FIFO for physical shares and section 14A limits on exempt-income disallowance were both applied, with partial relief granted.

FIFO applied to indistinguishable physical shares for capital gains computation, as physical form did not change their fungible character; the assessee could not use selective specific identification to reduce the taxable gain, so the short-term capital gains addition was sustained. Under section 14A read with Rule 8D, disallowance was confined to investments that actually yielded exempt income during the year and could not exceed the exempt income earned; the matter was remitted for recomputation on that basis, granting partial relief.

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Issues: (i) Whether capital gains on sale of physical shares were to be computed by applying FIFO or by specific identification of the transferred lots; (ii) Whether the disallowance under section 14A read with Rule 8D had to be confined to investments actually yielding exempt income and could exceed the exempt income earned.

Issue (i): Whether capital gains on sale of physical shares were to be computed by applying FIFO or by specific identification of the transferred lots.

Analysis: The shares were held in physical form, but the decision held that their physical form did not alter their fungible character for the purpose of capital gains computation. The assessee's books had reflected a different profit figure under accounting standards, while the return adopted a substantially lower gain by selective identification of later-acquired, higher-cost shares. The reasoning accepted that section 45(2A) and the CBDT circular on securities reflected the principle that FIFO is the neutral and objective method where the shares are indistinguishable, and that the assessee's approach amounted to an artificial tax-minimising device inconsistent with the statutory computation.

Conclusion: FIFO was held applicable even to the physical shares in the facts of the case, and the addition on account of short-term capital gains was sustained against the assessee.

Issue (ii): Whether the disallowance under section 14A read with Rule 8D had to be confined to investments actually yielding exempt income and could exceed the exempt income earned.

Analysis: The decision accepted the settled position that, for section 14A, only those investments which actually yielded exempt income during the year are relevant for computation. It also accepted that the disallowance cannot go beyond the exempt income earned. On that basis, the earlier working made by the assessing authority was not sustained in full and recomputation was directed.

Conclusion: The disallowance under section 14A was to be recomputed by restricting it to investments that actually yielded exempt income and by capping it at the exempt income earned, in favour of the assessee.

Final Conclusion: The appeal succeeded only in part, with relief granted on the section 14A issue, while the capital gains addition was upheld.

Ratio Decidendi: Where the shares are indistinguishable in substance, capital gains may be computed on a FIFO basis notwithstanding physical holding, and disallowance under section 14A is limited to investments yielding exempt income and cannot exceed such exempt income.

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