1.1 S. 14A has
been inserted in Chapter IV of the Income tax Act by the Finance Act, 2001, with
retrospective effect from 1-4-1962. This Section provides for disallowance of
expenditure incurred in relation to income which is not included in the total
income of the assessee (i.e. exempt income). The operative part of this
Section reads as under :
purposes of computing the total income under this chapter, no deduction shall
be allowed in respect of expenditure incurred by the assessee in relation to
income which does not form part of the total income under this Act."
1.2 Proviso to
the Section was added by the Finance Act, 2002 w.e.f. 11-5-2001. It provides
that the A.O. cannot reopen the assessment u/s.147 for any assessment year prior
to A.Y. 2001-02 for this purpose or pass any rectification order u/s.154 for
prior years to disallow any such expenditure.
1.3 In the case
of CIT v. Indian Bank Ltd., (56 ITR 77), Supreme Court had decided in
1964 that the condition for deductibility of an expenditure does not depend upon
its quality of directly or indirectly producing taxable income and, therefore,
there was no warrant for disallowing a proportionate part of the interest
referable to moneys borrowed for the purchase of tax free securities. This
principle was reiterated in the case of CIT v. Maharashtra Sugar Mills Ltd.,
(82 ITR 452). In this case it was held that no part of managing agency
commission can be disallowed on the ground that it partly relates to managing
sugarcane cultivation, the income from which was exempt from tax. Again, in the
case of Rajasthan State Warehousing Corporation v. CIT, (242 ITR 450) the
above principle was once again reiterated by the Supreme Court. In this case, it
was held that if business is one and indivisible, the expenditure cannot be
apportioned and disallowed to the extent it may relate to income which is exempt
from income tax.
1.4 It may be
noted that the explanatory memorandum issued with the Finance Bill, 2001, gives
the purpose for which the amendment is made. This reads as under :
incomes are not includible while computing the total income as these are
exempt under various provisions of the Act. There have been cases where
deductions have been claimed in respect of such exempt income. This in effect
means that the tax incentive given by way of exemptions to certain categories
of income is being used to reduce also the tax payable on the non-exempt
income by debiting the expenses incurred to earn the exempt income against
taxable income. This is against the basic principles of taxation whereby only
the net income, i.e., gross income minus the expenditure, is taxed. On
the analogy, the exemption is also in respect of the net income. Expenses
incurred can be allowed only to the extent they are relatable to the earning
of taxable income.
It is proposed
to insert a new S. 14A so as to clarify the intention of the legislature since
the inception of the Income-tax Act, 1961, that no deduction shall be made in
respect of any expenditure incurred by the assessee in relation to income
which does not form part of the total income under the Income-tax Act."
1.5 From the
above, it appears that only direct expenses incurred for earning the income
which is exempt will be covered by S. 14A. Even in the decisions of the Supreme
Court referred to above there is nothing to infer that direct expenses incurred
for earning exempt income is allowable. Therefore, even in the absence of a
provision contained in the new S. 14A law was well settled. There is nothing in
this Section to suggest that indirect expenses will be disallowed.
1.6 In actual
implementation of this provision, the Income-tax Department has been taking the
view that all items of income (including dividend on shares and units of Mutual
Funds etc. on which Dividend Distribution Tax is paid) stated in S. 10 of the
Income-tax Act are governed by S. 14A. The intention of this legislation was to
disallow only direct expenses incurred for earning exempt income. In almost all
cases even indirect expenses are also being disallowed on proportionate basis.
In order to ensure uniform approach, S. 14A was amended by the Finance Act,
2006, w.e.f. 1-4-2007 (A.Y. 2007-08). By this amendment Ss.(2) and Ss.(3) were
added in S. 14A to provide that AO shall determine the amount of expenditure
incurred in relation to the exempt income in accordance with such method as may
be prescribed by Rules. The reasons for making this amendment in S. 14A are
explained in Paras 11.1 to 11.3 of CBDT Circular No. 14/2006 of 28-12-2006.
2. New Rule
2.1 In exercise
of the powers given in S. 14A(2) C.B.D.T. has issued a Notification No. S.O.
547(E) on 24-3-2008 (299 ITR (ST) 88). This notification amends the Income-tax
Rules by insertion of a new Rule 8D providing for a "Method for determining
amount of expenditure in relation to income not includible in total income".
Reading this Rule it is evident that the Rule provides for disallowance of not
only direct expenditure incurred for earning the exempt income but also for
disallowance of proportionate indirect expenditure. This is clearly contrary to
the main objective with which S. 14A was enacted.
stated, the new Rule 8D provides as under :
(i) The method
prescribed in the Rule is to be applied only if the AO is not satisfied with :
correctness of the claim of expenditure incurred for earning the exempt
income made by the assessee or
(b) The claim
made by the assessee that no expenditure has been incurred for earning
(ii) The method
prescribed in the Rule states that the expenditure in relation to income which
does not form part of the total income shall be the aggregate of the
following amounts :
amount of expenditure directly relating to income which does not form part
of total income.
(b) In the
case of interest on borrowed funds which is not directly attributable to any
particular income or receipt, the amount computed in accordance with this
following formula :
A = Amount of
interest, other than the amount of interest which is directly attributable to
the exempt income stated in (a) above.
B = The average
of value of investment, income from which does not or shall not form
part of the total income, as appearing in the balance sheet of the
assessee, on the first day and the last day of the relevant accounting year.
C = The average
of total assets as appearing in the balance sheet of the assessee, on the
first day and the last day of the relevant accounting year. The term ‘Total
Assets’ means total assets as appearing in the balance sheet excluding the
increase on account of revaluation of assets but including the decrease on
account of revaluation of assets.
(c) An amount
equal to ½ % of the average of the value of investment, income from which
does not or shall not form part of
the total income, as appearing in the balance sheet of the assessee, on the
first day and the last day of the relevant accounting year.
2.3 From the
above Rule, it will be noticed that CBDT has, instead of prescribing a simple
method, prescribed a complicated formula. By applying this formula, in most
cases, expenditure which has no connection with earning the exempt income will
get disallowed. Some of the issues relating to this New Rule require
(i) As stated in
para 2.2(ii)(b) above, interest which is directly attributed to borrowed funds
used for the purpose of earning taxable income or receipts will not be
considered for disallowance of proportionate interest u/s.14 A. Therefore,
interest on term loan taken for purchase of Plant & Machinery, Motor car loan,
amount borrowed for acquiring factory or office building or any other business
asset will not be considered for such disallowance.
(ii) It is not
mentioned that interest which is disallowable u/s.43B or u/s.36(1)(iii) will
also be excluded. But it can be assumed that only such expenditure, which is
otherwise allowable in the computation of total income, will be considered for
(iii) In the
above formula in para 2.2(ii)(b) above while explaining the terms ‘B’ and ‘C’
there is a reference to the average value of investments and total assets as per
the Balance Sheet of the assessee. It is not clear as to what figures shall be
adopted in the cases of non-corporate assessees, such as Individuals and HUFs
who do no maintain books of accounts.
explanation to the term ‘B’ it is stated that for considering average
value of Investments, we have to consider "Investment, income from which
does not or shall not form part of the total income". This
will mean that even if there is no income from some or all of the investments,
the average value of these investments will enter the formula for disallowance
of proportionate interest. This will mean that in some cases where there is no
income from such investments and no exemption from tax is claimed on any income,
proportionate interest will be disallowed. In some cases, if income from some
investments is say only Rs.1 lac on which exemption is claimed, but disallowance
of proportionate interest under the formula may work out to Rs.2 lacs.
explaining the term ‘C’ it is stated that average of Total Assets as per Balance
sheet should be taken. It can be assumed that items like (a) Preliminary
Expenses not written off, (b) Deferred Revenue expenses, (c) Deferred Tax
Assets, (d) Debit Balance of Profit & Loss A/c. etc., which do not represent any
tangible or intangible asset, appearing in the Balance sheet of the assessee
will be excluded from Total Assets.
current liabilities which are to be deducted from current assets in the case of
the company can be added while working out the amount of Total Assets.
(vii) The formula
given in para 2.2.(ii)(c) above, states that amount equal to ½% of the average
value of investments, income from which is exempt from tax, should also be
disallowed u/s.14A. This provision is not at all equitable. Such disallowance is
to be made with reference to average value of such investments from which exempt
income is received or not. This disallowance has no relation to either the
exempt income or to the expenditure claimed by the assessee. In many cases the
amount worked out may exceed the exempt income or may exceed even the total
expenditure (for taxable as well as exempt income) incurred by the assessee. If
we take the illustration of a closely held Investment company it is common
knowledge that the administrative expenses are nominal as compared to the value
of the investments. In such cases, the amount to be disallowed under the formula
will far exceed the total expenses. It is suggested that a very strong
representation should be made for deletion of this part of the New Rule. In any
event, it should be represented that the total disallowance under the formula
should not exceed 5% of the income for which exemption is claimed.
validity of the New Rule 8D can be challenged on the ground that S. 14A
authorises CBDT to prescribe the method for determination of expenditure
incurred in relation earning the exempt income, but the method prescribed by
this Rule only determines the notional cost for holding investments which may or
may not yield an exempt income. Such notional cost for holding the investment
has no relationship with the actual expenditure incurred and claimed by the
assessee. Therefore, the New Rule goes beyond the authority given to CBDT by S.
2.4 As stated
earlier, the above amendment giving power to CBDT to prescribe the method for
determination of expenditure to be disallowed u/s.14A was made by the Finance
Act, 2006 w.e.f. A.Y. 2007-08. Therefore, the above method, as now prescribed by
New Rule 8D, should apply to computation of income for A.Y. 2007-08 and onwards.
However, there are certain judicial pronouncements which suggest that amendment
made in S. 14A(2) and (3) made by Finance Act, 2006, is a procedural provision
and, therefore, the method for computation of disallowable expenditure, whenever
prescribed, will be applicable to all pending assessments for earlier years
also. Reference in this connection may be made to the following decisions :
(i) ACIT v.
Citicorp Finance (India) Ltd., 108 ITD 457 (Mum.)
Kalpataru Construction Overseas (P) Ltd. v. DCIT, 13 SOT 194 (Mum.)
v. Seksaria Biswar Sugar Factory Ltd., 14 SOT 66 (Mum.)
Heat Treatment & Industries (P) Ltd. v. ITO, 14 SOT 348 (Mum.)
(v) DCIT v.
Smita Conductors Ltd., 16 SOT 251 (Mum.)
Narotamdas Bhau v. ACIT, 15 SOT 629 (Mum.)
Conwood Agencies (P) Ltd. v. ITO, 15 SOT 308 (Mum.)
Contrary view has
been taken in the case of Vidyut Investments Ltd. v. ITO, 10 SOT 284
(Delhi) where it is held that S. 14A(2) and (3) will only apply w.e.f. A.Y.
2007-08 and onwards.
3. What is
Exempt Income u/s.14A :
3.1 As stated
earlier, the objective behind enactment of S. 14A was to disallow expenditure
incurred in relation to any income which is completely exempt from tax e.g.
Agricultural Income. Interest on Tax Free Bonds etc. However, in view of the
wording of the said Section "expenditure incurred by the assessee in relation to
income which does not form part of the total income under this Act", courts and
ITA Tribunal have given very wide meaning to the scope of disallowance u/s.14A.
Therefore, income listed in S. 10, S. 10A, S. 10AA, S. 10B, S. 10BA, S. 10C as
well as Chapter VIA where 100% exemption is available will get covered u/s. 14A
for disallowance of direct and indirect expenditure relating to such income. S.
14A does not make any distinction between income which is completely exempt from
tax and income received after payment of tax (e.g. Dividend Distribution
tax, Tax payable by firms, etc.)
3.2 In this
respect reference may be made to some of the decisions wherein it is held that
disallowance can be made u/s.14A in respect of income from agricultural income,
dividend on shares or units of Mutual Fund, Share from Partnerships Firms,
income exempt under Chapter VIA, etc.
Agricultural Income : Haryana Land Reclamation & Development Corp.
v. CIT, 159 Taxman 271 (P & H).
Dividend on shares and units of mutual funds : Wallfort Shares &
Stock Brokers Ltd. v. ITO, 96 ITD 1 (Mum.) (SB), Harish Krishnakant
Bhatt v. ITO, 91 ITD 311 (Ahd.), DCIT v. S. G. Investments & Industries
Ltd., 89 ITD 44 (Kol.), Muruti Udyog Ltd. v. DCIT, 92 ITD 119
(Del.), Shree Synthetics Ltd. v. CIT, 205 CTR 386 (MP), Escorts Ltd.
v. ACIT, 102 TTJ 522 (Del.).
Share of Profit from Firm : Sudhir Dattaram Patil v. DCIT, 2
SOT 678 (Mum.), A. H. Baldota v. ACIT, 103 TTJ 517 (Mum.), Marezban
Bharucha v. ACIT, 12 SOT 133 (Mum.).
Free Bonds : Punjab National Bank v. DCIT, 103 TTJ 908 (Del.).
Chapter VIA Income : Punjab State Co-operative Milk Producers
Federation Ltd. v. ITO, 104 ITD 408 (Chand).
3.3 In view of
the above trend of judicial pronouncements, it is possible that the disallowance
may be made u/s.14A for expenditure relating to long term capital gain on sale
of shares or redemption of units of Mutual Fund which is exempt u/s.10(38) as
Securities Transaction Tax (STT) is paid. Whether S. 14A can be invoked for
disallowance of expenditure relating to dividend on shares held as
stock-in-trade or not is a matter on which divergent views have been expressed.
Therefore, this matter has been referred to a Special Bench of ITA Tribunal at
Mumbai in the case of Daga Management Pvt. Ltd. and its judgment is awaited.
4. To sum
4.1 From the
above discussion it will be noticed that the New Rule 8D prescribed by CBDT will
further complicate the working of the amount disallowable u/s.14A. Hitherto some
adhoc basis was being adopted. Now, if the method prescribed under the New Rule
8D is applied the expenditure to be disallowed will be substantial and will have
no relation to the actual expenditure incurred. In other words, in most cases, a
notional amount will be disallowed.
4.2 If we trace
the history of this legislation it will be noticed that S. 14A was introduced to
cover cases where expenditure in relation to income such as agricultural income,
tax free bonds, etc. which did not suffer any tax under the Income-tax Act, was
being claimed. This was held to be allowable by the Supreme Court in certain
cases. It was only to deny such claim that this provision was introduced.
4.3 In the
explanatory memorandum issued with the Finance Bill, 2001, while enacting S.
14A, it is stated that "the tax incentive given by way of exemptions to certain
categories of income is being used to reduce also the tax payable on the
non-exempt income by debiting the expenses incurred to earn the exempt income
against taxable income". S. 14A was enacted to curb this tendency.
4.4 In the case
of dividend income, the scheme of the Income-tax Act is to collect tax at 15%
plus applicable surcharge at the time of distribution. It is for this reason
that tax is not levied in the hands of the investor. Similarly, the firm is
required to pay tax at 30% plus applicable surcharge. For this reason, the
balance of profit apportioned to partners is exempted in the hands of the
partners. Similar exemption is given u/s.10(38) in respect of long term capital
gains on which STT is paid. This exemption is granted not as an incentive but
because the tax is levied at source. Therefore, there is no logic in disallowing
expenditure u/s.14A in such cases where tax is collected at source. It is,
therefore, suggested that the section should be suitably amended or CBDT should
clarify that S. 14A should not be invoked where income is received by the
assessee after payment of tax under the Income-tax Act.