Friday, June 23, 2017

Intention of the Legislature Under Section 14A of the Income Tax Act, 1961

[Post by Akash Santosh Loya, 3rd year B.A. LL.B.(Hons.) student from National University of Advanced Legal Studies, Kochi.]

In the case of Godrej Boyce & Manufacturing Ltd. v. Deputy Commissioner of Income Tax and Anr decided last month, the Supreme Court of India decided on the issue relating to the disallowance of expenditure under section 14A of the Income Tax Act, 1961 (the ‘Act’) incurred with respect to the earning of dividend income and income from mutual funds in the hands of a shareholder and unitholder respectively.

In this post, I will at the outset state and elaborate on the provisions relevant towards understanding of the issue. Thereafter, I will discuss the decision of the Supreme Court. Lastly, I will provide an analysis of the said decision.

Relevant provisions

Section 10(34)

Section 10 of the Act exempts certain income. Such income is not chargeable to tax under any provisions of the Act. In accordance with sub-section (34), dividend income referred to in section 115-O was exempt from tax. Before 2003, the said provision was numbered as section 10(33).

Section 10(35)

Section 10(35) exempts income received in respect of units mutual fund or a specified company. Before 2003, the said provision was part of section 10(33). 

Section 14A

Section 14A was enacted by the Finance Act, 2001. It states that any expenditure incurred by assessee with respect to income which does not form part of total income will be disallowed. Therefore, any expenditure incurred with respect to exempt income is disallowed. Further sub-sections (2) and (3) state that the assessing officer (‘AO’) shall determine the expenditure incurred as per the method prescribed in rule 8D of the Income Tax Rules, 1962, provided the AO is not satisfied with the expenditure claimed by the assessee. 

By virtue of decisions of the Supreme Court in Rajasthan State Warehousing Corporation v. C.I.T.,[1] C.I.T. v. Maharashtra Sugar Mills Limited[2] and C.I.T. vs. Indian Bank Limited,[3] the settled position of law was that in case of composite and individual businesses which earned both taxable and non-taxable income, expenditure towards non-taxable income could not be isolated by apportionment, and a disallowance could not be made. Thus, section 14A was enacted to remove the basis of the aforesaid decisions.

Section 115-O

Section 115-O was introduced by the Finance Act, 2003. Sub-section (1) of section 115-O states that an additional income tax will be charged on the profits distributed by the company. This income tax will be in addition to the tax paid by the Co. on its total income. Therefore, firstly, the company will be liable to pay normal income tax with respect to its total income mentioned in the tax return (which will include the profits distributed by the company). Secondly, it will be liable to pay the additional tax on the profits distributed by the company. Sub-section (2) states that the aforesaid additional income tax will be payable by the company even if it is liable to pay zero tax on its total income. Sub-section (4) states that no credit can be claimed either by the company or by the shareholder with respect to the amount of the tax paid under this section. The tax paid will be treated as the final payment of tax. Further sub-section (5) states that no deduction will be allowed to either the company or the shareholder in respect of the tax paid under this section.

Section 115-R

Section 115-R states that additional tax will be paid by the specified company or the mutual fund with respect to the income distributed to the shareholders or unit holders respectively. The other provisions of section 115-R are similar to that of section 115-O. Therefore, a reference to the aforesaid explanation can be made.

The statutory provisions summarised above can be found here.

Section 10(34) [which was then numbered as section 10(33)] and section 115-O were introduced in the Act by the Finance Act, 1997. Subsequently, both the provisions were deleted by the Finance Act, 2002. However, by virtue of Finance Act, 2003, sections 10(34) and 115-O were reintroduced into the Act. Similarly, sections 10(35) and 115-R were reintroduced together by the Finance Act, 2003.

Background

The assesse, Godrej Boyce, had earned a total income of Rs. 34.34 crores in the assessment year 2002-03. The following is the division of dividend income towards various sources:

1.      
Sister Godrej companies
98%
2.      
Non-Godrej companies
0.05%
3.      
Mutual Funds
1.95%

A substantial part of the investment was in form of bonus shares. Further, on the last date of the relevant financial year, i.e., 31 March 2002, Godrej Boyce had total reserves, surplus, share capital of Rs. 280.64 crores by way of interest-free funds.

Accordingly, Godrej Boyce claimed exemption of the aforesaid dividend income under sections 10(33) and 10(34). It contended that it had incurred zero expenditure in earning the said income and, therefore, no disallowance should be made section 14A. The AO rejected the claim of Godrej Boyce and made the disallowance. This order was upheld by Income Tax Appellate Tribunal (‘ITAT’). Godrej Boyce filed an appeal before the High Court of Bombay. The High Court upheld the view of ITAT and dismissed Godrej Boyce’s appeal.

In the previous assessment years as well, i.e., 1998-99, 1999-2000 and 2001-02, the AO had disallowed expenditure towards earning of dividend income and income from mutual funds under section 14A. However, the same was reversed and an order in favor of Godrej Boyce was granted by the ITAT. Therefore, the end result in previous assessment years was that the entire dividend income was exempt without any deductions.

Issues Raised

I.          Whether the phrase ‘income which does not form part of total income’ appearing in section 14A includes dividend income and mutual fund income on which tax is payable under sections 115-O and 115-R?

II.        Whether on the findings provided by lower authorities over a period of time, can there be any question of disallowance under section 14A in Godrej Boyce’s case?

Decision

Issue I

The Supreme Court upheld the judgement of Bombay High Court on the said issue. It held that section 14A would apply to dividend income on which tax is payable under section 115-O and income from mutual funds on which tax is payable under section 115-R. It came to the aforesaid conclusion on the basis of following grounds:

-           Section 14A states that expenditure incurred by an assessee for earning an income will be disallowed if the said income does not form part of the total income of the assessee. Therefore, on a plain reading of section 14A, it is very clear that section 14A does not cover a situation where firstly, income is exempt in the hands of an assessee shareholder and secondly, the tax on the said income is payable by the dividend paying company. Therefore, only by virtue of tax being paid by the dividend paying company on the said income, it does not confer the benefit to the shareholder assessee in whose hands the income is exempt. Further, it was held that the wordings of section 14A do not give rise to any absurdity and, therefore, section14A should be construed strictly.

-           There are various species of dividends other than those covered under section 115-O. However, the only specie of dividend exempt under section 10(33) (later engrafted as section 10(34)) is dividend covered under section 115-O. Therefore, section 14A will not be applicable to other species of dividend. However, whenever the dividend covered under section 115-O is earned, the applicability of section 14A will be beyond doubt.

-           The fact that section 10(33) (later engrafted as section 10(34)) and section 115-O were introduced, deleted and reintroduced together does not conclude that the intention of the legislature was to propose a composite scheme of taxation. The composite scheme being that on one hand the dividend income is taxed in the hands of dividend paying company, and on the other hand the same income is not being included in the total income of the assesse shareholder.

-           Sub-sections (4) and (5) of section 115-O clearly state that no benefit can be availed of the payments made either by the company or the shareholder. Therefore, the proposition that the tax on dividend income is paid by the company on behalf of the assesse shareholder cannot stand.

The Court also referred to its judgement in the case of Commissioner of Income-Tax vs. Walfort Share and Stock Brokers P. Ltd.[4] to reach the aforesaid conclusion.

Issue II

The Supreme Court reversed the ruling of the Bombay High Court on the said issue. It held that normally the principle of res judicata does not apply to assessment proceedings. However, strong reasons should be provided by the AO to deviate from the consistent findings made over the years. In the instant case, since no strong reasons were provided by the AO for deviating from the consistent findings over the years, Godrej Boyce is entitled for full benefit of exemption of dividend income without any deduction.

Implications

In the instant case, Godrej Boyce had no tax implications whatsoever. Even though Issue I was decided against it, by virtue of a decision in its favor with respect to Issue II the end result was that no tax liability was to be discharged by Godrej Boyce. Therefore, looking at the decision from a monetary angle, the revenue was the one who lost.

Analysis

It is a well settled principle of interpretation of statutes that one has to adopt a construction that will promote the general legislative intent and purpose underlying the provisions.[5] One of the sources for ascertaining the intention of the Legislature is the Memorandum of Finance Bill. Section 115-O and amended section 10(34) were introduced by virtue of Finance Act, 2003. The Memorandum of Finance Bill, 2003 should be referred to ascertain the intention of the legislature for the introduction of the aforesaid provisions. It states:

It has been argued that it is easier to collect tax at a single point, i.e., from the company rather than compel the company to compute the tax deductible in the hands of the shareholders.

It is, therefore, proposed to substitute sub-section (1) of section 115-O of the Income-tax Act to provide that the amounts declared, distributed or paid on or after 1st April 2003 by a domestic company by way of dividends shall be charged to additional income-tax at the flat rate of twelve and one-half per cent, in addition to the normal income-tax chargeable on the income of the company.

From the Memorandum of Finance Bill, 2003 it is apparent that the intention for the introduction of the aforesaid provision was only for the purpose of simplification of procedure. There was no intention to exempt any kind of income. Initially, when dividend income was chargeable in the hands of the shareholder, the company had to calculate and deduct the tax deducted at source on the dividend income earned by every shareholder. Considering the large number of shareholders that may be present in a corporation, the entire procedure was very cumbersome and time consuming. Therefore, in order to simply the procedure, the legislature imposed an additional burden on the company by making it liable to pay the additional tax. Further, in order to prevent the same income from being doubly taxed, an exemption under section 10(34) was granted. This arrangement ensured that the same income was not doubly taxed.

Further, a careful reading of section 14A also shows that the intention of legislature was not to disallow the expenditure incurred for earning dividend income and income from mutual funds.[6] For understanding the same, it is necessary to take closer look at the section 14A (1) and (2).

Expenditure incurred in relation to income not includible in total income.

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 AssessingOfficer, 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.

From a perusal of the above provision, the two highlighted terms need to be taken into consideration for providing a correct understanding regarding the intention of legislature

-           Total income under this Chapter – It means the total income of the assessee computed under Chapter IV, i.e., sections 14 to 59;

-           Total income under this Act – It means the total income computed under the entire Act. Thus, the income chargeable to tax under sections 115-O and 115-R also falls within the ambit of this expression.

Therefore, from a careful reading of the aforesaid provision, the intention of legislature is very clear. It is to not disallow expenditure incurred for earning income which is chargeable not only under Chapter IV of the Act but also under any other Chapters of the Act. Further, the intention is also to allow expenditure with respect to income directly or indirectly earned by the assesse. If the intention was only to allow expenditure incurred towards income which forms a part of Chapter IV or towards income which is earned directly by assesse, the same would have been expressed clearly. The aforesaid intention would have been expressed by using words ‘total income under this Chapter’ or ‘total income of assessee’ instead of ‘total income under this Act’.

Further, this intention is clear by virtue of sub-section (2) of section 14A as well. It states that the AO can compute the disallowable expenditure when the said income does not form part of total income under this Act. Therefore, the AO will compute the disallowable expenditure when the income does not form part of the total income under the Act, and not when the income does not form part of total income of assessee.

- Akash Santosh Loya



[1] (2000) 109 Taxman 145.
[2] (1971) 3 SCC 543
[3] AIR 1965 SC 1473
[4] (2010) 326 ITR 1 (SC)
[5] The Sole Trustee, Lok Shikshana Trust v. CIT, Mysore, AIR 1976 SC 10.
[6] CA Dev Kumar Kothari, ‘S. 14A: Scope of disallowance explained’, available at http://www.itatonline.org/articles_new/section-14a-scope-of-disallowance-explained/.

Wednesday, June 21, 2017

A Closer Look at the Cross-Border Mergers Regime in India

[Post by Suprotik Das, a 5th year law student at the Jindal Global Law School, Sonepat, Haryana.]

April 13, 2017 marked a momentous event in the cross-border merger regime in India with the Ministry of Corporate Affairs notifying section 234 of the Companies Act, 2013 as well as amendments to the Companies (Compromises, Arrangements and Amalgamations) Rules, 2016 in the form of Rule 25A. Read together, they allow for the merger of an Indian company and a foreign company, with the resultant entity being either Indian or foreign owned and controlled – something that was hitherto disallowed under the Companies Act, 1956 and up until April 13, 2017.

However, the successful implementation of a cross-border merger between an Indian company (“I”) and a foreign company (“F”) is fraught with a number of difficulties. For example, say ‘I’ is the transferor company, F is the transferee company and ‘G’ is the resultant entity, which is foreign, what happens to the ownership of assets in India? Issues such as management and administration of assets in India by a foreign entity pose a number of compliance hurdles. Against this milieu, I attempt to analyse the existing provisions on foreign exchange laws and regulations.

The Companies Act, 2013

1.         Section 234 now authorises mergers of an Indian company with a foreign company, with the resultant entity being either Indian-controlled or foreign-controlled.

2.         Sections 230 to 232 apply similarly to cross-border mergers, irrespective of whether the resultant entity is Indian or foreign.

3.         Section 234(2) further provides that the scheme of merger may include payment of consideration to the shareholders of the merging company in cash, or in Depository Receipts, or partly in cash and partly in Depository Receipts, as the case may be. In the event the company decides to adopt the Indian Depositary Receipts route, the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 and the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 will be applicable.

The Companies (Compromises, Arrangements and Amalgamations) Amendment Rules, 2017

1.         The newly introduced Rule 25A allows for a merger between a foreign company and an Indian company after:

(a)        procuring approvals from the Reserve Bank of India; and

(b)       complying with sections 230 to 232 of the Companies Act, 2013 and the Companies (Compromises, Arrangements and Amalgamations) Rules, 2016.

2.         Regarding valuation, the transferee company shall ensure that it is in accordance with:

(a)        the valuation conducted by a valuer who is a member of a recognised professional body in the jurisdiction of the transferee company; and

(b)       internationally accepted principles on accounting and valuation.

3.         However, an Indian company may only merge with foreign companies from the following jurisdictions:

(a)        whose securities market regulator is a signatory to the International Organization of Securities Commission’s Multilateral Memorandum of Understanding (Appendix A Signatories) or a signatory to a bilateral Memorandum of Understanding with the Securities and Exchange Board of India (“SEBI”), or

(b)       whose central bank is a member of Bank for International Settlements (BIS) AND one which is not identified in the public statement of Financial Action Task Force (FATF) as:

(i)     a jurisdiction having a strategic Anti-Money Laundering or Combating the Financing of Terrorism deficiencies to which counter measures apply; or

(ii)       a jurisdiction that has not made sufficient progress in addressing the deficiencies or has not committed to an action plan developed with the Financial Action Task Force to address the deficiencies.

The Foreign Exchange Management Act, 1999 (‘FEMA’)

1.         From our example set out earlier, ‘G’ will be considered a ‘foreign company’ as it qualifies as a person resident outside India in accordance with section 2(u) read with section 2(w) of FEMA.

2.         In accordance with section 6(5) of FEMA, a foreign company can hold, own, transfer or invest in Indian currency, security or any immovable property situated in India if such currency, security or property was acquired, held or owned by such person when he was resident in India or inherited from a person who was resident in India.

3.         FEMA, therefore, allows for a foreign company to hold assets in India.

The Foreign Exchange Management (Cross Border Merger) Draft Regulations, 2017 (the ‘Draft Regulations’).

Interestingly, within 13 days of the notification of section 234 and Rule 25A, the Reserve Bank of India had published draft regulations to deal with the implementation of cross border mergers. These Draft Regulations were open to public comments until May 9, 2017. The final version of these regulations is yet to be notified.

To answer the question posed earlier, Draft Regulation 5 lends some credence. It pertains to outbound mergers between an Indian company and foreign company where the resultant company is foreign. Sub-regulation (c) of the draft allows for the resultant foreign company to acquire and hold any asset in India, which it is permitted to acquire under the provisions of FEMA and the Rules or Regulations framed thereunder. Furthermore, the assets can be transferred in any manner for undertaking a transaction permissible under the FEMA, Rules or Regulations.

As per sub-regulation (d) of the draft, if the asset or security is not permitted to be acquired or held by the resultant foreign company under FEMA, Rules or Regulations, it shall sell such asset or security within a period of 180 days from the date of sanction of the scheme of cross border merger, and the sale proceeds shall be repatriated outside India immediately through banking channels.

It is interesting to note that sub-regulation (c) authorises the holding of any asset while sub--regulation (d) of the draft creates a dichotomy between a resultant foreign company holding an asset and a security. It is unclear why this dichotomy exists. Perhaps the final version of the Regulations will remedy this anomaly.

Master Direction dated January 1, 2016 on the Acquisition and Transfer of Immovable Property under FEMA

A Master Direction proceeds to compile and consolidate rules, regulations and circulars framed by the Reserve Bank of India pertaining to various foreign exchange issues and transactions. Clause 6, Part II of this Master Direction deals with the acquisition of immovable property by a person resident outside India for carrying on a permitted activity. Here I analyse the impact of this Master Direction on cross-border mergers.

Only a branch or office in India established by a person resident outside India, other than a liaison office, may acquire immovable property in India which is necessary for or incidental to the activity carried on in India by such branch or office. Therefore, this necessarily means that the resultant foreign company has to set up a branch office to administer the assets in India, which means complying with the FEMA Master Direction on Establishment of Branch Office (BO)/ Liaison Office (LO)/ Project Office (PO), or any other place of business in India by foreign entities, issued on January 1, 2016.

Conclusion

One can therefore conclude that theoretically Indian law allows for cross border mergers. However, in practice, one notices that implementation of a cross-border merger with the resultant entity being foreign is fraught with difficulty. This is due to complicated issues that may arise regarding ownership and management of Indian assets by a resultant foreign company. Furthermore, if the resultant entity is foreign, having to set up and run an Indian branch office will only add to transaction costs and may render this type of a merger less attractive. In this regard, India’s foreign exchange laws may have to be updated to reflect the new liberal intention of the government in allowing quick, seamless and easy cross-border mergers and acquisitions involving Indian companies.

- Suprotik Das