Volume 5, Issue 15


10th July, 2012


Tax Alert
No disallowance under Section 14A with reference to investments having potential of generating taxable income

In brief

In the recent case of Avshesh Mercantile P. Ltd. and Orsi (assessees or the Company), the Income-tax Appellate Tribunal, Mumbai Bench held that expenditure incurred by assessees to make any investment which is capable of earning taxable as well as exempt income (even though the same was actually not earned by assessees) cannot not attract disallowance under section 14A.

Facts

  • Assessees are investment and trading companies.
  • They issued unsecured optionally convertible premium notes. As per the terms of the said issue, the premium note holders could convert the said premium notes into equity shares of the company at the end of maturity period or redeem the same at any time after the end of three years from the date of allotment.  In case of early redemption, the premium note holder were entitle to a proportionate premium.
  • During the year under consideration, the holders of premium notes got the said notes redeemed and accordingly proportionate premium was paid by assessees to the premium note holders on redemption.
  • The premium so paid was claimed by assessees as a deduction being allowable business expenditure.
  • Amount received by assessees on issue of premium notes was utilized for making investment in the purchase of shares of Reliance Utilities and Power Ltd. (‘RUPL’)
  • The Assessing Officer (‘AO’) found that income arising from the said investment was exempt u/s 10(23G) of the Income-tax Act.
  • The entire premium paid by assessees on redemption of premium note was therefore disallowed by the AO u/s 14A of the Act.

AO’s contentions

  • The AO held that no cogent material was brought on record to support and substantiate the case of assessee companies that making of investments in the shares of RUPL was a part of their business activities. Accordingly, the contention of assessees that premium paid on redemption of premium notes was in the nature of expenditure incurred for the purpose of their business was rejected by the AO.
  • As regards the applicability of section 14A, the AO held that even though the investment in shares had not yielded any tax free income in the form of dividend in the year under consideration, the expenditure incurred in the form of premium paid on redemption of premium notes was in relation to earning of such exempt income.
  • He held that the only test that was required to be applied is whether the expenditure incurred was for the purpose of earning the exempt income or not.

Assessees’ contentions

  • Assessees are engaged in the business of investment and finance since incorporation and since the amount received on issue of premium notes was invested in the shares of RUPL in the normal course of their business, the premium paid on redemption of premium notes was an expenditure incurred for the purpose of its business and which should be allowed u/s 36(1)(iii).
  • As regards the applicability of section 14A, it was submitted that the only income by way of dividend on shares was exempt from tax in respect of securities notified for the purpose of section 10(23G). Since the said shares were also capable of generating other income in the form of short term capital gains, income from stock lending, income by way of guarantee commission by offering said shares as collateral etc., it was not a case wherein the borrowed funds were exclusively utilized for making investment in order to earn the exempt dividend income. Therefore, Section 14A does not get attracted.
  • No exempt income in the form of dividend was actually received by assessees from the shares of RUPL either in the year under consideration or in any other year.
  • To avail the exemption u/s.10(23G), certain conditions need to be fulfilled as per Notification issued. Keeping in view all these uncertainties and contingencies, the premium paid by assessees on redemption of premium notes utilized for making investment in the shares of RUPL could not be regarded as expenditure incurred in relation to earning of exempt income so as to invoke the provisions of section 14A.
  • Premium paid on redemption of premium notes cannot be treated as in the nature of interest and hence no disallowance can be made u/s 14A.
  • Alternatively, it was claimed by assessees that the premium so paid may be treated as interest and added as part of the cost of the shares of RUPL.

The AO did not agree with the contentions of assessees and disallowed the premium so paid. The CIT(A) has also  confirmed the disallowance. Being aggrieved by the order of the CIT (A), assessees carried the matter further before the Tribunal.

Issue before Tribunal

Whether disallowance made by the AO and confirmed by the learned CIT(A) on account of the premium paid on redemption of premium notes by invoking the provisions of section 14A was  justified.

Assessees’ contentions

Assessees reiterated the contentions raised before the AO. Additionally, it took the view that the premium paid was not in the nature of interest or period cost and hence the same could not be disallowed u/s 14A.  Even if the same is considered as in the nature of interest, it contained an element of interest attributable to earlier period and hence the entire amount can not be disallowed.

Revenue’s contentions

  • Revenue argued that such premium is nothing but interest paid. In any case, no such proposition under law which says that only interest expenditure can be disallowed u/s 14A and even expenses other than interest can also be disallowed u/s 14A if they are incurred in relation to earning of exempt income.
  • Assessees not brought any evidence on record to show that it was in the business of investment and redemption premium paid has to be allowed as business expenditure.
  • It is wrong to claim that there should be tax free income in the same year for invoking the provisions of section 14A to make the disallowance of expenditure incurred in relation to tax free income.

Tribunal’s Ruling

The Tribunal, on perusal of the copy of relevant notification issued u/s 10(23G), held that exemption u/s 10(23G) is subject to satisfaction of certain conditions. Keeping in view all these uncertainties and contingencies, the Tribunal further held that the premium paid by assessees on redemption of premium notes utilized for making investment in the shares/debentures of RUPL cannot be regarded as expenditure incurred exclusively in relation to earning of exempt income so as to invoke the provisions of section 14A.

More importantly, the Tribunal further observed that the said investment had the potential of generating taxable income in the form of short term capital gains etc. and  it is immaterial whether such taxable income was earned in the year under consideration or not. The mere possibility of an investment having the potential of earning taxable income was adequate to rule that disallowance u/s 14A could not be made.

The Tribunal has also accepted the assessees’ contention that if no exempt income is earned during the year under consideration, the provisions of section 14A could not be invoked. For this proposition the Tribunal relied upon the decision of the Mumbai High court in the case of Delite Enterpriseii

SKP’s Comments

  • Though the Tribunal ruling was based on specific facts of the case, it lays down the ratio that Section 14A can not be invoked if earning of exempt income is based on certain uncertainties and contingencies.
  • Secondly and very importantly, if the investment has the potential of generating taxable income like short term capital gain, disallowance u/s 14A could not be invoked. This would be very useful proposition when the investment is made in the Mutual Funds other than equity oriented fund and the shares of the private limited companies where the capital gains, both short term and long term are taxable. This decision is on the same lines as an earlier decision of the Pune Bench of the ITAT in the case of S. Balan Alias Shanmugam Balkrishnan Chettiariii .
  • Thirdly, if during the year under consideration, the assessee has not earned the exempt income, provisions of section 14A are not to be invoked.
  • This decision could prove to be useful where a large chunk of investment has been made in units of debt oriented mutual funds and shares of closely held / private group companies where the capital gains would be taxable and where the provisions of section 14A are invoked by the tax authorities.
 
Notes:
i ITA No. 6194/Mum/2006 and 15 other appeals
ii Income Tax Appeal No. 110 of 2009
iii 120 TTJ 397