Finance Act 2016 amended the existing Rule 8D of the Income Tax Rules. Before coming to the intricacies of the amended Rule, which have been put in effect from 2nd June, 2016, it would be important to cover a few basics of the section per se and the erstwhile methodology.
Sec 14A of the Income Tax Act, as most would know, talks about disallowance of expenditure in relation to earning of exempt income. In a situation where the assessee claims that no expenditure has been incurred which should be disallowed, or in a situation where the assessee suo moto disallows a certain portion of expenditure but the amount so disallowed is not to the satisfaction of the AO, then Rule 8D gets invoked. Sec 14A has always given way to many complications for a matter so simple and straight. The different views taken by courts, and at times by the same courts in a slightly different way drawing far fetching implications, is remarkable in my opinion.
In order to maintain brevity of this article, I wouldn’t like to go into greater depth of the old rule; however, it would be important to somewhat touch the older rule before we contrast it to understand the new rule. The erstwhile Rule 8D spoke about three different sub-methodologies, within the larger methodology of Rule 8D, the aggregate of which was supposed to be the disallowance u/s 14A r.w. Rule 8D, as following:
1. Amount of expenditure directly relating to income which does not form part of total income;
2. Amount derived by the famous formula (A*B) / C
3. Amount equal to one-half per cent 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 previous year
The new rule 8D has made two modifications:
i. Firstly, it has completely removed the sub-method specified in 2 above.
ii. Secondly, it has slightly modified the sub-method specified in 3 above.
To understand it better, let’s go through the plain reading of the amended Rule 8D:
The expenditure in relation to income which does not form part of the total income shall be the aggregate of following amounts, namely:—
|(i)||the amount of expenditure directly relating to income which does not form part of total income; and|
|(ii)||an amount equal to one per cent of the annual average of the monthly average of the opening and closing balances of the value of investment, income from which does not or shall not form part of total income :|
Provided that the amount referred to in clause (i) and clause (ii) shall not exceed the total expenditure claimed by the assessee
One can see that the amended rule talks about considering an annual average of the monthly average and not just the average of the opening and closing numbers for the financial year. This in my experience has been done to curb the mala fide practise of exiting investments right before the close of the financial year. In the erstwhile rule, the annual averages were considered and by reason of which any investment made and exited during the year went outside the purview of the taxing machinery, and to circumvent that, the new rule has now specified considering annual average but of the monthly averages. There still continues to remain a loophole, which need not be mentioned here; I believe you would have understood.
The second change in the amended rule is the increase in percentage from 0.5% to 1.0%. At once it looks as if the burden on the assessee has been increased, but if you have a closer at it, it transpires that it is not so. This is because one of the three taxing provisions that existed in the erstwhile Rule 8D talked about disallowing interest amount by way of the ‘famous formula’. That particular sub-provision is now completely removed. Thus, only two taxing tools are given under the amended Rule 8D which for the sake of ease are reproduced in simpler words:
i. Directly related expenditure (the word direct is important here & in most cases, this can be interpreted as ‘0’ if the case were to be tackled tactfully)
ii. 1% of annual average of monthly average
This change will impact two categories of assessees in two opposite ways:
1. For those assessees, who played with their investments extensively in-between the year, so as to trick around the formula and eventually contest purely on that basis at the time of assessment/appeals, the new change is going to be a nightmare. No more ground exists for such players.
2. For those assessees, who didn’t try to trick around but for one or the other reasons got into the trap (generally happens when an assessee has heavy debt in his books but which is primarily used for business purposes and not for share trading or mutual fund investments), the new change will be a blessing for them. This is because the concept of charging proportionate interest by way of the erstwhile ‘famous formula’ doesn’t exist anymore. The disallowance amount for them thus would come down significantly.
The paragraphs above spoke about the taxing tools given under Rule 8D, and the implied mathematics involved in it when one compares the old and the amended rule. Now coming to the legality, which may never come to one’s notice unless the Rules were to be read a couple of times, please observe the following:
⇒ Previously, clause (iii) of sub-rule 2 to Rule 8D, had the words “does not or shall not” form part of the total income. Here, the words “or shall not” played a dramatic role when it came to taxing an assessee on an imaginary basis. To clarify this with an example, department often took a stand, and the matters went all the way up to High Court several times, stating that in a situation where no exempt income is earned in the relevant previous year, even then, the disallowance under Rule 8D shall apply because of the words “or shall not”. Although there are enough judgments which then favoured the assessee stating that “no disallowance is called for where exempt income per se is not earned”; however, the matter was always subjudice.
⇒ The second controversy which the amended rule brings to eliminate is by adding a proviso that the amount of disallowance calculated herein cannot exceed the total expenditure claimed by the assessee. Apparently, to me, this is a “pretention” to give relief. Any which way, there is hardly a situation possible where disallowance can exceed the “total expenditure” on assesee’s book. Had the proviso been drafted as “Provided that the disallowance amount cannot exceed the amount of exempt income” – this might have been more receptive for the assessee.
Sec 14A is so niche but there is a huge scope for applying mind and dissecting it to whatever form one wants. It is these controversies that have given ample room to interpret the section in a way so as to suit ones requirement. Rarely would one get opportunity under the Income Tax Act to play around so much & as much as one wants to.
[Note: This article does not contain fundamentals like ‘establishing nexus’ and others because they still continue to hold true. It is important to understand that Sec 14A which is the charging section is not amended, it is rather the corresponding rule, Rule 8D, which has been restructured. This article therefore focuses on the comparative aspect of the amended & old rule, and on the striking features of the amended rule which will generate newer possibilities and degenerate some of the older controversies. Most of the judgments previously used in favour of assessee will still come to rescue.
The author is associated with R. K. Doshi & Co., Chartered Accountants, & can be reached at email@example.com for any questions]