C.I.T.,Mumbai vs M/S.Walfort Share & Stock Brokers P.Ltd

C.I.T., Mumbai ... Appellant (s)

Versus

M/s. Walfort Share & Stock Brokers P. Ltd. ... Respondent(s)

WITH

CIVIL APPEAL NO.4928 OF 2010 ARISING OUT OF S.L.P. (C) No.30283 of 2009 CIVIL APPEAL NO.4929 OF 2010 ARISING OUT OF S.L.P. (C) No.33749 of 2009 CIVIL APPEAL NO.4930 OF 2010 ARISING OUT OF S.L.P. (C) No.33144 of 2009 CIVIL APPEAL NO.4931 OF 2010 ARISING OUT OF S.L.P. (C) No.1701 of 2010 CIVIL APPEAL NO.4932 OF 2010 ARISING OUT OF S.L.P. (C) No.19492 of 2009 CIVIL APPEAL NO.4933 OF 2010 ARISING OUT OF S.L.P. (C) No.19464 of 2009 CIVIL APPEAL NO.4934 OF 2010 ARISING OUT OF S.L.P. (C) No.19465 of 2009 CIVIL APPEAL NO.4935 OF 2010 ARISING OUT OF S.L.P. (C) No.10417 of 2010 CIVIL APPEAL NO.4938 OF 2010 ARISING OUT OF S.L.P. (C) No.11328 of 2009 CIVIL APPEAL NO.4936 OF 2010 ARISING OUT OF S.L.P. (C) No.10212 of 2009 CIVIL APPEAL NO.4937 OF 2010 ARISING OUT OF S.L.P. (C) No.10213 of 2009 CIVIL APPEAL NO.4939 OF 2010 ARISING OUT OF S.L.P. (C) No.20919 of 2009 CIVIL APPEAL NO.4940 OF 2010 ARISING OUT OF S.L.P. (C) No.20916 of 2009 CIVIL APPEAL NO.4941 OF 2010 ARISING OUT OF S.L.P. (C) No.24051 of 2009 CIVIL APPEAL NO.4942 OF 2010 ARISING OUT OF S.L.P. (C) No.27741 of 2009 CIVIL APPEAL NO.4943 OF 2010 ARISING OUT OF S.L.P. (C) No.15866 of 2009 CIVIL APPEAL NO.4944 OF 2010 ARISING OUT OF S.L.P. (C) No.20282 of 2009 CIVIL APPEAL NO.4945 OF 2010 ARISING OUT OF S.L.P. (C) No.34131 of 2009 CIVIL APPEAL NO.4954 OF 2010 ARISING OUT OF S.L.P. (C) No.31781 of 2009 CIVIL APPEAL NO.4946 OF 2010 ARISING OUT OF S.L.P. (C) No.1122 of 2010 CIVIL APPEAL NO.4947 OF 2010 ARISING OUT OF S.L.P. (C) No.20853 of 2009 CIVIL APPEAL NO.4948 OF 2010 ARISING OUT OF S.L.P. (C) No.30857 of 2009 CIVIL APPEAL NO.4949 OF 2010 ARISING OUT OF S.L.P. (C) No.16501 of 2009 CIVIL APPEAL NO.4951 OF 2010 ARISING OUT OF S.L.P. (C) No.17757 of 2010 (CC 5709/2010) CIVIL APPEAL NO.4950 OF 2010 ARISING OUT OF S.L.P. (C) No.17756 of 2010 (CC 5726/2010) CIVIL APPEAL NO.4952 OF 2010 ARISING OUT OF S.L.P. (C) No.17758 of 2010 (CC 6028/2010) CIVIL APPEAL NO.4953 OF 2010 ARISING OUT OF S.L.P. (C) No.17759 of 2010 (CC 6806/2010)

JUDGMENT

S. H. KAPADIA, CJI.

Delay condoned.

Leave granted.

Whether the loss arising in the course of dividend stripping transaction taking place prior to

1.4.2002 was disallowable on the ground that such loss

was artificial as the dividend stripping transaction was

not a business transaction, is the question which arises

for determination in this batch of Civil Appeals; the

lead matter of which is C.I.T., Mumbai v. M/s. Walfort

Share & Stock Brokers Pvt. Ltd.

The facts in the lead matter are as follows:

The assessee is a member of Bombay Stock Exchange

and it earns income mainly from share trading and

brokerage. During the financial year 1999-2000,

relevant to the assessment year 2000-01, the Chola

Freedom Technology Mutual Fund came out with an

advertisement stating that tax free dividend income of

40% could be earned if investments were made before the

record date, i.e., 24.3.2000. The assessee by virtue of

its purchase on 24.3.2000 became entitled to the

dividend on the units at the rate of Rs. 4/- per unit

and earned a dividend of Rs. 1,82,12,862.80. As a

result of the dividend payout, the NAV of the said mutual fund which was Rs. 17.23 per unit on 24.3.2000,

at which rate it was purchased, stood reduced to Rs.

13.23 per unit on 27.3.2000, which was the succeeding

working day in the stock exchange. This fall in the NAV

was equal to the amount of the dividend payout. The

assessee sold all the units on 27.3.2000 at the NAV of

Rs. 13.23 per unit and collected an amount of Rs.

5,90,55,207.75. The assessee also received an incentive

of Rs. 23,76,778/- in respect of the said transaction.

Thus, the assessee thereby received back Rs. 7,96,44,847

(Rs. 1,82,12,862.80 + Rs. 5,90,55,207.75 + Rs.

23,76,778) against the initial payout of Rs.

8,00,00,000/-. For the income tax purposes, the

assessee, in its return, claimed the dividend received

of Rs. 1,82,12,862.80 as exempt from tax under Section

10(33) of the Income Tax Act, 1961 ("the Act" for short)

and also claimed a set-off of Rs. 2,09,44,793 as loss

incurred on the sale of the units thereby seeking to

reduce its overall tax liability.

The AO in his assessment order dated 21.3.2003 accepted that the dividend income amounting to Rs.

1,82,12,862.80 was exempt under Section 10(33) of the

Act. However, the AO disallowed the loss of Rs.

2,09,44,793 claimed by the assessee inter alia on the

ground that a dividend stripping transaction was not a

business transaction and since such a transaction was

primarily for the purpose of tax avoidance, the loss so-

called was an artificial loss created by a pre-designed

set of transaction. Accordingly, the AO deducted the

incentive income of Rs. 23,76,778 received by the

assessee + transaction charges from the loss of Rs.

2,09,44,793 and added back the reduced loss of Rs.

1,82,12,862.80 to the repurchase price/ redemption value

amounting to Rs. 5,90,55,207.75. (See page 77 of the SLP

Paper Book)

Being aggrieved by the disallowance of the

reduced loss of Rs. 1,82,12,862.80, the assessee filed

an appeal before CIT(A) who by his order dated

12.12.2003 confirmed the order of the AO saying that the

loss of Rs. 1,82,12,862.80 incurred by the assessee on the sale of units should be totally ignored and that the

same should not be allowed to be set-off or carried

forward. Thus, the Department disallowed the reduced

loss of Rs. 1,82,12,862.80 which amount was equal to the

dividend, on the units declared by the mutual fund, of

Rs. 1,82,12,862.80. In other words, by the impugned

orders passed by the AO, the Department sought to tax

the dividend income of the assessee during the relevant

assessment year of Rs. 1,82,12,862.80.

To complete the chronology of events, it may be

stated that the assessee moved the tribunal against the

order dated 12.12.2003. The disallowance stood deleted

by the Special Bench of the Tribunal vide its impugned

order dated 15.7.2005 by holding that the assessee was

entitled to set-off the said loss from the impugned

transactions against its other income chargeable to tax.

This view of the tribunal has been affirmed by the High

Court vide its impugned judgment dated 8.8.2008, hence

this civil appeal.

According to Shri Parag P. Tripathi, learned Additional Solicitor General and Shri Preetesh Kapur,

learned counsel for the Department, the amount received

by the assessee as "dividend", in fact and in law,

constitutes a "return of investment" in the hands of the

assessee and, therefore, it follows that the said amount

is required to be adjusted against the cost of purchase

of the original units and once that is done there is in

fact no loss suffered by the assessee on subsequent

sale/ redemption. Alternatively, if the so-called

"dividend" did not constitute a return of investment,

then since the price of units necessarily included the

price of dividend as an identifiable element embedded

therein to which a definite value could be assigned at

the time of the purchase, the "dividend" is in effect

"paid for". In such circumstances that part of the

price of units which clearly represented the cost of the

dividend, is the expenditure incurred for obtaining

exempt income and if that is the case then Section 14A

requires that such expenditure should be netted against

the receipt of dividend. Before us, it was also submitted that in any event "loss" is a commercial

concept under the Act, if a transaction is such that a

"tax loss" is created or contrived without suffering any

corresponding financial / commercial loss inasmuch as

the money has in fact been recouped in some other form

(such as dividend), then such a loss needs to be ignored

for tax purposes, only to the extent that the loss has

in fact been recouped in another form. This is because

such a loss, not being a "commercial loss", was never

intended to be allowed under the Act. As a corollary,

it was submitted that introduction of Section 94(7)

prospectively w.e.f. 1.4.2002 does not obliterate the

aforementioned last submission since a prospective

amendment, by its very definition, did not alter the

existing law in respect of the past transactions.

Moreover, Section 94(7) specifically adopts the above

principle of tax avoidance and modifies it for the

purpose of dealing with what is called as "dividend

stripping transactions".

On facts it was submitted that the assessee had the option to buy three different kinds of assets.

Option was available to the assessee to buy either the

unit (ex-dividend) or the unit and the dividend (cum-

dividend) or only the dividend. As far as the first two

assets, there was no issue. If an assessee wanted to

buy a unit after declaration of the dividend, then he

can buy the ex-dividend unit as soon as possible after

the record date so that he pays only for the NAV

relatable to ex-dividend unit, after declaration of the

dividend, without being affected by market fluctuations.

Similarly, if an assessee wants to buy an asset

consisting of the dividend and the unit, he can buy cum-

dividend unit at any point of time after the declaration

of the dividend but before the record date. According

to the Department, the problem arises in cases where an

assessee is desirous of buying only the dividend. In

order to do so, he buys the cum-dividend unit, after

declaration of dividend but as close as possible to the

record date (so as to isolate himself from market

fluctuations), whereby he becomes entitled to receive the dividend payout on the record date and immediately

after the record date is able to sell the ex-dividend

unit. Consequently, by a series of fiscal transactions,

the assessee ends up buying the dividend. Therefore, if

`x' is the price/ expenditure associated with the

purchase of dividend, `y' is the price/ expenditure

associated with the unit without dividend then, `x' +

`y' would be the price of cum-dividend unit. Then price

may be called `z' in which event, the equation is:

`x' + `y' = `z'

There is no dispute as to the identity of `z',

which is the price/ expenditure for purchasing cum-

dividend unit, i.e., Rs. 17.23. In that event, `y'

would represent the sale price of ex-dividend unit,

i.e., Rs. 13.23. Thus, `x' can be found by the simple

mathematical formula:

`x' = `z' - `y'

`x' is equal to Rs. 17.23 (`z') - Rs. 13.23 (`y')

= Rs. 4 According to the Department, therefore, in the

present case, Rs. 4 will be expenditure, attributable

towards earning tax free dividend income which is

disallowable under Section 14A of the Act. That, the

newspaper advertisements issued by the Mutual Fund in

the present case as on March 8, March 18 and March 22

amounted to an offer by Mutual Fund to the target

buyers, i.e., a buyer who wants to claim losses in the

trade of shares and securities so as to set it off

against his other income. The effect of the newspaper

advertisements is to segregate the unit into two assets,

namely, the asset of the tax free dividend and the ex-

dividend unit which will have an NAV reduced by the

amount of the dividend payout per unit. Since there are

two assets which are sold to the buyer of the cum-

dividend units, it follows that the difference between

the purchase and sale price of the unit, is nothing but

the expenditure incurred for purchasing the asset of tax

free dividend. In this connection, reliance is placed

on the Explanatory Memorandum accompanying the Finance Bill of 2001 reported in 248 ITR 195 (St.).

In conclusion, it was submitted before us that

the tax free dividend income was really in essence a

cost recovery mechanism which finds an independent

support in Accounting Standard No. 13, i.e., to the

effect that such a return should go to reduce the cost

of acquisition as such a return is really a return of

investment and not return on investment.

On behalf of assessee(s), Shri S.E. Dastur,

learned senior counsel, Shri Ajay Vohra, learned counsel

and Shri O.S. Bajpai, learned senior counsel, submitted

that the basic submission of the Department to the

effect that the amount received by the assessee as

"dividend", in fact and in law, constitutes "return of

investment" is fallacious for several reasons. Firstly,

the question whether an amount is a "cost return"

depends on the terms of the contract. Secondly, the

argument of the Department runs counter to Section

94(7). That sub-section clearly accepts that payment by

way of dividend is a revenue receipt but it is exempt from tax under Section 10(33). According to the

assessee, if the argument of the Department is to be

accepted that the amount represents "return of

investment" then it would constitute a capital receipt

and not a revenue receipt. Thirdly, if the dividend of

Rs. 4 per unit is treated as "expenditure" covered by

Section 14A and not as "dividend" as required by Section

94(7), it would mean that for the assessment years 2000-

01 and 2001-02 the assessee would be in a worse position

because for the relevant assessment years based on the

"fiscality principle" the entire loss of Rs. 1,85,68,015

would be disallowed whereas for the subsequent years

after insertion of Section 94(7) w.e.f. 1.4.2002 only

loss to the extent of the "dividend" amounting to Rs.

1,82,12,862 would stand disallowed leaving Rs.

3,55,153/- as loss allowable. That was never the

intention of the Parliament for inserting Section 94(7).

The said sub-section was not intended to be beneficial.

Fourthly, the fact that Section 94(7) allows loss in

excess of dividend means that it accepts that the transaction is genuine and in course of business. If

the transaction was a nullity, the entire loss would

have been disallowed and not only to the extent of the

dividend. Moreover, if losses could be disallowed on

fiscality/ first principles then Section 94(7) is

redundant. Fifthly, Section 14A is enacted for non-

deduction of expenditure whereas Section 94(7) is

enacted to curb creation of short-term losses. Lastly,

there is nothing to show that the NAV fell on the next

trading date after the record date on account of the

dividend payout. In this connection, it was submitted

that fall or increase in NAV depended upon the value of

the underlying assets and not on the basis of the

dividend payout. On interpretation of Sections 14A and

94(7) it was submitted that Section 14A deals with

expenditure in relation to income whereas Section 94(7)

deals with acquisition and sale of securities or units

and provides for a consequence where the purchase and

sale take place within a specified time period. Each

provision operates in its own field. When Section 14A refers to disallowance of expenditure in relation to

non-taxable income for computing the total income, what

is meant is that such expenditure should be taken into

account only for determining the quantum of the non-

taxable income. This would result in the exempt

dividend being reduced by the alleged expenditure. The

only impact on the exempting provision of Section 10(33)

for unit income is by Section 94(7) and one cannot

interpret Section 14A as leading to the same conclusion

as then Section 94(7) will be rendered nugatory. In

other words, the two provisions operate in different

time and space zones. In support of the above

contention, the assessee (s) has relied on the

Memorandum as well as Circular No. 14 which clearly

states that losses referred to in Section 94(7) are

allowable from the assessment year 2002-03 subject to

reduction of the actual computed loss to the extent of

the dividend. If Section 14A is also to apply

simultaneously then Section 94(7) will become nugatory.

Whereas Section 14A applies to expenditure incurred to earn tax free income from the inception of the Act,

Section 94(7) seeks to reduce the quantum of the loss

with reference to the dividend earned from the

assessment year 2002-03. The two terms "expenditure"

and "loss" are conceptually different. Section 94(7) is

a provision to set at naught "avoidance of tax". If

Sections 14A and 94(7) are applied to the same

transaction, it will result in Section 94(7) being a

"tax levying provision" and not an "avoidance of tax

provision". The effect of accepting the submission of

the Department is that in the present case the sum of

Rs. 1,82,12,862 would have to be considered twice, once,

by way of expenditure to earn the dividend income and

the second time by way of ignoring the loss to the

extent it does not exceed the dividend income of Rs.

1,82,12,862. According to the assessee (s), the embargo

in Section 14A on the deductibility of expenditure

applies where admittedly an expenditure has been

incurred and a deduction is claimed specifically in

respect thereof. In this connection, reliance was placed on the word "allowed" in the said Section. In

the present case, the assessee (s) has not made any

claim for deduction of Rs. 1,82,12,862 and, therefore,

the question of the said sum being disallowed did not

arise. On the other hand, Section 94(7) proceeds on the

footing that the entire dividend income falls within

Section 10(33) and the only adjustment is that the loss

which has arisen and would otherwise be allowable shall

be ignored to the extent it does not exceed the Section

10(33) income. Therefore, according to the assessee

(s), in applying Section 94(7) there is no question of

making a deduction at the stage of Section 14A as

suggested by the learned Solicitor General Shri Gopal

Subramanium. According to the assessee (s), under

Section 94(7) the dividend should go to reduce the loss

already worked out which implies that the loss is more

than the dividend income because it is only then that

the question of reducing the loss to some extent would

arise. In this connection, the assessee(s) submitted

that for the assessment year 2002-03 the loss was Rs. 1,85,68,015 which exceeded the dividend of Rs.

1,82,12,862 and, therefore, the loss allowable applying

Section 94(7) stood at Rs. 3,55,153. Therefore, in

order to reconcile Section 14A with Section 94(7) it was

suggested on behalf of the assessee(s) that Section 14A

should be confined to a case where there is expenditure

on earning tax free income but where there is no

acquisition of an asset and Section 94(7) should be

confined to a case where there is acquisition of an

asset thereby indicating a distinction between a claim

for deduction of an expenditure and a claim for

allowance of a business loss. Section 14A deals with

disallowance of expenditure per se and not with a

disallowance of a loss which arises at a point of time

subsequent to the purchase of units and the receipt of

exempt income and occurring only when there is a sale of

the purchased units. Section 14A is not concerned with

a purchase and subsequent sale of an asset which is

dealt with in Section 94(7) alone. In other words,

Section 14A does not apply to the case of a claim for set off of a loss which is dealt with only in Section

94(7) and that too from assessment year 2002-03.

Section 14A was inserted to meet cases where deductions

have been claimed in respect of expenditure for earning

exempt income like dividend income and the said Section

was never intended and does not apply to the case of a

claim for set off of a loss which as stated above is

dealt with in Section 94(7) alone and that too with

effect from the assessment year 2002-03. Thus, whereas

Section 14A was designed to overcome the problem created

by certain decisions of this Court in Rajasthan State

Warehousing Corporation v. Commissioner of Income-

Tax [242 ITR 450] and in the case of Commissioner of

Income-Tax, Madras v. Indian Bank Limited [56 ITR

77], Section 94(7) had no such object. The two,

therefore, operate in different fields and they have

different objects and because the two provisions

operated in two different fact situations Section 14A

was made effective from assessment year 1962-63 whereas

Section 94(7) is made effective from the assessment year 2002-03. Thus, the Parliament has treated both the

sections as dealing with separate circumstances and,

therefore, one must confine Section 14A to expenditure

of the type referred to in Sections 30 to 43B of the Act

which relates to expenditure which does not result in

acquisition of an asset. It is clear that where the

asset so acquired is sold and results in a loss Section

94(7) steps in.

According to the learned Solicitor General of

India, Section 14A was inserted by Finance Act 2001 with

effect from 1.4.1962. According to him, the fundamental

principle underlying Section 14A is that income which is

not taxable or exempt falls in a separate stream

distinct from income taxable under the Act. That,

expenditure which is incurred in relation to income

subject to tax would be admissible under Sections 30 to

43B whereas expenditure incurred to earn exempt income

would be extraneous in the computation of taxable income

under the Act. Thus, only that expenditure is

deductible which is incurred in relation to business or profession. Expenditure producing non-taxable income

would not be permitted to be claimed as admissible

expenditure. Thus, in all cases where the assessee has

some exempt income, his total expenditure has got to be

apportioned between taxable income and exempt income and

the latter would have to be disallowed. The only event

that triggers Section 14A is that the assessee has both

taxable and exempt income and, therefore, one need not

go by the "two asset" theory. According to the learned

SGI, Section 14A is not concerned with whether the

assessee makes a profit or a loss. According to the

learned SGI, application of Section 94(7) will not rule

out Section 14A. It was submitted that both the

provisions can apply simultaneously. In this

connection, it was urged that in the first stage Section

14A can be applied to determine the expenditure to be

excluded. After excluding such expenditure from the

cost of purchase, what remains may be called as adjusted

purchase cost. If units are bought and sold within 3/9

months period, then, the adjusted purchase cost must be deducted from the sale. If this leads to a profit then

Section 94(7) will not apply. However, if there is a

loss, such loss will have to be ignored to the extent of

the dividend received. This was the suggested mode for

reconciling Section 14A with Section 94(7) by the

learned SGI, which according to the assessee(s) would

result in double counting of the dividend amount of Rs.

1,82,12,862, one as dividend and the other as a loss.

In this batch of cases, we are required to decide

three distinct points which are as follows:

(i) Whether "return of investment" or "cost recovery"

would fall within the expression "expenditure

incurred" in Section 14A?

(ii) Impact of Section 94(7) w.e.f. 1.4.2002 on the

impugned transactions.

(iii)Reconciliation of Section 14A with Section 94(7)

of the Act.

To answer the above, we need to reproduce

hereinbelow Sections 10(33), 14A, 94(7) and the relevant paras of Circular No. 14 of 2001 issued by the CBDT:

Section 10 - Incomes not included in total income In computing the total income of a previous year of any person, any income falling within any of the following clauses shall not be included-

(33) any income by way of -

(i) dividends referred to in section 115-O; or

(ii) income received in respect of units from the Unit Trust of India established under the Unit Trust of India Act, 1963 (52 of 1963); or

(iii) income received in respect of the units of a mutual fund specified under clause (23D):

Provided that this clause shall not apply to any income arising from transfer of units of the Unit Trust of India or of a mutual fund, as the case may be. Section 14A - Expenditure incurred in relation to income not includible in total income

For the purposes of computing the total income under this Chapter, no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income which does not form part of the total income under this Act.

Provided that nothing contained in this section shall empower the Assessing Officer either to reassess under section 147 or pass an order enhancing the assessment or reducing a refund already made or otherwise increasing the liability of the assessee under section 154, for any assessment year beginning on or before the 1st day of April, 2001.

Chapter : X - SPECIAL PROVISIONS RELATING TO AVOIDANCE OF TAX

Section 94 - Avoidance of tax by certain transactions in securities

(7) Where -

(a) any person buys or acquires any securities or unit within a period of three months prior to the record date ;

(b) such person sells or transfers such securities or within a period of three months after such date;

(c) the dividend or income on such securities or unit received or receivable by such person is exempt,

then, the loss, if any, arising to him on account of such purchase and sale of securities or unit, to the extent such loss does not exceed the amount of dividend or income received or receivable on such securities or unit, shall be ignored for the purposes of computing his income chargeable to tax.

Circular No. 14 of 2001

56. Measures to curb creation of short-term losses by certain transactions in securities and units

56.1 Under the existing provisions contained in Section 94, where the owner of any securities enters into transactions of sale and repurchase of those securities which result in the interest or dividend in respect of such securities being received by a person other than such owner, the transactions are to be ignored and the interest or dividend from such securities is required to be included in the total income of the owner.

56.2 The existing provisions did not cover a case where a person buys securities (including units of a mutual fund) shortly before the record date fixed for declaration of dividends, and sells the same shortly after the record date. Since the cum-dividend price at which the securities are purchased would normally be higher than the ex-dividend price at which they are sold, such transactions would result in a loss which could be set off against other income of the year. At the same time, the dividends received would be exempt from tax under Section 10(33). The net result would be the creation of a tax loss, without any actual outgoings.

56.3 With a view to curb the creation of such short-term losses, the Act has inserted a new Sub-section (7) in the section to provide that where any person buys or acquires securities or units within a period of three months prior to the record date fixed for declaration of dividend or distribution of income in respect of the securities or units, and sells or transfers the same within a period of three months after such record date, and the dividend or income received or receivable is exempt, then, the loss, if any, arising from such purchase or sale shall be ignored to the extent such loss does not exceed the amount of such dividend or interest, in the computation of the income chargeable to tax of such person.

56.4 Definitions of the terms "record date" and "unit" have also been provided in the Explanation after sub-section (7) of section 94.

56.5 This amendment will take effect from 1st April, 2002, and will accordingly, apply in relation to the assessment year 2002-2003 and subsequent years.

The main issue involved in this batch of cases is

- whether in dividend stripping transaction (alleged to

be colourable device by the Department) the loss on sale

of units could be considered as expenditure in relation

to earning of dividend income exempt under Section

10(33), disallowable under Section 14A of the Act?

According to the Department, the differential amount between the purchase and sale price of the units

constituted "expenditure incurred" by the assessee for

earning tax-free income, hence, liable to be disallowed

under Section 14A. As a result of the dividend pay-out,

according to the Department, the NAV of the mutual fund,

which was Rs. 17.23 per unit on the record date, fell to

Rs. 13.23 on 27.3.2000 (the next trading date) and,

thus, Rs. 4/- per unit, according to the Department,

constituted "expenditure incurred" in terms of Section

14A of the Act. In its return, the assessee, thus,

claimed the dividend received as exempt under Section

10(33) and also claimed set-off for the loss against its

taxable income, thereby seeking to reduce its tax

liability and gain tax advantage.

The insertion of Section 14A with retrospective

effect is the serious attempt on the part of the

Parliament not to allow deduction in respect of any

expenditure incurred by the assessee in relation to

income, which does not form part of the total income

under the Act against the taxable income (see Circular No. 14 of 2001 dated 22.11.2001). In other words,

Section 14A clarifies that expenses incurred can be

allowed only to the extent they are relatable to the

earning of taxable income. In many cases the nature of

expenses incurred by the assessee may be relatable

partly to the exempt income and partly to the taxable

income. In the absence of Section 14A, the expenditure

incurred in respect of exempt income was being claimed

against taxable income. The mandate of Section 14A is

clear. It desires to curb the practice to claim

deduction of expenses incurred in relation to exempt

income against taxable income and at the same time avail

the tax incentive by way of exemption of exempt income

without making any apportionment of expenses incurred in

relation to exempt income. The basic reason for

insertion of Section 14A is that certain incomes are not

includible while computing total income as these are

exempt under certain provisions of the Act. In the

past, there have been cases in which deduction has been

sought in respect of such incomes which in effect would mean that tax incentives to certain incomes was being

used to reduce the tax payable on the non-exempt income

by debiting the expenses, incurred to earn the exempt

income, against taxable income. The basic principle of

taxation is to tax the net income, i.e., gross income

minus the expenditure. On the same analogy the

exemption is also in respect of net income. Expenses

allowed can only be in respect of earning of taxable

income. This is the purport of Section 14A. In Section

14A, the first phrase is "for the purposes of computing

the total income under this Chapter" which makes it

clear that various heads of income as prescribed under

Chapter IV would fall within Section 14A. The next

phrase is, "in relation to income which does not form

part of total income under the Act". It means that if

an income does not form part of total income, then the

related expenditure is outside the ambit of the

applicability of Section 14A. Further, Section 14

specifies five heads of income which are chargeable to

tax. In order to be chargeable, an income has to be brought under one of the five heads. Sections 15 to 59

lay down the rules for computing income for the purpose

of chargeability to tax under those heads. Sections 15

to 59 quantify the total income chargeable to tax. The

permissible deductions enumerated in Sections 15 to 59

are now to be allowed only with reference to income

which is brought under one of the above heads and is

chargeable to tax. If an income like dividend income is

not a part of the total income, the expenditure/

deduction though of the nature specified in Sections 15

to 59 but related to the income not forming part of

total income could not be allowed against other income

includible in the total income for the purpose of

chargeability to tax. The theory of apportionment of

expenditures between taxable and non-taxable has, in

principle, been now widened under Section 14A. Reading

Section 14 in juxtaposition with Sections 15 to 59, it

is clear that the words "expenditure incurred" in

Section 14A refers to expenditure on rent, taxes,

salaries, interest, etc. in respect of which allowances are provided for (see Sections 30 to 37). Every pay-out

is not entitled to allowances for deduction. These

allowances are admissible to qualified deductions.

These deductions are for debits in the real sense. A

pay-back does not constitute an "expenditure incurred"

in terms of Section 14A. Even applying the principles

of accountancy, a pay-back in the strict sense does not

constitute an "expenditure" as it does not impact the

Profit & Loss Account. Pay-back or return of investment

will impact the balance-sheet whereas return on

investment will impact the Profit & Loss Account. Cost

of acquisition of an asset impacts the balance sheet.

Return of investment brings down the cost. It will not

increase the expenditure. Hence, expenditure, return on

investment, return of investment and cost of acquisition

are distinct concepts. Therefore, one needs to read the

words "expenditure incurred" in Section 14A in the

context of the scheme of the Act and, if so read, it is

clear that it disallows certain expenditures incurred to

earn exempt income from being deducted from other income which is includible in the "total income" for the

purpose of chargeability to tax. As stated above, the

scheme of Sections 30 to 37 is that profits and gains

must be computed subject to certain allowances for

deductions/ expenditure. The charge is not on gross

receipts, it is on profits and gains. Profits have to

be computed after deducting losses and expenses incurred

for business. A deduction for expenditure or loss which

is not within the prohibition must be allowed if it is

on the facts of the case a proper Debit Item to be

charged against the Incomings of the business in

ascertaining the true profits. A return of investment

or a pay-back is not such a Debit Item as explained

above, hence, it is not "expenditure incurred" in terms

of Section 14A. Expenditure is a pay-out. It relates

to disbursement. A pay-back is not an expenditure in

the scheme of Section 14A. For attracting Section 14A,

there has to be a proximate cause for disallowance,

which is its relationship with the tax exempt income.

Pay-back or return of investment is not such proximate cause, hence, Section 14A is not applicable in the

present case. Thus, in the absence of such proximate

cause for disallowance, Section 14A cannot be invoked.

In our view, return of investment cannot be construed to

mean "expenditure" and if it is construed to mean

"expenditure" in the sense of physical spending still

the expenditure was not such as could be claimed as an

"allowance" against the profits of the relevant

accounting year under Sections 30 to 37 of the Act and,

therefore, Section 14A cannot be invoked. Hence, the

two asset theory is not applicable in this case as there

is no expenditure incurred in terms of Section 14A.

The next point which arises for determination is

whether the "loss" pertaining to exempted income was

deductible against the chargeable income. In other

words, whether the loss in the sale of units could be

disallowed on the ground that the impugned transaction

was a transaction of dividend stripping. The AO in the

present case has disallowed the loss of Rs. 1,82,12,862

on the sale of 40% tax-free units of the mutual fund. The AO held that the assessee had purposely and in a

planned manner entered into a pre-meditated transaction

of buying and selling units yielding exempted income

with the full knowledge about the guaranteed fall in the

market value of the units and the payment of tax-free

dividend, hence, disallowance of the loss.

In the lead case, we are concerned with the

assessment years prior to insertion of Section 94(7)

vide Finance Act, 2001 w.e.f. 1.4.2002. We are of the

view that the AO had erred in disallowing the loss. In

the case of Vijaya Bank v. Additional Commissioner of

Income Tax [1991] 187 ITR 541, it was held by this Court

that where the assessee buys securities at a price

determined with reference to their actual value as well

as interest accrued thereon till the date of purchase

the entire price paid would be in the nature of capital

outlay and no part of it can be set off as expenditure

against income accruing on those securities.

The real objection of the Department appears to

be that the assessee is getting tax-free dividend; that at the same time it is claiming loss on the sale of the

units; that the assessee had purposely and in a planned

manner entered into a pre-meditated transaction of

buying and selling units yielding exempted dividends

with full knowledge about the fall in the NAV after the

record date and the payment of tax-free dividend and,

therefore, loss on sale was not genuine. We find no

merit in the above argument of the Department. At the

outset, we may state that we have two sets of cases

before us. The lead matter covers assessment years

before insertion of Section 94(7) vide Finance Act, 2001

w.e.f. 1.4.2002. With regard to such cases we may state

that on facts it is established that there was a "sale".

The sale-price was received by the assessee. That, the

assessee did receive dividend. The fact that the

dividend received was tax-free is the position

recognized under Section 10(33) of the Act. The

assessee had made use of the said provision of the Act.

That such use cannot be called "abuse of law". Even

assuming that the transaction was pre-planned there is nothing to impeach the genuineness of the transaction.

With regard to the ruling in McDowell & Co. Ltd. v.

Commercial Tax Officer [154 ITR 148(SC)], it may be

stated that in the later decision of this Court in Union

of India v. Azadi Bachao Andolan [263 ITR 706(SC)] it

has been held that a citizen is free to carry on its

business within the four corners of the law. That, mere

tax planning, without any motive to evade taxes through

colourable devices is not frowned upon even by the

judgment of this Court in McDowell & Co. Ltd.'s case

(supra). Hence, in the cases arising before 1.4.2002,

losses pertaining to exempted income cannot be

disallowed. However, after 1.4.2002, such losses to the

extent of dividend received by the assessee could be

ignored by the AO in view of Section 94(7). The object

of Section 94(7) is to curb the short term losses.

Applying Section 94(7) in a case for the assessment

year(s) falling after 1.4.2002, the loss to be ignored

would be only to the extent of the dividend received and

not the entire loss. In other words, losses over and above the amount of the dividend received would still be

allowed from which it follows that the Parliament has

not treated the dividend stripping transaction as sham

or bogus. It has not treated the entire loss as

fictitious or only a fiscal loss. After 1.4.2002,

losses over and above the dividend received will not be

ignored under Section 94(7). If the argument of the

Department is to be accepted, it would mean that before

1.4.2002 the entire loss would be disallowed as not

genuine but, after 1.4.2002, a part of it would be

allowable under Section 94(7) which cannot be the object

of Section 94(7) which is inserted to curb tax avoidance

by certain types of transactions in securities. There

is one more way of answering this point. Sections 14A

and 94(7) were simultaneously inserted by the same

Finance Act, 2001. As stated above, Section 14A was

inserted w.e.f. 1.4.1962 whereas Section 94(7) was

inserted w.e.f. 1.4.2002. The reason is obvious.

Parliament realized that several public sector

undertakings and public sector enterprises had invested huge amounts over last couple of years in the impugned

dividend stripping transactions so also declaration of

dividends by mutual fund are being vetted and regulated

by SEBI for last couple of years. If Section 94(7) would

have been brought into effect from 1.4.1962, as in the

case of Section 14A, it would have resulted in reversal

of large number of transactions. This could be one

reason why the Parliament intended to give effect to

Section 94(7) only w.e.f. 1.4.2002. It is important to

clarify that this last reasoning has nothing to do with

the interpretations given by us to Sections 14A and

94(7). However, it is the duty of the court to examine

the circumstances and reasons why Section 14A inserted

by Finance Act 2001 stood inserted w.e.f. 1.4.1962 while

Section 94(7) inserted by the same Finance Act as

brought into force w.e.f. 1.4.2002.

The next question which we need to decide is

about reconciliation of Sections 14A and 94(7). In our

view, the two operate in different fields. As stated

above, Section 14A deals with disallowance of expenditure incurred in earning tax-free income against

the profits of the accounting year under Sections 30 to

37 of the Act. On the other hand, Section 94(7) refers

to disallowance of the loss on the acquisition of an

asset which situation is not there in cases falling

under Section 14A. Under Section 94(7) the dividend

goes to reduce the loss. It applies to cases where the

loss is more than the dividend. Section 14A applies to

cases where the assessee incurs expenditure to earn tax

free income but where there is no acquisition of an

asset. In cases falling under Section 94(7), there is

acquisition of an asset and existence of the loss which

arises at a point of time subsequent to the purchase of

units and receipt of exempt income. It occurs only when

the sale takes place. Section 14A comes in when there

is claim for deduction of an expenditure whereas Section

94(7) comes in when there is claim for allowance for the

business loss. We may reiterate that one must keep in

mind the conceptual difference between loss,

expenditure, cost of acquisition, etc. while interpreting the scheme of the Act.

Before concluding, one aspect concerning Para 12

of Accounting Standard AS-13 relied upon by the Revenue

needs to be highlighted. Para 12 indicates that

interest/ dividends received on investments are

generally regarded as return on investment and not

return of investment. It is only in certain

circumstances where the purchase price includes the

right to receive crystallized and accrued dividends/

interest, that have already accrued and become due for

payment before the date of purchase of the units, that

the same has got to be reduced from the purchase cost of

the investment. A mere receipt of dividend subsequent

to purchase of units, on the basis of a person holding

units at the time of declaration of dividend on the

record date, cannot go to offset the cost of acquisition

of the units. Therefore, AS-13 has no application to

the facts of the present cases where units are bought at

the ruling NAV with a right to receive dividend as and

when declared in future and did not carry any vested right to claim dividends which had already accrued prior

to the purchase.

For the above reasons, we find no infirmity in

the impugned judgment of the High Court and,

accordingly, these Civil Appeals filed by the Department

are dismissed with no order as to costs.

.................................CJI (S. H. Kapadia)

....................................J. (Swatanter Kumar)

New Delhi;

July 06, 2010