In a decision that may increase the tax liability of bulk security traders, the Income Tax Appellate Tribunal (ITAT) has ruled that income from dividends earned by them is not tax-exempt. A ruling to this effect was recently issued by a special bench of the Mumbai ITAT. Income from tax-free dividends cannot be allowed as deduction from total taxable income, the bench said.

The decision - pertaining to Daga Capital Management- has called for retrospective application of Rule 8D of the I-T Act - which gives revenue authorities a mode to derive at the correctness of an assessees claim for expenditure incurred with regard to its exempt income.

Rule 8D, which was notified on March 24, 2008, was aimed to clarify the position of Section 14A of the I-T Act, which says that no deduction shall be allowed in case for expenditure incurred in relation to any tax-free income.

In its majority decision, the tribunal held that provisions of section 14A will apply in respect of tax free dividend income earned from shares held as stock-in-trade. Stocks-in-trade are instruments which are constantly used as part of a profession or occupation.

The assessee had argued that as income by way of profit from trading in shares is taxable, section 14A should have no applicability on the dividends they earn in the process of trading.

The ITAT bench, however, turned down their contention that their income from dividends earned from share trading was incidental and was eligible to be tax-exempt. The bench observed that the said provision did not make any distinction between main or incidental tax free income.

The bench held that the computational provisions of Rule 8D are clarificatory and procedural and will apply to all pending matters even for periods prior to the date of their insertion, which was March 24, 2008.

Commenting on the decision, Ernst & Young tax partner Amitabh Singh said: The decision on retrospective application of Rule 8D will create lot of turbulence for assessees for prior years of their tax assessment.

Mr Singh said this order is likely to have a convincing applicability at the tribunal level in view that the order was of a special bench, while adding that the decision may be challenged.