CA Hiral Raja
Section 14A was introduced in the Income Tax Act, 1961 by the Finance Act 2001 with retrospective effect from 1st April 1962. The intent of introducing this section was reiteration of the well settled legal principle that when an assessee incurs any expenditure in relation to income which is not liable to tax under the Act, he would ideally not be allowed the benefit of claiming such expenditure. The need for introduction of this section had arisen to negate the decision of Supreme Court in Rajasthan State Warehousing Corporation vs. CIT  ITR 450.
Section 14A was amended by the Finance Act 2006 wherein subsection (2) and (3) were introduced stating that the assessing officer shall determine the amount of expenditure incurred in relation to such income which is not liable to tax in accordance with the method as prescribed if the assessing officer is not satisfied with the correctness of claim of the assessee in respect of such expenditure incurred in relation to income which does not form part of taxable income or where the assessee claims that no expenditure has been incurred by him in relation to such income. Hence it is very evident that under the Income tax Act, method of computation of disallowance u/s. 14A was first sought to be provided from 1st April 2007 and not before that. However no such method was prescribed until Rule 8D was introduced in the Income Tax Rules vide Notification No. 45/2008 w.e.f. 24.03.2008.
Hence even after introduction of Section 14A until 24.03.2008, there was no mechanism in the statute to determine the quantum of expenditure that should be subject to disallowance. Arbitrary disallowances were done by the Assessing Officers which were held against the revenue by Various High Court and Tribunal Judgements. However after introduction of Rule 8D in the Income Tax Rules w.e.f. 24.03.2008, Mumbai Tribunal Special Bench in case of ITO Vs. Daga Capital Management Pvt. Ltd  26 SOT 603 has held that Rule 8D applies retrospectively in respect of pending appeals. Also the assessing officers have been applying Rule 8D in respect of pending assessments prior to A.Y. 2008 – 2009. The moot question is since no method for computing disallowances u/s. 14A was provided prior to 1st April 2007/24th March 2008, whether Rule 8D prescribed on 24th March 2008 can be applied in respect of pending assessments/appeals prior to A.Y. 2008 – 2009?
Rule 8D was introduced in the Income Tax Rules vide notification no. 45 of 2008 dtd. 24th March 2008 (The Income – Tax (Fifth Amendment) Rules, 2008. The notification stated that the rules shall come into force on the date of their publication in the official gazette.
- Section 295 of the Income Tax Act gives power to the Board to make rules. Further subsection (4) of section 295 does give the power to the Board to give retrospective effect to any rule, but it also at the same time puts a restriction that no retrospective effect shall be given to any rule if it tends to prejudicially affect the interests of the assessee. In this case, if Rule 8D is applied retrospectively for pending assessments/appeals prior to A.Y. 2008 – 2009, then it might prejudicially affect the interests of the assessee. (mainly on account of third limb of the rule seeking to arbitrarily bring one half percent of the average value of the investment within the purview of Section 14A irrespective of the expenditure incurred against earning income from such investments).
- Bombay High Court in the case of Commissioner of Income Tax Vs. Mirza Ataullaha Baig and another  202 ITR 291 – BOM, had held that:
“Firstly, it is submitted that the amendment made on July 24, 1980, should be deemed to the retrospective in its operation. We find it difficult to accept this submission because the Income-tax Act itself, while conferring rule making power on the Board, has empowered the Board by making specific provision in section 295(4), to give retrospective effect to any rule. This power is subject to the only restriction that no retrospective effect should be given to any rule so as to prejudicially affect the interest of the assessee. If the Board wanted to make amendment in the rule made by it on July 24, 1980, applicable to the assessment year 1980-81, it could have made the amendments in the rules made by it on July 24, 1980, applicable to the assessment year 1980-81, it could have made the amendment Rules effective from 1st April, 1980, instead of bringing them into force “at once” thoughts from the date of notification which was July 24, 1980. The purpose of bringing the amendment into operation with immediate effect evidently was to make it known to the assessee that for the next assessment year they would be entitled to get depreciation at the rate of 40 per cent and also to enable them to compute their advance tax liability accordingly”. Hence this judgement clearly indicated that in case the notification comes into effect with immediate effect or “at once”, then the purpose of it is to make it known to the assessee this computation would be adopted by Assessing Officer in case of non satisfaction of the claim in future.
- Hon’ble Supreme Court in the case of Shri. B C Srinivas Shetty 128 ITR 294 (SC) held that the charging and the computation provision under the 1961 Act constituted an integrated code. Since no method for computing disallowance was provided prior to 1st April, 2007/24th March, 2008 as per the decision of the Hon’ble Supreme Court in the case of B. C. Srinivas Shetty reported in 128 ITR 294 (SC) followed in CIT vs. Infosys Technologies Ltd. 297 ITR 167 (SC) if the computational provisions fail, no liability can be fastened on the assessee.
- Mumbai Tribunal Special Bench in case of ITO Vs. Daga Capital Management Pvt. Ltd  26 SOT 603, has held that sub section (2) and (3) of section 14A provide for the procedure for disallowance u/s. 14A and hence relying on the Hon’ble Supreme Court in the case of CIT Vs. Sharwan Kumar Swarup & Others 210 ITR 886, it held that procedural law, generally speaking, is applicable to all pending cases since no person has vested right in the procedure and hence Rule 8D would be applicable to all pending cases.
Let’s try to see what was stated in the Hon’ble Supreme Court Judgement in case of CIT Vs. Hon’ble Sharwan Kumar Swarup 210 ITR 886. Supreme Court in case of CIT Vs. Sharwan Kumar Swarup 210 ITR 886 had held that “We may now turn to the scope and content of rule 1BB. We may now turn to the scope and content of rule 1BB. The said rule merely provides a choice amongst well-known and well-settled modes of valuation. Even in the absence of rule 1BB it would not have been objectionable, nor would there be any legal impediment, to adopt the mode of valuation embodied in rule 1BB, namely, the method of capitalisation of income on a number of years’ purchase value. The rule was intended to impart uniformity in valuations and to avoid vagaries and disparities resulting from application of different modes of valuation in different cases where the nature of the property is similar.”
It further held that “On a consideration of the matter, we are persuaded to the view that rule 1BB is essentially a rule of evidence as to the choice of one of the well-accepted methods of valuation in respect of certain kinds of properties with a view to achieving uniformity in valuation and avoiding disparate valuations resulting from application of different methods of valuation respecting properties of a similar nature and character. The view taken by the High Courts, in our opinion, cannot be said to be erroneous”.
However the method prescribed under Rule 8D is surely not the choice of one of the well accepted methods for computing expenditure incurred in relation to the income which does not form a part of total Income. In so far as first and second limbs the rule 8D are concerned, no rational minded assessee should have any qualms with the revenue. However, the real problem is the third limb of rule 8D. It seeks to bring one half percentage of the average value of investment, income from which shall not form a part of total income. Hence by no stretch of imagination, notional expenditure at the rate of 0.5% of the average value of such investments can be deemed as expenditure incurred in relation to tax free income generated from an investment in the context of section 14A. Such an mischievous provision also brings to tax those assesses who have not earned any tax free income from such investments, by artificially deeming one half percentage of such investments as expenditure in relation to tax free income??, when there is no such income as such???..
Based on the abovementioned judicial pronouncements and Rule 8D in its present form, to me it appears that this rule cannot be applied retrospectively at all.. Let’s wait for the courts to decide whether Rule 8D can be applied retrospectively.