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Daga Capital – A decision with implications for trade in shares and securities

In a case decided less than a month back, a special (3 member) bench of the Bombay ITAT considered and decided a number of tax issues arising with respect to entities dealing in shares and securities. Given the considerable attention devoted on late to financial institutions and mutual funds, this decision is one of enormous significance.

The Bench considered three appeals together, one by the Revenue in a case involving M/s Daga Capital Management Pvt. Ltd., and two by assessees (M/s Cheminvest Ltd., New Delhi and M/s Maxopp Investments Ltd., New Delhi). Daga Capital dealt in shares and securities, and had incurred expenditure in the form of losses incurred in dealing in shares and securities and also interest on the moneys borrowed for the purposes of purchasing shares. There was some income earned in the form of dividend, which was exempt under s. 10(33), Income tax Act. The Assessing Officer allowed the losses to be deducted, but didn’t allow the interest on moneys borrowed, on the basis of s. 14A, Income Tax Act. S. 14A(1) states: “For the purposes of computing the total income under this Chapter, no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income which does not form part of the total income under this Act.” The AO held that the interest was expenditure incurred ‘in relation to’ to the dividend income, which ‘did not form part of total income’ due to the exemption under s. 10(33). On this basis, he disallowed the expenditure. On appeal, the CIT(A) reversed the decision, which was appealed against by the Revenue. The cases of Cheminvest and Maxopp also involved allowability of interest on moneys borrowed for purchasing shares. However, the facts differed slightly, in that, the two were investment companies with largely stable shareholding and not too many transactions in shares.

In this factual matrix, the three major issues arose before the Court: (1) relationship between s. 14A and the rest of the Act; (2) the retrospectivity of ss. 14A(2) & (3), which are procedural provisions dealing with computation under s. 14A(1); and (3) the meaning on ‘in relation to’ as used in s. 14A(1). Of these, the first and the third and relevant for the purposes of this discussion, while the second was decided largely on the basis of the presumption of retrospectivity of procedural and clarificatory provisions, relying on the recent decision of the Supreme Court in Gold Coin health Foods Ltd. [(2008) 304 ITR 308 (SC)].

With regard to the first issue, all the members of the tribunal were unanimous in holding that the provision overrode the rest of the provisions of the Act. The assessee had contended that if an amount is deductible as business expenditure under s. 36, it cannot be disallowed under s. 14A. The Tribunal rightly held that such an interpretation would render s. 14A nugatory and should be rejected. Thus, irrespective of the allowability of expenditure under any other provision, if covered by s. 14A, the expenditure would be disallowed.

I now come to the crux of the case, the meaning of ‘in relation to’, on which the Vice-President of the Tribunal dissented from the other two members. The tribunal had before it two decisions of the Supreme Court – a 11 judge bench decision in H.H. Maharajadhiraja Madhav Rao Jivaji Rao Scindia Bahadur of Gwalior v. Union of India [(1971) 1 SCC 85] and a 2 judge decision in Doypack Systems Pvt. Ltd. V. Union of India [(1988) 2 SCC 299]. In Scindia, the Court had held that ‘in relation to’ meant ‘dominant and immediate connection’. On the other hand, Doypack held that the phrase includes ‘direct and indirect connection’. The Vice-President relied on a couple of Supreme Court dicta to hold that the meaning of a phrase as decided by prior decisions can be considered relevant when determining the meaning of the phrase when subsequently used by the legislature, which is deemed to be aware of these decisions. Given that Doypack was a smaller bench and had failed to cite Scindia, he opined that Doypack need not be followed. Thus, ‘in relation to’ required a dominant and immediate connection, which would have to be determined based on the intent of the parties. Having made this finding on law, he applied it to the facts at hand. He held that in the case of Daga Capital, the intent at the time of borrowing the money was to use it for purchasing and selling shares and securities and not making an investment. Hence, the expenditure was not in relation to the exempt income, and was allowable. However, for the other two assessees, he held that given the scarcity of share transactions entered into by them, their intent was to hold investments and not to trade in shares. Hence, the expenditure was not allowable due to s. 14A.

The majority of two members, in a decision marked by acute and literal statutory interpretation, held that even the expenditure incurred by Daga Capital should not be allowed. Starting first with the conflict between Scindia and Doypack, they disagreed with the view that the meaning of phrases in one statute could be blindly imported into another. On the other hand, they opined that the context in which the phrase was used in the statute is significant. Applying this, they held that while Scindia dealt with constitutional interpretation, Doypack dealt with a tax-related matter, and was of greater relevance. They also held, interestingly, that the phrase in question in Scindia was ‘relating to’ and not ‘in relation to’ further detracting from its application to the issue at hand. In addition, they opined that even applying the ‘dominant and immediate’ test, the expenditure would be disallowed. For arriving at this decision, they applied the but-for test, stating that it was only due to the moneys borrowed that the dividend income was earned, thus satisfying the ‘dominant and immediate’ test. On the interpretation of the statute, they pointed out that the provision does not talk of looking at the expenditure and then looking for income resulting from it. Instead, it mandates an examination of the exempt income followed by an examination of the expenditure which has been incurred ‘in relation to’ such exempt income. Thus, the dissenting decision, in their opinion, put the proverbial ‘cart before the horse’. They supported this interpretation by pointing out that the Rules meant for computation under s. 14A provided for interest and similar other indirect expenditures, which would not have been the case had the provision to be read narrowly. Next, the assessee contended that Rule 8D used the term ‘value of investment’, suggesting that only expenditure meant for an investment was envisaged by the provision and not money spent in something like trading in shares and securities. The members again drew a distinction between ‘value of investment’ and ‘value of assets held as investment’, holding that the former refers to any money spent, while the latter would refer to money spent in the form of a long-term investment. Finally, dealing with the argument of intent, they held that intent was irrelevant now that the ‘dominant and immediate’ test was rejected. Also, since there was no distinction drawn in the Act between directly and incidentally earned income, the mere fact that the dividend income was incidentally earned had no tax implications. Finally, the Tribunal looked at a few decisions prior to the introduction of s. 14A, which had held that if the business in indivisible, expenditure in relation to all the income should be allowed, notwithstanding the fact that some of the income was tax-exempt. The Tribunal observed that s. 14A was introduced precisely in order to remedy this situation. Hence, even if the business was indivisible, the tax-exempt income was to be computed and the expenditure proportionately spent in relation to it to be determined.

Thus, as things stand today, the interpretation of s. 14A, with regard to allowability of expenditures on exempt income is as follows:
• The first inquiry is to determine the income which is exempt under any provision of the Act
• Next, determine the expenditure which is, in any way, related to this income
• Such expenditure as is related is not allowed, the rest is
• The intent of the parties at the time of making the investment is not relevant
• Allowability of the expenditure under any provision of the Act is overridden by s. 14A
• Indivisibility of the business is not relevant, and the tax-exempt income is to be computed and the expenditure proportionate to it to be determined and disallowed