REPORTABLE

IN THE SUPREME COURT OF INDIA CIVIL APPELLATE JURISDICTION CIVIL APPEAL NO.4927 of 2010

(Arising out of S.L.P. (C) No. 19422 of 2009)

 C.I.T., Mumbai      … Appellant (s)

Versus   

 M/s. Walfort Share & Stock   Brokers P. Ltd.        …  Respondent(s)

WITH

 CIVIL APPEAL NO.4928  OF 2010 ARISING OUT OF  S.L.P. (C) No.30283 of  2009   CIVIL APPEAL NO.4929 OF 2010 ARISING OUT OF  S.L.P. (C) No.33749 of  2009   CIVIL APPEAL NO.4930 OF 2010 ARISING OUT OF  S.L.P. (C) No.33144 of  2009   CIVIL APPEAL NO.4931 OF 2010 ARISING OUT OF  S.L.P. (C) No.1701 of 2010   CIVIL APPEAL NO.4932 OF 2010 ARISING OUT OF  S.L.P. (C) No.19492 of  2009   CIVIL APPEAL NO.4933 OF 2010 ARISING OUT OF  S.L.P. (C) No.19464 of  2009   CIVIL APPEAL NO.4934 OF 2010 ARISING OUT OF  S.L.P. (C) No.19465 of  2009   CIVIL APPEAL NO.4935 OF 2010 ARISING OUT OF  S.L.P. (C) No.10417 of  2010   CIVIL APPEAL NO.4938 OF 2010 ARISING OUT OF  S.L.P. (C) No.11328 of  2009   CIVIL APPEAL NO.4936 OF 2010 ARISING OUT OF  S.L.P. (C) No.10212 of  2009   CIVIL APPEAL NO.4937 OF 2010 ARISING OUT OF  S.L.P. (C) No.10213 of  2009   CIVIL APPEAL NO.4939 OF 2010 ARISING OUT OF  S.L.P. (C) No.20919 of  2009   CIVIL APPEAL NO.4940 OF 2010 ARISING OUT OF  S.L.P. (C) No.20916 of  2009

 CIVIL APPEAL NO.4941 OF 2010 ARISING OUT OF  S.L.P. (C) No.24051 of  2009   CIVIL APPEAL NO.4942 OF 2010 ARISING OUT OF  S.L.P. (C) No.27741 of  2009   CIVIL APPEAL NO.4943 OF 2010 ARISING OUT OF  S.L.P. (C) No.15866 of  2009   CIVIL APPEAL NO.4944 OF 2010 ARISING OUT OF  S.L.P. (C) No.20282 of  2009   CIVIL APPEAL NO.4945 OF 2010 ARISING OUT OF  S.L.P. (C) No.34131 of  2009   CIVIL APPEAL NO.4954 OF 2010 ARISING OUT OF  S.L.P. (C) No.31781 of  2009   CIVIL APPEAL NO.4946 OF 2010 ARISING OUT OF  S.L.P. (C) No.1122 of 2010   CIVIL APPEAL NO.4947 OF 2010 ARISING OUT OF  S.L.P. (C) No.20853 of  2009   CIVIL APPEAL NO.4948 OF 2010 ARISING OUT OF  S.L.P. (C) No.30857 of  2009   CIVIL APPEAL NO.4949 OF 2010 ARISING OUT OF  S.L.P. (C) No.16501 of  2009   CIVIL APPEAL NO.4951 OF 2010 ARISING OUT OF  S.L.P. (C) No.17757 of  2010  

(CC 5709/2010)   CIVIL APPEAL NO.4950 OF 2010 ARISING OUT OF  S.L.P. (C) No.17756  of  2010   (CC 5726/2010)   CIVIL APPEAL NO.4952 OF 2010 ARISING OUT OF  S.L.P. (C) No.17758 of  2010   (CC 6028/2010)   CIVIL APPEAL NO.4953 OF 2010 ARISING OUT OF  S.L.P. (C) No.17759 of  2010   (CC 6806/2010)

J U D G M E N T

S. H. KAPADIA, CJI.

Delay condoned.

Leave granted.

Whether  the  loss  arising  in  the  course  of

dividend  stripping  transaction  taking  place  prior  to  

1.4.2002 was disallowable on the ground that such loss  

was artificial as the dividend stripping transaction was  

not a business transaction, is the question which arises  

for determination in this batch of Civil Appeals; the  

lead matter of which is C.I.T., Mumbai v. M/s. Walfort  

Share & Stock Brokers Pvt. Ltd.

The facts in the lead matter are as follows:

The assessee is a member of Bombay Stock Exchange  

and  it  earns  income  mainly  from  share  trading  and  

brokerage.    During  the  financial  year  1999-2000,  

relevant  to  the  assessment  year  2000-01,  the  Chola  

Freedom  Technology  Mutual  Fund  came  out  with  an  

advertisement stating that tax free dividend income of  

40% could be earned if investments were made before the  

record date, i.e., 24.3.2000.  The assessee by virtue of  

its  purchase  on  24.3.2000  became  entitled  to  the  

dividend on the units at the rate of Rs. 4/- per unit  

and  earned  a  dividend  of  Rs.  1,82,12,862.80.   As  a  

result  of  the  dividend  payout,  the  NAV  of  the  said

mutual fund which was Rs. 17.23 per unit on 24.3.2000,  

at which rate it was purchased, stood reduced to Rs.  

13.23 per unit on 27.3.2000, which was the succeeding  

working day in the stock exchange.  This fall in the NAV  

was equal to the amount of the dividend payout.  The  

assessee sold all the units on 27.3.2000 at the NAV of  

Rs.  13.23  per  unit  and  collected  an  amount  of  Rs.  

5,90,55,207.75.  The assessee also received an incentive  

of Rs. 23,76,778/- in respect of the said transaction.  

Thus, the assessee thereby received back Rs. 7,96,44,847  

(Rs.  1,82,12,862.80  +  Rs.  5,90,55,207.75  +  Rs.  

23,76,778)  against  the  initial  payout  of  Rs.  

8,00,00,000/-.   For  the  income  tax  purposes,  the  

assessee, in its return, claimed the dividend received  

of Rs. 1,82,12,862.80 as exempt from tax under Section  

10(33) of the Income Tax Act, 1961 (“the Act” for short)  

and also claimed a set-off of Rs. 2,09,44,793 as loss  

incurred on the sale of the units thereby seeking to  

reduce its overall tax liability.

The AO in his assessment order dated 21.3.2003

accepted  that  the  dividend  income  amounting  to  Rs.  

1,82,12,862.80 was exempt under Section 10(33) of the  

Act.   However,  the  AO  disallowed  the  loss  of  Rs.  

2,09,44,793 claimed by the assessee inter alia on the  

ground that a dividend stripping transaction was not a  

business transaction and since such a transaction was  

primarily for the purpose of tax avoidance, the loss so-

called was an artificial loss created by a pre-designed  

set of transaction.  Accordingly, the AO deducted the  

incentive  income  of  Rs.  23,76,778  received  by  the  

assessee  + transaction charges from the loss of Rs.  

2,09,44,793  and  added  back  the  reduced  loss  of  Rs.  

1,82,12,862.80 to the repurchase price/ redemption value  

amounting to Rs. 5,90,55,207.75. (See page 77 of the SLP  

Paper Book)

Being  aggrieved  by  the  disallowance  of  the  

reduced loss of Rs. 1,82,12,862.80, the assessee filed  

an  appeal  before  CIT(A)  who  by  his  order  dated  

12.12.2003 confirmed the order of the AO saying that the  

loss of Rs. 1,82,12,862.80 incurred by the assessee on

the sale of units should be totally ignored and that the  

same should not be allowed to be set-off or carried  

forward.  Thus, the Department disallowed the reduced  

loss of Rs. 1,82,12,862.80 which amount was equal to the  

dividend, on the units declared by the mutual fund, of  

Rs. 1,82,12,862.80.  In other words, by the impugned  

orders passed by the AO, the Department sought to tax  

the dividend income of the assessee during the relevant  

assessment year of Rs. 1,82,12,862.80.   

To complete the chronology of events, it may be  

stated that the assessee moved the tribunal against the  

order dated 12.12.2003.  The disallowance stood deleted  

by the Special Bench of the Tribunal vide its impugned  

order dated 15.7.2005 by holding that the assessee was  

entitled  to  set-off  the  said  loss  from  the  impugned  

transactions against its other income chargeable to tax.  

This view of the tribunal has been affirmed by the High  

Court vide its impugned judgment dated 8.8.2008, hence  

this civil appeal.

According  to  Shri  Parag  P.  Tripathi,  learned

Additional Solicitor General and Shri Preetesh Kapur,  

learned counsel for the Department, the amount received  

by  the  assessee  as  “dividend”,  in  fact  and  in  law,  

constitutes a “return of investment” in the hands of the  

assessee and, therefore, it follows that the said amount  

is required to be adjusted against the cost of purchase  

of the original units and once that is done there is in  

fact  no  loss  suffered  by  the  assessee  on  subsequent  

sale/  redemption.   Alternatively,  if  the  so-called  

“dividend” did not constitute a return of investment,  

then since the price of units necessarily included the  

price of dividend as an identifiable element embedded  

therein to which a definite value could be assigned at  

the time of the purchase, the “dividend” is in effect  

“paid for”.  In such circumstances that part of the  

price of units which clearly represented the cost of the  

dividend,  is  the  expenditure  incurred  for  obtaining  

exempt income and if that is the case then Section 14A  

requires that such expenditure should be netted against  

the  receipt  of  dividend.   Before  us,  it  was  also

submitted  that  in  any  event  “loss”  is  a  commercial  

concept under the Act, if a transaction is such that a  

“tax loss” is created or contrived without suffering any  

corresponding financial / commercial loss inasmuch as  

the money has in fact been recouped in some other form  

(such as dividend), then such a loss needs to be ignored  

for tax purposes, only to the extent that the loss has  

in fact been recouped in another form.  This is because  

such a loss, not being a “commercial loss”, was never  

intended to be allowed under the Act.   As a corollary,  

it  was  submitted  that  introduction  of  Section  94(7)  

prospectively w.e.f. 1.4.2002 does not obliterate the  

aforementioned  last  submission  since  a  prospective  

amendment, by its very definition, did not alter the  

existing  law  in  respect  of  the  past  transactions.  

Moreover, Section 94(7) specifically adopts the above  

principle  of  tax  avoidance  and  modifies  it  for  the  

purpose  of  dealing  with  what  is  called  as  “dividend  

stripping transactions”.

On facts it was submitted that the assessee had

the  option  to  buy  three  different  kinds  of  assets.  

Option was available to the assessee to buy either the  

unit (ex-dividend) or the unit and the dividend (cum-

dividend) or only the dividend.  As far as the first two  

assets, there was no issue.  If an assessee wanted to  

buy a unit after declaration of the dividend, then he  

can buy the ex-dividend unit as soon as possible after  

the  record  date  so  that  he  pays  only  for  the  NAV  

relatable to ex-dividend unit, after declaration of the  

dividend, without being affected by market fluctuations.  

Similarly,  if  an  assessee  wants  to  buy  an  asset  

consisting of the dividend and the unit, he can buy cum-

dividend unit at any point of time after the declaration  

of the dividend but before the record date.  According  

to the Department, the problem arises in cases where an  

assessee is desirous of buying only the dividend.  In  

order to do so, he buys the cum-dividend unit, after  

declaration of dividend but as close as possible to the  

record  date  (so  as  to  isolate  himself  from  market  

fluctuations), whereby he becomes entitled to receive

the dividend payout on the record date and immediately  

after the record date is able to sell the ex-dividend  

unit.  Consequently, by a series of fiscal transactions,  

the assessee ends up buying the dividend.  Therefore, if  

‘x’  is  the  price/  expenditure  associated  with  the  

purchase  of  dividend,  ‘y’  is  the  price/  expenditure  

associated with the unit without dividend then, ‘x’ +  

‘y’ would be the price of cum-dividend unit.  Then price  

may be called ‘z’ in which event, the equation is:

‘x’ + ‘y’ = ‘z’

There is no dispute as to the identity of ‘z’,  

which  is  the  price/  expenditure  for  purchasing  cum-

dividend unit, i.e., Rs. 17.23.  In that event, ‘y’  

would  represent  the  sale  price  of  ex-dividend  unit,  

i.e., Rs. 13.23.  Thus, ‘x’ can be found by the simple  

mathematical formula:

‘x’ = ‘z’ – ‘y’

‘x’ is equal to Rs. 17.23 (‘z’) – Rs. 13.23 (‘y’)  

= Rs. 4

According  to  the  Department,  therefore,  in  the  

present case, Rs. 4 will be expenditure, attributable  

towards  earning  tax  free  dividend  income  which  is  

disallowable under Section 14A of the Act.  That, the  

newspaper advertisements issued by the Mutual Fund in  

the present case as on March 8, March 18 and March 22  

amounted  to  an  offer  by  Mutual  Fund  to  the  target  

buyers, i.e., a buyer who wants to claim losses in the  

trade  of  shares  and  securities  so  as  to  set  it  off  

against his other income.  The effect of the newspaper  

advertisements is to segregate the unit into two assets,  

namely, the asset of the tax free dividend and the ex-

dividend unit which will have an NAV reduced by the  

amount of the dividend payout per unit.  Since there are  

two  assets  which  are  sold  to  the  buyer  of  the  cum-

dividend units, it follows that the difference between  

the purchase and sale price of the unit, is nothing but  

the expenditure incurred for purchasing the asset of tax  

free dividend.  In this connection, reliance is placed  

on the Explanatory Memorandum accompanying the Finance

Bill of 2001 reported in 248 ITR 195 (St.).

In conclusion, it was submitted before us that  

the tax free dividend income was really in essence a  

cost  recovery  mechanism  which  finds  an  independent  

support  in  Accounting  Standard  No.  13,  i.e.,  to  the  

effect that such a return should go to reduce the cost  

of acquisition as such a return is really a return of  

investment and not return on investment.

On  behalf  of  assessee(s),  Shri  S.E.  Dastur,  

learned senior counsel, Shri Ajay Vohra, learned counsel  

and Shri O.S. Bajpai, learned senior counsel, submitted  

that  the  basic  submission  of  the  Department  to  the  

effect  that  the  amount  received  by  the  assessee  as  

“dividend”, in fact and in law, constitutes “return of  

investment” is fallacious for several reasons.  Firstly,  

the  question  whether  an  amount  is  a  “cost  return”  

depends on the terms of the contract.  Secondly, the  

argument  of  the  Department  runs  counter  to  Section  

94(7).  That sub-section clearly accepts that payment by  

way of dividend is a revenue receipt but it is exempt

from  tax  under  Section  10(33).   According  to  the  

assessee, if the argument of the Department is to be  

accepted  that  the  amount  represents  “return  of  

investment” then it would constitute a capital receipt  

and not a revenue receipt.  Thirdly, if the dividend of  

Rs. 4 per unit is treated as “expenditure” covered by  

Section 14A and not as “dividend” as required by Section  

94(7), it would mean that for the assessment years 2000-

01 and 2001-02 the assessee would be in a worse position  

because for the relevant assessment years based on the  

“fiscality principle” the entire loss of Rs. 1,85,68,015  

would  be  disallowed  whereas  for  the  subsequent  years  

after insertion of Section 94(7) w.e.f. 1.4.2002 only  

loss to the extent of the “dividend” amounting to Rs.  

1,82,12,862  would  stand  disallowed  leaving  Rs.  

3,55,153/-  as  loss  allowable.   That  was  never  the  

intention of the Parliament for inserting Section 94(7).  

The said sub-section was not intended to be beneficial.  

Fourthly, the fact that Section 94(7) allows loss in  

excess  of  dividend  means  that  it  accepts  that  the

transaction is genuine and in course of business.  If  

the transaction was a nullity, the entire loss would  

have been disallowed and not only to the extent of the  

dividend.  Moreover, if losses could be disallowed on  

fiscality/  first  principles  then  Section  94(7)  is  

redundant.  Fifthly, Section 14A is enacted for non-

deduction  of  expenditure  whereas  Section  94(7)  is  

enacted to curb creation of short-term losses. Lastly,  

there is nothing to show that the NAV fell on the next  

trading date after the record date on account of the  

dividend payout.  In this connection, it was submitted  

that fall or increase in NAV depended upon the value of  

the  underlying  assets  and  not  on  the  basis  of  the  

dividend payout.  On interpretation of Sections 14A and  

94(7)  it  was  submitted  that  Section  14A  deals  with  

expenditure in relation to income whereas Section 94(7)  

deals with acquisition and sale of securities or units  

and provides for a consequence where the purchase and  

sale take place within a specified time period.  Each  

provision operates in its own field.  When Section 14A

refers  to  disallowance  of  expenditure  in  relation  to  

non-taxable income for computing the total income, what  

is meant is that such expenditure should be taken into  

account only for determining the quantum of the non-

taxable  income.   This  would  result  in  the  exempt  

dividend being reduced by the alleged expenditure.  The  

only impact on the exempting provision of Section 10(33)  

for  unit  income  is  by  Section  94(7)  and  one  cannot  

interpret Section 14A as leading to the same conclusion  

as then Section 94(7) will be rendered nugatory.  In  

other  words,  the  two  provisions  operate  in  different  

time  and  space  zones.   In  support  of  the  above  

contention,  the  assessee  (s)  has  relied  on  the  

Memorandum  as  well  as  Circular  No.  14  which  clearly  

states  that  losses  referred  to  in  Section  94(7)  are  

allowable from the assessment year 2002-03 subject to  

reduction of the actual computed loss to the extent of  

the  dividend.   If  Section  14A  is  also  to  apply  

simultaneously then Section 94(7) will become nugatory.  

Whereas Section 14A applies to expenditure incurred to

earn tax free income from the inception of the Act,  

Section 94(7) seeks to reduce the quantum of the loss  

with  reference  to  the  dividend  earned  from  the  

assessment year 2002-03.  The two terms “expenditure”  

and “loss” are conceptually different.  Section 94(7) is  

a provision to set at naught “avoidance of tax”.  If  

Sections  14A  and  94(7)  are  applied  to  the  same  

transaction, it will result in Section 94(7) being a  

“tax levying provision” and not an “avoidance of tax  

provision”.  The effect of accepting the submission of  

the Department is that in the present case the sum of  

Rs. 1,82,12,862 would have to be considered twice, once,  

by way of expenditure to earn the dividend income and  

the  second  time  by  way  of  ignoring  the  loss  to  the  

extent it does not exceed the dividend income of Rs.  

1,82,12,862.  According to the assessee (s), the embargo  

in  Section  14A  on  the  deductibility  of  expenditure  

applies  where  admittedly  an  expenditure  has  been  

incurred  and  a  deduction  is  claimed  specifically  in  

respect  thereof.   In  this  connection,  reliance  was

placed on the word “allowed” in the said Section.  In  

the present case, the assessee (s) has not made any  

claim for deduction of Rs. 1,82,12,862 and, therefore,  

the question of the said sum being disallowed did not  

arise.  On the other hand, Section 94(7) proceeds on the  

footing  that  the  entire  dividend  income  falls  within  

Section 10(33) and the only adjustment is that the loss  

which has arisen and would otherwise be allowable shall  

be ignored to the extent it does not exceed the Section  

10(33)  income.   Therefore,  according  to  the  assessee  

(s), in applying Section 94(7) there is no question of  

making  a  deduction  at  the  stage  of  Section  14A  as  

suggested by the learned Solicitor General Shri Gopal  

Subramanium.   According  to  the  assessee  (s),  under  

Section 94(7) the dividend should go to reduce the loss  

already worked out which implies that the loss is more  

than the dividend income because it is only then that  

the question of reducing the loss to some extent would  

arise.  In this connection, the assessee(s) submitted  

that for the assessment year 2002-03 the loss was Rs.

1,85,68,015  which  exceeded  the  dividend  of  Rs.  

1,82,12,862 and, therefore, the loss allowable applying  

Section  94(7)  stood  at  Rs.  3,55,153.   Therefore,  in  

order to reconcile Section 14A with Section 94(7) it was  

suggested on behalf of the assessee(s) that Section 14A  

should be confined to a case where there is expenditure  

on  earning  tax  free  income  but  where  there  is  no  

acquisition  of  an  asset  and  Section  94(7)  should  be  

confined to a case where there is acquisition of an  

asset thereby indicating a distinction between a claim  

for  deduction  of  an  expenditure  and  a  claim  for  

allowance of a business loss.  Section 14A deals with  

disallowance  of  expenditure  per  se  and  not  with  a  

disallowance of a loss which arises at a point of time  

subsequent to the purchase of units and the receipt of  

exempt income and occurring only when there is a sale of  

the purchased units.  Section 14A is not concerned with  

a purchase and subsequent sale of an asset which is  

dealt with in Section 94(7) alone.  In other words,  

Section 14A does not apply to the case of a claim for

set off of a loss which is dealt with only in Section  

94(7)  and  that  too  from  assessment  year  2002-03.  

Section 14A was inserted to meet cases where deductions  

have been claimed in respect of expenditure for earning  

exempt income like dividend income and the said Section  

was never intended and does not apply to the case of a  

claim for set off of a loss which as stated above is  

dealt with in Section 94(7) alone and that too with  

effect from the assessment year 2002-03.  Thus, whereas  

Section 14A was designed to overcome the problem created  

by certain decisions of this Court in Rajasthan State  

Warehousing Corporation v.  Commissioner of Income-

Tax [242 ITR 450] and in the case of Commissioner of  

Income-Tax, Madras  v.  Indian Bank Limited  [56 ITR  

77],  Section  94(7)  had  no  such  object.   The  two,  

therefore,  operate  in  different  fields  and  they  have  

different  objects  and  because  the  two  provisions  

operated in two different fact situations Section 14A  

was made effective from assessment year 1962-63 whereas  

Section 94(7) is made effective from the assessment year

2002-03.   Thus,  the  Parliament  has  treated  both  the  

sections  as  dealing  with  separate  circumstances  and,  

therefore, one must confine Section 14A to expenditure  

of the type referred to in Sections 30 to 43B of the Act  

which relates to expenditure which does not result in  

acquisition of an asset.  It is clear that where the  

asset so acquired is sold and results in a loss Section  

94(7) steps in.

According  to  the  learned  Solicitor  General  of  

India, Section 14A was inserted by Finance Act 2001 with  

effect from 1.4.1962.  According to him, the fundamental  

principle underlying Section 14A is that income which is  

not  taxable  or  exempt  falls  in  a  separate  stream  

distinct  from  income  taxable  under  the  Act.   That,  

expenditure  which  is  incurred  in  relation  to  income  

subject to tax would be admissible under Sections 30 to  

43B whereas expenditure incurred to earn exempt income  

would be extraneous in the computation of taxable income  

under  the  Act.   Thus,  only  that  expenditure  is  

deductible which is incurred in relation to business or

profession.   Expenditure  producing  non-taxable  income  

would  not  be  permitted  to  be  claimed  as  admissible  

expenditure.  Thus, in all cases where the assessee has  

some exempt income, his total expenditure has got to be  

apportioned between taxable income and exempt income and  

the latter would have to be disallowed.  The only event  

that triggers Section 14A is that the assessee has both  

taxable and exempt income and, therefore, one need not  

go by the “two asset” theory.  According to the learned  

SGI,  Section  14A  is  not  concerned  with  whether  the  

assessee makes a profit or a loss.  According to the  

learned SGI, application of Section 94(7) will not rule  

out  Section  14A.   It  was  submitted  that  both  the  

provisions  can  apply  simultaneously.   In  this  

connection, it was urged that in the first stage Section  

14A can be applied to determine the expenditure to be  

excluded.   After  excluding  such  expenditure  from  the  

cost of purchase, what remains may be called as adjusted  

purchase cost.  If units are bought and sold within 3/9  

months period, then, the adjusted purchase cost must be

deducted from the sale.  If this leads to a profit then  

Section 94(7) will not apply.  However, if there is a  

loss, such loss will have to be ignored to the extent of  

the dividend received.  This was the suggested mode for  

reconciling  Section  14A  with  Section  94(7)  by  the  

learned SGI, which according to the assessee(s) would  

result in double counting of the dividend amount of Rs.  

1,82,12,862, one as dividend and the other as a loss.

In this batch of cases, we are required to decide  

three distinct points which are as follows:

(i) Whether “return of investment” or “cost recovery”  

would  fall  within  the  expression  “expenditure  

incurred” in Section 14A?

(ii)Impact of Section 94(7) w.e.f. 1.4.2002 on the  

impugned transactions.

(iii)Reconciliation of Section 14A with Section 94(7)  

of the Act.

To  answer  the  above,  we  need  to  reproduce  

hereinbelow Sections 10(33), 14A, 94(7) and the relevant

paras of Circular No. 14 of 2001 issued by the CBDT:

Section 10 - Incomes not included in total income  

In computing the total income of a previous year of any  person, any income falling within any of the following  clauses shall not be included-

(33) any income by way of -  

(i) dividends referred to in section 115-O; or

(ii) income received in respect of units from  the Unit Trust of India established under the Unit Trust  of India Act, 1963 (52 of 1963); or

(iii) income  received  in  respect  of  the  units  of  a  mutual fund specified under clause (23D):

Provided that this clause shall not apply to any  income arising from transfer of units of the Unit Trust  of India or of a mutual fund, as the case may be.

Section 14A - Expenditure incurred in relation to income  not includible in total income    

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.

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.

between  the  purchase  and  sale  price  of  the  units  

constituted “expenditure incurred” by the assessee for  

earning tax-free income, hence, liable to be disallowed  

under Section 14A.  As a result of the dividend pay-out,  

according to the Department, the NAV of the mutual fund,  

which was Rs. 17.23 per unit on the record date, fell to  

Rs.  13.23  on  27.3.2000  (the  next  trading  date)  and,  

thus, Rs. 4/- per unit, according to the Department,  

constituted “expenditure incurred” in terms of Section  

14A of the Act.  In its return, the assessee, thus,  

claimed the dividend received as exempt under Section  

10(33) and also claimed set-off for the loss against its  

taxable  income,  thereby  seeking  to  reduce  its  tax  

liability and gain tax advantage.

The insertion of Section 14A with retrospective  

effect  is  the  serious  attempt  on  the  part  of  the  

Parliament  not  to  allow  deduction  in  respect  of  any  

expenditure  incurred  by  the  assessee  in  relation  to  

income, which does not form part of the total income  

under the Act against the taxable income (see Circular

No.  14  of  2001  dated  22.11.2001).   In  other  words,  

Section  14A  clarifies  that  expenses  incurred  can  be  

allowed only to the extent they are relatable to the  

earning of taxable income.  In many cases the nature of  

expenses  incurred  by  the  assessee  may  be  relatable  

partly to the exempt income and partly to the taxable  

income.  In the absence of Section 14A, the expenditure  

incurred in respect of exempt income was being claimed  

against taxable income.  The mandate of Section 14A is  

clear.   It  desires  to  curb  the  practice  to  claim  

deduction  of  expenses  incurred  in  relation  to  exempt  

income against taxable income and at the same time avail  

the tax incentive by way of exemption of exempt income  

without making any apportionment of expenses incurred in  

relation  to  exempt  income.   The  basic  reason  for  

insertion of Section 14A is that certain incomes are not  

includible  while  computing  total  income  as  these  are  

exempt under certain provisions of the Act.  In the  

past, there have been cases in which deduction has been  

sought in respect of such incomes which in effect would

mean that tax incentives to certain incomes was being  

used to reduce the tax payable on the non-exempt income  

by debiting the expenses, incurred to earn the exempt  

income, against taxable income.  The basic principle of  

taxation is to tax the net income, i.e., gross income  

minus  the  expenditure.   On  the  same  analogy  the  

exemption is also in respect of net income.  Expenses  

allowed can only be in respect of earning of taxable  

income.  This is the purport of Section 14A.  In Section  

14A, the first phrase is “for the purposes of computing  

the  total  income  under  this  Chapter”  which  makes  it  

clear that various heads of income as prescribed under  

Chapter IV would fall within Section 14A.  The next  

phrase is, “in relation to income which does not form  

part of total income under the Act”.  It means that if  

an income does not form part of total income, then the  

related  expenditure  is  outside  the  ambit  of  the  

applicability  of  Section  14A.   Further,  Section  14  

specifies five heads of income which are chargeable to  

tax.  In order to be chargeable, an income has to be

brought under one of the five heads.  Sections 15 to 59  

lay down the rules for computing income for the purpose  

of chargeability to tax under those heads.  Sections 15  

to 59 quantify the total income chargeable to tax.  The  

permissible deductions enumerated in Sections 15 to 59  

are now to be allowed only with reference to income  

which is brought under one of the above heads and is  

chargeable to tax.  If an income like dividend income is  

not  a  part  of  the  total  income,  the  expenditure/  

deduction though of the nature specified in Sections 15  

to 59 but related to the income not forming part of  

total income could not be allowed against other income  

includible  in  the  total  income  for  the  purpose  of  

chargeability to tax.  The theory of apportionment of  

expenditures  between  taxable  and  non-taxable  has,  in  

principle, been now widened under Section 14A.  Reading  

Section 14 in juxtaposition with Sections 15 to 59, it  

is  clear  that  the  words  “expenditure  incurred”  in  

Section  14A  refers  to  expenditure  on  rent,  taxes,  

salaries, interest, etc. in respect of which allowances

are provided for (see Sections 30 to 37).  Every pay-out  

is  not  entitled  to  allowances  for  deduction.   These  

allowances  are  admissible  to  qualified  deductions.  

These deductions are for debits in the real sense.  A  

pay-back does not constitute an “expenditure incurred”  

in terms of Section 14A.  Even applying the principles  

of accountancy, a pay-back in the strict sense does not  

constitute an “expenditure” as it does not impact the  

Profit & Loss Account.  Pay-back or return of investment  

will  impact  the  balance-sheet  whereas  return  on  

investment will impact the Profit & Loss Account.  Cost  

of acquisition of an asset impacts the balance sheet.  

Return of investment brings down the cost.  It will not  

increase the expenditure.  Hence, expenditure, return on  

investment, return of investment and cost of acquisition  

are distinct concepts.  Therefore, one needs to read the  

words  “expenditure  incurred”  in  Section  14A  in  the  

context of the scheme of the Act and, if so read, it is  

clear that it disallows certain expenditures incurred to  

earn exempt income from being deducted from other income

which  is  includible  in  the  “total  income”  for  the  

purpose of chargeability to tax.  As stated above, the  

scheme of Sections 30 to 37 is that profits and gains  

must  be  computed  subject  to  certain  allowances  for  

deductions/ expenditure.  The charge is not on gross  

receipts, it is on profits and gains.  Profits have to  

be computed after deducting losses and expenses incurred  

for business.  A deduction for expenditure or loss which  

is not within the prohibition must be allowed if it is  

on the facts of the case a proper Debit Item to be  

charged  against  the  Incomings  of  the  business  in  

ascertaining the true profits.  A return of investment  

or a pay-back is not such a Debit Item as explained  

above, hence, it is not “expenditure incurred” in terms  

of Section 14A.  Expenditure is a pay-out.  It relates  

to disbursement.  A pay-back is not an expenditure in  

the scheme of Section 14A.  For attracting Section 14A,  

there  has  to  be  a  proximate  cause  for  disallowance,  

which is its relationship with the tax exempt income.  

Pay-back or return of investment is not such proximate

cause,  hence,  Section  14A  is  not  applicable  in  the  

present case.  Thus, in the absence of such proximate  

cause for disallowance, Section 14A cannot be invoked.  

In our view, return of investment cannot be construed to  

mean  “expenditure”  and  if  it  is  construed  to  mean  

“expenditure” in the sense of physical spending still  

the expenditure was not such as could be claimed as an  

“allowance”  against  the  profits  of  the  relevant  

accounting year under Sections 30 to 37 of the Act and,  

therefore, Section 14A cannot be invoked.  Hence, the  

two asset theory is not applicable in this case as there  

is no expenditure incurred in terms of Section 14A.

The next point which arises for determination is  

whether  the  “loss”  pertaining  to  exempted  income  was  

deductible  against  the  chargeable  income.   In  other  

words, whether the loss in the sale of units could be  

disallowed on the ground that the impugned transaction  

was a transaction of dividend stripping.  The AO in the  

present case has disallowed the loss of Rs. 1,82,12,862  

on the sale of 40% tax-free units of the mutual fund.

The AO held that the assessee had purposely and in a  

planned manner entered into a pre-meditated transaction  

of  buying  and  selling  units  yielding  exempted  income  

with the full knowledge about the guaranteed fall in the  

market value of the units and the payment of tax-free  

dividend, hence, disallowance of the loss.

In  the  lead  case,  we  are  concerned  with  the  

assessment  years  prior  to  insertion  of  Section  94(7)  

vide Finance Act, 2001 w.e.f. 1.4.2002.  We are of the  

view that the AO had erred in disallowing the loss.  In  

the case of  Vijaya Bank  v.  Additional Commissioner of  

Income Tax [1991] 187 ITR 541, it was held by this Court  

that  where  the  assessee  buys  securities  at  a  price  

determined with reference to their actual value as well  

as interest accrued thereon till the date of purchase  

the entire price paid would be in the nature of capital  

outlay and no part of it can be set off as expenditure  

against income accruing on those securities.   

The real objection of the Department appears to  

be that the assessee is getting tax-free dividend; that

at the same time it is claiming loss on the sale of the  

units; that the assessee had purposely and in a planned  

manner  entered  into  a  pre-meditated  transaction  of  

buying  and  selling  units  yielding  exempted  dividends  

with full knowledge about the fall in the NAV after the  

record date and the payment of tax-free dividend and,  

therefore, loss on sale was not genuine.  We find no  

merit in the above argument of the Department.  At the  

outset, we may state that we have two sets of cases  

before  us.   The  lead  matter  covers  assessment  years  

before insertion of Section 94(7) vide Finance Act, 2001  

w.e.f. 1.4.2002.  With regard to such cases we may state  

that on facts it is established that there was a “sale”.  

The sale-price was received by the assessee.  That, the  

assessee  did  receive  dividend.   The  fact  that  the  

dividend  received  was  tax-free  is  the  position  

recognized  under  Section  10(33)  of  the  Act.   The  

assessee had made use of the said provision of the Act.  

That such use cannot be called “abuse of law”.  Even  

assuming that the transaction was pre-planned there is

nothing to impeach the genuineness of the transaction.  

With regard to the ruling in  McDowell & Co. Ltd.  v.  

Commercial  Tax  Officer [154  ITR  148(SC)],  it  may  be  

stated that in the later decision of this Court in Union  

of India v.  Azadi Bachao Andolan [263 ITR 706(SC)] it  

has been held that a citizen is free to carry on its  

business within the four corners of the law.  That, mere  

tax planning, without any motive to evade taxes through  

colourable  devices  is  not  frowned  upon  even  by  the  

judgment of this Court in  McDowell & Co. Ltd.’s case  

(supra).  Hence, in the cases arising before 1.4.2002,  

losses  pertaining  to  exempted  income  cannot  be  

disallowed.  However, after 1.4.2002, such losses to the  

extent of dividend received by the assessee could be  

ignored by the AO in view of Section 94(7).  The object  

of  Section  94(7)  is  to  curb  the  short  term  losses.  

Applying  Section  94(7)  in  a  case  for  the  assessment  

year(s) falling after 1.4.2002, the loss to be ignored  

would be only to the extent of the dividend received and  

not the entire loss.  In other words, losses over and

above the amount of the dividend received would still be  

allowed from which it follows that the Parliament has  

not treated the dividend stripping transaction as sham  

or  bogus.   It  has  not  treated  the  entire  loss  as  

fictitious  or  only  a  fiscal  loss.   After  1.4.2002,  

losses over and above the dividend received will not be  

ignored under Section 94(7).  If the argument of the  

Department is to be accepted, it would mean that before  

1.4.2002  the  entire  loss  would  be  disallowed  as  not  

genuine  but,  after  1.4.2002,  a  part  of  it  would  be  

allowable under Section 94(7) which cannot be the object  

of Section 94(7) which is inserted to curb tax avoidance  

by certain types of transactions in securities.  There  

is one more way of answering this point.  Sections 14A  

and  94(7)  were  simultaneously  inserted  by  the  same  

Finance  Act,  2001.  As  stated  above,  Section  14A  was  

inserted  w.e.f.  1.4.1962  whereas  Section  94(7)  was  

inserted  w.e.f.  1.4.2002.  The  reason  is  obvious.  

Parliament  realized  that  several  public  sector  

undertakings and public sector enterprises had invested

huge amounts over last couple of years in the impugned  

dividend stripping transactions so also declaration of  

dividends by mutual fund are being vetted and regulated  

by SEBI for last couple of years. If Section 94(7) would  

have been brought into effect from 1.4.1962, as in the  

case of Section 14A, it would have resulted in reversal  

of  large  number  of  transactions.  This  could  be  one  

reason why the Parliament intended to give effect to  

Section 94(7) only w.e.f. 1.4.2002. It is important to  

clarify that this last reasoning has nothing to do with  

the  interpretations  given  by  us  to  Sections  14A  and  

94(7). However, it is the duty of the court to examine  

the circumstances and reasons why Section 14A inserted  

by Finance Act 2001 stood inserted w.e.f. 1.4.1962 while  

Section  94(7)  inserted  by  the  same  Finance  Act  as  

brought into force w.e.f. 1.4.2002.

The  next  question  which  we  need  to  decide  is  

about reconciliation of Sections 14A and 94(7).  In our  

view, the two operate in different fields.  As stated  

above,  Section  14A  deals  with  disallowance  of

expenditure incurred in earning tax-free income against  

the profits of the accounting year under Sections 30 to  

37 of the Act.  On the other hand, Section 94(7) refers  

to disallowance of the loss on the acquisition of an  

asset  which  situation  is  not  there  in  cases  falling  

under Section 14A.  Under Section 94(7) the dividend  

goes to reduce the loss.  It applies to cases where the  

loss is more than the dividend.  Section 14A applies to  

cases where the assessee incurs expenditure to earn tax  

free income but where there is no acquisition of an  

asset.  In cases falling under Section 94(7), there is  

acquisition of an asset and existence of the loss which  

arises at a point of time subsequent to the purchase of  

units and receipt of exempt income.  It occurs only when  

the sale takes place.  Section 14A comes in when there  

is claim for deduction of an expenditure whereas Section  

94(7) comes in when there is claim for allowance for the  

business loss.  We may reiterate that one must keep in  

mind  the  conceptual  difference  between  loss,  

expenditure,  cost  of  acquisition,  etc.  while

interpreting the scheme of the Act.

Before concluding, one aspect concerning Para 12  

of Accounting Standard AS-13 relied upon by the Revenue  

needs  to  be  highlighted.   Para  12  indicates  that  

interest/  dividends  received  on  investments  are  

generally  regarded  as  return  on  investment  and  not  

return  of  investment.   It  is  only  in  certain  

circumstances  where  the  purchase  price  includes  the  

right  to  receive  crystallized  and  accrued  dividends/  

interest, that have already accrued and become due for  

payment before the date of purchase of the units, that  

the same has got to be reduced from the purchase cost of  

the investment.  A mere receipt of dividend subsequent  

to purchase of units, on the basis of a person holding  

units at the time of declaration of dividend on the  

record date, cannot go to offset the cost of acquisition  

of the units.  Therefore, AS-13 has no application to  

the facts of the present cases where units are bought at  

the ruling NAV with a right to receive dividend as and  

when declared in future and did not carry any vested

right to claim dividends which had already accrued prior  

to the purchase.

For the above reasons, we find no infirmity in  

the  impugned  judgment  of  the  High  Court  and,  

accordingly, these Civil Appeals filed by the Department  

are dismissed with no order as to costs.  

........…………………….CJI      (S. H. Kapadia)

.......………………………..J.     (Swatanter Kumar)

New Delhi;  July 06, 2010