2017 (3) TMI 1971 - AT - Income Tax

Interest disallowance under u/s 14A read with Rule 8D(2)(ii) deleted; Rule 8D(2)(iii) limited to Rs.32,400

M/s. Uma Polymers Ltd. Versus DCIT CIR 3 (3), Mumbai

ITAT MUMBAI (AT) dismissed Revenue's appeal upholding CIT(A)'s deletion of interest disallowance u/s 14A read with Rule 8D(2)(ii), finding the assessees' ... Disallowance u/s.14A - interest expenditure and other administrative expenses - AO observed that assessee is in receipt of dividend income which was claimed as exempt from tax u/s.10(34) - HELD THAT:- As per the audited balance sheet on record, assessee was having its own capital and free reserves which were much more than the investment made in tax free securities. A categorical finding has been recorded by CIT(A) to the effect that assessee company was having its own capital as on 31/03/2011 at Rs.11,15,51,500/- and reserves and surplus of Rs.41,85,75,205/- total to Rs.53,01,30,705/-. These capital and reserves were much more than the investment made of Rs.28,23,07,012/-. In terms of the decision of HDFC bank [2014 (8) TMI 119 - BOMBAY HIGH COURT] and Reliance Utilities [2009 (1) TMI 4 - BOMBAY HIGH COURT] it would have to be presumed that investment made by assessee would be out of interest free funds available with the assessee. The ratio and the principle laid down by the Hon'ble Bombay High Court in the case of Reliance Utilities Ltd., (supra) and HDFC Bank, (supra) are clearly applicable, wherein their Lordships have reiterated several times that if the assessee has surplus funds in the form of reserves & surplus or share capital, then presumption is that investment would have been made from surplus funds/interest free funds and not from the borrowed funds. No reason to interfere in the findings of CIT(A) deleting the disallowance of interest u/s.14A read with Rule 8D (2)(ii). Accordingly appeal filed by Revenue is dismissed. Assessee is aggrieved for restricting disallowance of other expenditure under Rule 8D (2)(iii) - We found that during the year under consideration assessee was in receipt of dividend income of Rs.32,400/- which was claimed u/s.10(34). We direct the AO to restrict disallowance under Rule 8D(2)(iii) at Rs.32,400/- i.e., to the extent of exempt income received by assessee during the year under consideration. We direct accordingly. ISSUES PRESENTED AND CONSIDERED 1. Whether interest disallowance under section 14A read with Rule 8D(2)(ii) is sustainable where the assessee's interest-free funds (share capital and reserves) exceed the investments yielding exempt income. 2. Whether the notional disallowance under Rule 8D(2)(iii) (the 0.5% 'other expenditure' component) should be computed after excluding: (a) strategic/business investments (e.g., investments in subsidiaries for control), and (b) investments that did not yield exempt income during the year. 3. Whether the disallowance computed under Rule 8D(2)(iii) can exceed the actual exempt income received in the relevant year. 4. Consequential issue: treatment of any disallowance under section 14A for computation of book profit under section 115JB (i.e., whether such disallowance is required to be added back under Explanation 1(f) to section 115JB). ISSUE-WISE DETAILED ANALYSIS Issue 1 - Interest disallowance under section 14A / Rule 8D(2)(ii) where interest-free funds exceed investments Legal framework: Section 14A disallows expenditure incurred in relation to exempt income. Rule 8D prescribes a three-component methodology; sub-rule (2)(ii) apportions interest expenditure to exempt income by reference to the ratio of average value of investments yielding exempt income to average value of total assets. Precedent treatment: The Tribunal applied the principle established by the jurisdictional High Court decisions which adopt the presumption that where interest-free funds (share capital, reserves and surplus) exceed investments producing exempt income, the investments are to be presumed to have been funded from interest-free funds and not from borrowings - leading to deletion of interest disallowance. Those High Court rulings, and Reliance Utilities principle, were followed. Interpretation and reasoning: The Court examined audited balance-sheet figures showing share capital and reserves substantially exceeding investments in tax-free securities. Applying the High Court precedent, it is presumed that the investments were made out of interest-free funds and therefore not funded by borrowings; consequently, no part of interest expense is attributable to earning exempt income. The Tribunal endorsed CIT(A)'s finding as factually supported by the accounts and cash-flow statement. Ratio vs. Obiter: Ratio - where interest-free funds exceed investment in exempt securities, interest disallowance under Rule 8D(2)(ii) cannot be sustained; this follows the binding principle applied from the jurisdictional High Court. Obiter - explanatory discussion of the scope and purpose of section 14A and Rule 8D (though grounded in authority) is ancillary. Conclusion: Disallowance of interest under Rule 8D(2)(ii) deleted; Revenue appeal dismissed on this point. Issue 2 - Scope of Rule 8D(2)(iii): exclusion of strategic/business investments and non-yielding investments Legal framework: Rule 8D(2)(iii) prescribes a notional figure (0.5% of average value of investments yielding exempt income) as one component of expenditure relatable to exempt income. The rule requires computing the 'average value of investment, income from which does not or shall not form part of the total income'. Precedent treatment: The Tribunal relied on a series of prior decisions (from this Tribunal and other benches) holding that strategic/business investments (particularly where control of group companies is the objective) should be excluded from average investment under Rule 8D(2)(iii). Similarly, decisions were cited holding that investments not yielding tax-exempt income during the year should be excluded from the Rule 8D(2)(iii) computation. These authorities were followed. Interpretation and reasoning: The Tribunal reasoned that Rule 8D(2)(iii) is intended to capture expenses attributable to earning exempt income and that investments made for strategic or business reasons (e.g., to acquire control of subsidiaries) are not investments the income from which is properly characterized as exempt income for the purpose of attributing overheads. Where such strategic investments constitute a large proportion (here ~98%) of the aggregate investment, they should be excluded from the 'average value of investment' computation. Likewise, investments that did not yield exempt income in the relevant year should not be counted. Ratio vs. Obiter: Ratio - Rule 8D(2)(iii) disallowance should exclude strategic/business investments and investments which did not yield exempt income in the year; where exclusion reduces the base, corresponding disallowance is reduced or eliminated. Obiter - references to multiple ancillary authorities and policy considerations underlying Rule 8D were explanatory. Conclusion: The Tribunal directed exclusion of strategic investments (constituting the bulk of the investments) and non-yielding investments from the Rule 8D(2)(iii) base; accordingly, no disallowance of 'other expenditure' is warranted to the extent of those excluded investments. Issue 3 - Whether Rule 8D(2)(iii) disallowance can exceed the exempt income received Legal framework: Rule 8D(2)(iii) produces a notional figure; section 14A disallows expenditure 'in relation to' exempt income. There is judicial authority addressing whether disallowance may be limited to the quantum of exempt income in the year. Precedent treatment: Decisions were cited where courts/tribunals have limited Rule 8D(2)(iii) disallowance to the amount of exempt income received in the relevant year. The Tribunal considered these authorities in the context of the facts. Interpretation and reasoning: After applying the exclusions discussed under Issue 2, the Tribunal noted that the only declared exempt income in the year was a dividend of Rs.32,400. Considering the legal position and the totality of facts and authorities limiting disproportionate notional disallowances relative to actual exempt receipts, the Tribunal concluded it was appropriate to restrict the Rule 8D(2)(iii) disallowance to the amount of exempt income actually received. Ratio vs. Obiter: Ratio - where, after appropriate exclusions, the computed Rule 8D(2)(iii) figure would exceed the actual exempt income, the disallowance may be restricted to the quantum of exempt income received in the year; this was applied on the facts. Obiter - broader commentary on the interplay of notional disallowances and actual exempt receipts beyond these facts. Conclusion: Disallowance under Rule 8D(2)(iii) restricted to the exempt income actually received (here Rs.32,400); assessee's appeal allowed in part on this point. Issue 4 - Addition back for book profit under section 115JB Legal framework: Explanation 1(f) to section 115JB requires addition back to book profits of amounts of expenditure 'relatable to' exempt income. Section 14A disallowance addresses expenditure in relation to exempt income. Precedent treatment: Tribunal considered prior rulings holding that any expenditure finally disallowed under section 14A is to be added back for purpose of computing book profit under section 115JB; sub-sections of section 14A and Rule 8D are treated as machinery provisions, while the substantive effect of disallowance impacts book profit computation. Interpretation and reasoning: The Tribunal observed that the language of Explanation 1(f) is wide and does not require that the amount be specifically debited to the profit & loss account; expenditure disallowed under section 14A is expenditure 'relatable to' exempt income and therefore falls within clause (f) and must be added back. Ratio vs. Obiter: Ratio - disallowance finally made under section 14A is to be added back to book profit under Explanation 1(f) to section 115JB; this follows settled decisions and was affirmed. Obiter - discussion on the conceptual alignment between 'in relation to' and 'relatable to'. Conclusion: Any disallowance finally sustained under section 14A/Rule 8D must be added back for computing book profit under section 115JB; however, in the present facts the interest disallowance was deleted and Rule 8D(2)(iii) was limited to the exempt income amount, which should be reflected in book profit computation as per law.