The Government is making several attempts to drive its initiatives to improve the ease of doing business in India. It has simplified laws and regulations, to some extent, and provided tax incentives for entrepreneurs and start-ups when setting up their businesses. With a continuous surge in competition, there is also an increase in the number of Indian conglomerates that are performing well, resulting in an increase in profit distribution to investors. In general, the corporates opt to distribute these profits in the form of dividends that are exempt from taxation in the hands of shareholders, depending upon the type of assessee and the threshold of the dividend income.
Section 14A of the Income-Tax Act, 1961, provides that a taxpayer will not be allowed any deductions for expenditure that is incurred ‘in relation to’ income that does not form part of the total income under the Act, i.e., exempt income. This section has been the subject matter of considerable litigation over the years.
The Supreme Court, a few weeks ago, pronounced an important judgement in the case of Maxopp Investment Limited, on the applicability of section 14A, in cases where the dominant purpose of the shareholder in acquiring shares was not to earn dividend income, but instead, to obtain control over a company, or to hold the shares as stock-in-trade.
The key conclusions of the Supreme Court were:
- Disallowance under section 14A of the Act, shall be triggered even in cases where the investments in shares are made with the purpose of acquiring controlling interest in the company and not to earn dividend income. Accordingly, if any expenditure is incurred in this regard, the amount of such expenditure that is attributable to the dividend income must be disallowed.
- Even where the shares are held as ‘stock-in-trade’ and the dividend income received is incidental to the shares held as stock-in-trade, the earning of such dividend income will trigger the applicability of section 14A of the Act. Therefore, in such cases, depending upon the facts,the expenditure that is incurred in acquiring such shares will have to be apportioned between taxable and non-taxable income.
- In cases where taxpayers have suo motu computed disallowance under section 14A of the Act based on some scientific allocation, the Assessing Officer will have to record their satisfaction in rejecting the methodology adopted by the taxpayer before applying the proportionate disallowance provisions under section 14A of the Act.
This ruling may have an effect on Indian conglomerates where the dominant purpose is not to earn dividends, but to provide financial assistance to the group company. This decision also paves the way for the tax department to re-open and scrutinise the past cases, wherein the courts ruled in favour of the taxpayer, thereby settling the issue unfavourably. This decision shall also have an impact on the following parties:
Banks and NBFCs: As per the statutory requirement of the Reserve Bank of India (RBI), banks are required to maintain a Minimum Statutory Liquidity Ratio (SLR). To comply with this, banks are allowed to invest in securities yielding exempt income. Given the principles of the Supreme Court, the purpose test (which in this case is to comply with SLR norms), may be ignored and the provisions of section 14A may apply.
The purchase and sale of securities, being an integral part of business, are held as stock-in-trade. The dividends earned from these securities may be incidentally received, however, upon applying the principles of the Supreme Court, apportionment of expenses between taxable and non-taxable income needs to be undertaken.
Special purpose vehicles (SPVs): The government in its drive to promote investments into India has introduced new investment vehicles for the ease of finance pooling like the Real Estate Investment Trust (REIT), and the Alternate Investment Funds (AIF). In general, these SPVs have a pass-through status, i.e., any taxation is in the hands of the investors, subject to the characterisation of income (business income or capital gains).
The aforesaid ruling of the Supreme Court will have an impact on SPVs or investors, depending on the characterisation of the income, wherein, the interest costs that are incurred, if any, for making a downward investment, shall not be allowed to be claimed as deductions under section 14A of the Act.
Start-ups: Promoting its vision for encouraging entrepreneurship in India, the government has granted certain tax reliefs/incentives to eligible start-ups. With the recent and welcome attempt of the government to exempt start-ups from angel tax (a tax which was proposed by revenue officers for excess share premium received under section 56 of the Act), where the aggregate amount of the paid-up share capital and the share premium of the start-up after funding, does not exceed Rs 10 crore, this ruling puts a tax liability on the investor.
They will be impacted on receipt of the dividend income from the start-ups (investee), on account of disallowance under section 14A of the Act, ignoring the purpose test.
Individuals: With regards to individual investors, they shall be less impacted by this ruling due to existing provisions wherein, dividend received in excess of Rs 10 lakh shall not be treated as exempt income, resulting in no computation of disallowance under section 14A of the Act. There exists no such threshold for domestic corporates, and certain pooling vehicles like Mutual Funds or AIFs.
With this ruling, there has been an evolution in structuring the investments, wherein, the cost of an equity investment (including the recurring cost to maintain the investment), is clearly demarcated and captured through SPVs or hybrid instruments (which segregate the different rights available in an equity). A pertinent point to note is that this decision should not impact Indian entities having overseas investments, as dividend received from foreign companies is liable for taxation in India.
By Aditya Hans & Ritik Zaveri
Hans is partner, and Zaveri is senior associate Dhruva Advisors LLP
With inputs from Umesh Gala, and Hariharan Gangadharan, partners, Dhruva Advisors LLP