Analysis of Rule 8D of laying down formula for disallowance of expenses incurred in relation to exempt income
In March 2008, Central Board of Direct Taxes (CBDT) inserted Rule 8D in the income tax rules laying down the formula for the disallowance of expenses incurred in relation to exempt income. With the recent pressures to boost tax collections, the rule has created an endless bout of litigation as authorities are taking aggressive tax positions resulting in massive unjustified additions.
Rule 8D lays down the formula for computing disallowance of expenses incurred in relation to exempt income. At the outset, the formula in Rule 8D appeared to be a straight jacket one. However, over a period of time, differing views as regards its interpretation have emerged resulting in litigation.
Emergence of Rule 8D
First the background. In 2001, a new section, 14A, was introduced by the Finance Act with retrospective effect from April 1, 1962, to provide that no deduction would be allowed for expenses incurred in relation to exempt income.
Prior to the introduction of section 14A, a tax payer did not have to pay taxes on exempt income, and at the same time, expenses incurred to earn exempt income were deductible against other incomes. Section 14A put an end to this.
The Supreme Court, via its order in the case of Rajasthan State Warehousing Corporation (242 ITR 450), provided relief to the taxpayers. However, on occasions, amendments are brought about which overturn a favourable order. Section 14A was no exception.
The amendment brought about by introducing section 14A resulted in frivolous and ad-hoc disallowances by the tax authorities in almost all cases without analysing the facts whether any actual expenditure has been incurred for earning such exempt income.
To add to the agony of the taxpayer, two new sub-sections were introduced with effect from April 1, 2007 giving power to the Assessment Officer (AO) to determine the disallowance if he is not satisfied with the correctness of the claim of the taxpayer. This complicated the issue even further.
CBDT, by notifying Rule 8D in March 2008, has added fuel to the litigation fire.
Rule 8D prescribes a formula to determine the amount of disallowance as being aggregate of:
* Amount of expenditure directly relating to income which does not form part of total income;
* Proportionate interest expenditure on borrowed funds with reference to investments and total assets of the taxpayer;
* Amount equal to one half percent of the average investments, which does not or shall not form part of total income
This above formula has turned out to be atrocious for the taxpayers. Rule 8D has opened up a pandora’s box, which has severe implications for the taxpayers.
Absurdity of Rule 8D
At the outset, let me make you aware of the absurdity that might arise after applying the above rule to determine the expenditure incurred in relation to exempt income:
* Rule 8D can be applied retrospectively to all pending assessments and/or appeals;
* It can be applied even if interest expenditure is directly attributable to earning taxable income;
* Even the expenses unrelated to the exempt income can be disallowed under this rule;
* Disallowance can be made even if no exempt income is earned or negligible income is earned during a particular year;
* Disallowing an amount equal to one half percent of the average value of investments has no nexus to either the exempt income or to the expenditure claimed by the taxpayer;
* The amount of disallowance can exceed the exempt income;
* Rule 8D could give absurd results for different taxpayers even for same amount value of average investments held by them and many more of such bizarre results….
So, even if you have not earned any exempt income in a particular year (but have investments yielding tax-free investments) or have earned even Rs 100 of exempt income (like dividend), be watchful as you may be trapped under the above draconian rule.
Significant rulings on Rule 8D
Post the introduction of Rule 8D, various tribunal benches, including two special benchs, heard and decided upon certain controversies in relation to Rule 8D. A gist of the rulings is enunciated below:
The Delhi special bench in the case of Aquarius Travel Pvt Ltd (301 ITR 111) held that:
* The AO cannot resort to reassessment/rectification proceedings for assessments prior to Assessment Year 2001-02;
* Tribunal and Commissioner Appeals have powers to invoke Section 14A to all pending appeals even if lower authorities have not invoked Section 14A in the earlier proceedings;
* The proviso to Section 14A restrains only the powers of AO and not of the Commissioner, Commissioner Appeals and Tribunal.
The Mumbai special bench in the case of Daga Capital Management Ltd (119 TTJ 289) held that:
* These provisions are procedural in nature, and, accordingly, Rule 8D would be applicable retrospectively to all pending assessment and/or appeals;
* Section 14A is wide enough to cover all types of expenses i.e direct as well as indirect;
* Section 14A clearly demonstrates applicability to all “Heads of Income” while computing total income.
Post the above rulings given by the special benchs of Delhi and Mumbai, there have been other rulings, which are outlined below:
* Indexport (2009-TIOL-136-ITAT-MUM) – The Mumbai tribunal held that the taxpayer cannot be put in a worse situation than what it was before.
* GHCL (ITA No. 473, 492/Ahd/2005) – The Ahmedabad tribunal held that Rule 8D cannot be applied to the years prior to its insertion since the legislation’s intent is clearly to introduce both Section 14A(2) and Rule 8D prospectively. Therefore, Rule 8D should not be applied retrospectively.
* Datamatics (2009-TIOL-89-ITAT-MUM) – The Mumbai tribunal held that the company has to establish that there is no nexus between the interest bearing borrowed funds and the investment in question. The case was restored to AO to decide the issue in the light of Daga Capital.
* DLF (27 SOT 22) – The Delhi tribunal held that the AO cannot artificially disallow any expenditure unless the same is linked to the exempt income.
These rulings clearly set the tone of the tax authorities’ approach to this controversy, which will make the on-going battle of wits between taxpayers and tax authorities more interesting.
Other Open Issues
As we move forward, in the backdrop of Rule 8D, many other practical and legal issues would arise including:
* What is exempt income – the tribunals have given a very wide meaning to the term ‘income which does not form part of the total income.’
* Whether Section 14A and Rule 8D can be applied to dividend and mutual fund income.. one can argue that the exemption for dividend and mutual fund income is not granted as an incentive because the tax is levied on source. This exemption is granted for administrative convenience of the tax authorities.
* Application of Rule 8D on long-term capital gain on sale of shares or mutual fund units. Here again, the exemption is granted only if the transaction takes place on stock exchanges, and is subject to Security Transaction Tax (STT).
* Section 14A presupposes the existence of books of account. How can one deal with a situation where no regular books of account are required to be maintained by the taxpayer under the tax laws?
The rulings of the special benchs can be challenged on certain legal aspects. The onus is on the AO to express a reasoned dissatisfaction before invoking Rule 8D. He also has to provide an opportunity to the taxpayer. Further, only those indirect expenses which have ‘some relation’ to the exempt income can be disallowed.
Rule 8D has created havoc among taxpayers who are facing the brunt of it. Taxpayers should now prepare themselves adequately to defend their case, especially from the penalty perspective.
Taxpayers could take precautions such as computing the disallowance on most reasonable and accurate basis to the extent possible coupled with adequate disclosures in the return of income. In spite of all the precautions, it is likely that taxpayers would still have to face protracted litigation.