SKP Tax Alert
Volume 10 Issue 12 | 15 May 2017
Supreme Court: Section 14A is applicable to dividend income irrespective of Dividend Distribution Tax (DDT) payment

Section 14A of the Income Tax Act, 1961 (Act) provides for disallowance of expenditure incurred in relation to income which is not included in the total income of the assessee. In a recent judgement[1], the issue before the Supreme Court (SC) was whether Section 14A would be applicable to dividend income irrespective of the fact that DDT is paid by the company.

Facts of the case
  • The taxpayer declared dividend income of INR 343.4 million.
  • The Assessing Officer (AO) had disallowed a portion of the total interest expenses on a notional basis in the ratio of cost of investment in shares and units to the cost of total assets appearing on the balance sheet. The Commissioner of Income Tax (Appeals) (CIT(A)) reversed the order of the AO following the stand taken in the earlier order.
  • The Income Tax Appellate Tribunal (ITAT) upheld the order of the CIT(A) on the premise that the AO failed to establish any nexus between investments in shares/mutual funds and the borrowed funds. However, the ITAT remanded the order to the AO for a fresh adjudication in light of the amendments made under Section 14A read with Rule 8D of the Income Tax Rules, 1962.
  • On being aggrieved by the order of the ITAT, an appeal was filed before the High Court (HC). The HC held that the amendment in Rule 8D were to be applied prospectively and accordingly the same would not apply to the year under consideration (Assessment Year 2002-03). The HC further held that on a plain reading of the section, the same also applies to dividend income subjected to DDT on the premise that it is not includible in the total income of the taxpayer.
Taxpayer’s contentions
  • Section 14A of the Act applies only in circumstances where income is tax-free, non-taxable and there is no incidence of tax on such income.
  • The fact that dividend is paid by the dividend-paying company and not by the recipient of such dividend is insignificant. Accordingly, the person paying the tax is not relevant for the purposes of Section 14A read with Section 115-O of the Act as the DDT is paid by the dividend-paying company. Thus, dividend income was being taxed in one way or the other and hence, the same can not be regarded as totally exempt from tax.
  • A literal interpretation of Section 14A is not required as the same could result in an absurd interpretation of the law by placing reliance on the decision of this court in the case of K P Varghese vs Income Tax Officer[2].
Revenue’s contentions
  • The purpose behind the insertion of Section 14A in the Act was to counterpoise various judicial pronouncements that allowed the entire expenditure irrespective of the taxpayer earning exempt/taxable income.
  • The Revenue relied on the Memorandum explaining the provisions of the Finance Bill, 2001 and Circular No. 14 issued by the Central Board of Taxes (CBDT) explaining the purpose of inserting Section 14A in the Act.
  • On a plain reading of the provisions of Section 14A, an essential principle was enshrined by the Act that expenses are allowable only to the extent the same has a nexus to the earning of taxable income.
  • Pursuant to the provisions of Section 115-O of the Act, it is evident that the tax paid on dividend by the dividend-paying company cannot assume the character of tax paid on dividend income by the taxpayer.
  • The situation is further fortified by the fact that the provisions of Section 199 of the Act do not provide for credit of DDT in any manner in the hands of the recipient of dividend (the taxpayer).
Issues before the Supreme Court
  • Whether the phrase ‘income which does not form part of total income under this Act’ appearing in Section 14A includes dividend income on which DDT is payable within its scope.
  • Whether the disallowance under Section 14A is attracted in spite of the favourable order of earlier years passed by Tax Authorities based on similar facts.
 Key observations of Supreme Court
  • The SC upheld the literal interpretation of the provisions of Section 14A of the Act on the premise that the language used was clear and free from any ambiguity. Accordingly, it was not necessary to apply any other principles of interpretation by placing reliance on the host of judicial decisions[3].
  • The SC further observed that the deletion and reintroduction of Section 10(33) and the Section 115-O simultaneously, does not make any difference with respect to the applicability of Section 14A of the Act. In fact, the above serves as a countenance for holding that the dividend income would be exempt in the hands of the recipient only when the same is being taxed in the hands of the dividend-paying company. 
  • As far as the second issue is concerned, the SC noted that there was no change in the facts of the case pertaining to the year under consideration vis-a-vis earlier Assessment Years where the Revenue failed to establish a nexus between expenditure disallowed and dividend income and thereby granted the benefit of full exemption applying the rule of consistency.
Conclusion
The SC held that based on the observations and the facts of the case, the provisions of Section 14A of the Act would apply to dividend income on which tax is payable under Section 115-O of the Act. However, the decision of this Court shall not impact the case of the taxpayer mainly on two grounds. Firstly, the AO was not able to establish any link between the expenditure disallowed and the dividend income earned. Secondly, on similar facts, the Tax Authorities granted the full exemption in earlier years.
 
[1] Godrej and Boyce Manufacturing Company Limited vs Deputy CIT and Another Civil Appeal No. 7020 of 2011
[2]  (1981) 131 ITR 597 (SC)
[3] CIT vs Calcutta Knitwears (2014) 6 SCC 444, CIT vs Tara Agencies (2007) 292 ITR 444 (SC), Cape Brandy Syndicate vs IRC (1921) 1 KB 64  
 
SKP's comments
The controversy pertaining to the applicability of Section 14A to dividend income has been discussed extensively within the tax arena and is one of the most debatable issues. This issue has been the subject matter of various judicial pronouncements. However, this decision of the SC comes as a major relief on at least two fronts:
  • Tax authorities have to give reasons for their non-satisfaction of the correctness of the claim of the taxpayer before (re)quantifying the disallowance.
  • Though each year is a separate year, the principle of consistency has to be followed with respect to similar facts.
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