IN THE HIGH COURT OF JUDICATURE AT BOMBAY by qiF57a

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									                                     AIT-2008-343-HC

                     IN THE HIGH COURT OF JUDICATURE AT BOMBAY

                        ORDINARY ORIGINAL CIVIL JURISDICTION

                             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 & J.P.DEVADHAR, JJ.

DATED : 8TH AUGUST, 2008

AIT Head Note: 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?(Para 59)
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

J    U    D   G    M    E   N    T

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 :-

         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,




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               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 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 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



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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 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 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 a transaction cannot be
considered as a business or trade transaction and consequently the artificial loss incurred in



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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. reported in 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 Rameshchandra reported
in 167 I.T.R. 507 (Guj.) and two decisions of the Apex Court in the case of Senairam
Doongarmall V/s. Commissioner of Income Tax, Assam reported in 42 I.T.R. and 392 (S.C.)
Sole Trustee, Loka Shikshana Trust V/s. Commissioner of Income-Tax, Mysore reported in
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 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



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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 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 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. 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 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.



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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 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 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 Limited reported in 58 ITR 328 (P.C.) which is followed in the case of Finsburry
Securities V/s. Inland Revenue Commissioner reported in 43 Tax Cases 591 (HL) and in the
case of Lupton V/s. F.A. & A.B. Limited reported in 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 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



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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 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. reported in 63 ITR 651 and
decision in the case of Calcutta Co. Ltd. V/s. C.I.T. Limited reported in 37 ITR 1 (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 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 the present case leaves no room for doubt that these represented the contribution
made by the tax-payers currently participating in the scheme.

24. Mr.Srivastav further submitted that in the present case the entry / exit load of 2%
has been returned to the assessee through the broker. No financial institution would return
the entire amount received from a transaction, because, the mutual fund is required to pay
1% fee to the asset management company and incur other administrative expenses and,
therefore, in the ordinary course of business the mutual fund cannot afford to return the
entire 2% entry load to the assessee through the broker. Similarly, the letter addressed by
the broker to the assessee on 19/4/2000 shows that the amount was paid towards
brokerage @ 2% against investment. An investor is not a broker in the transaction. The



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letter addressed by the broker on 25/4/2000 also indicates that the brokerage was paid
not on the sale price of the units but on the original investment of Rs.8 crores which is a
clear evidence of the fact that the units were meant to be sold and that the incentive was
not linked to either the purchase or the sale but was linked to the entirely make believe
transaction. All these factors clearly establish that the transaction in question was not a
genuine business transaction but a colourable device adopted by the mutual fund, broker and
the tax payers to evade payment of tax by creating artificial loss and setting off the same
against the other taxable income of the tax payers.

25. Mr.Srivastav further submitted that the fact that SEBI has not taken any action
against Chola Mutual Fund for its complicity in the transaction, it does not mean the
transaction is not colourable. He submitted that tax avoidance schemes do not break the
law but they dodge the law. In the present case, the entire arrangement of purchase and
sale was to create tax loss at a cost of less than 1/2% of the total value of the transaction,
which demolishes the argument of the assessee that the mutual fund had nothing to do with
what the assessee did with the units or the argument that there was no prearrangement
between the two. Such a scheme of tax avoidance cannot be said to be business transaction.
In this context, he relied upon the decision of the Apex Court in the case of McDowell & Co.
Limited reported in 159 I.T.R. 140 (S.C.). Relying upon a decision of the Calcutta High Court
in the case of David Mitchell V/s. C.I.T. reported in 30 I.T.R. 701 and a decision of the
Karnataka High Court in the case of ICDS Ltd. C.I.T. reported in 291 I.T.R. 18 (Karn),
Mr.Srivastav submitted that loss is a commercial concept and can be allowed only if it is
incidental to business and if the loss occurs due to arithmetical difference or as a
consequence of voluntary act, the same cannot be allowed.

26. Mr.Srivastav further submitted that the Tribunal has misconstrued the argument of
the revenue relating to section 94 (7) of the Act. The contention of the revenue before the
Tribunal was that, insertion of section 94(7) with effect from 1/4/2002 cannot be
construed to mean that prior to 1/4/2002, the legislature intended to approve such tax
avoidance transactions. He submitted that even prior to the insertion of section 94(7) it
was open to the income tax authorities to disallow the loss if the same was not incurred in a
bonafide business transaction. He submitted that the CBDT circular No.14 of 2001 and the
CBDT instruction dated 23/2/2004 have to be read together. Relying upon a decision of the
Punjab & Harayana High Court in the case of Vaneet Jain V/s. C.I.T. reported in 294 I.T.R.
432 (which is set aside and remanded by the Apex Court), Mr.Srivastav submitted that the
artificial and manipulated loss could not be allowed in law. Accordingly, Mr.Srivastav
submitted that the order of the Tribunal being contrary to law and passed contrary to the
facts on record, is liable to be quashed and set aside and the substantial questions framed
above be answered in favour of the revenue.

27. Mr.Dastur, learned senior Advocate appearing for the respondents on the other hand
submitted that the transaction of purchase and sale of the units of Chola Mutual Fund by
the assessee were two independent transactions. He submitted that the assessee purchased
the units with a view to earn 40% dividend which was more attractive than any other mutual
fund. After purchasing the units on 24/3/2000 and after receiving the dividend income, on
27/3/2000 the assessee decided to sell the units, anticipating that the price of the units



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may drop gradually. The apprehension of the assessee has come true because in fact in the
month of March-April, 2000 the unit price of Chola Mutual Fund fell gradually. Thus, in the
present case, the decision to sell the units on 27/3/2000 was a wise commercial decision
taken by the assessee. The fact that the assessee in its discretion sold the units shortly
after the declaration of results, it cannot be inferred that the transaction of purchase and
sale of the units of Chola Mutual Fund was a composite transaction.

28. Mr.Dastur further submitted that prior to the insertion of section 94(7) of the Act
there was no provision under the Act to disallow the loss arising from the transaction in
question. As the legislature has stepped in to curb this lacuna with effect from 1-4-2002,
the loss incurred from the aforesaid transactions which took place prior to 1-4-2002 were
liable to be allowed to set off against the taxable income of the assessee.

29. Mr.Dastur further submitted that in view of the binding circular No.14 of 2001 issued
by CBDT wherein it is clearly stated that prior to insertion of section 94(7), it was legally
permissible to claim the loss in the manner in which the assessee has done and the same was
allowable, it is not open to the revenue to contend that such loss was not allowable. He
submitted that the CBDT instruction dated 23/2/2004 has no relevance to the facts of the
present case, because, firstly the said instruction issued on 23/2/2004 cannot be applied to
the assessment year in question i.e. A.Y.2001-02 and secondly, as per the said instruction
indepth investigation or marshalling of facts has not been carried out to establish that the
transaction was not a genuine business transaction.

30. Mr.Dastur further submitted that in the present case, the revenue has failed to
establish that neither the purchase transaction nor the sale transaction was contrary to
law. If the purchase and sale of the units are within the four corners of law, it is not open
to the Income Tax authorities to hold that the transaction is not a commercial transaction
and disallow the set off of loss incurred by the assessee.

31. Relying on the decision of the Apex Court in the case of Union of India V/s. Azadi
Bachao Andolan reported in 263 I.T.R. 706 (S.C.), Mr.Dastur submitted that for
ascertaining the validity of a transaction, the Court has to see whether the series of legal
steps taken have achieved the intended legal result and if so, consequence of those legal
steps must be given full effect to. He submitted that the legal steps taken cannot be
treated as non est on the basis of a hypothetical assessment of the ‘real motive’ of the
assessee. In the present case, all the legal steps taken have achieved the intended result
and, therefore, the Tribunal was justified in holding that the transaction was a genuine
transaction and the assessee was entitled to set off of the business loss.

32. Relying upon the decision of the Apex Court in the case of Vijaya Bank Ltd. V/s. C.I.T.
reported in 187 I.T.R. 541 (S.C.), Mr.Dastur submitted that the amount paid to purchase the
unit of a mutual fund is based on the Net Asset Value (NAV) and it has nothing to do with
the dividend declared by the mutual fund. Therefore, the amount paid to purchase the unit
can never be regarded as ‘expenditure incurred in relation to the dividend’ as contemplated
under section 14A of the Act. Similarly, sale of the units at a loss after receiving dividend
has nothing to do with the purchase of the unit for earning dividend. Therefore, loss



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incurred on sale of the units cannot be considered as an expenditure incurred for earning
the dividend. Consequently, making disallowance under section 14A of the Act does not arise
at all.

33. Mr.Dastur submitted that the entire argument of the revenue rests on the presumption
that the incentive paid by the broker to the assessee is ‘equal’ to the brokerage received by
the broker and, therefore, this unnatural transaction cannot be considered as genuine
business transaction. He submitted that there is no material on record to show what amount
of brokerage was paid by the mutual fund to the broker. In any event there cannot be any
linkage between the entry and exit load paid by the investor to the mutual fund and the
brokerage paid by the mutual fund to the broker. In view of the finding of fact recorded by
the Tribunal to the effect that the transactions between the assessee and the mutual fund
were at arm’s length and that the mutual fund has acted in accordance with the applicable
law and complied with the regulatory requirement of SEBI, it is not open to the revenue to
contend that the transactions in question were not genuine business transactions.

34. We have carefully considered the rival submissions.

35. The basic question to be considered in this appeal is, where dividend bearing units of a
mutual fund are purchased on or before the record date and redeemed at a loss immediately
after the record date, whether the loss could be disallowed on the ground that the
transaction was not a business transaction and that the transaction was executed with the
sole intention of tax avoidance by creating artificial loss which could be set off against
other taxable income of the assessee?

36. According to the revenue the transactions in question are not genuine trading
transactions but are tax avoidance transactions. With a view to curb such transactions
section 94(7) has been inserted in Chapter X of the Act with effect from 1-4-2002.
Section 94 (7) reads thus:-

       "94 Avoidance of tax by certain transactions in securities.

       (7) Where-

       (a)     any person buys or acquires any securities or unit within a period of three
               months prior to the record date;

       (b)     such person sells or transfers such securities or unit within a period of
               three months after such date.

       (c)     the dividend or income on such securities or unit received or receivable by
               such person is exempt, then, the loss, if any, arising to him on account of
               such purchase and sale of securities or unit, to the extent such loss does not
               exceed the amount of dividend or income received or receivable on such
               securities or unit, shall be ignored for the purpose of computing his income
               chargeable to tax. "



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37. Prior to the insertion of section 94(7), the dividend income received from the units of a
mutual fund was tax free. However, there was neither any provision under the Act requiring
the unit purchasers to hold the units for any particular period before selling the units nor
there was any provision to disallow the loss arising from the transaction. Taking advantage
of this lacuna, the tax payers resorted to purchasing the dividend bearing units and selling
the same at a loss immediately after receiving the dividend income. The effect of the
transaction was that the amount invested in the units were virtually received back in a day
or two in the form of dividend / incentive income and sale proceeds of the units and at the
same time, the tax payers were entitled to set off the loss arising on sale of the units
against other taxable income earned by the tax payer during the year. As a result of the
set off, other taxable income of the tax payer became reduced and consequently, the tax
liability was reduced. Thus, by executing the transaction in question, on the one hand the
tax payers virtually received back the amount invested in the transaction and on the other
hand got the tax liability reduced on other taxable income by setting off the short term
loss arising from the transaction in question.

38. Section 94(7) has been introduced to curb creation of short term losses by executing
the transactions in question. The scope of section 94(7) can be demonstrated by the
following illustration. Suppose the record date fixed by a mutual fund for entitlement of
the unit holder to receive dividend income was 1/8/2002 and an assessee had purchased the
units of a mutual Fund worth Rs.1,000/- on 1/8/2002 and after receiving dividend income of
Rs.250/- redeemed the units on 2/8/2002 at Rs.725/-. In such a case, in the ordinary
course the entire loss of Rs.275/- (Rs.1,000/- - Rs.725/-) would be set off against other
taxable income of the assessee. However, by inserting section 94(7) with effect from 1-4-
2002, it was provided that out of the total loss of Rs.275/-, the loss to the extent of the
tax free income received or receivable (Rs.250/- in the present case) would be ignored and
the balance loss of Rs.25/- (Rs.275/- - Rs.250/-) alone would be allowed to be set off
against other taxable income.

39. It is however, contended by the revenue that since section 94(7) operates
prospectively with effect from 1-4-2002, the loss arising from the transactions in question
taking place into prior to the insertion of section 94(7) could be disallowed firstly, where it
is established that the transactions are not business transactions executed with profit
motive but are executed with the preordained and predetermined intention to make
artificial loss. Secondly, where the loss if any, is virtually recovered in the form of dividend
/ incentive income, the loss claimed would only be an artificial loss and not the actual loss
incurred and in such a case the loss cannot be allowed as business loss. Thirdly, where the
transaction is a scheme of tax avoidance which is not covered under any of the provisions of
the Act, then, while computing the taxable income, the tax authorities would be justified in
ignoring the loss arising from the transaction in question. Alternatively, it is contended that
even if the transactions were entered into with a view to earn tax free dividend income,
then, the artificial loss would constitute expenditure incurred for earning the dividend
income not includible in the total income as contemplated under section 14A of the Act and
hence disallowable. It is contended that in the present case, all the above criteria were




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satisfied and, therefore, the loss arising from the transaction in question was liable to be
disallowed.

40. We find it difficult to accept the above contention of the revenue. It is true that
without any profit motive, no prudent businessman would enter into any business
transaction. However, in the transaction in question, there is, both income as well as loss.
Dividend is admittedly received which is the income and there is loss because the amount
received on sale of the units is less than the amount at which the units were purchased. It
is not in dispute that if the units purchased were held by the assessee for some time and
thereafter sold, then the loss arising from the transaction could be set off against other
taxable income of the assessee. As the units were sold immediately after receiving the
dividend income it is contended by the revenue that the only motive of the transaction was
to earn loss and hence the loss is not allowable.

41. In such cases, since it was difficult to find out the motive of the transaction, the
legislature has inserted section 94(7) in Chapter X of the Act which deals with tax
avoidance transactions. Section 94(7) provides that where the units are purchased and sold
by a person within the time stipulated therein and the income on those units received or
receivable by such person are exempt, then, while computing the taxable income of such
person, the loss to the extent of income received or receivable on those units shall be
ignored. Thus, by inserting section 94(7) the legislature has made it clear that the loss
arising from the transaction in question was liable to be set off against other taxable
income, however, from AY 2002-03 the set off of the loss would be restricted to the loss
which is in excess of the income received or receivable on the units in question.

42. It is true that section 94(7) operates prospectively. However, in respect of the
transactions taking place prior to 1-4-2002, the revenue cannot take a stand which renders
section 94(7) redundant or nugatory. As noted earlier, section 94(7) was enacted to curb
creation of losses by executing the transactions in question which were liable to be set off
against other taxable income. If such loss could be disallowed on the ground that the loss
was artificial loss then there was no need to insert section 94(7). It is only because such
losses were allowable and it resulted in revenue loss, section 94(7) has been enacted.
Therefore, the argument of the revenue that the loss arising from the transactions in
question taking place prior to 1-4-2002 could be disallowed on the ground that the loss was
artificial cannot be accepted.

43. Moreover, accepting the argument of the revenue would lead to anomalous situation. If
the argument of the revenue that prior to the insertion of section 94(7), the loss arising
from the transaction in question could be disallowed is accepted, then it would mean that by
inserting section 94(7) the legislature has made the disallowable loss into allowable loss to
the extent specified therein. As noted earlier, section 94(7) was inserted as a preventive
measure to curb tax avoidance transactions and not with a view to grant relief to the tax
payers. Therefore, the argument of the revenue which runs contrary to the scheme of the
Act cannot be accepted.




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44. In this context, we may refer to the memorandum explaining the Finance Bill relating to
the introduction of section 94(7) to the Income Tax Act, 1961, the relevant portion of
which reads thus :-

       "Measures to curb creation of short-term losses by certain transactions in
       securities and units. Under the existing provision contained in section 94,
       transactions of sale and purchase of securities which result in the interest or
       dividend in respect of such securities being received by a person not being the
       owner of the securities, are to be ignored and the interest or dividend from such
       securities is required to be included in the total income of the owner. It has been
       pointed out that the purchase and resale of securities including units of equity
       oriented mutual funds, is being carried on for the purposes of creating short-term
       losses. These losses are set off against other incomes and thus an unintended
       benefit flows to the tax-payer. This practice popularly known as dividend stripping is
       being widely used to reduce the tax which would have been otherwise payable by the
       tax-payers.

       It is proposed to insert a new sub-section (7) in the said section to provide that
       where any person buys or acquires securities or unit within a period of three months
       prior to the record date fixed for declaration of dividend or distribution of income
       in respect of the securities or unit, and sells or transfers the same within a period
       of three months after such record date, and the dividend or income received or
       receivable is exempt, then, the loss, if any, arising from such purchase or sale shall
       be ignored to the extent such loss does not exceed the amount of such dividend or
       income, in the computation of the income, chargeable to tax, of such person. "

45. Moreover, the CBDT has issued a Circular No.14 of 2001 in this context, the relevant
paras of which read as under:-

       "56. Measures to curb creation of short-term losses by certain transactions in
       securities and units

       56.1 Under the existing provisions contained in section 94, where the owner of any
       securities enters into transactions of sale and re-purchase of those securities which
       result in the interest or dividend in respect of such securities being received by a
       person other than such owner, the transactions are to be ignored and the interest
       or dividend from such securities is required to be included in the total income of the
       owner.

       56.2 The existing provisions did not cover a case where a person buys securities
       (including units of a mutual fund) shortly before the record date fixed for
       declaration of dividends, and sells the same shortly after the record date. Since the
       cum-dividend price at which the securities are purchased would normally be higher
       than the ex-dividend price at which they are sold, such transactions would result in
       a loss which could be set off against other income of the year. At the same time,




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       the dividends received would be exempt from tax under section 10(33). The net
       result would be the creation of a tax loss, without any actual outgoings.

       56.3 With a view to curb the creation of such shortterm losses, the Act has
       inserted a new sub-section (7) in the section to provide that where any person buys
       or acquires securities or units within a period of three months prior to the record
       date fixed for declaration of dividend or distribution of income in respect of the
       securities or units, and sells or transfers the same within a period of three months
       after such record date, and the dividend or income received or receivable is
       exempt, then, the loss, if any, arising from such purchase or sale shall be ignored to
       the extent such loss does not exceed the amount of such dividend or interest, in the
       computation of the income chargeable to tax of such person. "

46. From the aforesaid CBDT circular, it is clear that the necessity to introduce section
94(7) was that the tax payers were entering into the transaction in question as a tax
avoidance device, because the dividend income received from the transaction was tax free
and in the absence of any provision in the Act, the loss arising from the transaction was
liable to be set off against other taxable income of the tax payers. As a result, the taxable
income of the tax payer from other transactions / sources stood decreased and
consequently tax payable thereon also was reduced. Thus, the CBDT Circular No.14 of 2001
makes it abundantly clear that the loss arising from the transaction in question were liable
to be set off against other taxable income of the assessee and since such set off resulted
in revenue loss, section 94(7) has been inserted. It is well established in law and in fact the
Apex Court in the case of CST V/s. Indra Industries reported in 248 ITR 338 and this
Court in the case of UTI V/s. P.K. Unny reported in 249 ITR 612 have held that CBDT
circulars are binding on the revenue and it is not open to the revenue to argue contrary to
the CBDT Circulars. Therefore, in the light of the CBDT circular No.14 of 2001, it is not
open to the revenue to contend that prior to the insertion of section 94(7) the loss arising
from the transaction in question could be disallowed on the ground that the transaction was
not a business transaction and that the loss was artificial loss.

47. Strong reliance was placed by the counsel for the revenue on the CBDT instructions
dated 23/2/2004 which reads as under:-

       "The Finance Act, 2001 introduced inter alia sub- section (7) of section 94 of the
       Income Tax Act, w.e.f. 1-4-2002 to curb tax avoidance through dividend stripping.
       The sub-section provides, inter alia, that if securities or units of a Mutual Fund are
       purchased within a period of three months prior to the record date, and are sold
       within three months after that date, the loss, if any, arising will be ignored to the
       extent of the exempt dividends received.

       It has been brought to the notice of the Board that some Assessing Officers are
       disallowing losses arising from purchase and sale of securities or units in similar
       circumstances, even in respect of assessment years prior to assessment year 2002-
       2003 (when section 94(7) came into effect), on the ground that the relevant
       transactions have been entered into for the purpose of tax avoidance. In other



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       words, the said section is being applied retrospectively by the Assessing Officers
       taking the plea of fiscal nullity.

       In this regard, I am directed to convey that the Board desires that such
       disallowances in respect of assessment years prior to assessment year 2002-2003,
       should be made only after indepth investigation and proper recording and
       marshalling of all relevant facts, so as to establish the motive of tax avoidance. "

48. As rightly contended by the counsel for the assessee, the aforesaid CBDT instruction
does not support the case of the revenue, because, the said instruction merely states that
the assessing officers should not apply section 94(7) retrospectively and disallow the loss
on the ground that the transaction has been entered into for the purpose of tax avoidance.
The said CBDT instruction further provides that the disallowance should be made only after
indepth investigation and after establishing the motive of tax avoidance. Thus, the said
instruction does not alter or modify the CBDT Circular No.14 of 2001, but it requires the
assessing officers to disallow the loss only if it is established after detailed investigation
that the motive of the transaction was primarily to incur loss and thereby avoid payment of
tax due to the revenue. Therefore, in the light of the CBDT Circular No.14 of 2001 which is
binding on the revenue, it is not open to the revenue to contend that the loss arising from
the transactions in question prior to 1-4-2002 could be disallowed on the ground that the
transaction was not a business transaction or that the loss was artificial loss and not actual
loss.

49. Assuming that the motive of the transaction was relevant, the question to be
considered is, whether the revenue has established that in the present case, the motive of
the transaction was to earn loss ? The Tribunal has recorded a finding of fact that the
transactions between the mutual fund and the assessee were at arms length and that the
mutual fund had not acted in any manner different from what it was doing in the ordinary
course of business. Consistent stand taken by the assessee is that the units were purchased
in view of the attractive 40 dividend declared by the mutual fund and that the units were
sold immediately after receiving dividend income anticipating fall in the unit prices. The
assessee has demonstrated that in fact the unit prices of the Mutual Fund continuously fell
during the month of March / April, 2000 and that the commercial decision taken by the
assessee to sell the units immediately after receiving the dividend income was a wise
decision. In these circumstances, it cannot be said that the motive of the transaction was
to earn loss and, therefore, the decision of the Tribunal to allow the loss to be set off
against other taxable income cannot be faulted.

50. Considerable argument was advanced by the counsel for the revenue in support of his
contention that the transaction of purchase and sale of units was one composite transaction
and that no prudent businessman would purchase and sell the units on the very next day at a
loss of crores of rupees, unless the intention or motive was to earn loss. It was contended
that since the loss was virtually recovered in the form of dividend income, it is apparent
that the motive of the transaction in question was to incur artificial loss which could be set
off against other taxable income. We find it difficult to accept these arguments because,
purchase of units and sale of units are two independent transactions. Whether to sell the



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units after receiving the dividend income or not is within the sole discretion of the unit
purchasers. Therefore, the fact that the unit purchasers have exercised their discretion to
sell the units after receiving dividend income would not make the two independent
transactions into one composite transaction. There is nothing on record to suggest that the
assessee was aware as to what would be the redemption price of the units immediately
after distribution of the dividend. Therefore, in the absence of any material on record it
cannot be said that the purchase and sale transactions were one composite transaction and
that the transactions were executed with an intention to earn loss.

51. Counsel for the revenue strongly urged before us that there was complicity between
the mutual fund, the tax payers like the assessee and the brokers. It is contended that the
mutual fund played the role of facilitator of the scheme of tax avoidance. We see no merit
in the above contentions. It is pertinent to note that the advertisement issued by the Chola
Mutual Fund was a general advertisement intended to attract the attention of all the tax
payers and it was not restricted to any particular tax payer or a group of tax payers.
Neither the advertisement issued by the mutual fund required the unit purchasers to
redeem the units immediately after receiving the dividend units nor there is any material on
record to suggest any such understanding between the parties. On the contrary, it was
specifically stated in the advertisement that the unit purchasers would have to pay 2% exit
load if the units were redeemed within the time stipulated therein. In these circumstances,
merely because the assessee and also almost all the unit purchasers sought redemption of
units immediately after receiving the dividend income, it cannot be inferred that there was
complicity between the unit purchasers and the mutual fund. The inference sought to be
drawn by the revenue is based on conjectures and surmises and is not based on facts and
hence the argument of the revenue cannot be accepted.

52. It is strongly urged by the counsel for the revenue that the mutual fund had no funds
to distribute dividend at 40% and by manipulating the price of the units, the mutual fund
has paid dividend out of the amount received from the unit purchasers. It is further
contended that the fact that the mutual fund has virtually paid the entire amount of exit
load as brokerage to the broker and the broker has virtually paid the brokerage amount to
the assessee as ‘incentive’ for purchase / sale of the units clearly shows that there was
complicity between the mutual fund, tax payers and the brokers. We do not agree. Neither
the SEBI which is the regulatory authority for the mutual funds has found any irregularity
or illegality in the transactions executed by the mutual fund nor before us, the counsel for
the revenue could point out any irregularity or illegality on the part of the mutual fund in
executing the transactions in question. If the transactions are legal and the parties to the
transaction have in fact earned the profits from the transaction, merely because the
brokers have given incentive to the unit purchasers from the brokerage received by them, it
cannot be presumed that there was complicity between the mutual fund, tax payers and the
brokers.

53. Once it is held that in the facts of the present case, the Tribunal was justified in
holding that the loss arising from the transaction in question was liable to be set off against
other taxable income of the assessee, it is not necessary to deal with various decisions
relied upon by the counsel for the revenue in support of his contention that the transaction



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in question was not a business transaction and that the loss arising from the transaction in
question was not allowable. However, we may refer to some of the cases. Strong reliance
was placed by the counsel for the revenue on the decision of the Apex Court in the case of
McDowell & Co. (supra) in support of his contention that the transaction in question was a
colourable transaction entered into solely for the purpose of creating artificial loss and
thereby reduce the tax liability. That decision has no relevance to the facts of the present
case. In that case the assessee therein was liable to pay the excise duty on the total sale
consideration. However, by an amicable device, the assessee therein made the buyer to pay
excise duty. Since the buyer was not liable to pay excise duty, it was evident that the
amount of excise duty paid by the buyer to the department was nothing but the sale price
liable to be included in the sale consideration. In that context, it was held that the
transaction was a colourable device. In the present case, none of the transactions are found
to violate any of the legal provisions. Therefore, the decision of the Apex Court in the case
of McDowell & Co. Ltd. does not support the case of the revenue.

54. It is pertinent to note that the Apex Court in the case of Azadi Bachao Andolan (supra)
has held that every transaction or arrangement which is perfectly permissible in law, but
has the effect of reducing the tax burden of the assessee cannot be treated as illegitimate
and ignored. In the present case, the assessee has demonstrated that the units were
purchased for earning dividend income and that the sale of the units immediately after
receiving the dividend was a commercial decision taken by the assessee. Even the majority
decision in the case of Griffiths (supra) supports the case of the assessee that the
transaction in question was a trading transaction and in the absence of any allegation that it
was a sham transaction, the assessee was entitled to claim set off of the loss irrespective
of the fiscal impact. The minority view in Griffiths case which was followed in Finsburry
Securities (supra) and Lupton (supra) would make no difference, because, the facts in those
cases are wholly distinguishable. The decision of the Apex Court in the case of C.C.E. V/s.
Modi Alkalies & Chemicals Ltd. reported in 171 E.L.T. 155 is also distinguishable on facts
because, in that case, the finding recorded was that both the entities were inter dependent
and there was common financial management. In the present case, admittedly mutual fund
and the assessee are two independent and wholly unconnected entities.

55. Strong reliance was placed by the counsel for the revenue on the decision of the Punjab
& Haryana High Court in the case of Vaneet Jain (supra) and the decision of the Karnataka
High Court in the case of ICDS Ltd. (supra). It is pertinent to note that the decision of the
Punjab & Haryana High Court referred to hereinabove has been set aside by the Apex Court
reported in 294 ITR 435 (S.C.) and the matter has been remanded back for de novo
consideration. Therefore, reliance placed on the decision of Punjab & Haryana High Court in
the case of Vaneet Jain (supra) is misplaced.

56. Similarly, the decision of the Karnataka High Court in the case of ICDS Ltd. (supra) is
distinguishable on facts. In that case, the assessee therein had purchased assets and leased
the same to some institutions and claimed depreciation on the said assets. Since the
assessee therein had received refundable security deposits equivalent to the purchase value
of the assets and the lease rental payable by the institutions was equal to the interest
payable on the security deposit and the personnel in the management of the assessee



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therein as well as the institutions were common, it was held that the transaction was a
colourable transaction. In the present case, the categorical finding given by the Tribunal is
that the transactions were at arms length and no material is placed on record by the
revenue to establish to the contrary. Moreover, in the present case, the income received by
the mutual fund as well as the broker have been taxed in their hands. Even the dividend
income received by the assessee has been assessed as tax free income. It is only while
considering the allowability of the loss it is contended by the revenue that the transaction
is a colourable transaction. Thus, the decision of the Karnataka High Court does not support
the case of the revenue.

57. The alternative argument of the revenue is that the loss arising from the transaction in
question is liable to be treated as an expenditure incurred for earning the tax free income
and hence disallowable under section 14A of the Act. There is no merit in this contention.
Section 14A deals with the expenditure incurred for earning tax free income. Admittedly,
no expenditure is incurred in purchasing the dividend bearing units. It is only because the
units are sold at a loss immediately after receiving the dividend income, the revenue wants
to treat the loss as a deemed expenditure incurred for earning tax free dividend income.
What section 14A contemplates is the expenditure actually incurred for earning tax free
income and not assumed expenditure or deemed expenditure. In these circumstances, the
decision of the Tribunal in rejecting the alternate argument of the revenue cannot be
faulted.

58. Reliance was placed by the counsel for the revenue on the decisions of the Apex Court
in the case of Calcutta Co. Ltd. (supra) and Miss Dhun Dadabhoy Kapadia (supra). In our
opinion, those decisions have no bearing on the facts of the present case. What is held in
those cases is that while computing the profits of business one has to take into
consideration the expenditure actually incurred for earning such profits or any liability
incurred for earning such profits but liable to be discharged at some future date. In the
present case, there is no expenditure incurred for earning dividend income and even under
the newly inserted section 94(7), the loss arising from the transaction in question is not
considered as an expenditure incurred for earning dividend income. Therefore, reliance
placed on the aforesaid two decisions of the Apex Court are misplaced.

59. For all the aforesaid reasons, we hold that in the facts of the case, the Tribunal was
justified in holding that the loss arising from the transaction in question was liable to be set
off against the other taxable income of the assessee.

60. In the result, both the questions are answered in the affirmative i.e. in favour of the
assessee and against the revenue. Appeal is dismissed with no order as to costs.




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