Supreme Court clarifies disallowance of interest under Section 14A of Income Tax Act for Banks: South Indian Bank Ltd. vs. Commissioner of Income Tax (2021)

Introduction

Date of the Judgment: September 09, 2021
Citation: Not Available
Judges: Sanjay Kishan Kaul J. and Hrishikesh Roy J.

Can banks avoid disallowance of interest expenses on tax-free investments if they possess sufficient interest-free funds? The Supreme Court of India recently addressed this critical question in a batch of appeals concerning the interpretation of Section 14A of the Income Tax Act, 1961. This section deals with the disallowance of expenditure incurred in relation to income that is not included in the total taxable income. The core issue revolves around whether banks should face proportionate disallowance of interest expenses when they invest in tax-free bonds and securities, even if they have enough interest-free funds to cover these investments. The judgment was delivered by a bench comprising Justice Sanjay Kishan Kaul and Justice Hrishikesh Roy, with the opinion authored by Justice Hrishikesh Roy.

Case Background

The appellants in this case are scheduled banks that, as part of their regular business, invest in bonds, securities, and shares. These investments generate income in the form of interest and dividends, which are often tax-free. The Income Tax Act, 1961, under Section 14A, disallows deductions for expenditures incurred in relation to income that is exempt from tax. The dispute arose because the banks did not maintain separate accounts for their tax-free investments, making it difficult to determine the exact expenditure incurred to earn this tax-free income. Consequently, the Assessing Officer made a proportionate disallowance of interest expenses, based on the average cost of deposits for the relevant year.

Timeline:

Legal Framework

The core of this case revolves around Section 14A of the Income Tax Act, 1961, which states:

“14A. Expenditure incurred in relation to income not includible in total income – (1) 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.”

This provision disallows deductions for expenses related to income that is exempt from tax. The Act was amended to include sub-sections (2) and (3) which further elaborate on how the Assessing Officer should determine the amount of expenditure to be disallowed if not satisfied with the assessee’s claim.

Sub-section (2) of Section 14A of the Income Tax Act, 1961 states:

“(2) The Assessing Officer shall determine the amount of expenditure incurred in relation to such income which does not form part of the total income under this Act in accordance with such method as may be prescribed, if the Assessing Officer, having regard to the accounts of the assessee, is not satisfied with the correctness of the claim of the assessee in respect of such expenditure in relation to income which does not form part of the total income under this Act.”

Sub-section (3) of Section 14A of the Income Tax Act, 1961 states:

“(3) The provisions of sub-section (2) shall also apply in relation to a case where an assessee claims that no expenditure has been incurred by him in relation to income which does not form part of the total income under this Act:”

The proviso to Section 14A of the Income Tax Act, 1961 states:

“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.”

Arguments

Appellant Banks’ Arguments:

• The banks argued that their investments in tax-free bonds and shares were made from their interest-free funds, which were significantly more than the total investments.
• They contended that the interest paid on deposits and other borrowings should not be considered as expenditure related to tax-free income.
• They asserted that if the interest-free funds are sufficient to cover the investments, no disallowance under Section 14A of the Income Tax Act is warranted.
• They relied on the principle that when payments are made from a mixed fund (containing both interest-free and interest-bearing funds), the assessee has the right to appropriate and designate the source of funds, and it should be presumed that investments are made from the interest-free portion.
• They cited several High Court judgments, such as Pr. CIT v. Bombay Dyeing and Mfg. Co. Ltd, Commissioner of Income Tax (Large Tax Payer Unit) Vs. Reliance Industries Ltd, HDFC Bank Ltd. Vs. Deputy Commissioner of Income Tax, CIT Vs. Suzlon Energy Ltd., CIT Vs. Microlabs Ltd. and CIT Vs. Max India Ltd., which supported their position.

Respondent Revenue’s Arguments:

• The Revenue argued that since the banks did not maintain separate accounts for their tax-free investments, a proportionate disallowance of interest was justified.
• They contended that the investments were made from a mixed pool of funds, and therefore, a portion of the interest paid on borrowings should be attributed to the tax-free income.
• They relied on the decision in SA Builders v. CIT, arguing that there is no finality on the issue of disallowance when mixed funds are used.
• They cited Honda Siel Power Products Ltd. v. DCIT to argue that it is the responsibility of the assessee to fully disclose all material facts.

Innovativeness of the argument: The appellant banks innovatively argued that they have the right to appropriate and designate the source of funds when payments are made from a mixed fund, which has been accepted by the Supreme Court.

Submissions by Parties

Issues Framed by the Supreme Court

The Supreme Court framed the following issue for consideration:

• Whether proportionate disallowance of interest paid by the banks is called for 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 when assessee had sufficient interest free own funds which were more than the investments made.

Treatment of the Issue by the Court

The following table demonstrates as to how the Court decided the issues:

Authorities

The Supreme Court considered the following authorities:

On the principle of presumption that investments are made from interest-free funds when sufficient funds are available:

• Pr. CIT v. Bombay Dyeing and Mfg. Co. Ltd, (Bombay High Court) – The court held that when funds available are both interest-free and loans, the investments are presumed to be from interest-free funds, provided these funds are sufficient to meet the investments.
• Commissioner of Income Tax (Large Tax Payer Unit) Vs. Reliance Industries Ltd (Supreme Court) – The court held that where there is finding of fact that interest free funds available to assessee were sufficient to meet its investment it will be presumed that investments were made from such interest free funds.
• HDFC Bank Ltd. Vs. Deputy Commissioner of Income Tax (Bombay High Court) – The court observed that if an assessee possesses sufficient interest-free funds against investments in tax-free securities, it is presumed that the investment came from the interest-free funds.
• CIT Vs. Suzlon Energy Ltd. (Gujarat High Court) – The court held that if there are sufficient interest free funds available with the assessee, then it can be presumed that investments were made out of such funds.
• CIT Vs. Microlabs Ltd. (Karnataka High Court) – The court held that if there are sufficient interest free funds available with the assessee, then it can be presumed that investments were made out of such funds.
• CIT Vs. Max India Ltd. (Punjab & Haryana High Court) – The court held that if there are sufficient interest free funds available with the assessee, then it can be presumed that investments were made out of such funds.

On the interpretation of Section 14A of the Income Tax Act:

• Maxopp Investment Ltd. v. CIT (Supreme Court) – The court clarified that the purpose of Section 14A is to prevent double benefits, and expenditure is only disallowed if it has a causal connection with exempted income.
• Godrej and Boyce Manufacturing Company Ltd. V. DCIT (Supreme Court) – The court held that for disallowance under Section 14A, it is necessary to prove that the expenditure was incurred to earn exempt income.

On the nature of investments made by banks:

• CIT Vs. Nawanshahar Central Cooperative Bank Ltd. (Supreme Court) – The court held that investments made by a banking concern are part of their banking business.
• Pr. CIT, vs. State Bank of Patiala (Punjab and Haryana High Court) – The court concluded that shares and securities held by a bank are stock in trade, and all income from them is business income.

On the obligation to maintain separate accounts:

• Honda Siel Power Products Ltd. v. DCIT (Supreme Court) – The court held that the assessee has the obligation to provide full material disclosures at the time of filing of Income Tax Return.

Authority Consideration

Judgment

How each submission made by the Parties was treated by the Court?

How each authority was viewed by the Court?

The Court relied on several High Court judgments, including Pr. CIT v. Bombay Dyeing and Mfg. Co. Ltd, Commissioner of Income Tax (Large Tax Payer Unit) Vs. Reliance Industries Ltd, HDFC Bank Ltd. Vs. Deputy Commissioner of Income Tax, CIT Vs. Suzlon Energy Ltd., CIT Vs. Microlabs Ltd. and CIT Vs. Max India Ltd., to support the principle that if an assessee has sufficient interest-free funds, it is presumed that investments are made from those funds. The Court also relied on its own judgment in Maxopp Investment Ltd. v. CIT, to clarify the scope of Section 14A of the Income Tax Act, emphasizing that disallowance is only applicable when there is a causal connection between the expenditure and the exempt income. Additionally, the court considered Godrej and Boyce Manufacturing Company Ltd. V. DCIT to reiterate the need to prove that the expenditure was incurred to earn the exempt income. The Court distinguished Honda Siel Power Products Ltd. v. DCIT, noting that the case was related to re-opening of assessment and not to the obligation to maintain separate accounts.

What weighed in the mind of the Court?

The Supreme Court’s decision was primarily influenced by the following factors:

• Presumption of Interest-Free Funds: The Court emphasized that when an assessee has sufficient interest-free funds, it is presumed that investments are made from these funds. This principle was crucial in determining that disallowance under Section 14A of the Income Tax Act is not warranted in such cases.
• Absence of Legal Obligation for Separate Accounts: The Court noted that there is no statutory provision that obligates assessees to maintain separate accounts for different types of funds. This lack of legal requirement undermined the Revenue’s argument for proportionate disallowance based on the absence of separate accounts.
• Causal Connection between Expenditure and Exempt Income: The Court reiterated that for disallowance under Section 14A, there must be a direct causal connection between the expenditure and the exempt income. When investments are made from interest-free funds, this connection is not established.
• Clarity and Certainty in Taxation: The Court stressed the importance of clarity and certainty in taxation, quoting Adam Smith’s principle that taxes should be clear and not arbitrary. This principle guided the Court’s decision to avoid implied or presumptive taxation.

Sentiment Analysis of Reasons Given by the Supreme Court

Fact:Law Ratio

The Court’s reasoning was primarily based on legal principles and interpretations, with a lesser emphasis on the factual aspects of the case.

Logical Reasoning:

The court considered the argument of the revenue that the assessee was required to maintain separate accounts. The court rejected this argument because the revenue could not refer to any statutory provision which obligate the assessee to maintain separate accounts which might justify proportionate disallowance. The court also rejected the reliance on Honda Siel Power Products Ltd. v. DCIT, noting that the case was related to re-opening of assessment and not to the obligation to maintain separate accounts.

The Supreme Court, therefore, concluded that the proportionate disallowance of interest under Section 14A of the Income Tax Act is not warranted for investments made in tax-free bonds/securities when the assessee banks have sufficient interest-free funds that exceed their investments.

The court quoted Adam Smith:
“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.”

Key Takeaways

• Banks with Sufficient Interest-Free Funds: Banks that have interest-free funds exceeding their investments in tax-free securities are not subject to proportionate disallowance of interest under Section 14A of the Income Tax Act.
• No Obligation for Separate Accounts: There is no legal requirement for banks to maintain separate accounts for different types of funds.
• Importance of Causal Connection: For disallowance under Section 14A, a direct causal connection between the expenditure and the exempt income must be established.
• Clarity in Taxation: The judgment emphasizes the need for clarity and certainty in taxation, avoiding implied or presumptive taxation.

Directions

No specific directions were given by the Supreme Court in this judgment.

Specific Amendments Analysis

The judgment discusses the introduction of Section 14A of the Income Tax Act by the Finance Act, 2001, with retrospective effect from 01.04.1962. The retrospective effect was later neutralized by a proviso introduced by the Finance Act, 2002 with effect from 11.05.2001 which prohibited re-assessment for any assessment year, up-to the assessment year 2000-2001. The judgment also mentions the introduction of sub-sections (2) and (3) to Section 14A by the Finance Act, 2006, with effect from 01.04.2007.

Development of Law

The ratio decidendi of this case is that proportionate disallowance of interest under Section 14A of the Income Tax Act is not warranted for investments made in tax-free bonds/securities when the assessee banks have sufficient interest-free funds that exceed their investments. This judgment clarifies that when an assessee has sufficient interest-free funds, it is presumed that investments are made from these funds, and there is no legal obligation to maintain separate accounts for different types of funds. This decision reinforces the principle that for disallowance under Section 14A, a direct causal connection between the expenditure and the exempt income must be established. This judgment clarifies the law on the issue and settles the position in favour of the assessee.

Conclusion

In conclusion, the Supreme Court ruled in favor of the assessee banks, holding that proportionate disallowance of interest under Section 14A of the Income Tax Act is not warranted when banks have sufficient interest-free funds to cover their investments in tax-free securities. The court emphasized the principle that investments are presumed to be made from interest-free funds when available, and there is no legal obligation for banks to maintain separate accounts for different types of funds. This judgment provides clarity on the interpretation of Section 14A and reinforces the need for a direct causal connection between expenditure and exempt income for disallowance.