South Indian Bank Limited v/s Commissioner Of Income Tax was recently resolved by a Supreme Court of India, double bench comprising of Sanjay Kishan Kaul and Hrishikesh Roy, JJ. on September 9th, 2021 

Whether proportionate disallowance of interest paid by banks is required under Section 14-A of the Income Tax Act for investments made in tax-free bonds/securities that yield tax-free dividend and interest to assessee Banks when assessee had sufficient interest-free own funds that were greater than the investments made?

Was the question asked. And it was held that the proportionate disallowance of interest under Section 14-A of the Income Tax Act for investments made in tax-free bonds/securities that yield tax-free dividend and interest to assessee Banks is not warranted in those situations where the assessee's interest-free own funds available exceeded their investments is not warranted. With this conclusion, the Hon’ble Bench wholeheartedly concur with the learned ITAT's assessment in favour of the assessees.

To get to this conclusion, have a look at section 14-A of the Act, which states:
14-A. Expenditure incurred in relation to income not includible in total income:

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 under Section 147 or pass an order enhancing the assessment or reducing a refund already made or otherwise increasing the liability of the assessee under Section 154, for any assessment year beginning on or before the 1st day of April, 2001.

Section 14-A refers to expenses incurred in connection with income that are not taxable and are not included in total income. As a result, no taxes are imposed on such exempted income. Section 14-A of the Income Tax Act was added to ensure that expenses made in generating tax-exempt income are not permitted as a deduction when determining total income for the assessee.

The disallowance of expenditure incurred by the assessee in connection to income that does not form part of their total income was granted by the above mentioned clause. As a result, if the assessee incurs any expenditure for the purpose of producing tax-free income, such as interest paid on borrowed funds or investment in a business that generates tax-free revenue, the assessee is not eligible to deduct such interest or other expense.

Despite the fact that the clause was retroactive from 1-4-1962, the retroactive effect was neutralised by a proviso later included by the Finance Act of 2002, which took effect on 11-5-2001. It should be emphasised that the current batch of appeals is concerned with Section 14-A disallowances for assessment years beginning in 2001-2002 or for pending assessments.

There could be a separate account maintained by the assessee to calculate and find total expenditure incurred on the earning of tax-free income, but none of the assessee Banks among the appellants maintained separate accounts for the investments made in bonds, securities, and shares wherefrom the tax-free income is earned, so that disallowances could be limited to the actual expenditure incurred by the assessee. As a result, in the lack of separate accounts for investments that yielded tax-free income, the assessing officer disallowed interest attributable to money invested to earn tax-free income proportionately.

As a result of the lack of actual expenditure information for calculating disallowance under Section 14-A, the assessing officer calculated proportionate disallowance by reference to the average cost of deposit for the relevant year, which raises a legal concern. The CIT (A) had agreed with the assessing officer's conclusion.

As a result, ITAT accepted the assessee's argument and determined that, in the lack of clear identification of funds, disallowance under Section 14-A is not justified.

However, the High Court overturned the ITAT judgement by accepting the Revenue's arguments in their appeal, and the assessee Bank is now before Supreme Court to appeal the High Court's decision, which was averse to the assessee. As a result, the question before the Supreme Court is whether Section 14-A allows the Department to disallow expenditures incurred for earning tax-free income in cases where assessees, such as the current appellant, do not keep separate accounts for investments and other expenditures incurred for earning tax-free income.

The Supreme Court has gone over numerous landmark and key judgments decided by the Supreme Court and high courts in this case, and the primary question the court asked the revenue department was concerning the statute that requires assessees to have separate accounts. The learned ASG, however, was unable to provide a suitable response and instead relied on Honda Siel Power Products Ltd. v. CIT, (2012) 12 SCC 762 to argue that the assessee is responsible for completely disclosing all material information.

As can be seen, the bench analysed the cited judgement and concluded that while an assessee has a legal obligation to provide full material disclosures when filing an income tax return, there is no corresponding legal obligation for the assessee to keep separate accounts for different types of funds held by it. The judgement cited by the learned Additional Solicitor General will have no application to support the Revenue's case against the assessee because there is no statutory provision requiring the assessee to keep separate accounts for different types of funds.

As a result, the court concludes that the proportionate disallowance of interest under Section 14-A of the Income Tax Act for investments made in tax-free bonds/securities that yield tax-free dividend and interest to assessee Banks in situations where the assessee's interest-free own funds available exceeded their investments is not warranted. With this decision, the court unquestionably agrees with the learned ITAT's decision in favour of the assessees.

Conclusion
The purpose of Section 14-A of the Act, by not allowing deduction of expenditure made in regard to income that does not form part of total income, is to ensure that the assessee does not gain double advantage," writes Dr. A.K. Sikri, J in Maxopp Investment Ltd. v. CIT. There is no legitimate basis for the benefit of deduction of the expenditure paid in producing such an income once it is not to be included in the total income and is free from tax.

However, in my opinion, the present judgement that I have been dealing with has overridden or silenced the foremost and primary intent of Section 14A of the Act, as one can now plainly mitigate Section 14A liability by not keeping separate accounts of the expenditure incurred, and all they have to show is that interest-free own funds available to the assessee exceeded their investments.

The ruling, in my opinion, should be overturned by the larger bench of this court and reviewed since enabling such a loop in a country like India, which is still developing in many ways, necessitates a tighter and more progressive taxation system. As in this case, institutions and other entities can readily benefit from this ruling by receiving an exemption on expenditures incurred on tax-free income.

The court should develop specific guidelines regarding this clause, as the Hon'ble Bench was already inquisitive about the fact that is the legislation requires the assessor to keep a separate account? And if no such obligations were found, the court, as the court of last resort, should have made it a requirement to manage two separate accounts with respect to Section 14A, and assesses should have been obliged to reveal the account in totality as per the judgement cited by ASG, required to pay the tax they deserve to pay, as in the current scenario, the judgement has opened the loose ends and given a loophole to avoid the liability created by Section 14A.