Under the provisions of the Income Tax Act, 1961 (‘Act’), any expenditure incurred in relation to income which is exempt from tax is not allowed as a deduction against taxable income. The intention of the law is that where any income is not charged to tax, the expenditure incurred for earning that income should also not be allowed as a deduction. Where a tax payer incurs expenditure which is not directly identifiable towards exempt income or taxable income, a question arises regarding quantification of expenditure incurred for earning exempt income. For this purpose, the Government had introduced Rule 8D from 24th March 2008 to provide a formula to compute such expenses. The applicability of Rule 8D was subject to intense dispute between the tax payer and Revenue Authorities. The Mumbai Tribunal, in the case of Daga Capital Management1, had held that Rule 8D is valid and has retrospective effect. The validity of Rule 8D was challenged in the Bombay High Court in the case of Godrej and Boyce Mfg. Co. Ltd v DCIT2. The Bombay High Court has recently delivered an elaborate judgment running into 122 pages. This Tax Alert summarises the broad principles given by the Bombay High Court. A detailed analysis of the Godrej and Boyce case would follow in due course. Facts of the case: The tax payer had earned dividend income from investment in shares for AY 2002‐03 which was claimed as exempt from tax. The tax payer contended that it had acquired the shares from its own funds and that it had not incurred any expenditure for earning the dividend income. Hence, no disallowance was called for. The tax authorities noted that the tax payer had incurred interest expenditure. It had own funds as well as borrowed funds. However it was not possible to identify whether investment in shares was made from own funds or borrowed funds. On this ground, the tax authorities disallowed proportinate interes t expenditure. On appeal, the Tribunal remanded the matter back to the tax authorities to examine whether any expenditure was actually incurred to earn exempt income Questions raised before the High Court: Section 14A is applicable only where the tax payer earns exempt income. Dividend income cannot be considered as exempt income since the company which distributes dividend is required to pay Dividend Distribution Tax (‘DDT’). Instead of a large number of shareholders paying taxes, the company distributing the dividend is required to pay the DDT as a matter of administrative convenience. In effect, DDT is the tax on the dividend income of the shareholders. A literal interpretation of section 14A that it will apply to all cases of exempt income would result in unintended consequences, since dividend income is not exactly exempt as argued above.

• Provisions of Rule 8D are not retrospective in nature. Rule 8D was notified on 24th March 2008 and hence cannot be applied to AY 2002‐ 03.
• Provisions of Rule 8D are arbitrary and violative of the Constitution.
• The Tribunal has wrongly remanded the matter back to the tax authorities.

Decision of the High Court:

• Where a tax payer carries out two businesses – one business the income from which is chargeable to tax and the other business the income from which is exempt from tax, the common expenditure incurred needs to be apportioned between the two businesses. The expenses apportioned to the business giving rise to exempt income should be disallowed.
• DDT is a tax on distributed profits and not a tax on dividend income. It is not a tax which is paid by the company on behalf of or as an agent of the shareholders. This position is enforced by the fact that the shareholder cannot claim any deduction for the DDT paid by the company.
• In absence of exemption under section 10(33) of the Act, dividend income would be taxable even though DDT was paid. Hence, DDT is not in substitution of the tax liability of the shareholders. Accordingly, there is no absurdity in a literal interpretation of section 14A.
• The provisions of Rule 8D are to enforce and implement the provisions of section 14A. Rule 8D is to ensure uniformity in computing the disallowances. It also intends to remove the possibility of different officers adopting different ways of computing disallowances and consequent dispute between the Revenue and the tax payer.
• Advantages or disadvantages to any tax payer in any particular case, as a result of a provision of law are inevitable as it is necessary to ‘draw a line somewhere’. Such advantages or disadvantages do not, by themselves, make the provision of law unconstitutional
• Rule 8D brings into existence an artificial method of computing the disallowance for expenses relating to exempt income. Before its insertion, there was no definite way of computing this disallowance. Hence, Rule 8D cannot have a retrospective operation.
• Whether the investments are made out of own funds or out of borrowed funds is not determinative to conclude whether any expenditure is incurred to earn exempt income
• The Tax Authorities can invoke Rule 8D only where they are satisfied that the claim of the tax payer regarding expenditure relating to exempt income is not valid, having regard to the accounts of the tax payer. Since such an examination was not undertaken in this case, the Tribunal was right in remanding the matter back to the Tax Authorities
• Rule 8D was notified on 24th March 2008 and hence would apply from AY 2008‐09 onwards. It cannot be applied retrospectively.

SKP’s comments:

The decision in the case of Godrej and Boyce has laid down the law regarding making disallowances for expenses in relation to exempt income in an elaborate manner. The High Court has examined the arguments placed before it and the legal position in great detail and has pronounced an elaborate judgment. The judgment will have to be examined and analysed in detail to fully ascertain the impact of the decision and complexities, if any, that may arise there from.