While refusing to extend the fiscal benefit of Section 36(1)(viii) of the Income Tax Act to the ‘dividend income on investments in shares’, the Supreme Court ruled that the statute specifically mandates ‘interest on loans’ for allowing deduction under the said provision, and extending the said benefits to ‘dividends on shares’ would defy the legislative intent. Therefore, the Court held that the dividend income does not qualify as ‘profits derived from the business of providing long-term finance’.
The Court clarified that a fundamental distinction exists between a shareholder and a creditor, and the basic characteristic of a loan is that the person advancing the money has a right to sue for the debt. In stark contrast, a redeemable preference shareholder cannot sue for the money due on the shares or claim a return of the share money as a matter of right, except in the specific eventuality of winding up.
The Court explained that the dividends are a return on investment dependent on the profitability of the investee company, and this distinction is fundamental to the genealogy of the income. Essentially, dividend income is derived from the contractual relationship of the shareholder, not the underlying activity or the nature of the funds.
As far as the interest on short-term deposits in banks is concerned, the Court said that there is a vital distinction between the general genus of “Business Income” and the specific species of “profits derived from the business of providing long-term finance”. Just because an income falls into the broad bucket of “Business Income” does not automatically mean it qualifies for the 40% deduction under Section 36(1)(viii) for the later specific species.
The Court explained that even if a receipt is classified as “Business Income” under Section 28 of the Income Tax Act, it does not automatically qualify for the special deduction unless it satisfies the strict rigour of being “derived from” the specific activity of long-term finance defined in the Explanation. The legislative intent was to incentivise the specific act of providing long-term credit, not the passive investment of surplus capital.
The Court therefore concluded that interest earned from bank deposits, at best, is attributable to the business, but certainly not derived from the activity of providing long-term finance.
A Two-Judge Bench of Justice Pamidighantam Sri Narasimha and Justice Atul S. Chandurkar referred to Section 28, which provides a deduction in respect of any financial corporation engaged in providing long-term finance for industrial or agricultural development, and observed that ‘long-term finance’ means any loan or advance where the terms provide for repayment along with interest during a period of not less than five years.
As far as the meaning of long-term finance is concerned, the Bench then referred to the Memorandum explaining the Finance Bill, 1995, which explicitly states that the objective of the amendment to Section 36(1) of the Income Tax Act was to limit the deduction of 40% only to the income derived from providing long-term finance, thereby taking it out of the deduction for income arising from other business activities.
The Bench then explained that the phrase “derived from” is narrower than “attributable to” under Section 28, and it requires a direct and proximate connection, or a “first-degree nexus”, between the income and the specific activity. The addition of the words “the business of” simply clarifies which activity is the source; it does not dilute the requirement for a direct link.
Finding that the disputed income in the present case is not a reimbursement of business costs, nor does it come from the core activity of long-term lending, the Bench refused to accept the argument that the appellant’s business should be treated as a “single, indivisible and integrated activity” in order to expand the scope of a specific deduction under Section 36(1).
As far as ‘Service Charge on Sugar Development Fund loans’ is concerned, the Bench noted the admitted factual position that the funds belong to the Government of India, and the appellant bears no risk and utilises no capital of its own. The receipts in question are service charges paid by the Government for the administrative tasks of monitoring and disbursement. Thus, the proximate source of this income is the agency agreement with the Government, not the lending activity itself.
Hence, the Bench clarified that a fee received for agency services cannot be equated with “profits derived from the business of providing long-term finance,” which implies the deployment of the corporation’s own funds and the earning of interest thereon. Consequently, this income stream is rightly excluded from the deduction.
Accordingly, the Bench concluded that Section 36(1)(viii) is not a general exemption granted to a statutory corporation for all its business activities; rather, it is a specific incentive attached strictly to the profits arising from a defined activity, namely, the provision of long-term finance. The legislative transition from a broader deduction regime to the restrictive “derived from” formulation by the Finance Act, 1995, manifests a clear parliamentary intent to “ring-fence” the fiscal benefit.
When a fiscal statute grants a benefit based on a specific source, the concept of an integrated business cannot be utilised to expand the scope of that benefit to cover distinct streams of income that do not strictly satisfy the statutory definition, added the Bench.
Briefly, the appellant, a statutory corporation mandated to advance initiatives for the production, processing, and marketing of agricultural produce, had claimed deductions under Section 36(1)(viii) of the Income Tax Act. The AO, however, noted that the provision allows for a deduction of forty per cent of profits, but strictly limits this benefit to profits “derived from the business of providing long-term finance”. As the appellant is generally engaged in financing, not all income receipts qualify for this specific statutory deduction.
As regards the dividend income, the AO held that this was a return on investment in shares, which is legally distinct from interest earned on long-term loans. Similarly, with respect to the interest on short-term bank deposits, the AO reasoned that these accrued from the investment of idle surplus funds in the interregnum period, rather than from the core activity of providing agricultural credit. As regards service charges received for the Sugar Development Fund (SDF), the AO noted that the appellant was acting merely as a nodal agency for the Central Government, and the funds disbursed belonged to the government, and the appellant received a service fee for its administrative role in monitoring these loans. Consequently, the AO concluded that none of these three streams of income could be characterised as “profits derived from the business of providing long-term finance”. Accordingly, the AO disallowed the deductions and added them back to the total income of the appellant.
On appeal, the CIT(A) and the ITAT upheld the disallowances, relying heavily on the legislative intent and the definition of “long-term finance” in the Explanation to Section 36(1)(viii). When the matter reached the High Court, it was held that under Section 85 of the Companies Act, preference shares are part of share capital and cannot be treated as loans. Therefore, investments in redeemable preference shares do not satisfy the definition of ‘long-term finance’, and dividends derived from such shares are not deductible under Section 36(1)(viii).
Regarding the interest on short-term deposits, the High Court concluded that such interest is a step removed from the business of providing long-term finance. Since the immediate source of this income is the bank deposit and not a long-term loan extended by the appellant, the strict requirements of the ‘derived from’ test were not met. On the issue of service charges for Sugar Development Fund (SDF) loans, the High Court noted that the appellant merely acted as a nodal agency for monitoring and disbursement, and therefore, it could not be considered to be carrying on the business of providing long-term finance in this specific context.
Case Distinguished:
CIT vs. Meghalaya Steels Ltd [(2016) 6 SCC 747]
Appearances:
AOR Christi Jain, along with Advocates Mann Arora, Akriti Sharma, Harsh Jain, Om Sudhir Vidyarthi, Aditya Jain, Yogit Kamat, Siddharth Jain, for the Appellant/ Taxpayer
AORs Anil Katiyar and Madhu, for the Respondent/ Revenue
