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Analysis On SC Decision On Section 14A of the Income Tax Act by Invoking Adam Smith’s Principle

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The main question presented before the Court was whether proportionate disallowance of interest paid by banks was called for under Section 14A of the Income Tax Act for the investment made in tax-free bonds which yielded tax-free dividends.

Facts in brief 

The Appellant banks were scheduled banks and in the course of their banking businesses, also engaged in the business of investing in bonds, securities, and shares which in return provided interest, dividends to the banks which were essentially tax-free. None of the banks maintained a separate account for the investment made in shares, securities, and bonds from which tax-free income was earned so that disallowances be limited to the expenditure incurred. In absence of separate accounts, the assessing officer made proportionate disallowance of interest attributable to the funds invested to earn tax-free income. The banks approached CIT, which agreed with the view of the assessing officers. On appeal, the Income Tax Appellate Tribunal ruled that disallowance under Section 14A was not warranted, in absence of a clear identity of funds. On  further appeal, the Delhi High Court reversed the decision of ITAT by ruling in favour of Respondents. Aggrieved by the said order the Appellants approached the Supreme Court via Special Leave. 

Relevant Law

Under Section 14 of the Income Tax Act, various incomes are classified under this Section under the head salaries, income from house property, profit, and gains from business and profession, capital gains, and income from other sources which ultimately form part of total income. 

Section 14A states that expenditure incurred in generating tax-free income is not deducted while calculating the total income of the concerned assessee

The contention of the Appellants 

The Appellants argued that the investments made in bonds and shares should be considered to have been made out of interest-free funds, which were more than the investments made, and therefore the interest paid by the bank on deposits and other borrowings should not be considered to be expenditure incurred in connection with tax-free income. They relied on the Commissioner of Income Tax (Large Taxpayer Unit) Vs. Reliance Industries Ltd. that stated where there was a finding of fact that interest-free funds available to the assessee were sufficient to meet its investment, it would be presumed that investments were made from such interest-free funds

The contention of the Respondents 

The Respondents contended that the decision given by the High Court was sound in law and required no interference from this Court. They placed reliance on SA Builders v. CIT, where the Court ruled on the issue of disallowance concerning funds lent to sister concern out of mixed funds. They pleaded that the issue was pending before a larger Bench and therefore the decision on disallowance when mixed funds were in the picture had not yet reached finality. 

Reasons for decision 

The Court pointed out that the High Court primarily ruled in the favour of the Respondents relying solely on the fact that the Appellants had not maintained a separate account and on enquiring from the Respondents they were not able to justify this reasoning due to lack of backing of the law. The Court noted that there was no law requiring the Appellants to maintain a separate account. The Court placed reliance on Maxopp Investment Ltd. v. CIT, which ruled that the objective of Section 14A was to prevent double benefit being provided to a concerned assessee. It also stated that if an expenditure incurred had no causal connection with the exempted income, then such an expenditure would be treated as not related to the income that was exempted from tax. The Court also relied on the decision rendered in Godrej and Boyce Manufacturing Company Ltd. V. DCIT ruled that, for disallowance of expenditure incurred in earning an income, it was a condition precedent that such income should not be included in the total income of the assessee.

The decision of the Court 

The Court hesitatingly agreed with the decision of the Income Tax Appellate Tribunal, ruling in favour of the assessee in terms of exemptions and observed that proportionate disallowance of interest was not warranted, under Section 14A of Income Tax Act for investments made in tax-free bonds/ securities which yielded tax-free dividend and interest to assess Banks in those situations where, interest-free own funds available with the assessee, exceeded their investment. The Court also quoted 18th-century economist Adam Smith to nudge the government to ease out the taxing regime to ensure better compliance. 

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