Deductibility of interest on loans for buying shares

Deductibility of interest on loans for buying shares
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First Published: Wed, Oct 27 2010. 08 57 PM IST
Updated: Wed, Oct 27 2010. 08 57 PM IST
The recent spate of initial public offers has seen several investors seeking to leverage their resources by taking loans to make share applications for large amounts, hoping to benefit from appreciation of the share prices on listing. Finance companies promoted by brokers have also sought to encourage investors to do so, earning interest as well as brokerage for the broking group. One risk which many of these investors may not have factored in is while computing their taxable income, is the interest paid by them fully deductible from the short-term capital gains that they may earn?
The normal principle is that interest paid is deductible from the taxable income earned from the assets acquired out of borrowed funds. If the asset yields a tax-free income, since the income is exempt, the interest is also not deductible.
In the case of shares, at the time when dividends were taxable, interest paid on loans taken to acquire shares was deductible from the dividends. At that time, even if no dividends were earned, the Supreme Court had held that the interest was deductible. However, now that dividend on shares is exempt from taxation in the hands of the investor, the deductibility of the interest is a question mark.
Can an investor argue that dividend distribution tax—paid by the company is really a tax paid on behalf of and ultimately borne by the shareholder in respect of the dividends—is a substitute for the tax to be paid on the dividends by the shareholders and that, therefore, the dividend income is really taxable and not actually exempt as the tax is being paid by the company instead of the shareholder? The Bombay high court, in a recent decision in the case of Godrej and Boyce, did not accept this argument and confirmed the disallowance of interest earned in respect of dividends.
Can this interest be then added to the cost of the shares, and claimed as a deduction in computing the capital gains? Though there has been an old Karnataka high court decision accepting that interest on loans taken for purpose of acquiring shares can be added to the cost of shares for computing capital gains if the interest had not been allowed as a deduction from the dividend income, one needs to keep in mind the fact that this decision was rendered at a time when dividend income was taxable. Now that it is exempt and there is a specific provision for disallowance of such expenditure incurred in relation to exempt income, the validity of this decision in the context of the current law is debatable.
Is it possible to claim that the loan has been taken for investing in shares, which yield both exempt dividend income as well as taxable short-term capital gains, and that, therefore, interest proportionate to the taxable short-term capital gains should be allowed as a deduction? If this argument is accepted, then in a situation where the shares are sold shortly after allotment, no dividend would normally have been received and the entire interest would effectively be allowable. There does seem to be scope for such a claim, leaving some hope for such investors.
Where the shares are held for at least a year and, thereafter, sold on the stock market, there seems to be no scope for claim of deduction of interest paid on loans taken for acquisition of the shares as both the incomes yielded by the shares—dividend income as well as long-term capital gains—are tax-exempt.
In a situation where the investor claims to be carrying on a share trading business by applying for shares and selling them soon after as a systematic activity for earning profits, the case is stronger, as one can argue that the interest paid is a business expense incurred for acquiring stock-in-trade, which yields taxable income. In such a situation, though the special bench of the Mumbai tribunal has taken the view that even in such a case the disallowance would apply, one can certainly argue that the disallowance can only be of an amount proportionate to the dividend and that the interest proportionate to the business profits should be allowable.
All in all, deductibility of such interest is an issue likely to lead to litigation, until the issue is finally resolved by the Supreme Court. Of course, by the time the Supreme Court resolves the issue, we would have a new law in the form of the Direct Taxes Code. A fresh bout of litigation is, therefore, assured on account of the fact that the Supreme Court decision would be rendered based on the language of the current law and may no longer hold good under the changed language of the new law.
Gautam Nayak is a chartered accountant. Your comments are welcome at mintmoney@livemint.com
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First Published: Wed, Oct 27 2010. 08 57 PM IST