(2017) 394 ITR 449 (SC)
Heads of income; expenditure relating to exempt income
The disallowance applies, because the dividend is exempt in the shareholder's hands whatever tax the company has paid. The prescribed method operates prospectively, and before it the Assessing Officer must determine the disallowance on a reasonable basis.
Does the disallowance for expenditure relating to exempt income apply to dividends on which the company has already paid distribution tax, and from when does the prescribed computation method operate?
The assessee received dividend income which was exempt in its hands, the distributing companies having paid dividend distribution tax. It contended that no disallowance of related expenditure should be made because the income had already borne tax at the company level, so it was not truly exempt in an economic sense. A second question concerned the years before the prescribed computation method was notified, and whether that method could be applied to them.
The Bombay High Court decided the principal question against the assessee while holding the prescribed method to be prospective. The matter came before the Supreme Court on appeal.
For the assessee
Dividend distribution tax is a charge on the same income, collected at the company's end for administrative convenience. To disallow expenditure on the footing that the dividend is exempt, when tax has in fact been paid on it, produces double taxation in substance. In any event the prescribed formula cannot be applied to years before it was brought into force.
For the Revenue
The statute exempts the dividend in the shareholder's hands, and the disallowance is triggered by that exemption. The incidence of distribution tax on the company is a separate charge on a different person and does not alter the character of the receipt in the recipient's hands.
The Court held that the disallowance turns on whether the income does not form part of the total income of the assessee, and dividend income falling within the exemption satisfies that test regardless of the distribution tax borne by the company. The charge on the distributing company is a distinct levy on a different taxable person; it does not convert an exempt receipt in the shareholder's hands into a taxable one, and the argument based on economic double taxation could not displace the statutory language. On the second question, the Court confirmed that the prescribed computation method operates prospectively from the date it was brought into force and cannot be applied to earlier years. For those earlier years the Assessing Officer must determine the amount of expenditure relatable to exempt income on a reasonable basis, having regard to the accounts, and must record reasons for rejecting the assessee's own computation before doing so. The Court reiterated that the disallowance cannot exceed what is genuinely relatable to the exempt income.
The disallowance now sits in Section 14 of the IT Act 2025. Note that the dividend regime has since changed fundamentally — dividends are taxable in the shareholder's hands rather than subjected to distribution tax — so the specific controversy is largely spent for current years. The case remains important for older assessments and for its insistence that any disallowance be confined to expenditure genuinely relatable to exempt income, read with Maxopp and South Indian Bank.