IN THE HIGH COURT OF JUDICATURE AT BOMBAY IN THE HIGH COURT OF JUDICATURE AT BOMBAY IN THE HIGH COURT OF JUDICATURE AT BOMBAY ORDINARY ORDINARY ORDINARY ORIGINAL CIVIL JURISDICTION ORIGINAL CIVIL JURISDICTION ORIGINAL CIVIL JURISDICTION INCOME TAX APPEAL NO.18 OF 2006 INCOME TAX APPEAL NO.18 OF 2006 INCOME TAX APPEAL NO.18 OF 2006 The Commissioner of Income Tax, ) City 4, 6th Floor, Aayakar ) Bhavan, Maharshi Karve Road, ) Mumbai - 400 020) )..Appellant. V/s. M/s.Walfort Share & Stock ) Brokers Pvt. Ltd., 205, ) Gundecha Chambers, Nagindas ) Master Road, Mumbai - 400 001. )..Respondent. Mr.G.C.Srivastav with Mr.Beni Chatterjee, Advocates for the appellant. Mr.S.E.Dastur, Senior Advocate with Mr.R.Murlidhar and P.C.Tripathi and A.K.Jasani for the respondent. CORAM : DR.S.RADHAKRISHNAN & CORAM : DR.S.RADHAKRISHNAN & CORAM : DR.S.RADHAKRISHNAN & J.P.DEVADHAR, JJ. J.P.DEVADHAR, JJ. J.P.DEVADHAR, JJ. DATED : 8TH AUGUST, 2008 DATED : 8TH AUGUST, 2008 DATED : 8TH AUGUST, 2008 JUDGMENT (PER J.P.DEVADHAR, J.) JUDGMENT (PER J.P.DEVADHAR, J.) JUDGMENT (PER J.P.DEVADHAR, J.) 1. This appeal is filed by the Commissioner of Income Tax (‘revenue’ for short) under section 260A of the Income Tax Act, 1961 against the respondent (‘assessee’ for short). The appeal is filed to challenge the decision of the I.T.A.T., Special Bench, Mumbai dated 15-7-2005 in I.T. Appeal No.2307/Mum/04. Basically, two questions of law are raised by the revenue in this appeal, namely :- -= : 2 : =- i) Whether on the facts and in the circumstances of the case, the I.T.A.T. was justified in holding that the transaction of purchase and sale of the units of Chola Freedom Technology Fund was a bonafide commercial transaction and not a colourable device adopted with a view to avoid the tax liability and, therefore, the loss arising from the transaction was liable to be set off against the taxable income of the assessee ? ii) Whether on the facts and in the circumstances of the case, the Tribunal was justified in holding that the artificial loss arising from the above transaction could not be considered as an expenditure incurred for earning tax free dividend, so as to make disallowance under section 14A of the Income Tax Act, 1961 ? 2. The appeal is admitted on the aforesaid questions and, taken up for final hearing by consent of both the parties. 3. The assessment year involved herein is A.Y. 2000-01. 4. The assessee is a member of the Bombay Stock Exchange and earns income from brokerage and also from trading in shares of various companies on its own account or on behalf of its clients. 5. In the assessment year in question, apart from the normal business of trading in shares, the assessee had also entered into a transaction of purchasing dividend bearing units of Chola Freedom -= : 3 : =- Technology Fund (‘Mutual Fund’ for short) and redeeming the same at a loss immediately after receiving the dividend income (‘transaction in question’ for short). 6. Chola Mutual Fund had published an advertisement in the newspapers sometime in March, 2000, inviting the general public to invest in their units before 24th March, 2000 and get double advantage, namely, 100% investment in high growth Technology stocks and 40% Tax Free dividend on the said units subject to 2% entry load and 2% charge on exit if the unit purchaser seeks redemption of the units within 3 months of purchase. The assessee purchased 45,53,215,709 units from Chola Mutual Fund on 24/3/2000 at the rate of Rs.17.57 per unit totally amounting to Rs.8,00,00,000/-. On the same day, that is on 24/3/2000 itself, Chola Mutual Fund distributed dividend amount of Rs.1,82,12,862/- to the assessee at the rate of 40% per unit. On the next working day i.e. on 27/3/2000 (25/4/2000 and 26/4/2000 being Saturday and Sunday, the capital markets were closed), the assessee sold the said units by way of redemption and the Chola Mutual Fund repurchased the said units at the rate of Rs.12.97 per unit and paid to the assessee Rs.5,90,55,207/- as repurchase price of the said units. It may be noted that the assessee had also received Rs.23,76,778/- as an incentive for purchase and sale of units of Chola Mutual Fund. Thus, in the above -= : 4 : =- transaction as against the investment of Rs.8,00,00,000/- the assessee received back Rs.7,96,44,847/- (dividend income of Rs,1,82,12,862/- + incentive income of Rs.23,76,778/- + sale consideration of Rs.5,90,55,207/-) and at the same time on sale of units there was loss of Rs.2,09,44,793/- (Rs.8,00,00,000 purchase price - Rs.5,90,55,207/- sale price). 7. In the return of income, the assessee claimed that the dividend income of Rs.1,82,12,862/- received from Chola Mutual Fund was exempt under Section 10(33) (as it then stood) of the Income Tax Act, 1961 (‘Act’ for short). The assessee claimed that the loss of Rs.2,09,44,793/- was a business loss liable to be set off against other income of the assessee. 8. The Assessing Officer in his assessment order dated 21-3-2003 accepted that the dividend income was exempt under Section 10(33) of the Act. However, the assessing officer disallowed the loss claimed by the assessee inter alia on the ground that there was no commercial purpose involved in the transaction. The assessing officer held that, the transaction being primarily for the purpose of tax avoidance, the artificial loss created by pre-designed, pre-ordained set of transactions cannot be taken cognizance of. Accordingly, the assessing officer deducted the -= : 5 : =- incentive income of Rs.23,76,778/- received by the assessee from the loss of Rs.2,09,44,793/- and added back the balance amount of Rs.1,85,68,015/- to the trading income of the assessee. 9. Challenging the disallowance of the loss of Rs.1,85,68,015/- the assessee filed an appeal before C.I.T.(A), who by his order dated 12-12-2003 dismissed the appeal by following his decision in the case of the assessee for A.Y. 2001-02. The C.I.T.(A) held that the loss of Rs.1,85,68,015/- incurred on sale of units should be ignored totally and the same should not be allowed to be set off or carried forward. 10. On further appeal filed by the assessee, the matter was referred to a Special Bench and the Special Bench of I.T.A.T. by the impugned judgment and order dated 15/7/2005 deleted the disallowance by holding that the loss claimed by the assessee was liable to be set off against the income from any other transaction or source. Challenging the aforesaid decision, the present appeal is filed by the revenue. 11. Mr.G.C.Srivastav, learned counsel appearing on behalf of the revenue submitted that the entire transaction of purchase and sale of the units of Chola Mutual Fund was one composite transaction executed for the sole purpose of creating artificial loss with a -= : 6 : =- view to avoid payment of tax and there was no element of trade involved in it. He submitted that a transaction may be legal, but, if it is executed with an intention to avoid payment of tax due to the revenue, then such a transaction would constitute a colourable device and the loss arising from such transaction would not be allowable. 12. Elaborating his arguments, Mr.Srivastav submitted that the preordained purpose of the transaction of purchasing the units of Chola Mutual Fund and selling the said units virtually on the next day after receiving dividend was solely with a view to create artificial loss, so as to seek set off of the said artificial loss against other taxable income of the assessee and thereby avoid payment of tax payable on the chargeable income. In the assessment year in question, the profit of the assessee as per the Profit and Loss Account was Rs.9,70,52,757/-. By reducing the artificial loss of Rs.2,09,44,793/- and other allowable claims from the said profit, the assessee had offered to tax the total income of Rs.6,69,72,260/-. Thus, on account of the set off of the above artificial loss, the assessee paid tax on Rs.6,69,72,260/- instead of paying tax on Rs.9,70,52,757/-. He submitted that where the transaction of purchase and sale of units is a mere pretence to produce artificial loss without actually acquiring or disposing of the units then such -= : 7 : =- a transaction cannot be considered as a business or trade transaction and consequently the artificial loss incurred in such a transaction cannot be allowed as business expenditure. In this connection, he relied upon the principles laid down by the Madras High Court in the case of Velliappan (M.V.) V/s. I.T.O. Velliappan (M.V.) V/s. I.T.O. Velliappan (M.V.) V/s. I.T.O. reported in 170 I.T.R.238 (Mad) 170 I.T.R.238 (Mad) 170 I.T.R.238 (Mad). 13. Mr.Srivastav further submitted that the concept of business or trade necessarily connotes an activity for earning profit though in the process it may incur loss as well. But where the motive is not to earn profit but only to earn loss, the transaction cannot be termed as business transaction or adventure in the nature of trade. He submitted that the price of the cum dividend units invariably fall after the dividend is distributed. Therefore, where the cum dividend units are purchased and sold immediately after the dividend is distributed, it would be crystal clear that such a transaction is entered into only for creating artificial loss. Where, substance of the transaction is to create artificial loss and by setting off the said loss avoid payment of tax, then, such a transaction cannot be said to be a business transaction. In this connection he relied upon a decision of the Gujarat High Court in the case of Commissioner of Income Tax V/s. Smt. Minal Commissioner of Income Tax V/s. Smt. Minal Commissioner of Income Tax V/s. Smt. Minal Rameshchandra Rameshchandra Rameshchandra reported in 167 I.T.R. 507 (Guj.) 167 I.T.R. 507 (Guj.) 167 I.T.R. 507 (Guj.) and -= : 8 : =- two decisions of the Apex Court in the case of Senairam Senairam Senairam Doongarmall V/s. Commissioner of Income Tax, Assam Doongarmall V/s. Commissioner of Income Tax, Assam Doongarmall V/s. Commissioner of Income Tax, Assam reported in 42 I.T.R. 42 I.T.R. 42 I.T.R. and 392 (S.C.) Sole Trustee, 392 (S.C.) Sole Trustee, 392 (S.C.) Sole Trustee, Loka Shikshana Trust V/s. Commissioner of Income-Tax, Loka Shikshana Trust V/s. Commissioner of Income-Tax, Loka Shikshana Trust V/s. Commissioner of Income-Tax, Mysore Mysore Mysore reported in 101 I.T.R. 234 (S.C.) 101 I.T.R. 234 (S.C.) 101 I.T.R. 234 (S.C.). 14. Mr.Srivastav further submitted that the transaction in question is a colourable device designed to create artificial loss and thereby evade payment of tax due to the revenue is apparent from the facts on record. Once the transaction is found to be a colourable device entered with the sole objective of the tax avoidance, it would be open to the tax authorities and the Courts not to give effect to such transaction, though it may all be legal. The fact that there is no specific provision directed against specific scheme of tax avoidance, it does not mean that such tax avoidance scheme has the sanction of law. The substance theory and the rule against tax avoidance necessarily demands that the tax advantages normally arising or available to a genuine business transaction must be denied in the case of non commercial and non business transaction. It would be unjust to grant the benefits available to a genuine business transaction to a non genuine transaction particularly when the latter is predominantly aimed at tax avoidance. Thus, once the true nature of the transaction is unfolded, the treatment available to a genuine transaction would not -= : 9 : =- be available to a non genuine transaction. In this connection, he relied upon a decision of the Apex Court in the case of McDowell & Co. Limited V/s. C.T.O. reported in 154 ITR 148. 15. Mr.Srivastav further submitted that in the present case, the assessee has not suffered any loss in the transaction and by a colour device or transaction an artificial loss has been created on paper. Colourable transaction means a transaction which is not genuine and which appears to be in existence but not really existing or is only a pretence. In the present case, the colourable device adopted was that the Mutual Fund gave an advertisement in the newspapers few days before the record date for declaration of dividend, whereby the tax payers were lured to invest in their units before the record date and get the benefit of ‘double advantage’. Although the double advantage was stated to be (one) availing 40% tax free dividend and (two) 100% safe investment in technology stocks, the real motive was to create an artificial loss. The modus operandi of the transaction was that the Mutual Fund would purport to sell the units at a high premium to the tax payer and repurchase the said units immediately after distribution of the dividend at a much lower price. As a result, the loss arising on sale of units was only on paper, because, in reality, the amount of loss was virtually returned to the -= : 10 : =- assessee by way of dividend / incentive income. In other words, the loss incurred in the transaction in question was an artificial loss, because, in reality the amount invested in the units was virtually returned to the assessee by way of dividend income plus incentive income plus the sale consideration. Thus, in the transaction in question, the loss was only on paper and such an artificial loss cannot be allowed to be to be set off against the other taxable income of the assessee. 16. Mr.Srivastav further submitted that in the present case, the assessee had invested Rs.8,00,00,000/- on 24/3/2000. The next two days, namely, 25-3-2000 and 26-3-2000 being Saturday and Sunday the capital markets were closed. On 27/3/2000 the assessee sold the entire units to the Chola Mutual Fund for Rs.5,90,55,207/- after receiving dividend income of Rs.1,82,12,862.80 and incentive amount of Rs.23,76,778/-. Thus, in this transaction which virtually lasted for a day, the assessee has invested Rs.8,00,00,000/- and has in fact received back Rs.7,96,44,847.80 (Rs.5,90,55,207/- + Rs.1,82,862.80 + Rs.23,76,778/-) and at the same time claims to have incurred loss of Rs.2,09,44,793/- on sale of units (Rs.8,00,00,000/- - Rs.5,90,55,207/-) and seeks to set off the said loss from the other taxable income of the assessee. Neither the units have been actually -= : 11 : =- delivered nor any loss has been actually incurred by the assessee. If the cloak of purported ‘purchase & sale of units’ is lifted, one reaches to the inevitable conclusion that the loss claimed is purely artificial and had to be ignored for tax purposes. Every loss is not a business loss allowable under the Act. If from the commercial or business point of view, there is no loss and there is no real outgo in monetary terms the claim cannot be entertained in law. In the present case, there is no element of trade and, therefore, artificial loss created in such a transaction cannot be said to be a business loss so as to set off the same against other taxable income of the assessee. In this connection he relied upon a decision of the Gujarat High Court in the case of Banyan & Berry V/s. C.I.T. Banyan & Berry V/s. C.I.T. Banyan & Berry V/s. C.I.T. 222 I.T.R. 831 (Guj.) 222 I.T.R. 831 (Guj.) 222 I.T.R. 831 (Guj.). 17. Mr.Srivastav further submitted that in this scheme of tax avoidance, the complicity between the mutual fund and the tax payers is established from the fact that the advertisement issued by the Mutual Fund was backed by several brokers who were handsomely paid by the Mutual Fund and within two days of the advertisement, Chola Mutual Fund sold nearly 67 crore units to the tax payers for a consideration of Rs.1,200 crores and on the next working day repurchased the entire 67 crore units from the tax payers for approximately Rs.873 crores. The balance amount -= : 12 : =- represented dividend pay out. Unless there was complicity between the mutual fund and the tax payers, it is inconceivable that units worth Rs.67 crores could be sold and repurchased by the mutual fund within a day or two. In the present case, Chola mutual fund had income of only Rs.2.72 crores but it had distributed dividend of Rs.290 crores. This was possible only from the funds received from the tax payers who responded to the scheme of tax avoidance. Thus, in effect, the mutual fund returned to the tax payer their own money within a span of a day or two in two different nomenclatures, namely dividend and sale proceeds. Nothing materially had happened to alter the financial position of the tax payer except to the extent of entry / exit load paid to the mutual funds. 18. Mr.Srivastav further submitted that it is not the business of the mutual fund to collect funds from the subscriber and to return the same in a day or two in different form. The mutual funds are supposed to invest the funds received from the investors in securities so as to protect their long term interest and save them from volatility of the stock market. Neither the assessee had money for investment nor the mutual fund had the income or the necessary reserves to pay such huge amount of dividend. The assessee borrowed money from the overdraft account to make the investment and the mutual fund virtually returned the -= : 13 : =- entire investment amount in the form of dividend, incentive and redemption price. Both the mutual fund and the assessee were the gainers in the transaction - the assessee by saving tax on accumulated profits of the year from other transactions and the mutual fund by getting some part of the fee by way of entry load and exit load. The assessee knew before hand that the transaction would result in loss and, therefore, in a preordained transaction which lacked any business or commercial purpose, the artificial loss, if any, cannot be allowed to be set off. Thus, it is evident that the assessee had subscribed to the tax avoidance scheme floated by the mutual fund and there was a definite complicity between the mutual fund and the assessee in the entire operation, where both stood to gain at the cost of the revenue. 19. Mr.Srivastav further submitted that to establish complicity, it is not necessary that there should be a formal agreement or arrangement on one to one basis. In a Scheme of this nature which is floated mainly for the benefit of the tax payers who have taxable profits earned during the financial year, the complicity is implicit because the mutual fund accommodated all such tax payers who came to avail of the benefits of the scheme. He submitted that the Tribunal adopted a too simplistic approach by holding that the Chola Mutual Fund may be aware that the scheme -= : 14 : =- was being used for tax avoidance. In a scheme of this magnitude, the practicalities and processes could not have been accomplished without the complicity of the Mutual Fund. Thus, there was no commercial or business purpose in these transactions except gaining undue tax advantages and the loss arising from such a transaction which was a colourable device could not be directed to be set off against taxable income. 20. Relying upon the minority view of the Privy Council in the case of Griffiths V/s. J.P. Harrison Griffiths V/s. J.P. Harrison Griffiths V/s. J.P. Harrison Limited Limited Limited reported in 58 ITR 328 (P.C.) 58 ITR 328 (P.C.) 58 ITR 328 (P.C.) which is followed in the case of Finsburry Securities V/s. Inland Finsburry Securities V/s. Inland Finsburry Securities V/s. Inland Revenue Commissioner Revenue Commissioner Revenue Commissioner reported in 43 Tax Cases 591 (HL) 43 Tax Cases 591 (HL) 43 Tax Cases 591 (HL) and in the case of Lupton V/s. F.A. & A.B. Limited Lupton V/s. F.A. & A.B. Limited Lupton V/s. F.A. & A.B. Limited reported in 47 Tax cases 580 (HL) 47 Tax cases 580 (HL) 47 Tax cases 580 (HL), Mr.Srivastav submitted that if greater part of a transaction is explicable only on fiscal grounds, the mere presence of an element of trading will not be sufficient to make the transaction in the realm of trading. He submitted that, if what is erected is predominantly an artificial structure remote from trading and fashioned so as to secure tax advantage, the mere presence of that structure which by itself could fairly be described as trading will not cast the cloak of trade over the whole structure. 21. As an alternative argument, Mr. Srivastav -= : 15 : =- submitted that the artificial loss incurred by the assessee would constitute expenditure incurred for earning the tax free dividend income and hence disallowable under section 14A of the Act. Even though the assessee had not claimed any expenditure for earning the tax free dividend income, the substance of the transaction clearly established that for earning tax free dividend the assessee had to purchase units at a higher price and sell at a lower price and, therefore, the differential amount between the purchase price and sale price of the units constituted expenditure incurred by the assessee for earning the tax free dividend income. Such an expenditure incurred in relation to the tax free dividend income which is not includible in the total income of the assessee is liable to be disallowed under section 14A of the Act. He submitted that in any event, the difference between the closing NAV on the record date and the opening NAV on the next working day i.e. 27th March, 2000 would have been the reasonable amount of expenditure attributable to the earning of dividend income and hence disallowable. He submitted that the Tribunal committed an error in declining to make any disallowance under section 14A of the Act. 22. Mr.Srivastav further submitted that in the present case actually the assessee has not suffered any loss in the commercial sense of the term, but -= : 16 : =- artificial loss was claimed only to gain the tax advantage. In such a case, the artificial loss being an expenditure incurred for earning tax free income, the normal accounting principles would not apply and the tax authorities would be entitled to go through the substance of the matter and hold that in effect and substance the entire expenditure or part thereof was attributable to the earning of the dividend income and hence disallowable under Section 14A of the Act. The fact that the assessee did not claim deduction of the expenditure attributable to the dividend income would not preclude the tax authorities from applying the principles which are part of the commercial practice or which an ordinary man of business would resort to while computing profit or loss. In this connection, he relied upon the decisions of the Apex Court in the case of Dhun Dadabhoy Kapadia (Miss) V/s. C.I.T. Dhun Dadabhoy Kapadia (Miss) V/s. C.I.T. Dhun Dadabhoy Kapadia (Miss) V/s. C.I.T. reported in 63 ITR 651 63 ITR 651 63 ITR 651 and decision in the case of Calcutta Co. Calcutta Co. Calcutta Co. Ltd. V/s. C.I.T. Limited Ltd. V/s. C.I.T. Limited Ltd. V/s. C.I.T. Limited reported in 37 ITR 1 37 ITR 1 37 ITR 1 (S.C.). (S.C.). (S.C.). 23. Mr.Srivastav further submitted that the finding recorded by the Tribunal that there was no material to suggest that the same money was returned to the tax payer and that the dividend pay out might have been made by drawing from past reserves, is based on incorrect appreciation of relevant facts. He submitted that the record clearly shows that apart from the money -= : 17 : =- received from the tax payers, the Chola Mutual Fund had no other funds available to pay back to the tax payers. The statement of account (page 33 of the paper book) also shows that the funds for dividend pay out were not transferred from past reserves. In fact the amounts were transferred from Equalisation / Unit Premium Reserve, which in