No Expense is Attributable to the Exempted Income as the revenue failed to establish direct nexus between expenses incurred & income earned: Punjab & Haryana HC [Read Judgment]

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The first bench of Punjab and Haryana High Court has upheld the ITAT order that, No Expense is Attributable to the Exempted Income as the revenue failed to establish direct nexus between expenses incurred & income earned.

During the relevant assessment year, the assessee earned interest on Maharashtra State Electricity Bonds and dividend income which are exempted in come under the Income Tax Act. The assessee deducted Rs. 3,46,97,852/-from the total income. The question involved in the case was that whether expense is attributable to the exempted income? If it is yes, whether the provisions of Section 14A of the Income Tax Act would apply?

The assessee submitted that it had not incurred any expenditure for the purpose of earning the exempt income observing that the possibility of the assessee having incurred expenditure relatable to such exempt income could not be ruled out. The assessing Officer rejected the claim on ground that on identical facts for the Assessment Year 2001-02, ad hoc disallowance relatable to such expenditure incurred for the purpose of earning exempt income was made. Accordingly he passed an order disallowing Rs.1.5 crores under Section 14A of the Income Tax Act. The assessee maintained that there was no nexus between the dividend expenditure and the expenses which were sought to be deducted for the reason that the investment had been made out of its own funds and not from the borrowed funds and, therefore, disallowance was not called for; that the dividend was received as long term investment during the relevant previous year and that no expenditure was attributable towards earning the same as the dividend received was only incidental to the holding of shares; that the dividend was received by single dividend warrants no expenditure was incurred to earn such dividend; that the assessee had not claimed any expenditure in relation to income which did not form part of the total income;

On appeal, the Commissioner of Income Tax (Appeals) sustained the assessment order and enhanced the amount of disallowance by observing that “In the light of the facts noted earlier and in the absence of details, a reasonable basis for the disallowance out of interest expenditure would be to consider that both interest bearing and non-interest bearing funds available with the assessee have been used in all the assets in their respective proportions of the total funds available with the assessee as shareholders’ funds and as borrowed funds. This includes utilization in investment from which exempt income is earned or can be earned. However, taking into account the fact that some loans do have a specific covenant for non-utilization in shares etc. and that borrowed funds invested in such shares may have been repaid from the profits or other non-interest bearing funds during the year, I think it fair to allow a 50% reduction on the borrowings so determined, on estimate, to take care of such situations. Since these funds change throughout the year, the averages of their values at the beginning and at the end of the year as per the balance sheet are considered to determine the ratios. Since many of the investments are coming from earlier years and the assessee had borrowed funds in earlier years also, I am of the view that the balance sheet of the assessee will be a better guide for apportionment of expenses as compared to the cash flow statement, since it takes into account the brought forward capital as well as the borrowings and investments. The financial cost of the borrowed funds is computed by the working out the average cost of funds, which is the total interest expenditure divided by the average of the borrowings at the beginning and at the end of the year and applying it to the average of the specified investments for the year. For this purpose, the investments in share of companies listed outside India (to which Section 115 O is not applicable), and the taxable bonds like the 6% capital index bonds, debentures of NALCO and bonds from HDFC are excluded from the total investments to arrive at the specified investments from which no income is expected to be earned.”

On appeal, the Income Tax Appellate Tribunal set aside the above order by holding that no expense is attributable to the exempted income as the revenue had failed to establish a direct nexus between the expenses incurred and the income earned ignoring that even indirect expenses are attributable u/s 14A as has been made clear by providing for Rule 8D(2)  in subsequent assessment year.

Concurring with the findings of the Tribunal, the first bench comprising of Chief Justice S.J Vazifdar and Justice Deepak Sibal observed that “The Tribunal was certainly entitled to draw such an inference. It is a reasonable inference. The Tribunal addressed itself to the correct question, namely, to determine if there was any nexus between the additional investments with the interest-free borrowed funds. The following findings of fact of the Tribunal are of vital importance: the assessee had during the relevant time invested an aggregate amount of ` 152.05 crores out of which an amount of ` 28.18 crores was made in shares of foreign companies. The dividend from foreign companies was taxable. This, therefore, left an amount of ` 123.87 crores which yielded dividends that were exempt from income tax. The assessee realized 117.97 crores from the sale of its investments in the earlier years; ` 46 crores were generated from the assessee’s operating activities; ` 6.87 crores were received from the sale of fixed assets and there was an opening cash balance of ` 8.90 crores. The aggregate of surplus funds on which there was no interest burden was179.74 crores. This amount was available during the relevant previous year. Thus such funds were in excess of the investment of 123.87 crores. In addition thereto the assessee had generated cash from its financing activities of an aggregate amount of ` 24.24 crores. It had purchased fixed assets aggregating only to ` 54.62 crores during the relevant period. The findings, therefore, that the assessee had sufficient interest free funds to make the investment yielding tax free returns cannot be faulted. The absence of bank books in these circumstances would not justify an adverse inference being drawn for whichever way the matter is viewed, the assessee had sufficient funds available to it on which no interest was payable. This brings us to the legal issue of a presumption to be made when there is a pool of funds which include interest-bearing funds and interest free funds.”

Read the full text of the Judgment below.

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