Treaty-based capital gains exemption and prospective Rule 8D application shape cross-border tax treatment

Rule 8D for section 14A disallowance was treated as prospective from assessment year 2008-09, so for earlier years the Assessing Officer had to compute any disallowance by a reasonable method on the facts rather than apply Rule 8D mechanically; the disallowance was therefore remitted for fresh consideration. Capital gains from sale of shares in a Sri Lankan company were treated as outside the Indian tax net under Article 13(4) of the India-Sri Lanka DTAA, because the treaty phrase "may be taxed" was read as giving exclusive taxing rights to the source State. Treaty exclusion prevailed over section 5, and the income was not taxable in India.

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Issues: (i) Whether disallowance under section 14A of the Income-tax Act, 1961 could be computed by applying Rule 8D of the Income-tax Rules, 1962 for assessment years 2006-07 and 2007-08; (ii) Whether capital gains arising from sale of shares of a Sri Lankan company by an Indian resident assessee were taxable in India under the India-Sri Lanka DTAA.

Issue (i): Whether disallowance under section 14A of the Income-tax Act, 1961 could be computed by applying Rule 8D of the Income-tax Rules, 1962 for assessment years 2006-07 and 2007-08.

Analysis: Rule 8D was held to apply prospectively from assessment year 2008-09. For the years in question, the Assessing Officer was required to determine disallowance by adopting a reasonable method having regard to the facts and circumstances, and not by mechanically applying Rule 8D. Since the disallowance had been made under an inapplicable rule, the matter required reconsideration by the Assessing Officer.

Conclusion: The issue was remitted to the Assessing Officer for fresh consideration in accordance with law.

Issue (ii): Whether capital gains arising from sale of shares of a Sri Lankan company by an Indian resident assessee were taxable in India under the India-Sri Lanka DTAA.

Analysis: Under Article 13(4) of the DTAA, gains from alienation of stocks and shares may be taxed in the Contracting State in which they have been issued. The expression "may be taxed" was construed as excluding the taxing right of the residence State where the treaty language indicated taxation only in the source State. The Court also held that the treaty-based exclusion method prevailed over the Revenue's reliance on section 5 of the Income-tax Act, 1961 and that Article 24 on tax credit was inapplicable where the income stood excluded by the treaty itself. The notification issued under section 90A(3) of the Income-tax Act, 1961 was held not to govern the India-Sri Lanka DTAA.

Conclusion: The capital gains were held not taxable in India and the assessee succeeded on this issue.

Final Conclusion: The appeals relating to section 14A were set aside for fresh computation on a lawful basis, while the capital gains issue was decided in favour of the assessee by holding the income outside the Indian tax net under the treaty.

Ratio Decidendi: Where a DTAA uses the expression "may be taxed" in a context showing exclusive taxation by the source State, the residence State is precluded from taxing the income and treaty exclusion prevails over the domestic charging provision.

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