Amendments to Section 14A to provide that (i) dividend received after suffering dividend-distribution tax and share income from firm suffering tax in the firm’s hands will not be treated as exempt income and no expenditure will be disallowed as relatable to them; (ii) expenditure disallowed shall not exceed the amount claimed. Recommendation for issue of executive instructions that no interest be disallowed if source of investment is directly relatable to taxable income.

AMENDMENTS RECOMMENDED TO SECTION 14A REGARDING DISALLOWANCE OF EXPENDITURE INCURRED IN RELATION TO INCOME NOT INCLUDIBLE IN TOTAL INCOME

Section 14A was inserted by the Finance Act, 2001 with retrospective effect from 1-4-1962. The section provided for a disallowance of all expenditure incurred to earn exempt income, that is, income not includible in the total income of a tax payer. The Assessing Officer was to determine the amount of such expenditure in accordance with the method prescribed by Rule 8-D if he, having regard to the accounts maintained by the assessee, is not satisfied that the claim of the assessee with regard to the expenditure incurred in relation to the exempt income is correct. The section further provides that the Assessing Officer can also make the disallowance in 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. A proviso to the section was inserted by the Finance Act, 2002 to provide that though the section operated retrospectively from 1-4-1092 (the commencement of the Act) no action will be taken to apply the section for any assessment year prior to the assessment 1-4-2002.

Rule 8-D provides for the mechanism to quantify the amount of disallowance. The amount to be disallowed shall be the aggregate of (i) expenditure directly incurred to earn exempt income, (ii) interest expense worked out on the basis of a prescribed formula even though the interest is not directly attributable to any income or receipt and (iii) 1/2% of the average value of the investment the income from which is exempt from tax.

There has been a spate of litigation on the application of the section. The Committee is informed that around 15% of the tax litigation is attributed to the determination of expenditure relating to exempt income. The Committee therefore felt that there is an urgent need to clarify and simplify some of the provisions of the section and the rule.

The Committee recommends that suitable instructions may be administratively issued by the CBDT to the Assessing Officers that they should adequately record their satisfaction or otherwise in the assessment order while dealing with the applicability of the section.

Another issue relates to the quantification of the amount of expenditure attributable to exempt income. Under the existing provisions, the application of Rule 8-D sometimes results in an unintended outcome whereby the amount of such expenditure exceeds the total amount otherwise claimed as expenditure; obviously, the disallowance cannot exceed the amount claimed. Sometimes the disallowance under the Rule also results in the disallowance exceeding the exempt income. The Committee recommends that the law should be amended appropriately.

A further dispute which arises in the application of the section is what constitutes exempt income. In terms of the existing provisions, an income is treated as exempt if the said income is not includible in the total income of the assessee regardless of the fact that it has suffered economic taxation. In other words, legal taxation is the basis at present for determining whether an income is exempt or not. As a matter of principle, tax provisions must be designed on the basis of the economics of taxation and a deviation, if any, should be only on consideration of externalities, ease of compliance and administration and anti-abuse. Income like dividend suffers economic taxation by way of dividend distribution tax (“DDT”) and therefore in an economic sense cannot be construed to be exempt income. Such income, in the view of the

Committee, having suffered DDT in the hands of the payer-company, should be treated as having been taxed in the hands of the recipient.

In view of the above, the Committee recommends that the provisions of Section 14A should be designed to appropriately reflect the principle of economic taxation. Accordingly, income which has been subject to dividend distribution tax (DDT) should be deemed to form part of the total income of the assessee for the purpose of the section. Other similar income, such as share of profit from a partnership firm should also be deemed to be part of the total income for the purposes of section 14A.

2.2 The Committee accordingly recommends the following amendments to Section 14A of the Act:

In the section—

(A) After sub-section (3), the following sub-section may be inserted and shall be deemed to have been inserted with effect from the 1st day of April, 2001, namely:-

“(4) The amount of expenditure determined under sub-section (2) shall not exceed the aggregate of the amount of expenditure claimed under any provisions of the Act (other than the provisions of sections 32 to 35E) in respect of any income forming part of the total income”.

(B) After sub-section (4) so inserted, the following sub-section shall be inserted with effect from the 1st day of April, 2017, namely:-

“(5) For the purposes of this section, income referred to in clause (2A), or clause (34) or clause (34A) or clause (35) or clause (35A) of section 10 shall be deemed to form part of the total income of the assessee”.

2.3 These amendments are recommended to simplify section 14A and also reduce litigation on account of interpretative differences between the assesses and the income-tax department.

The Committee is aware that in some cases disallowance of interest is made on the ground that the borrowings are made in relation to exempt income even where the assessee on the basis of the books of account and other records is able to demonstrate that the borrowings were not used to make investments earning tax-free income. This situation can be taken care of by the CBDT by issuing suitable instructions to the Assessing Officers and no statutory amendment is necessary.

Source- ​Draft Report of Justice R.V. Easwar (Retd) Committee to Simplify the provisions of Income-tax Act, 1961

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