Bombay High Court Upholds Section 14A and Rule 8D – Part I

Earlier posts discussed the decision of the Mumbai Special Bench of the ITAT in Daga Capital, and exceptions to the seemingly assessee-adverse ruling that had been carved by other tribunals and courts. The issue was then heard by the Bombay High Court, which finally pronounced judgment yesterday. The decision in Godrej & Boyce v. DCIT, has not provided as much of a reprieve to assessees as would have been hoped- only holding that the dubious Rule 8D of the Income Tax Rules is to be applied prospectively, while upholding its constitutionality and that of section 14A of the Income Tax Act.

The case before the Court involved a typical scenario in which section 14A is usually invoked. Section 14A provides that in computing the total income of an assessee, no deduction shall be allowed in respect of expenditure incurred in relation to income which does not form a part of the total income under the Act. This expenditure can be that claimed by the assessee; or if the Assessing Officer is not satisfied with the claim made, such expenditure as the AO may compute in accordance with Rule 8D of the Rules (introduced w.e.f. March 2008). The assessee here had earned dividend income, which is exempt under the Act; and contended that no expenditure had been incurred in relation to that income. However, the AO differed and held made a disallowance of `6.92 crore, which was overturned in appeal by the Commissioner (Appeals). However, on appeal by the Revenue before the ITAT, it was held following Daga Capital, that Rule 8D had retrospective effect, and also applied to assessment year 2002-03, which was under consideration. On this ground, the matter was remanded back to the AO for a fresh consideration in light of section 14A(2) and Rule 8D. It was against this remand that the assessee appealed to the High Court, which clubbed with it a writ petition challenging the vires of section 14A and Rule 8D.

The Court formulated three questions for its consideration, answering two of them in favour of the Revenue, and the third in favour of the assessee-

(a) Can dividend income be considered to be income ‘not includible in total income’, for the purposes of section 14A?

(b) Do section 14A(2) and (3), and Rule 8D pass Constitutional muster?

(c) Can Rule 8D be applied with retrospective effect?

Of these, I shall discuss the first question in this post, and the other two questions in a subsequent post.

Dividend income is covered by section 14A

After a detailed discussion of the object of section 14A, and in particular sections 142A(2) and (3), Justice Chandrachud moves to examine the first issue regarding the inclusion of dividend income under the provision. Under section 115-O, income tax is levied on any amount ‘declared, distributed or paid … by way of dividends’. Section 115R levies a tax on income distributed by a Mutual Fund to its unit-holders. The assessee contended that although dividend income is exempt from taxation under section 10(34) of the Act, it is still taxable in the hands of the company under the abovementioned provisions. Hence, far from being a provision which excludes dividend income from total income, section 10(34) is only a provision that prevents double taxation of dividend income.

However, following the Supreme Court’s dictum in CIT v. Indian Bank Ltd. (AIR 1965 SC 1473), that “it is income that is taxed but it is not taxed in vacuo. It is taxed in the hands of a person”, Justice Chandrachud dismissed this contention. The Court clarified that the tax paid by a company under section 115-O or 115R is not a tax paid on behalf of the shareholders, neither is it a tax on dividend. The tax paid by the company is a tax on the profits of the company, which means that the dividend earned by the shareholder is exempt from tax. Thus, as far as the shareholder is concerned, the dividend income being earned is not includible in the total income, and comes under the purview of section 14A.

The issue of constitutionality and the retrospectivity of Rule 8D will be discussed in a subsequent post.

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