Ita/467/2009 Of The Commissioner Of Income Tax,Trichur v. The Catholic Syrian Bank Ltd.,Trichur

IN THE HIGH COURT OF KERALA AT ERNAKULAM PRESENT : THE HONOURABLE MR. JUSTICE C.N.RAMACHANDRAN NAIR & THE HONOURABLE MR. JUSTICE K.SURENDRA MOHAN THURSDAY, THE 21ST OCTOBER 2010 / 29TH ASWINA 1932 ITA.No. 467 of 2009() --------------------- ITA.108/COCH/2004 of I.T.A.TRIBUNAL,COCHIN BENCH .................... APPELLANT/RESPONDENT: -------------------- THE COMMISSIONER OF INCOME TAX, THRISSUR. BY ADV. SRI.JOSE JOSEPH, SC, FOR INCOME TAX RESPONDENT/APPELLANT: --------------- M/S.THE CATHOLIC SYRIAN BANK LTD.,THRISSUR. SR. ADV. SRI.SARANGAN ADV. SRI. K.VINOD CHANDRAN FOR R1 THIS INCOME TAX APPEAL HAVING BEEN FINALLY HEARD ALONG WITH ITA NO.720/2009 & CONN. CASES ON 21/10/2010, THE COURT ON THE SAME DAY DELIVERED THE FOLLOWING: C.N.RAMACHANDRAN NAIR &K.SURENDRA MOHAN, JJ. ....................................................................I.T. Appeal Nos.467, 720, 730, 843, 479, 1324 & 1045 of 2009 & 40 of 2010 .................................................................... Dated this the 21st day of October, 2010. C.R. JUDGMENT Ramachandran Nair, J. The question raised in the 8 connected appeals, 7 filed by theRevenue and one by one of the Banks is one and the same i.e. whetherproportionate disallowance of interest paid by the Bank is called forunder Section 14A of the Income Tax Act (hereinafter called "the Act")for the investments made in U.T.I. shares, tax free bonds/securities etc.which yielded tax free dividend and interest. We have heard Seniorcounsel Sri.P.K.R.Menon appearing for the Revenue and Seniorcounsel Sri.Sarangan appearing along with Adv. Sri.P.Balakrishnan forthe assessee-Banks. 2. The assessees are all Scheduled Banks engaged in the bankingbusiness and in the course of banking business they are also engaged inthe business of investment in bonds, securities and in shares which earnthe assessees interest from such securities and bonds and also dividend ITA No.467/2009 & conn. on investments in shares of companies and from units of U.T.I. etc.,which are tax free. Section 14A was introduced to the Income Tax Actby Finance Act, 2001 with retrospective effect from 1.4.1962. Thisprovision provide for disallowance of expenditure incurred by theassessee in relation to income which does not form part of the totalincome. In other words, if the assessee incurs any expenditure forearning tax free income such as interest paid for funds borrowed, forinvestment in any business which earns income that is free from tax,assessee is not entitled to deduction of such interest or otherexpenditure. Even though the provision was brought to the statute withretrospective effect from 1.4.1962, the retrospectivity is neutralised bya proviso later introduced by Finance Act, 2002 with effect from11.5.2001 whereunder reassessment, rectification of assessment etc.were prohibited for any assessment year beginning on or before 1stApril, 2001. In other words, assessments for any assessment year uptothe assessment year 2000-2001 that were finalised when the provisowas introduced without making any disallowance under Section 14A,were allowed to achieve finality. Disallowance under Section 14A was ITA No.467/2009 & conn. ITA No.467/2009 & conn. intended to be made only for pending assessments and for assessmentsfor the assessment years commencing from 2001-2002 onwards. In allthese cases disallowance made under Section 14A are either inpending assessments or for assessments for the assessment yearscommencing from 2001-2002 onwards. No dispute is raised by theassessees against application of Section 14A by virtue of operation ofthe proviso to the said Section introduced by Finance Act, 2002.Admittedly none of the assessee-Banks have separate accounts for theinvestments made in bonds, securities and shares wherefrom tax freeincome is earned so that disallowance could be limited to the actualexpenditure incurred. In other words, the assessee-Banks do not haveseparate accounts for the expenditure incurred towards interest paid onfunds borrowed such as deposits utilised for investments in securities,bonds and shares which yielded tax free income. The position issame so far as the overhead and administrative expenditure of theassessee is concerned. In the absence of separate accounts forinvestments which earn tax free income, the Assessing Officer workedout a formula which is the average cost of deposit in the year under ITA No.467/2009 & conn. 4 consideration and applying the same he made proportionatedisallowance of interest attributable to the funds invested to earn taxfree income. As a specimen case we extract hereunder actual figuresavailable in the assessment of Catholic Syrian Bank Ltd. for theassessment year 2001-2002 (I.T.A. No.467/2009). Net income from business as per return- Rs.15,79,50,512/- Interest from tax free bonds- Rs.1,05,97,555/-Tax free dividend- Rs.1,42,27,983/- What is clear from the above is that assessee has earned substantial taxfree income by way of interest from tax free bonds and dividendincome which is also tax free. So much so, substantial expenditure isincurred for earning the tax free income such as interest paid onborrowed funds (including deposits) utilised for investment andadministrative expenditure for the same. Since actual expenditureincurred for earning the tax free income is not available for makingdisallowance under Section 14A, the Assessing Officer found out theaverage cost of deposit of the relevant year. Since the assessee'sinvestment on tax free bonds and shares during the relevant year was ITA No.467/2009 & conn. Rs.13.06 crores, the Assessing Officer worked out 8.72% of this as theinterest expenditure incurred by the assessee for earning tax freeincome. The disallowance was accordingly worked out atRs.1,13,88,320/-. In other words, for earning a total tax free incomeunder two heads of Rs.2,48,25,538/-, the Assessing Officer found thatthe assessee would have suffered an interest liability ofRs.1,13,88,320/- and, therefore, this amount was disallowed underSection 14A of the Act. Even though in the case of some of theassessees the Assessing Officer has even determined proportionateadministrative cost and disallowed the same, in the case of thisassessee for this assessment year we do not find any such disallowance.In other words, disallowance under Section 14A is limited to interestalone. Since the issue raised has to be decided with reference to thescope of Section 14A, we extract hereunder the said Section with sub-clauses (2) and (3) and the proviso: "S.14A. (1) For the purposes of computing the totalincome under this Chapter, no deduction shall be allowed inrespect of expenditure incurred by the assessee in relation toincome which does not form part of the total income underthis Act. "S.14A. (1) For the purposes of computing the totalincome under this Chapter, no deduction shall be allowed inrespect of expenditure incurred by the assessee in relation toincome which does not form part of the total income underthis Act. (2) The Assessing Officer shall determine the amountof expenditure incurred in relation to such income whichdoes not form part of the total income under this Act inaccordance with such method as may be prescribed, if theAssessing Officer, having regard to the accounts of theassessee, is not satisfied with the correctness of the claim ofthe assessee in respect of such expenditure in relation toincome which does not form part of the total income underthis Act. (3) The provisions of sub-section(2) shall also apply inrelation to a case where an assessee claims that noexpenditure has been incurred by him in relation to incomewhich does not form part of the total income under this Act: Provided that nothing contained in this section shallempower the Assessing Officer either to reassess underSection 147 or pass an order enhancing the assessment orreducing a refund already made or otherwise increasing theliability of the assessee under section 154, for any assessmentyear beginning on or before the 1st day of April, 2001." It has to be noted that sub-sections (2) and (3) were introduced to the main Section by Finance Act, 2006 with effect from 1.4.2007.Subsequently Rule 8D was prescribed by the Government for thepurpose of sub-section(2) of Section 14A from 2007-2008 onwards.By virtue of the subsequent legislation, now there is precise formulafor working out the disallowance to be made under Section 14A even ifassessees do not have separate account showing the expenditure ITA No.467/2009 & conn. incurred on investments made for earning tax free income. 3. The question, therefore, to be considered is whether Section14A prior to the introduction of sub-sections (2) and (3) entitles thedepartment to make disallowance of expenditure incurred for earningtax free income in cases where assessee like the Banks do not maintainseparate accounts for the investments and other expenditure incurredfor earning tax free income. Senior counsel appearing for the Revenuerelied on our judgment in I.T.A. No.1784/2009 dated 14.6.2010 in thecase of COMMISSIONER OF INCOME TAX VS. SMT.LEENARAMACHANDRAN for the proposition that estimated disallowanceunder Section 14A is permissible. Another decision cited by theRevenue in support of their contention is the recent decision of theSupreme Court in COMMISSIONER OF INCOME TAX VS.WALFORT SHARE AND STOCK BROKERS P. LTD. reported in(2010) 326 ITR 1. Both counsel appearing for assessee-Banks reliedon decision of the Supreme Court in COMMISSIONER OF INCOMETAX VS. INDIAN BANK LTD. reported in (1965) LVI ITR 77 andcontended that where separate accounts are not available with the Bank ITA No.467/2009 & conn. ITA No.467/2009 & conn. with regard to expenditure incurred on earning tax free income, there isno scope for disallowance under Section 14A at all. According to bothcounsel for the assessees proportionate disallowance is called for onlyunder sub-section (2) read with Rule 8D of the Income Tax Ruleswhich came into force from 2007-2008 onwards and the same cannotbe applied for any earlier assessment year. We do not think muchreliance can be placed on the decision of the Supreme Court in the caseof INDIAN BANK LTD. because the said decision was rendered muchprior to the introduction of Section 14A and the purpose of Section14A itself is to get over judgments of the Supreme Court and HighCourts declaring assessee's eligibility for deduction of businessexpenditure incurred for earning the income irrespective of whethersuch income is taxable or not. In our view, the object of Section 14A isto ensure that so much of the expenditure incurred for earning incomethat do not constitute total income of the assessee, should not beallowed. In other words, when income is outside the tax net,expenditure incurred for earning such income also should not beallowed to be set off in the computation of taxable income. Therefore, ITA No.467/2009 & conn. the short question to be considered is whether non-maintenance ofseparate accounts by the assessee with regard to expenditure incurredfor earning non-taxable income is justification for them to claimimmunity from the operation of Section 14A. In fact, the subsequentlegislation i.e. introduction of sub-section (2) and the prescription ofRule 8D thereunder, make it clear that there may be cases where itwould be difficult for assessees to maintain separate accounts forearning taxable as well as non-taxable income. However, what we feelis that such difficulty may be experienced in the case of overheadexpenditure and administrative expenditure incurred by the assessee-Banks. So far as investments in securities and bonds and also inshares, the income wherefrom is tax free are concerned, we see noreason why assessee could not have maintained separate accounts forthe sources of funds utilised for such investments which, in our view, ifthe assessee-Banks wanted, they could have maintained. In otherwords, if the assessee-Banks had a case that surplus funds available orfunds sourced other than through borrowing only were utilised forinvesting in securities, bonds and shares which yield tax free income, ITA No.467/2009 & conn. they could have maintained such accounts and produced the samebefore the Assessing Officer when proportionate disallowance wasproposed by the Assessing Officer. By subsequent amendmentthrough sub-section (2) and by prescribing Rule 8D therein what isachieved is prescribing specific guideline for disallowance in caseswhere separate accounts are not available on the expenditure incurredfor earing tax free income. These are, therefore, only clarificatoryprovisions and in our view, the main clause of Section 14A apply forall periods after the introduction of the same in the statute whichauthorises the officer to make disallowance of the expenditure incurredfor earning tax free income, irrespective of whether assesseemaintained separate accounts or not. Considering the significantamount of tax free income earned by the assessee-Banks for all theyears involved, we are of the view that the investments for earning taxfree income is substantial and if assessment is made without makingdisallowance under Section 14A, the same will render a distorted figureof taxable income which is not permissible under the Act. If theassessee does not maintain separate accounts, it is for the Assessing ITA No.467/2009 & conn. ITA No.467/2009 & conn. Officer to estimate the same by adopting a rational basis. In principle,we, therefore, uphold the disallowance made by the Assessing Officerunder Section 14A. We, therefore, uphold the order of the Tribunalimpugned in I.T.A. No.40/2010 wherein they have followed a SpecialBench decision of the Bombay Bench of the Tribunal in I.T.O. vs.DAGA CAPITAL MANAGEMENT PVT. LTD. reported in 312 ITR(AT) 1 (Mum.) (SB) and reverse the orders of the Tribunal and that ofthe first appellate authority in all other seven appeals. 4. The next question to be considered is whether the methodadopted by the Assessing Officer in estimating average cost of depositand making the disallowance by working out average interest cost onthe investments made for earning the tax free income is correct. Afterhearing both sides, we feel the matter requires reconsideration becausein the first place, facts and figures are not available. Further, theassumption of the Assessing Officer that the entire investments inbonds, shares and securities for earning tax free income is from out ofborrowed funds (deposits) is also not justified. Assessee-Banks have aspecific case that they have funds available with them which are neither ITA No.467/2009 & conn. borrowals nor interest bearing deposits and such funds also have beenutilised in making investments for earning tax free income. We findforce in this contention because when accounts are not available, thedisallowance could be made only on the expenditure incurred forearning the tax free income which is to be estimated on a rational basis.In fact, in our view, the Assessing Officer could have taken thefollowing formula to arrive at the interest liability incurred by theassessee-Banks to earn interest free income: Total interest liability ------------------------- x Tax free income earned by the assesseeTotal income 5. What we have stated above is only a reasonable suggestion forthe Assessing Officer to adopt which arises only if assessee is not ableto establish more accurately the interest spent on earning tax freeincome. We, therefore, leave this matter to be decided by the AssessingOfficer with reference to the accounts of the assessee-Banks for eachyear. Since we find that the rational adopted by the Assessing Officerto estimate the expenditure for the purpose of disallowance underSection 14A is not tenable, we feel the matter should be restored to the ITA No.467/2009 & conn. Assessing Officer for making disallowance under Section 14A byreasonably estimating as nearly as possible the expenditure incurred forearning the tax free income. This should be done after givingopportunity to the assessee-Banks to suggest their own formula withreference to accounts for the purpose of arriving at the actual amount ornear actual amount. The disallowance on estimated basis has to bedone as above until Rule 8D was framed and thereafter it is for theAssessing Officer to make disallowance by following sub-section (2)of Section 14A and Rule 8D of the Income Tax Rules. 6. So far as the disallowance of administrative expenditure isconcerned, we feel considering the fact that there is no precise formulafor proportionate disallowance, no disallowance is called for, forproportionate administrative cost attributable to earning of tax freeincome until Rule 8D came into force. We, therefore, dispose of theappeals by setting aside the orders of the Tribunal and that of the firstappellate authority on this issue and remand all the assessments back tothe Assessing Officer for reworking disallowance under Section 14A inthe case of each assessee for each assessment year. The proportionate ITA No.467/2009 & conn. disallowance under Section 14A should be limited to only interestliability and not overheads or administrative expenditure; which shouldbe considered for disallowance under Rule 8D from 2007-2008onwards. C.N.RAMACHANDRAN NAIRJudge K.SURENDRA MOHANJudge pms