2021 (9) TMI 566 - SC - Income Tax

Banks win Section 14A dispute over tax-free bond investments when own funds exceed investment amounts

The SC ruled in favor of assessee banks regarding disallowance under Section 14A for investments in tax-free bonds/securities. The court held that ... Disallowance u/s 14A - Exempted Income - proportionate disallowance of interest paid by the banks for investments made in tax free bonds/ securities which yield tax free dividend and interest to assessee Banks - whether assessee had sufficient interest free own funds which were more than the investments made? - whether Section 14A, enables the Department to make disallowance on expenditure incurred for earning tax free income in cases where assessee like the present appellant, do not maintain separate accounts for the investments and other expenditures incurred for earning the tax-free income? - HELD THAT:- Revenue does not contend that the Assessee Banks had held the securities for maintaining the Statutory Liquidity Ratio (SLR), as mentioned in the circular - when there is no finding that the investments of the Assessee are of the related category, tax implication would not arise against the appellants, from the said circular. The aforesaid discussion and the cited judgments advise this Court to conclude that the proportionate disallowance of interest is not warranted, under Section 14A of Income Tax Act for investments made in tax free bonds/ securities which yield tax free dividend and interest to Assessee Banks in those situations where, interest free own funds available with the Assessee, exceeded their investments. With this conclusion, we unhesitatingly agree with the view taken by the learned ITAT favouring the assessees. The above conclusion is reached because nexus has not been established between expenditure disallowed and earning of exempt income. The respondents as earlier noted, have failed to substantiate their argument that assessee was required to maintain separate accounts. Their reliance on Honda Siel [2011 (7) TMI 275 - SC ORDER] to project such an obligation on the assessee, is already negated. The learned counsel for the revenue has failed to refer to any statutory provision which obligate the assessee to maintain separate accounts which might justify proportionate disallowance - Decided in favour of the assessee. 1. ISSUES PRESENTED and CONSIDEREDThe core legal question considered by the Court was the interpretation and applicability of Section 14A of the Income Tax Act, specifically:Whether proportionate disallowance of interest paid by banks is warranted under Section 14A for investments made in tax-free bonds or securities yielding tax-free dividend and interest, when the assessee banks possess sufficient interest-free own funds exceeding the amount invested.Whether the absence of separate accounts maintained by the assessee for investments in tax-free income-generating securities justifies proportionate disallowance of expenditure under Section 14A.The extent of the Assessing Officer's power to determine disallowance under Section 14A in cases where the assessee claims no expenditure has been incurred in relation to exempt income.The legal obligation, if any, on the assessee to maintain separate accounts for tax-free investments to avoid disallowance under Section 14A.The applicability of precedents and statutory provisions in cases involving mixed funds (interest-free and interest-bearing) and the presumption regarding the source of investment funds.2. ISSUE-WISE DETAILED ANALYSISIssue 1: Whether proportionate disallowance under Section 14A is called for when investments in tax-free bonds/securities are made out of sufficient interest-free funds.The legal framework revolves around Section 14A of the Income Tax Act, introduced retrospectively from 1962 but effectively operative for assessment years commencing 2001-2002 onwards, which disallows deduction of expenditure incurred in relation to income exempt from tax. Sub-sections (2) and (3), introduced in 2007, empower the Assessing Officer to determine such expenditure if the assessee's claim is unsatisfactory.Precedents such as the Supreme Court's decision in Reliance Industries Ltd. (2019) and the Bombay High Court's ruling in HDFC Bank Ltd. (2016) establish a presumption that if the assessee has sufficient interest-free funds to meet investments in tax-free securities, the investments are deemed to have been made out of such funds, negating the applicability of Section 14A disallowance. The Court emphasized that in cases of mixed funds, it is the assessee's right to appropriate investments to interest-free funds if sufficient, and the Revenue cannot arbitrarily impose proportionate disallowance.The Court noted that the Revenue's contention, relying on a pending larger bench decision in SA Builders, was distinguishable since the facts involved loans to sister concerns rather than investments in bonds/securities by banks.Applying these principles, the Court held that proportionate disallowance of interest is impermissible where interest-free funds exceed investments in tax-free securities. The nexus between expenditure disallowed and earning of exempt income was not established by the Revenue.Issue 2: Whether the absence of separate accounts for tax-free investments justifies proportionate disallowance under Section 14A.The Assessing Officer and High Court had upheld proportionate disallowance on the ground that the assessee banks did not maintain separate accounts for investments yielding tax-free income, thus necessitating apportionment of expenditure.The Court rejected this reasoning, finding no statutory obligation on the assessee to maintain separate accounts for different funds or investments. The reliance on Honda Siel Power Products Ltd., which dealt with re-opening of assessments due to non-disclosure, was held inapposite to justify a mandatory accounting requirement. The Court underscored that while full disclosure is mandatory, no law compels segregation of accounts for tax-free investments.Issue 3: The scope and application of Section 14A and related rules (e.g., Rule 8D) in determining disallowance.The Court referred extensively to Maxopp Investment Ltd. (2018), which clarified that Section 14A disallowance applies only to expenditure incurred 'in relation to income which does not form part of the total income.' The Court emphasized that if there is no causal connection between the expenditure and exempt income, the expenditure is allowable. The Court rejected the 'dominant purpose' test and accepted the principle of apportionment only in cases of divisible business activities.Further, the Court noted that the Assessing Officer must record satisfaction before making suo moto disallowance under Section 14A(2), especially when the assessee has made an apportionment claim. This procedural safeguard ensures reasoned application of the provision.Issue 4: Treatment of investments by banks as stock-in-trade and implications for Section 14A applicability.The Court considered the CBDT Circular No. 18 of 2015 and the Punjab and Haryana High Court's decision in State Bank of Patiala, which held that shares and securities held by banks (other than for SLR requirements) are stock-in-trade and income therefrom is business income, not exempt income. Hence, Section 14A would not apply.In the present appeals, since the Revenue did not contend that investments were held for SLR purposes, the income was business income, further negating Section 14A's applicability.3. SIGNIFICANT HOLDINGSThe Court's crucial legal reasoning includes the following verbatim excerpts:'Section 14-A of the Act, by not permitting deduction of the expenditure incurred in relation to income, which does not form part of total income, is to ensure that the assessee does not get double benefit. Once a particular income itself is not to be included in the total income and is exempted from tax, there is no reasonable basis for giving benefit of deduction of the expenditure incurred in earning such an income.''It is to be kept in mind that in those cases where shares are held as 'stock-in-trade', it becomes a business activity of the assessee to deal in those shares as a business proposition. Whether dividend is earned or not becomes immaterial.''In a situation where the assessee has mixed fund (made up partly of interest free funds and partly of interestbearing funds) and payment is made out of that mixed fund, the investment must be considered to have been made out of the interest free fund. To put it another way, in respect of payment made out of mixed fund, it is the assessee who has such right of appropriation and also the right to assert from what part of the fund a particular investment is made and it may not be permissible for the Revenue to make an estimation of a proportionate figure.''The learned counsel for the revenue has failed to refer to any statutory provision which obligate the assessee to maintain separate accounts which might justify proportionate disallowance.''The tax which each individual is bound to pay ought to be certain and not arbitrary. The time of payment, the manner of payment, the quantity to be paid ought all to be clear and plain to the contributor and to every other person.'Core principles established:Disallowance under Section 14A is permissible only when expenditure is incurred in relation to exempt income and such nexus is established.Where interest-free funds are sufficient to meet investments in tax-free securities, the investments are presumed to be made from such funds, negating disallowance.The absence of separate accounts for tax-free investments does not justify proportionate disallowance in the absence of statutory mandate.Investments by banks in shares and securities (not held for SLR) are stock-in-trade and income therefrom is business income, not attracting Section 14A.The Assessing Officer must record satisfaction before making suo moto disallowance under Section 14A(2), especially where the assessee has claimed no expenditure or apportioned expenditure.Taxation must be certain and not arbitrary; the regime should facilitate compliance and avoid presumptions without basis.Final determinations on each issue:Proportionate disallowance of interest under Section 14A is not warranted where the assessee banks have sufficient interest-free funds exceeding the investments in tax-free bonds/securities.There is no legal obligation on the assessee to maintain separate accounts for tax-free investments; absence thereof cannot justify disallowance.Investments by banks in tax-free securities, being stock-in-trade, generate business income and thus do not attract Section 14A disallowance.The Revenue failed to establish necessary nexus between disallowed expenditure and exempt income.The appeals by the assessees were allowed, and the proportionate disallowances made by the Revenue were set aside.