(2018) 402 ITR 640 (SC)
Heads of income; expenditure relating to exempt income
No. The dominant purpose of holding the shares is irrelevant. Once exempt dividend income is in fact earned, expenditure relatable to it must be disallowed. The disallowance must, however, be computed on a proper basis with recorded satisfaction.
Where shares are acquired to obtain control rather than to earn dividends, does the dominant purpose of the investment take the expenditure outside the disallowance for exempt income?
The appeals covered two situations. In the first, companies had acquired shares in group companies to secure or retain controlling interest, funding the acquisition partly through borrowings, and received dividends which were exempt. In the second, banks and share dealers held shares as stock in trade in the course of their trading business and received dividends incidentally while holding the stock. In both, the Revenue disallowed a portion of the interest and administrative expenditure as relatable to the exempt dividend income, applying the prescribed formula.
The Delhi High Court had accepted a dominant purpose approach in the controlling-interest cases, while the Punjab and Haryana High Court had taken a different view in the stock-in-trade cases. The Supreme Court heard the matters together and resolved the conflict.
For the assessee
Shares were acquired to obtain control, or were held as trading stock with a view to profit on sale. In neither case was the objective to earn dividend, which arose incidentally and without any expenditure being incurred to produce it. The disallowance is directed at expenditure incurred in relation to exempt income, which presupposes that earning the exempt income was the purpose of the outlay.
For the Revenue
The provision is triggered by the earning of exempt income and the incurring of expenditure in relation to it. It contains no exception based on the taxpayer's motive in acquiring the asset. Dividends were in fact received and were exempt, and the funds deployed in the shares carried a cost.
The Court rejected the dominant purpose theory. It held that the provision is engaged where exempt income is earned and expenditure is incurred in relation to it, and that the taxpayer's motive in acquiring the shares is not a criterion the section recognises. Whether shares are held for control or as trading stock, the dividend they yield is exempt, and expenditure attributable to earning it must be disallowed; a contrary reading would introduce an exception the legislature did not provide. In the stock-in-trade cases the Court acknowledged the practical difficulty that the dominant purpose is to trade, but held that the apportionment must still be made in respect of the exempt dividend actually received. At the same time the Court gave full weight to the statutory safeguard: the Assessing Officer must, having regard to the accounts, record objective satisfaction that the taxpayer's own computation of expenditure relatable to exempt income is incorrect, and must do so with reasons, before invoking the prescribed formula. The formula cannot be applied mechanically or as a matter of course, and a disallowance made without that recorded satisfaction is bad.
The disallowance now sits within Section 14 of the IT Act 2025, which absorbs the former standalone provision. Both halves of the ruling continue to matter — the rejection of dominant purpose, which favours the Revenue, and the mandatory recorded satisfaction, which remains the most common ground on which such disallowances are set aside.