) the correctness of the claim of expenditure made by the assessee; or

­(b) the claim made by the assessee that no expenditure as been incurred, in relation to income which does not form part of the total income under the Act for such previous year, he shall determine the amount of expenditure in relation to such income in accordance with the provisions of sub­rule (2).

(2) The expenditure in relation to income which does not form part of the total income shall be the aggregate of following amounts, namely:­

(i) the amount of expenditure directly relating to income which does not form part of total income;

(ii) in a case where the assessee has incurred expenditure by way of interest during the previous year which is not directly attributable to any particular income or receipt, an amount computed in accordance with the following formula, namely:­ A x B



A = amount of expenditure by way of interest other than the amount of interest included in clause (i) incurred during the previous year;

B = 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 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.

Based on these provisions, the assessee contended that section 14A(2) provided an undue license to the AO to disallow expenditure incurred by an assessee. Further, Rule 8D did not make a distinction between different types of businesses, applying a uniform rule for the determination of expenditure to be disallowed. The import of Article 14 is that equals be treated equally, and also that unequals be treated unequally. By treating all businesses on par, the assessee contended that Rule 8D violated Article 14, and should be struck down as unconstitutional. However, in an act of judicial deference, the Bombay High Court rejected this contention. The Court cites several decisions of the Supreme Court to the effect that the presumption of constitutionality enjoys an exalted status, particularly in the case of tax statutes. Article 14, although requiring classification having a rational nexus to the object of the law, had to be applied cautiously to tax statutes. “Only if there is perversity or capriciousness in the method adopted by the Legislature” would a tax statute violate Article 14. Here, there was no such perversity or capriciousness, since the mechanism laid down by section 14A(2) and Rule 8D had a nexus with the determination of the expenditure to be disallowed. The Court also observed that Rule 8D(2)(iii), though laying down a blanket rule, would in most cases lead to a determination much lower than that would follow from an application of sub-clause (ii). On the basis of the requirement of judicial deference, and the supposed reasonability of the provision, the Court held that Rule 8D and section 14A(2) and (3) were constitutionally valid.

While the Courts observations on judicial deference to the Parliament’s tax policy cannot be faulted, the application to the facts at hand and are not free from doubt. The Court cited several provisions to the effect that the principle of rational classification under Article 14 should be applied cautiously to tax laws. However, it is submitted that when the dicta cited by the Court referr to classification, they refer to the Legislature being given “a free hand to devise classes – whom to tax or not to tax, whom to exempt and whom not to exempt” (State of U.P. v. Kamla Palace, (2000) 1 SCC 557). It is not clear whether once the types of tax and the persons on whom it is to be levied, the judicial deference extends to allowing legislative mechanisms to deem certain incomes or expenditures in whatever way they deem fit. Admittedly, the Supreme Court in Gujarat Ambuja Cement v. Union of India, AIR 2005 SC 3020, held that legislative discretion extends to determining what should be taxed, and also “the manner in which the tax may be imposed”. However, I am not sure if this can be taken to allow the use of mechanisms which have little or no rational nexus with concepts such as income and expenditure. It seems from a perusal of the decision that the Court anticipates and answers this contention, when it observes that that primary basis of the assessee’s challenge is the equal treatment of unequals, which does not hold water in light of the Supreme Court decisions cited. That leaves only the question of arbitrary discretion. In response to that, the Court holds that the discretion granted by section 14A(2) is not uncanalised- it is only on an objective assessment of the accounts of the assessee, and after giving him/her a fair hearing, that the AO may use Rule 8D to make an independent determination of the disallowed expenditure.

Thus, in the Court’s view, the arguments on neither irrational classification nor arbitrariness held water, and section 14A(2) and (3) and Rule 8D were held constitutionally valid.

Rule 8D may not be applied retrospectively

After failing in its first two contentions, the assessee did manage to convince the Court to see weight in its third contention- challenging the retrospective application of Rule 8D. The Revenue contended that since Rule 8D was merely procedural, it should be given retrospective effect. The Court admitted that the legislature had the power to enact both prospective and retrospective provisions, and that there was a presumption that procedural provisions were intended to have retrospective effect. However, noting that this presumption could be rebutted by the language of the amending statute, the Court held that Rule 8D could not be given retrospective effect.

For starters, it is submitted that the detailed examination of the principles of retrospective legislation was not relevant, as was pointed out by the Court itself. Section 295(4) of the Act provides that while there is the power to make retrospective rules, this power cannot be employed to prejudicially affect the interests of assessees. Given this provision, noted by the Court, the discussion of the law on the presumption of retrospectivity seems to be little more than obiter. In any event, the Court, relying on the Supreme Court’s dictum in CWT v. Shravan Kumar Swarup, 210 ITR 886 (1994), held that since Rule 8D was not a “well known, well settled or well accepted method”, but was an “artificial method of determining expenditure”, it should not be given retrospective effect. Further, the legislative history of section 14A, and the introduction of Rule 8D clearly suggested that the legislature did not intend the provision to have retrospective effect.


In sum, the Bombay High Court laid down the following propositions-

(a) Dividend income was ‘income not included in total income’ for the purpose of section 14A (In an interestingly timed development, the Kerala High Court has also upheld this position in CIT v. Leena Ramachandran)

(b) Rule 8D is not unconstitutional, since there is irrational classification

(c) Section 14A(2) and (3) are not unconstitutional on grounds of arbitrariness, since the satisfaction of the AO has to be objective, based on the accounts of the assessee, and after providing a fair hearing

(d) Rule 8D cannot be given retrospective effect.

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