Commissioner of Income Tax vs Catholic Syrian Bank Ltd. and Others

C.N. Ramachandran Nair, J.—The question raised in the 8 connected appeals, 7 filed by the Revenue and one by one of the banks is one and the same i.e., whether proportionate disallowance of interest paid by the bank is called for u/s 14A of the IT Act (hereinafter called "the Act") for the investments made in UTI shares, tax free bonds/securities etc. which yielded tax free dividend and interest. We have heard senior counsel Sri P.K.R. Menon appearing for the Revenue and senior counsel Sri Sarangan appearing along with advocate Sri P. Balakrishnan for the Assessee-banks.

The Assessees are all scheduled banks engaged in the banking business and in the course of banking business they are also engaged in the business of investment in bonds, securities and in shares which earn the Assessees interest from such securities and bonds and also dividend on investments in shares of companies and from units of UTI etc., which are tax free. Section 14A was introduced to the IT Act by Finance Act, 2001 with retrospective effect from 1st April, 1962. This provision provides for disallowance of expenditure incurred by the Assessee in relation to income which does not form part of the total income. In other words, if the Assessee incurs any expenditure for earning tax free income such as interest paid for funds borrowed, for investment in any business which earns income that is free from tax, Assessee is not entitled to deduction of such interest or other expenditure. Even though the provision was brought to the statute with retrospective effect from 1st April, 1962, the retrospectivity is neutralised by a proviso later introduced by Finance Act, 2002 w.e.f. 11th May, 2001 whereunder reassessment, rectification of assessment etc. were prohibited for any assessment year beginning on or before 1st April, 2001. In other words, assessments for any assessment year upto the asst. yr. 2000-01 that were finalised when the proviso was introduced without making any disallowance u/s 14A, were allowed to achieve finality. Disallowance u/s 14A was intended to be made only for pending assessments and for assessments for the assessment years commencing from 2001-02 onwards. In all these cases disallowances made u/s 14A are either in pending assessments or for assessments for the assessment years commencing from 2001-02 onwards. No dispute is raised by the Assessees against application of Section 14A by virtue of operation of the proviso to the said section introduced by Finance Act, 2002. Admittedly none of the Assessee-banks have separate accounts for the investments made in bonds, securities and shares wherefrom tax free income is earned so that disallowance could be limited to the actual expenditure incurred. In other words, the Assessee-banks do not have separate accounts for the expenditure incurred towards interest paid on funds borrowed such as deposits utilised for investments in securities, bonds and shares which yielded tax free income. The position is same so far as the overhead and administrative expenditure of the Assessee is concerned. In the absence of separate accounts for investments which earn tax free income, the AO worked out a formula which is the average cost of deposit in the year under consideration and applying the same he made proportionate disallowance of interest attributable to the funds invested to earn tax free income. As a specimen case we extract hereunder actual figures available in the assessment of Catholic Syrian Bank Ltd. for the asst. yr. 2001-02 (IT Appeal No. 467 of 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 tax free income by way of interest from tax free bonds and dividend income which is also tax free. So much so, substantial expenditure is incurred for earning the tax free income such as interest paid on borrowed funds (including deposits) utilised for investment and administrative expenditure for the same. Since actual expenditure incurred for earning the tax free income is not available for making disallowance u/s 14A, the AO found out the average cost of deposit of the relevant year. Since the Assessee''s investment on tax free bonds and shares during the relevant year was Rs. 13.06 crores, the AO worked out 8.72 per cent of this as the interest expenditure incurred by the Assessee for earning tax free income. The disallowance was accordingly worked out at Rs. 1,13,88,320. In other words, for earning a total tax free income under two heads of Rs. 2,48,25,538, the AO found that the Assessee would have suffered an interest liability of Rs. 1,13,88,320 and, therefore, this amount was disallowed u/s 14A of the Act. Even though in the case of some of the Assessees the AO has even determined proportionate administrative cost and disallowed the same, in the case of this Assessee for this assessment year we do not find any such disallowance. In other words, disallowance u/s 14A is limited to interest alone. Since the issue raised has to be decided with reference to the scope of Section 14A, we extract hereunder the said section with Sub-clause (2) and (3) and the proviso:

Section 14A(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.

(2) The AO 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 AO, 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.

(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:

Provided that nothing contained in this section shall empower the AO either to reassess u/s 147 or pass an order enhancing the assessment or reducing a refund already made or otherwise increasing the liability of the Assessee u/s 154, for any assessment year 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 w.e.f. 1st April, 2007. Subsequently Rule 8D was prescribed by the Government for the purpose of Sub-section (2) of Section 14A from 2007-08 onwards. By virtue of the subsequent legislation, now there is precise formula for working out the disallowance to be made u/s 14A even if Assessees do not have separate account showing the expenditure incurred on investments made for earning tax free income.

The question, therefore, to be considered is whether Section 14A prior to the introduction of Sub-sections (2) and (3) entitles the Department to make disallowance of expenditure incurred for earning tax free income in cases where Assessee like the banks do not maintain separate accounts for the investments and other expenditure incurred for earning tax free income. Senior counsel appearing for the Revenue relied on our judgment in IT Appeal No. 1784 of 2009 dt. 14th June, 2010 in the case of CIT v. Smt. Leena Ramachandran [reported at (2010) 235 CTR 512 : (2010) 45 DTR 312--Ed.] for the proposition that estimated disallowance u/s 14A is permissible. Another decision cited by the Revenue in support of their contention is the recent decision of the Supreme Court in CIT v. Walfort Share and Stock Brokers (P) Ltd. (2010) 233 CTR (SC) 42: (2010) 41 DTR (SC) 233: (2010) 326 ITR 1 (SC). Both counsel appearing for Assessee-banks relied on decision of the Supreme Court in Commissioner of Income Tax, Madras Vs. Indian Bank Ltd., and contended that where separate accounts are not available with the bank with regard to expenditure incurred on earning tax free income, there is no scope for disallowance u/s 14A at all. According to both counsel for the Assessees proportionate disallowance is called for only under Sub-section (2) r/w Rule 8D of the IT Rules which came into force from 2007-08 onwards and the same cannot be applied for any earlier assessment year. We do not think much reliance can be placed on the decision of the Supreme Court in the case of Indian Bank Ltd. (supra) because the said decision was rendered much prior to the introduction of Section 14A and the purpose of Section 14A itself is to get over judgments of the Supreme Court and High

Courts declaring Assessee''s eligibility for deduction of business expenditure incurred for earning the income irrespective of whether such income is taxable or not. In our view, the object of Section 14A is to ensure that so much of the expenditure incurred for earning income that do not constitute total income of the Assessee, should not be allowed. In other words, when income is outside the tax net, expenditure incurred for earning such income also should not be allowed to be set off in the computation of taxable income. Therefore, the short question to be considered is whether non-maintenance of separate accounts by the Assessee with regard to expenditure incurred for earning non-taxable income is justification for them to claim immunity from the operation of Section 14A. In fact, the subsequent legislation i.e., introduction of Sub-section (2) and the prescription of Rule 8D thereunder, make it clear that there may be cases where it would be difficult for Assessees to maintain separate accounts for earning taxable as well as non-taxable income. However, what we feel is that such difficulty may be experienced in the case of overhead expenditure and administrative expenditure incurred by the Assessee-banks. So far as investments in securities and bonds and also in shares, the income wherefrom is tax free are concerned, we see no reason why Assessee could not have maintained separate accounts for the sources of funds utilised for such investments which, in our view, if the Assessee-banks wanted, they could have maintained. In other words, if the Assessee-banks had a case that surplus funds available or funds sourced other than through borrowing only were utilised for investing in securities, bonds and shares which yield tax free income, they could have maintained such accounts and produced the same before the AO when proportionate disallowance was proposed by the AO. By subsequent amendment through Sub-section (2) and by prescribing Rule 8D therein what is achieved is prescribing specific guideline for disallowance in cases where separate accounts are not available on the expenditure incurred for earning tax free income. These are, therefore, only clarificatory provisions and in our view, the main clause of Section 14A apply for all periods after the introduction of the same in the statute which authorises the officer to make disallowance of the expenditure incurred for earning tax free income, irrespective of whether Assessee maintained separate accounts or not. Considering the significant amount of tax free income earned by the Assessee-banks for all the years involved, we are of the view that the investment for earning tax free income is substantial and if assessment is made without making disallowance u/s 14A, the same will render a distorted figure of taxable income which is not permissible under the Act. If the Assessee does not maintain separate accounts, it is for the AO to estimate the same by adopting a rational basis. In principle, we, therefore, uphold the disallowance made by the AO u/s 14A. We, therefore, uphold the order of the Tribunal impugned in IT Appeal No. 40 of 2010 wherein they have followed a Special Bench decision of the Mumbai Bench of the Tribunal in (2009) 117 ITD 169 and reverse the orders of the Tribunal and that of the first appellate authority in all other seven appeals.

The next question to be considered is whether the method adopted by the AO in estimating average cost of deposit and making the disallowance by working out average interest cost on the investments made for earning the tax free income is correct. After hearing both sides, we feel the matter requires reconsideration because in the first place, facts and figures are not available. Further, the assumption of the AO that the entire investments in bonds, shares and securities for earning tax free income is from out of borrowed funds (deposits) is also not justified. Assessee-banks have a specific case that they have funds available with them which are neither borrowals nor interest-bearing deposits and such funds also have been utilised in making investments for earning tax free income. We find force in this contention because when accounts are not available, the disallowance could be made only on the expenditure incurred for earning the tax free income which is to be estimated on a rational basis. In fact, in our view, the AO could have taken the following formula to arrive at the interest liability incurred by the Assessee-banks to earn interest (sic--tax) free income:

Total interest liability ------------------------ x Tax free income earned by the Assessee Total income

What we have stated above is only a reasonable suggestion for the AO to adopt which arises only if Assessee is not able to establish more accurately the interest spent on earning tax free income. We, therefore, leave this matter to be decided by the AO with reference to the accounts of the Assessee-banks for each year. Since we find that the rational adopted by the AO to estimate the expenditure for the purpose of disallowance u/s 14A is not tenable, we feel the matter should be restored to the AO for making disallowance u/s 14A by reasonably estimating as nearly as possible the expenditure incurred for earning the tax free income. This should be done after giving opportunity to the Assessee-banks to suggest their own formula with reference to accounts for the purpose of arriving at the actual amount or near actual amount. The disallowance on estimated basis has to be done as above until Rule 8D was framed and thereafter it is for the AO to make disallowance by following Sub-section (2) of Section 14A and Rule 8D of the IT Rules.

So far as the disallowance of administrative expenditure is concerned, we feel considering the fact that there is no precise formula for proportionate disallowance, no disallowance is called for, for proportionate administrative cost attributable to earning of tax free income until Rule 8D came into force. We, therefore, dispose of the appeals by setting aside the orders of the Tribunal and that of the first appellate authority on this issue and remand all the assessments back to the AO for reworking disallowance u/s 14A in the case of each Assessee for each assessment year. The proportionate disallowance u/s 14A should be limited to only interest liability and not overheads or administrative expenditure, which should be considered for disallowance under Rule 8D from 2007-08 onwards.