Certain types of income are not includible in the tax computation because these are exempt under various provisions of the Act. There have been cases where deduction has 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 again to reduce the tax payable on the taxable income by debiting the expenses incurred to earn the exempt income against taxable income.

Section 14-A of the Income Tax Act, 1961, has been inserted with effect from the inception of the Act, to ensure that no deduction is allowed in respect of any expenditure incurred by the assessee in relation to income, which does not form part of the total income under the Act.

The provision has been made pursuant to Heydon’s Rule, also known as the ?mischief rule,” which deals with ascertaining the correct intention of the legislature by looking into the mischief that was sought to be remedied. The mischief rule has been approved by several courts, including the Supreme Court in the case of CIT v Shahzada Nand and Sons (60 ITR 392).

The main point to be considered is that unless there is a direct and proximate connection between the expenditure and the exempt income, there cannot be any disallowance of the expenditure under this section. This is based on the meaning given to the expression ?in relation to? used in this section as having only direct and proximate connection between the expenditure and exempt income.

The contrary view is that this expression is very wide and it encompasses both, direct and indirect expenditure. It would be relevant to consider two Supreme Court judgments in the case of HH Maharajadhiraja Madhav Rao Jivaji Rao Scindia Bahadur of Gwalior v Union of India (1 SCC 85). In this case, a petition was filed under Article 32 of the Constitution claiming a declaration under the Presidential order dated September 6, 1970, derecognising the rulers as unconstitutional. The Union of India contended, inter alia, that Articles 291 and 362 of the Constitution did not invest the petitioner and other rulers with any enforceable right as the recognition of the rulers under Article 366(22) was a matter of State Policy and the President was competent to pass the order. Thus, the question before the Supreme Court was to examine if it had the jurisdiction to construe the three articles.

In this context, the expression ?relating to? came up for consideration. After examining the issue in detail, the Supreme Court, by a majority, came to the conclusion that the expression ?relating to? should mean a direct and immediate connection with the subject-matter. It was, therefore, held that the Court had jurisdiction to construe Articles 291, 362 and 366 (22) in so far as the dispute in question was concerned.

It would be important to have a look at different expressions used in the Act that spell out the scope of the respective provision in the light of such expression. For example, section 72-AB(3)(i) uses the phrase ?directly relatable to? while dealing with the set-off of accumulated losses and unabsorbed depreciation allowable to the resulting co-operative bank. Likewise, the phrase ?attributable to? has been employed in various sections including Explanation 6 to section 43(6), section 44-AC prior to its omission, and section 10(23-B). The expression ?in relation to? has been also used in various sections apart from section 14-A, such as sections 36(1)(ix) and 35(2-AB). The phrase ?relating to? has been used again in several section including 36(1)(vii) and 28(ii)(c). The phrase ?wholly and exclusively for the purposes of? has been used in sections 37 and 57(iii).

This point was considered by the Special Bench of the Income Tax Appellate Tribunal in Income Tax officer v Daga Capital Management Pvt Ltd (321 ITR (AT) 1). The majority view of the tribunal was that if a person invests in shares from which dividend income is earned and thereafter such dividend is deposited in the bank from where interest income results, in such a situation the relation between the interest paid by the assessee on the borrowed funds for the purchase of shares with the dividend income is dominant and immediate, being that of the first degree but the relation of such interest paid with the interest income earned on the amount invested in the bank would be of the second degree, being indirect and non-immediate.

According to the tribunal, dominant and immediate connection refers to the first degree of relation between two things. However, it would cease to be dominant if the degree of relationship slips from first to second. It was noticed that there is a dominant and immediate connection between the expenditure incurred by the assessee by way of interest on borrowings for purchase of shares and the dividend income. It is only due to the investment in the shares that the dividend income had resulted.

Such investment resulted in two types of income, viz, profit on its sale and the dividend. Both these incomes were the direct result of investment.

The tribunal also held that the status of income is not enhanced or diminished if it is earned from the main business activity or incidentally. There may be a difference in classification of such income under one head or the other but no special treatment is envisaged for the main or incidental income under the Act. There is no provision in the Act, which exempts a particular income from taxation simply on the ground that it is an incidental income.

The tribunal concluded by stating that there is no indication in section 14-A that the disallowance is not applicable in respect of incidental income, which is otherwise exempt from tax. Thus, the provisions of Section 14-A are applicable in respect of dividend income earned by an assessee engaged in the business of dealing in shares and securities where the shares are held as stock-in-trade, and when earning of such dividend income is incidental to trading in shares.

The aforesaid order of the tribunal may come up in appeal before the High Court and thereafter the Supreme Court because a substantial question of law is involved.

The author is advocate, Supreme Court