Commissioner of Income Tax vs Dhanalakshmy Bank Ltd.

C.N. Ramachandran Nair, J.—The question raised in the eight connected appeals, seven 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 income tax Act (hereinafter called "the Act") for the investments made in the 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 G. 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 investments 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 the UTI, etc., which are tax-free. Section 14A was introduced to the income tax Act by the Finance Act, 2001, with retrospective effect from April 1, 1962. This provision provide 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, the 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 April 1, 1962, the retrospectivity is neutralised by a proviso later introduced by the Finance Act, 2002, with effect from May 11, 2001, whereunder reassessment, rectification of assessment, etc., were prohibited for any assessment year beginning on or before April 1, 2001. In other words, assessments for any assessment year up to the assessment year 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 disallowance 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 the 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 the 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 Assessing Officer 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 the tax-free income. As a specimen case we extract hereunder the actual figures available in the assessment of Catholic Syrian Bank Ltd. for the assessment year 2001-02 (I. T. A. No. 467 of 2009).

What is clear from the above is that the 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 Assessing Officer 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 Assessing Officer worked out 8.72 per cent. of this as the interest expenditure incurred by the assessee for earning the 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 Assessing Officer 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 Assessing Officer 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-sections (2) and (3) and the proviso:

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 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.

(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 Assessing Officer 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 the Finance Act, 2006, with effect from April 1, 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 accounts 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 the tax-free income in cases where the assessee like the banks do not maintain separate accounts for the investments and other expenditure incurred for earning the tax-free income. Senior counsel appearing for the Revenue relied on our judgment in I. T. A. No. 1784 of 2009, dated June 14, 2010, in the case of The Commissioner of Income Tax Vs. Smt. Leena Ramachandran and Homfit, 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 Commissioner of Income Tax, Mumbai Vs. Walfort Share and Stock Brokers P. Ltd., . Both counsel appearing for assessee-banks relied on the 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) read with rule 8D of the income tax 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 Commissioner of Income Tax, Madras Vs. Indian Bank Ltd., 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 the 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 the 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 Assessing Officer when proportionate disallowance was proposed by the Assessing Officer. By a 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 applies 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 the tax-free income, irrespective of whether the 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 investments for earning the 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 Assessing Officer to estimate the same by adopting a rational basis. In principle, we, therefore, uphold the disallowance made by the Assessing Officer u/s 14A. We, therefore, uphold the order of the Tribunal impugned in I. T. A. No. 40 of 2010 wherein they have followed a Special Bench decision of the Bombay 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 Assessing Officer in estimating the average cost of deposit and making the disallowance by working out the 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, the facts and figures are not available. Further, the assumption of the Assessing Officer that the entire investments in bonds, shares and securities for earning the tax-free income is from out of the borrowed funds (deposits) is also not justified. The 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 the 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 Assessing Officer could have taken the following formula to arrive at the interest liability incurred by the assessee-banks to earn interest-free income:

What we have stated above is only a reasonable suggestion for the Assessing Officer 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 Assessing Officer with reference to the accounts of the assessee-banks for each year. Since we find that the rational adopted by the Assessing Officer to estimate the expenditure for the purpose of disallowance u/s 14A is not tenable, we feel the matter should be restored to the Assessing Officer 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 Assessing Officer to make disallowance by following sub-section (2) of section 14A and rule 8D of the income tax 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 Assessing Officer 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.