DIVIDEND IS CHARGED WITH INCOME TAX AT DISTRIBUTION STAGE SO IT IS NOT EXEMPT INCOME IN CONTEXT OF INCOME TAX ACT 1961 AND THE INDIAN CONSTITUTION - A revised article

[DEV KUMAR KOTHARI]

Summary:

An income can be considered as exempt only if tax in not collected on it in any manner. If a tax on income is collected directly or indirectly and such tax is not refundable of adjustable against any other liability of tax on income, then tax has been finally collected and the related income has suffered tax under the I.T.Act and it is not an exempt income or income not chargeable to tax.

Dividend - in old scheme tax was paid by shareholders, wherein a large portion of dividend was exempt from tax for several reasons. The additional tax payable by companies and mutual funds, on distribution made all dividends taxable and tax collected from companies and mutual funds are finally collected tax. Only as a consequence to tax on distribution exemption for dividend is granted in computation of shareholders. Therefore, it is wrong to say that dividend referred to in section 115 O is not part of taxable income, in the overall context of tax on income or 'total income' in the Act. Shares and units of mutual funds are purchased mainly to earn gains by way of appreciation and dividend is merely incidental. Average yield by way of dividend is about 1%, therefore, no one will invest in shares merely to receive dividend. Merely because dividend is earned and it is excluded from income of shareholder that too because tax is already paid by the company, section 14A should not be applied to disallow interest and other expenses incurred in connection with purchasing and holding shares and units of mutual funds, which is also a systematic and organized activity and share are  capital assets of such business  activity just like land, building , furniture and plant and machinery used in any business sale of which also results profit or gains or loss under the head 'capital gains'. 

Purpose of the Income -tax Act, 1961: The preface and object of the Act reads as  follows:

INCOME-TAX ACT, 1961

[43 OF 1961]

[AS AMENDED BY FINANCE ACT, 2008]

An Act to consolidate and amend the law relating to income-tax and super-tax

As per above preamble the 1961 Act is to consolidate and amend the law relating to income-tax and super-tax.  Going into history of the income-tax laws we find that the purpose of the Income-tax, Act 1961 is basically to provide for provisions relating to charge of tax on income, different manner of levying and collecting tax like by way of income tax on different type of assesses, income tax by way of FBT and tax on distributed profits, determination of taxable income for levy of tax as may be charged as per any Central Enactment (usually the annual Finance Act), collection of tax which may be so charged, assessments, appeals, revisions, recovery, and other related issues for administration of income tax levy and collection. Though in the preamble it is stated that it is an Act to consolidate and amend the law relating to income-tax and super tax.

Chargeable income -Total income:

In the Income-tax Act, 1961 the expression 'total income' is used to mean 'taxable income' or 'chargeable income'. In section 14A also the expression ' which does not form part of total income under this Act'  is used , this can mean only such income on which no tax at all is chargeable under the Act for example, agricultural income, or interest on some tax free bonds etc. and not such income which are taxed in some other manner or in hands of some other person. Once income tax is levied in any manner under the Act, it cannot be said that 'it is does not form part of total income under the Act', though it may not be included in particular hands. Thus, tax paid on income whether directly or indirectly under any provisions of the Income-tax Act, or any Finance Act is tax on income. Once a tax is levied on any income, in any manner by the Central Government, it is a tax on income and nothing else. Under our Constitution the Central Government is empowered to impose tax on income (other than agricultural income). The tax can be imposed and collected in any suitable manner provided it is tax on income.

Tax on distributed profits S. 115-O:

As per sub-section (1) tax imposed is additional income-tax, as per sub-section (4), the tax paid by the company at the time of distribution of profits, shall be treated as the final payment of tax in respect of the amount of dividend declared, distributed or paid and no further credit of such tax shall be claimed by the company or by any other person in respect of the amount of tax so paid.

As per sub-section (5) no deduction under any other provision of the Act shall be allowed to the company or a shareholder in respect of the amount which has been charged to tax under sub-section (1) and the amount of   tax paid thereon.

Similarly, in respect of divided distributed by some mutual funds similar provisions are made in section 115 R.

From these provisions it is clear that the dividend paid by the company, UTI or Mutual Fund which is subjected to tax at the time of distribution is not to be allowed as an expenditure to the company or the mutual find and the tax paid by the company, UTI or mutual fund as the case may be is treated as final payment of tax for which no further credit or refund can be claimed or allowed to any one:- in particular  the company or its shareholders and the mutual fund and its unit holders.

Dividend distribution tax (DDT) and Security Transaction Tax (STT) are nothing but tax on income:

From the provisions of S. 115O and 115 R it is clear that  the tax paid by the company or mutual fund is an additional income-tax collected from the person who distribute dividend. Fifth proviso to S. 48 also prescribes that Security Transaction Tax (STT) shall not be allowed while computing capital gains. STT  is not an allowable deduction against business income vide S.40 (a) (ib) till assessment year 2008-09 however a tax rebate is allowed. From A.Y. 2009-10 STT will be allowed as deduction from business income however tax rebate shall not be allowed.  All these provisions clearly shows that DDT and STT are nothing but income-tax. Therefore, in the overall context of the income-tax Act, 1961 dividend as well as long term capital gains which are exempted u/s 10 are already taxed in other manner and the tax imposed as DDT or STT is income tax levied and collected in an easy and convenient manner.

Exemption under section 10:

Vide sub-sections (34) and (35)  any income by way of dividends referred to in section 115 O and 115 R respectively  are not to be included in total income.

The Income-tax Act is a self-contained code  and entire enactment needs to be considered:

The income-tax Act, 1961 is a self contained code and it has to be considered as a whole and not in piecemeal manner.  Therefore, it would be wrong to read section 10 (34) and 10 (35) in isolation of section 115O and 115R.

One provision cannot be read in isolation with other provisions.  Though some provisions may have limited application to a particular head of income or to a particular purpose but in that case it is clearly mentioned expressly or it may be implied by the provisions.

So far the provisions relating to tax on distribution of income as contained in Chapter XIID and XIIE relating to tax on distribution of profit by companies and mutual funds respectively are concerned, it is found that the Chapters were inserted by the Finance Act, 1997 w.e.f. 01.06.97 and finance Act, 1999 w.e.f. 01.06.1999 respectively. Correspondingly S. 10 was amended by insertion of subsection 33 to provide for exemption of dividend referred to in section 115-O and then amended to income distributed by mutual funds.

Thereafter an amendment was brought and tax payable by companies on distributed profit  was withdrawn and simultaneously exemption u/s 10 was also withdrawn. Again these sections were amended w.e.f. from 1.4.2003 and tax on distributed profit was again imposed and simultaneously exemption u/s 10 was again reintroduced.  From the history of tax on distributed income and exemption of dividend under section 10 we can observe that the exemption u/s 10 was granted only when tax was levied at the time of distribution on the companies and the mutual funds.

Thus, it is clear that tax has all along been charged on dividend, it is only for the simplicity and easiness to collect that tax has been levied at the time of distribution and made exempt in hands of recipients of dividend. The implicit purpose is to tax entire amount of dividend distributed by companies and not to grant exemption to any dividend.

By tax on distribution and non-taxable dividend has also been made taxable:

When there was no tax u/s 115 O and 115R at the time of distribution the following categories of dividend declared was fully or partially exempted:-

a) In hands of individuals and Hindu undivided families there was exemption due to basic exemption.

b) In case of individuals and Hindu undivided families there was also exemption due to deduction provided u/s 80L.

c) Dividend paid to the companies was also partially exempted by application of section 80M.

d) Dividend paid to registered charitable institutions, other exempted  institutes , mutual funds etc. whose income was exempt u/s 10 or 11 was also exempted.

e) Dividend declared in favor of the Government was exempt.

f) Dividend earned by assesses also became non-taxable because of reason that the assesses could set off their business loss, depreciation, loss under other sources etc. against dividend income.

Therefore, it can be seen that prior to tax on distribution a larger portion of dividend declared and distributed was exempted and no tax was paid thereon due to some or other exemptions or applicability of set off of losses.

No exemption on any distribution

As per provisions of section 115-0 and 115-R, there is no exemption on dividend declared, distributed and paid.  The dividend is also not allowed as expenditure.  The tax paid is also not allowed as expenditure. The tax collected is final tax collected.  Therefore, entire amount of dividend declared, distributed or paid by companies or mutual find is subjected to compulsory and final tax payment.

Dividend is not exempt under Income-tax Act

In view of above discussion we find that although dividend is not included in the income of shareholder because of provisions of section 10 but in fact, the exemption is only because  tax is already paid on such dividend and such payment is final.  Earlier when there was no exemption u/s 10 tax was deducted at source at the time of payment of dividend and the records shows that a larger part of such TDS was refunded.

Simultaneous amendments in section 115-O, 115-R , Section 80L, 80M and section 10 clearly indicate that exemption u/s 10 exists only as a matter of scheme of collection of  tax on entire dividend and not as a scheme to grant exemption.  The tax is levied and collected in one or other form and manner.  Therefore, it cannot be said that dividend covered by section 115-O or 115-R is not taxable under the Act. Dividend is definitely taxable and tax is collected in bulk at the stage of distribution instead of from shareholders or unit holders.

The provision can be compared with provisions of clubbing of income. Suppose an item of income is included in hands of parent or spouse or other relatives as per provisions of section 64. The same item of income cannot be included in the income of person to whom the income belongs (minor child , spouse or relative as the case may be). Does it mean that the income earned by minor is not taxed merely because it is not included in income of minor but income of parent? The obvious answer is No. the income has born tax in hands of parent, therefore, it is a taxable income in the overall context of the Act.

Similarly tax is paid on dividend by companies or mutual fund as per the relevant provisions. it does not mean that the dividend is not taxable or that it has not been included in 'total income', for levy of tax.   

Tax under income tax Act:

Under the provisions of the income Tax Act, tax is imposed on income. The purpose of imposing tax is achieved even when tax is collected at the time of distribution of income by companies or mutual funds. Therefore, there is no gain saying that dividend is exempt under the income Tax Act, 1961.

If it is argued that tax on distribution of dividend is not a tax on income earned by way of dividend by shareholders or unit holders, then it is felt that the provisions may be ultravirse the purpose of the Income-tax Act, as well as our constitution. By imposing tax at the stage of distribution itself, it is assumed that there is element of taxable income in the dividend distributed, and to keep a balanced overall tax rate for collection relatively lower rate of tax has been imposed on distributed income. 

Section 14A vis-à-vis dividend

Section 14A was inserted by the Finance Act, 2001 with retrospective effect from 1.4.1962 and a proviso thereto was inserted by the Finance Act, 2002 with retrospective effect from 11.5.2001.  The section as stands now reads as follows:-

Expenditure incurred in relation to income not includible in total income.

14A. 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 lst day of April, 2001.]

A reading of the above section clearly shows that this provision will apply only when the particular expenditure is in relation to only such types of income, which do not form part of total income under all provisions of the Act. The expression 'total income' is used in the context of 'taxable income'. Once we find that dividend suffers a payment of tax, it cannot be said that dividend is an exempt income and does not form part of the total income under the whole Act.

The expression 'total income', has been used in the context of taxable income. In Section 14A it is not stated that the expenses will not be allowed when any income does not form part of the total income of an assessee. Rather the words used are 'does not form part of the total income under this Act'. Thus, the clear meaning is that when the income is not exigible to tax under the Act in any manner, then only section 14A would apply.

Merely because dividend is not included in income of the person who received it does not mean that the dividend is not included in total income (meaning chargeable or taxable income) under the Act.

Thus, section 14A can be applied in relation to only such income which does not attract tax liability in any manner under the Act. For example, agricultural income is one such income which cannot be taxed under the income tax Act by the Central Government. Or some other income which does not attract tax in hands of any person - the recipient or the payer can only be considered to  be subject to section 14A.

Merely because the dividend is exempted u/s 10 while computing income of share holder it  cannot be said that section 14A would be applicable.  Section 10 cannot be read in isolation of other special provisions under which tax is imposed and collected on dividend.

Therefore, it appears that in the context of such income which bears tax at the time of distribution, the context require that the expression total income as used in section 14A should not be confined to the total income of an assessee.  Rather, it must be looked from the point of view of income which has been subjected to tax under any provision of the Act, and therefore, the section needs to be interpreted in a manner to restrict its applicability in respect of only such income which is not at all taxable at any stage and no where under the Income Tax Act.

Section 4:

In this regard section 4, which is a charging section, is relevant. According to S.4 tax is charged where any Central Act enacts that income tax shall be charged for any assessment year at any rate ---. Now tax on distributed profits are also charged as per Central Act, tax on shareholders who receive dividend is also charged as per such Central Act. In case of distributed profits the basis of tax is the amount of dividend distributed. Therefore, for this purpose and in this context it can be said without any doubt that dividend distributed is the 'total income' or 'chargeable income' or 'taxable income' on which tax is paid under section 115O or 115R, as the case may be.

This factual position also becomes clear when we notice that the rate of tax on dividend paid to different types of assesses is different. This is because the average rate of tax on different types of assesses is different. Therefore, the rate of tax on distributed profits has been kept low in case of individuals and HUF who enjoys basic exemption and lower rate as per slab of income. On other hand rate of tax is higher in case of companies and firms who do not enjoy any basic exemption and there is flat rate of tax on their income.   

Dividend as compared to other exempted incomes:

There are several other types of income which are exempted under the Income Tax Act , from being included in total income at any stage and in any hand. Most of incomes prescribed in Chapter III are such which are not at all taxed at any stage and in any hand.

Apparently cases of tax in hands of other persons are income received from HUF and firm. The income may be taxable in hands of HUF or it may be exempt due to basic exemption in hands of HUF, the income received by member will be exempt (except when S. 64(2) is applicable), share in profit of firm which is assessed in hands of firm is exempt in hands of partner.

Thus applying corollary of HUF and Firm it can be said that dividend which bears tax at the stage of distribution itself is not exempt while computing total income under the Act though it may not be included in income of recipient.

 Shareholding is not only for earning dividend 

On a long term analysis of price earning ratio of the overall share market capitalization, we find that earning by way of dividend is hardly 1.5 to 2%.  There are large number of companies which do not declare any dividend.  If we consider average market capitalization at BSE and total amount of dividend declared by all companies, the yield by way dividend will not be more than 1%.  Therefore, it is clear that shares are not purchased merely to earn the dividend, rather, the purpose of earning dividend though implicit, comes much after in priority.  The purpose of investment in shares can be given priority as follows:-

a) To diversify portfolio of investment in liquid, appreciating assets with a greater element of risk.  And to diversify in different sectors of economy, different industries and different companies thereby to reduce risk and have a balance portfolio.

b) To earn capital gains by way of short term to long term capital gains;

c) To have a controlling stake in companies and to manage companies (this will apply to investment as promoter or controller of company);

d) To earn by taking advantages of cyclical movement in profitability of industry.

e)  To earn by way of intra day trading as a hedging activity and keeping portfolio active and performing.

f) To earn dividend.

Thus we find that earning of dividend is last in priority. In fact many wise investors find it more advantageous to sell shares and units cum dividend to fetch higher price. In many cases it is noticed that while selling shares cum dividend, one may realize many times more by way of price than dividend. A share sold cum dividend of Rs. 5/- at a price of say Rs.125/- may be available at a price of Rs.100-110 or even lower after some days when it becomes ex dividend. Thus, by sacrificing dividend of Rs.5/- one may earn Rs.10-25 or more extra by way of price realization by selling share cum dividend. This is because:

a. Before the date of book closure or record date there is usually  short supply and Extra demand for shares so price is increased.

b.After book closure and record date, there is selling pressure and supply increase.

c. some investors have fancy of earning dividend as they consider it tax free. 

Taxable earnings in hands of share holders:

Even in hands of share or unit holders the earnings by way of share trading as trading profit or speculative profit is taxable.  The profit by way of capital gains is also taxable by way of income tax and now by way of Security Transaction Tax and / or Income tax.  Similarly, profits derived by managing or controlling companies is also taxable as income form business or profession or other sources.  The dividend is also taxable may be in the hands of the recipient or in the hands of dividend distributor.  Therefore, it can be said that any direct or indirect income derived by purchasing, holding, transferring shares in companies or units of mutual fund is taxable in one or other form under the Income Tax Act , and it is wrong to say that dividend is exempt all together.

Distribution policy:

It is worth to note that good companies devise dividend policy in such a manner as to maximize shareholders wealth. Where it is considered that the company can deploy funds in more effective manner and by deployment of Funds Company can increase shareholders worth, the company may not pay dividend or pay lower dividend. In most of cases  profits are ploughed back ( fully or partly)  and it forms part of shareholders funds. Increased shareholders funds added advantages of improving book value per share and earning per share. When company's share quote at substantially higher price to book value ratio and at higher price earning ratio, the share price may improves much higher by such retention.

For a simple example,  suppose a company's share is quoted at price to book value ratio of 10.

 The present book value is    Rs.30 including to date profits.

The present market price is Rs. 30 X 10 = 300

Suppose the company declare dividend of Rs. 3 per share in that case book value per share shall come down to Rs.27 and therefore revised market price of share would be 27 X 10 = 270/-

In this case the shareholder will loose Rs. 30 in market price per share and gain Rs.3 by way of dividend, therefore there would be a loss of Rs.27 to the shareholder. In such a situation it may be preferable for the company and its shareholders to retain maximum profits.

   However, for maintaining goodwill and market price of shares it is also necessary to pay some regular dividend. Market price of shares is based on number of factors including book value, earning per share, dividend per share and profits retained per share etc. which reflects current scenario and past performance. Furthermore it is also dependent on future prospects of the company. Therefore, dividend policy is also based on all these factors. The same being very complex, and not very relevant to reach the desired point, is not discussed in this write-up.   

Long term capital gain and security transaction tax (STT)

With effect from 1.10.04, security transaction tax has been imposed and when a transfer of share or unit of mutual fund bears STT then only exemption in case of long term capital gains is allowed. Therefore, it is clear that the STT is in lieu of long term capital gain tax on shares and units.  The scheme of STT is also designed to tax all long term capital gains and to have an easy method of collection and there is no scope for any refund.  Whereas when long term capital gain tax was imposed it was found that in many cases no tax was payable because of indexed cost being more than sale value, brought forward long term capital loss or short term capital loss, set off of losses under other heads of income etc.  Whereas when STT is levied the tax is collected whether there is a profit or a loss in the transaction.  Therefore, in the context of overall taxation of long term capital gains also it can be said that the long term capital gains are not fully exempt from tax though it may be exempt from Income-tax but every purchase and sale is subject to STT.

Where transaction is not subject to STT e.g in case of off market deals, STT is not chargeable and the transaction is subject to normal provisions of tax on capital gains.

For an example we can consider sale of quoted shares sold through private negotiations on 'spot delivery' basis and not through stock exchange. In such case the sale will not be subject to STT and the gains arising will also not be exempt. Therefore, it is clear case that STT is in lieu of income tax.

Though STT is not levied under the provisions of the income-tax Act, 1961, but is nothing but tax on income, charged and levied in a different manner. As per the provisions of the Indian Constitution it can be and has been levied under the entry and enabling provision for taxes on income and not under any other entry.

Shares purchased as stock-in-trade 

In case of a trader in share he purchases shares for the purpose of trading.  Therefore, capital is borrowed for the purpose of share business and it is  capital borrowed for the purpose of business and therefore, interest payable on such borrowed capital shall be allowable u/s 36 and such interest cannot be disallowed by applying section 14A although dividend earned, if any, will be exempt in hands of recipient.

Shares purchased for controlling companies

Shares purchased by persons as promoter, manager or controller of companies is acquisition of shares for the purpose of business and profession of promoting, managing or controlling companies.  Therefore, interest payable on capital borrowed for purchasing shares by such persons will be allowable and section 14A cannot be applied though dividend received may not be taxable, if the company has paid tax under section 115 O .

In this regard we can consider another issue of deemed dividend under section 2(22)(e), by way of loan , advance etc. such dividend is not considered dividend for the purpose of section 115 O vide explanation given at the end of the Chapter XII D. Therefore, such dividend is not a dividend referred to in section 115 O. accordingly the shareholder is liable to include such dividend in his total income and pay tax.

Shares purchased to derive capital gains

When shares are purchased as an investor the immediate purpose is to gain out of fluctuation in price of shares over short to long period.  Short term capital gains are taxable. While purchasing shares, one cannot envisage the period of holding if the price appreciates the investor will not wait for share becoming a long term capital asset.  From the statistics of high and low price during 52 weeks period it is apparent that the price may go up several times or may come down several times. Therefore, when share is purchased it cannot be assumed that share is purchased to gain long-term capital gain only.  Therefore, even purchase of share by investors is basically to earn capital gains mostly, within short term which is taxable and in case of long term capital gain also there is tax by way of STT or if the shares are not sold through stock exchange then also long term capital gain tax will be payable.  In case of unquoted shares the sale through stock exchange and the levy of STT is out of question and therefore in that case long term capital gain will be taxable.  Furthermore, the future is contingent the shares, which are quoted and traded on a stock exchange today, may not be treated or remain quoted at the stock exchange in long term.  The cases of de listing of companies, suspension of trading of shares is not uncommon.  Many shares which were highly traded sometimes ago are now suspended, de listed or not traded for some other reason.  Therefore, it cannot be assumed that the shares are purchased only to derive income by way of dividend and long term capital gain, which are exempt u/s 10.

Therefore, for whatever purpose share may be purchased it cannot be said that shares were purchased to earn tax-free income. No wise man will purchase shares to earn 1- 2% of investment by way of dividend. If the capital is borrowed to purchase shares, it cannot be said that interest is an expenditure incurred to earn income by way of dividend, which is not included in total income under the Act and which has not suffered tax. The commitment of interest begun at the time of borrowing and not when a dividend is earned. Similarly the opportunity to earn by deploying funds in other manner is lost once money is invested in shares. Payment of interest or loss of other earnings take place even when on dividend is earned. Therefore, it cannot be said that interest is expenditure to earn dividend.

Even if it is so said, it cannot be said that the dividend is not included in 'total income' / chargeable income or taxable income under the Act, when we find that tax is finally and compulsorily collected at the time of distribution.

A possible way out

As discussed earlier shares may be purchased as a share-trader in that case capital borrowed for purchasing shares shall be for the purpose of business and interest will be allowable. Even purchase of shares by investors is basically to gain out of capital gains - which are taxable. On change of circumstances, if required, stock-in-trade of share may be transferred to investment account and held as capital asset.  Considering legal provision that a holding period of one year makes shares and units as long-term capital asset a reasonable period of one month can be considered to change the character of shares or units to investment account from trading account.  Therefore, a policy decision may be taken that if any share or unit is held for more than 30 days, then it will be consider as an investment - a capital asset.  In such a case interest paid on capital borrowed at the time of purchasing of the shares or units as stock- in- trade will be allowable though subsequently such shares or units may be treated as capital asset.

Investment in shares, units, bonds, debentures, saving certificates and even fixed deposits is a systematic and organized activity. This also requires organized and specialized actions. Services of experts are available for such business also. Thus, the investment activity is also a business or professional activity.

Some decisions of ITAT:

In ACIT vs. Dakshes S. Shah decided by Mumbai Bench ITAT 272 ITR (AT) 131 the assessee had made investment in shares by obtaining loans in earlier years.  The Assessing Officer disallowed the interest of Rs.4,97,090/- payable to an investment company for the assessment year 1998-99 on the ground that the dividend income had been excluded from the computation of taxable income by virtue of its being exempt from tax under the provisions of section 10(33) read with section 115-O of the Income-tax Act, 1961.  Since the dividend income was not chargeable under the head "Income from other sources" the Assessing Officer disallowed the interest expenditure referable to the investment under section 57 of the Act.  However, the Commissioner (Appeals) allowed the interest payable amounting to Rs.4,97,090/-.  On appeal by revenue before the ITAT, the Tribunal  while allowing appeal held,  that dividend income was exempt from tax by virtue of the provisions of section 10(33).  Section 14A expressly prohibits allowance of such claims.  If the intention of the Legislature was only to collect the tax from the recipients of the dividend through the medium of the company, then there should have been a provision whereby the company should not be made to pay tax in respect of that part of the dividend, which was attributable to the assessee who has no taxable income.  In the absence of such a provision it could not be said that the tax was collected from the company though the Legislature intended to collect tax from the recipients of the dividends.  Section 14A is couched in specific terms which did not leave any room for doubt or dispute with regard to the fact that in order to claim deduction of expenditure in relation to a particular income, the assessee has to show that the said income forms part of the total income.  Hence, the assessee was not entitled to claim deduction of the interest referable to the amount borrowed for the purpose of investment in shares.

The Revenue filed appeal before the Tribunal and contended that in view of section 14A inserted by the Finance Act, 2001 with retrospective effect from 1.4.62 interest payment cannot be allowed.  The Tribunal considered the provisions of section 14A, the memorandum explaining the provisions in the Finance Act, 2001 which read as follows:-

"No deduction for expenditure incurred in respect of exempt income against taxable income.

Certain incomes are not includible while computing the total income as these are exempt under various provisions of the Act.  There have been cases where deductions have been claimed in respect of such exempt income.  This in effect means that the tax incentive given by way of exemptions to certain categories of income is being used to reduce also the tax payable on the non-exempt income by debiting the expenses incurred to earn the exempt income against taxable income.  This is against the basic principles of taxation whereby only the net income, i.e., gross income minus the expenditure, is taxed.  On the same analogy, the exemption is also in respect of the net income.  Expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income."

Thereafter the Tribunal held as follows:-

Section 14A is part of Chapter IV.  In other words, it applies to expenditure referable to any head of income referred to in section 14 of the Act, 1961.  The contention of learned counsel is that dividend income is not exempt from tax but the Legislature intended to collect the tax indirectly by deducting tax in the hands of the company.  I am unable to appreciate the contention of the assessee.  There are lakhs of shareholders whose income falls below the taxable limit and in their case there may not be any assessable income which is liable to tax even if dividend income is held to be taxable in the hands of such assesses.  Hence, if the intention of the Legislature is only to collect the tax from the recipients of the dividend through the medium of the company, then there should have been a provision whereby the company should not be made to pay tax in respect of that part of dividend, which is attributable to assesses who has no taxable income.  In the absence of such a provision it cannot be said that the tax is collected from the company though the Legislature intended to collect tax from the recipients of the dividends.  At any rate, section 14A is couched in specific terms which does not leave any room for doubt or dispute with regard to the fact that in order to claim deduction of expenditure in relation to a particular income, the assessee has to show that the said income forms part of the total income.  Thus, looking at from any angle, I am of the opinion that the assessee is not entitled to claim deduction of the interest referable to the amount borrowed for the purpose of investment in shares.  No doubt, learned counsel raised an alternative plea that the shares as and when they are sold, the income/loss is assessable to tax under the head "capital gains" in which event, expenditure has to be allowed as deduction.  However, it may be noticed that the assessee has not sold any shares till date and so far as this year is concerned, the contention of the assessee is academic.  The case laws cited by the learned Authorised Representative are distinguishable on facts, particularly in the light of section 14A of the Income-tax Act, 1961.

On consideration of the above, the order of the Commissioner of Income-tax (Appeals), on this issue, was reversed and the order of the Assessing Officer is upheld.

There are many other cases decided by the Tribunal in which the learned Tribunal has taken similar view that dividend earned being exempt u/s 10 (33), expenses incurred for earning dividend cannot be allowed in view of section 14A. Some of the decisions are referred to below:

Mohan T.Advani Finance P. Ltd V ITO (2006) 9 SOT 675 (MUM.)

Everplus securities & finance P. Ltd V Dy. CIT (2006) 101 ITD 151 (Delhi)   

Punjab National Bank V Dy. CIT (2006) 103 TTJ (Delhi) 908.

Dy.CIT V S.G.Investment & Industries Ltd (2004) 84 TTJ (Kol) 143/ 89 ITD 44 (KOL).

Case of a share trader - purpose being trading gain expenses were allowed:

In case of Vidyut Investment Ltd V ITO (2006) 10 SOT 284 (Delhi) the Tribunal held that where shares were held as trading stock with a view to earn trading profits, earning of dividend was incidental to share trading and therefore, the Assessing Officer was not justified in disallowing a par to expenses by invoking section 14A. 

Authors point of view on Tribunals orders:

In view of author with due respect to the tribunals section 14A was applied merely on the ground that dividend earned was not included in the income of assessee. It is felt that section 14A has not been interpreted correctly and a very narrow view has been taken ignoring the purpose of purchasing and holding of shares as appreciation and deriving gains which will be taxable in due course.

As noted earlier dividend earning is merely incidental to share holding and not the sole purpose of holding shares. Furthermore, tax on dividend is paid by company in lieu of shareholders, which is result of the legislative intention to collect tax on all dividend payments and to simplify collection and achieve finality of collection. It is not the case that the tax is not levied or cannot be levied due to some other policy reasons.

In view of the author it can be put in other manner that the legislative intention is to consider entire amount of dividend distributed as a taxable income which is part of  'total income' but because tax is paid separately by the company, at source, so it is excluded while making individual computations of share holders. Tax on distribution is apparently to make a final collection on dividend to whomsoever paid without granting any exemption for any reason and without granting any credit for tax paid by companies.   

With due respect the author feels that the cases before the Tribunal were nor properly argued and / or  considered and they  requires reconsideration in view of reasoning as discussed in this write-up.

The author is of the view that what is applicable in case of a share trader is equally applicable in case of investor also. Investment is also a systematic and organized activity and is in nature of an adventure in nature of commerce. Therefore, investment is also a business. In case of a business or profession also certain incomes may fall under heads of income other than business or profession. For example, gains on sale of fixed assets used in business fall under the head 'capital gains', because the asset was a capital asset and not a trading asset. Similarly investments are capital assets of investment business, the gains may be taxable under the head 'capital gains', yet the assets are held in the course of business of investment. Therefore, so far purpose of holding of shares is concerned, there is no difference in holding as stock-in-trade or as investment. Accordingly authors view is that in overall context of the provisions and the purpose of holding of shares and securities, section 14A should not be applied to investor merely because dividend earned is not included in taxable income of shareholder assessee.