Income Tax Act - 1961 Sec 14A disallowance

Introduction

1. Section 14A was first inserted by the Finance Act, 2001. However, same was inserted with retrospective effect from 1-4-1962. The inserted section reads as under:—

'14A. Expenditure incurred in relation to income not includible in total income.—For the 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.'

Purpose for which the section was introduced, and given in the explanatory memorandum issued with the Finance Bill, 2001, reads as under:—

'Certain 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 same 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 section 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. The proposed amendment will take effect retrospectively from 1st April, 1962 and will, accordingly, apply in relation to the assessment year 1962-1963 and subsequent assessment years.'

However, the introduced section was being used by the Assessing Officers for reopening the assessments as section was retrospectively effected till another amendment made by the Finance Act, 2002 when the Government realized its mistake and sub-section (2) of section 14A was inserted by the Finance Act, 2002 as under:—

'Provided that nothing contained in this section shall empower the Assessing Officer either to reassess under section 147 or pass an order enhancing the assessment or reducing a refund already made or otherwise increasing the liability of the assessee under section 154, for any assessment year beginning on or before the 1st day of April, 2001.'

There was another amendment by the Finance Act, 2006 to section 14A which enlarged the scope of applicability of section 14A. Previously introduced section had not generated expected revenue or compliance up to the mark. This was the basic reason for this amendment. The newly inserted section w.e.f. 1-4-2007 reads as under:—

'14A. Expenditure incurred in relation to income not includible in total income.—(1)For the 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.

(2) The Assessing Officer shall determine the amount of expenditure incurred in relation to such income which does not form part of the total income under this Act in accordance with such method as may be prescribed, if the Assessing Officer, having regard to the accounts of the assessee, is not satisfied with the correctness of the claim of the assessee in respect of such expenditure in relation to income which does not form part of the total income under this Act.

(3) The provisions of sub-section (2) shall also apply in relation to a case where an assessee claims that no expenditure has been incurred by him in relation to income which does not form part of the total income under this Act:

Provided that nothing contained in this section shall empower the Assessing Officer either to reassess under section 147 or pass an order enhancing the assessment or reducing a refund already made or otherwise increasing the liability of the assessee under section 154, for any assessment year beginning on or before the 1st day of April, 2001.'

The section was amended for the reasons explained in explanatory statement for the Finance Act, 2006 under Circular No.14/2006, dated 28-12-2006 in para 11. It is reproduced hereunder:—

'11. Method for allocating expenditure in relation to exempt income.

11.1 Section 14A of the Income-tax Act, 1961, provides that for the purposes of computing the total income under Chapter-IV of the said Act, 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 the Income-tax Act. In the existing provisions of section 14A, however, no method of computing the expenditure incurred in relation to income which does not form part of the total income has been provided for. Consequently, there is considerable dispute between the taxpayers and the Department on the method of determining such expenditure.

11.2 In view of the above, a new sub-section (2) has been inserted in section 14A so as to provide that it would be mandatory for the Assessing Officer to determine the amount of expenditure incurred in relation to such income which does not form part of the total income in accordance with such method as may be prescribed. However, the Assessing Officer shall follow the prescribed method if, having regard to the accounts of the assessee, he is not satisfied with the correctness of the claim of the assessee in respect of expenditure in relation to income which does not form part of the total income. Provisions of sub-section (2), will also be applicable in relation to a case where an assessee claims that no expenditure has been incurred by him in relation to income which does not form part of the total income

Rule 8D of the Income-tax Rules - In view of specific language of sub-section (2), the prescribed method of Rule 8D is to be applied by the Assessing Officer only if he having regard to the accounts of the assessee is not satisfied with the correctness of the claim of the assessee in respect of an expenditure incurred in relation to exempt income. Sub-section (3) also provides that provisions of sub-section (2) would apply where an assessee claims that no expenditure has been incurred in relation to exempt income. Accordingly, in the cases where either the assessee claims that no expenditure has been incurred or the assessee makes disallowance on the basis of his own calculations or determinations, Rule 8D can be applied by the Assessing Officer only if he is not satisfied as regards the claim of the assessee. It may further be stated that Rule 8D of Income Tax Rules also uses the same language as has been mentioned in sub-section (2) of section 14A of the Act. It also provides that the basis provided therein will be applied only if the Assessing Officer is not satisfied with the correctness of the claim of the assessee. Further, the basis provided in Rule 8D for determination of an expenditure is that apart from expenditure incurred directly in relation to exempt income, proportionate disallowance on account of interest is to be made with reference to average investments to average total assets and in addition thereto, an amount equal to 0.5% of average investment is disallowable on account of administrative expenses.

Controversies in the determination of an expenditure incurred in relation to exempt income

In the light of provisions of section 14A of the Income-tax Act and also Rule 8D of Income Tax Rules various controversies have arisen in the context of determination of an expenditure incurred in relation to exempt income. An attempt is being made in this article to list the controversies and discuss the views expressed thereon by the appellate authorities. Major controversies have been as under:—

No interest disallowance, if investment is out of own funds or own funds are more than investments - As regards the direct expenditure incurred by an assessee in relation to exempt income, there is no controversy whether it is in the nature of interest or otherwise is disallowable. The controversy, however, is in respect of the expenditure which is not directly relatable to the investments or to the exempt income. Most important controversy in this regard is on account of disallowance of interest expenditure incurred by an assessees. In a case where the assessee has incurred interest expenditure, the Assessing Officers are invariably taking a view that proportionate disallowance in the ratio of average investments and average assets is to be made. The assessees, however, are claiming that no disallowance on account of interest is called for where the assessee is having its own sufficient funds to make investments. In such a case it becomes necessary for an assessee to prove on facts that investments have been made out of his own funds. In case an assessee is able to prove on the basis of his facts and bank statements that investments have undoubtedly been made out of own funds and no borrowed funds have been utilized, there would no case of disallowance. The controversy, however, arises in the circumstances where there are mixed funds. The Assessing Officer in such a case holds that proportionate disallowance is to be made. There are, however, following decisions of Supreme Court and High Courts wherein it has been held, in the context of interest free loans given to sister concerns, that where an assessee is having own funds more than interest free loans it should be presumed that interest free loans have been given out of own funds and no disallowance of interest is called for:—

In the light of the aforesaid legal position an assessee can very well argue that since he has sufficient own funds to make investments, even if he is not able to match entries of investments to interest free funds, no disallowance on account of interest is called for. Relying on above decisions, the claim of the assessee is likely to succeed. In certain cases this issue has already come up before the Courts in the context of disallowance under section 14A also and view has been taken by the High Courts and the Tribunals that no disallowance is called for where the assessee has made investments out of his own funds or the own funds available with the assessee are quite sufficient to make investments, which have given rise to exempt income. In this regard following decisions can be referred to:—

Disallowance where shares are held as stock-in-trade - Special Bench of the ITAT Mumbai had taken a view in the case of ITO v. Daga Capital Management (P.) Ltd. [2009] 117 ITD 169 that disallowance is to be made in respect of shares held as stock-in-trade also. The aforesaid view has been subject matter of controversy and discussion in other cases. It is being claimed by the assessees that since shares held as stock-in-trade are held as part of its business asset and income arising on sale and purchase of shares is in the nature of business income, which is taxable, no disallowance on account of interest as well as other expenditure in relation to such holding can be made. Dividend income is only incidental income in such cases. This controversy has been considered by the Courts and various Benches of the Tribunals and almost a consistent view is now emerging that no disallowance can be made under section 14A of the Income-tax Act where shares are held as stock-in-trade. In this regard reference can be made to decisions in the following cases:—

In the context of above controversy language of Rule 8D of the Income Tax Rules is also very important. The language used in Rule 8D for the purpose of disallowance is "Investments". Investments cannot include shares held as stock-in-trade. Investments would imply only the shares which have been held as investments. Accordingly, the language of Rule 8D also supports the proposition that no disallowance is called for in a case where shares are held as stock-in-trade.

3.4 Disallowance under section 14A on account of depreciation - A controversy has also come up before the Special Bench of the ITAT, Ahmedabad in the case of Vishnu Anant Mahajan v. Asstt. CIT [2012] 137 ITD 189/22 taxmann.com 88 in the context of disallowance of depreciation in respect of car maintained by the assessee. The Tribunal has held that depreciation is not in the nature of an expenditure, being a statutory allowance as per section 32 of the Income-tax Act and, accordingly, same is not covered under section 14A of the Income-tax Act.

Disallowance is to be made even if no income is earned during the year - A controversy has arisen in certain cases to the effect that disallowance can be made even if no income has been earned by an assessee which has been claimed as exempt during the year. If we look at the language of section 14A of the Income-tax Act, it provides for disallowance of an expenditure incurred in relation to income which does not form part of total income. In case there is no exempt income during the year, it can very well be argued that no disallowance is called for, as no expenditure can be said to be incurred in relation to income which does not form part of total income. The Rule, 8D, however, provides for disallowance of an expenditure in respect of an income, which does not or shall not form part of total income. Accordingly, the language of the Rule goes beyond the language of section 14A of the Income-tax Act and also provides for disallowance with reference to income which shall not form part of the total income. Further, in the light of the intention of the Legislature one can say that an expenditure which has been incurred by an assessee which is likely to give rise to exempt income, irrespective of the fact whether income has been earned during the year or not, such expenditure is not allowable. For example, if an assessee has incurred an expenditure on agriculture activities, same cannot be claimed as deduction even if there is no income from agriculture activities during the year. View, to the effect that disallowance is to be made even if there is no income earned during the year, has been taken by the Tribunal in the cases of Cheminvest Ltd. v. ITO [2009] 121 ITD 318 (Delhi)(SB)and Sanchayita Mercantile (P.) Ltd. v. Asstt. CIT [2008] 25 SOT 57 (Mum.). Recently the Chandigarh Bench of the Tribunal, however, has taken a view in the case of Gurdas Mann v. Dy. CIT [2013] 31 taxmann.com 392 that no disallowance was to be made since there was no dividend income. Notwithstanding above controversy, the fact whether exempt income has been received during the year or not can definitely be one of the important factors to decide the quantum of an expenditure incurred.

Revision under section 263 on the issue of disallowance under section 14A of the Income-tax Act - This issue had come up for consideration before the Hon'ble Delhi High Court in the case of CIT v. DLF Ltd. [2013] 214 Taxman 91/31 taxmann.com 158. In the facts of above case the assessee had made certain disallowance, which was accepted by the Assessing Officer. The CIT passed the order under section 263 of the Income-tax Act holding that the disallowance under section 14A was not examined. The High Court held that issue was debatable and, therefore, CIT could not exercise the powers under section 263 of the Income Tax Act. The Hon'ble Calcutta High Court, however, in the case of CIT v. RKBK Fiscal Services (P.) Ltd. [2013] 214 Taxman 89/32 taxmann.com 153 took a view that it was the responsibility of the assessee to give one-to-one co-relation between the funds available and funds deployed in the investments for the purpose of determining the disallowance on account of interest. Since the Assessing Officer had not examined the same, CIT was justified in passing the order under section 263 of the Income-tax Act.

Assessing Officer is required to record as to why disallowance offered by assessee is not correct before invoking Rule 8D

As matter of clear legal mandate it has already been held by the Tribunals in a number of cases that the Assessing Officer is required to record satisfaction as to why the disallowance offered by an assessee is not correct before invoking Rule 8D. In this regard recent decision of the Hon'ble Mumbai Bench of the Tribunal in the case of Kodak India (P.) Ltd. v. Addl. CIT [IT Appeal No. 7349/Mum./2012, dated 30-4-2013] can be referred to wherein the Hon'ble Bench has observed as under:—

"106. In our opinion, Rule 8D is not automatic, it is for the AO to examine, at the outset, the correctness of the claim of the assessee, whether he has incurred any expenditure or not and has to give a definite finding, as to how the claim of the assessee is unacceptable. If, on examination, it is found that such expenditure is lower than the disallowance, as computed under Rule 8D, then actual expenditure, as estimated by the AO would have to be disallowed. If, on the other hand, the assessee is able to substantiate on facts, that the exempt income does not bear any cost/expenditure, in such cases, disallowance under section 14A, may become invalid.

107. As observed above, Rule 8D cannot be invoked directly and mechanically, i.e., without giving a detailed and speaking reasons. Bald statement, made by the AO that he has referred to the accounts, does not give him an automatic jurisdiction to invoke the provisions of section 14A read with Rule 8D. Disallowance, made on such basis is not permissible."

In the light of above holding of the Tribunal and also the logical interpretation of section 14A and Rule 8D of the Income Tax Rules, it is stated that it is the requirement of the law that facts of each case have to be examined by the Assessing Officer and the expenditure, as is relatable to the exempt income, is to be disallowed. Sub-section (1) of section 14A is the basic and primary provision, which provides for disallowance of an expenditure incurred in relation to exempt income. Sub-section (2) is only supplementary to provisions of sub-section (1) and cannot override the same. In any case language of sub-section (2) also makes it clear that Rule 8D can be invoked only if the Assessing Officer is not satisfied as regards the claim of the assessee. In these circumstances it becomes necessary for an assessee as well as for the Assessing Officer that disallowance should be determined on a reasonable basis. Therefore, the assessees should make the disallowance in the return of income on account of administrative expenses on a reasonable basis, duly supported by the facts of the case and the expenditure incurred. The disallowance should be duly authenticated by the auditors in the Tax Audit Report after giving the basis and calculations thereof. As and when the Assessing Officer raises the query during the course of the assessment proceedings a detailed explanation should be given alongwith full facts justifying the disallowance offered in the return. In case the assessee is able to justify the amount of disallowance with reference to facts, the Assessing Officer will have no power to invoke the basis provided in Rule 8D and the disallowance as offered by the assessee has to be accepted by the Assessing Officer.

Relevant case laws - It cannot be said that Assessing Officer has no power to determine the amount of disallowance with reference to actual expenses incurred and he has to mandatorily follow the basis provided for in Rule 8D of I.T. Rules. In regard to determination of quantum of expenses disallowable under section 14A of the Act on a reasonable basis, which can be adopted by an assessee or by the Assessing Officer, reference can be made to the following decisions:—

Asstt. CIT v. Oriental Structural Engineers (P.) Ltd. [IT Appeal No. 4245 (Delhi) of 2011, dated 2-12-2011] – affirmed by Delhi High Court in ITA No. 605/2012 decided on 15-1-2013 - In the facts of this case the Assessing Officer had made the disallowance by applying Rule 8D. The CIT(A) apart from the interest disallowance, had restricted the disallowance on account of administrative expenses to the extent of 2% of dividend income earned during the year. The Tribunal had also upheld the basis adopted by the CIT(A). The Department had also gone in appeal before the Hon'ble Delhi High Court against the order of the Tribunal. It was argued before the Hon'ble High Court that Rule 8D of the Income Tax Rules had not been applied in this case and it was a case for A.Y. 2008-09. The Hon'ble High Court, however, upheld the order of the Tribunal wherein disallowance was restricted to 2% of dividend income, disregarding Rule 8D of the Income Tax Rules.

Escorts Ltd. v. Asstt. CIT [2007] 104 ITD 427 (Delhi) - In the facts of this case relating to an earlier year, the assessee had earned dividend income of Rs. 8.9 crores and interest income of Rs. 10.13 crores which were claimed as exempt. The Assessing Officer determined the disallowance at Rs. 2.01 crores. It was claimed by the assessee that it had primarily incurred administrative expenses only for the purpose of carrying on the business and not for the purpose of earning exempt income. After examining the details the CIT(A) had restricted the disallowance to Rs. 21.70 lakhs. The Tribunal while considering the case had observed that estimate was inevitable, the estimate could not be made by the Assessing Officer on thumb rule basis and the assessee had primarily incurred expenditure for the purpose of carrying on its business. Accordingly, the Tribunal held that an ad hoc disallowance of Rs. 2 lakhs would meet the ends of justice.

Jt. CIT v. Pilani Inv. & Ind. Corpn. Ltd. [IT Appeal No. 653/Kol./2012, dated 4-2-2013] - The case related to the assessment year 2008-09. The facts of the case as discussed in the order of the Tribunal revealed that the Assessing Officer had himself adopted the basis of tax exempt receipts to gross total receipts for determining the administrative expenses disallowable.

Conclusion

The assessees should make disallowance under section 14A of the Act on a reasonable basis in the light of actual expenses incurred. The basis should be duly disclosed in the return and it should be such a disclosure which the assessee will be able to substantiate when a question is raised by the Assessing Officer. In the light of facts and the holdings in the various decisions mentioned above, the basis can be volume and the frequency of the transactions. It can be the receipts of exempt income to the receipts/turnover of other activities or any other basis as may be suitable in the facts of the case. The Assessing Officer, while examining the claim of the assessee, should carefully go into the facts of the case and also the basis adopted by the assessee. In case the basis and the quantum of disallowance made by the assessee are justified in the light of the facts of the case, same should be accepted. In case the basis adopted by the assessee is not correct in view of the Assessing Officer, he should give a holding as regards the facts as to why the basis adopted by the assessee is not correct and how another basis would be more appropriate. Further, he should also determine the quantum of an expenditure as has been incurred in his view, either on the basis adopted by the assessee or on another basis, which is appropriate in his view. In case quantum of expenditure incurred, as is estimated by the Assessing Officer, is more than the amount of disallowance offered by the assessee, the Assessing Officer should make the disallowance on the basis of his estimate of actual expenditure, in case same is lower than the disallowance as per Rule 8D. If estimated actual expenditure is more than the disallowance as per Rule 8D, the Assessing Officer should make the disallowances as per Rule 8D. It is also suggested that the CBDT, in the interest of avoiding litigations, should clarify the position and also suitably modify Rule 8D. Further, it is also suggested that since determination of an expenditure on an estimated basis is practically difficult, the Rule should provide for the disallowance, based on a percentage of exempt income, limited to the disallowance as per Rule 8D.

By: Ram Bajaj