CA Umesh Sharma
Arjuna (Fictional Character): Krishna, expenditure incurred in relation to exempt income is a controversial issue and matter of discussion in these days. But what is exempt income, deduction of expenditure incurred on exempt income. What should taxpayer learn at the time of calculating tax or filling of return from this?
Krishna (Fictional Character): Arjuna, exempt income and deduction of expenditure incurred on exempt income is a very debatable issue as there are various issues and interpretation to it. It is to be determined on the basis of situation of every taxpayer’s exempt income and expenditure. So there are various appeals, judgments on this Topic. The provisions related to this have been mentioned in section 14A of Income Tax Act. Many Taxpayers ignore this provision while filling Return of Income but later on in Assessment Penalty and Interest is levied on it.
Arjuna: Krishna, What is Exempt Income and expenditure incurred on it?
Krishna: Arjuna, Taxpayer get Exempt Income from various sources e.g. Dividend, Share of Profit from Partnership Firm, STT paid long term capital gain, Agriculture Income etc. For earning Exempt Income Investments are made and for making Investments Loans from Banks are taken or Loans taken for the Business purpose are used for making Investments. Interest Expenditure on this loan is Expenditure on Exempt Income. Also STT, Bank Charges etc. are the expenditure made for earning Exempt Income.
Arjuna: Krishna, What is section 14 A in Income Tax Act?
Krishna: Arjuna, According to section 14 of Income Tax Act, Income of person is calculated by taking Gross Total of Income from Salary, House Property, Profit and gains from Business and Profession, Capital Gains and Income from Other Sources. According to the provisions of section 14 A of Income Tax Act, no deduction of expenditure shall be made in respect of expenditure incurred in relation to income which does not form part of above stated heads of income. E.g. if a taxpayer has taken loan of Rs. 10 Lakhs for the purpose of business and from that he invested Rs. 2.5 Lakhs in Shares and received dividend of Rs. 50,000/- which is exempt and Interest on Loan amounted to Rs. 120,000/- then the Taxpayer should take deduction of interest of Rs. 90,000/- only and should not take deduction of Rs. 30,000 as it is expenditure for earning exempt income. That means taxpayer should avail deduction of Expenditure on taxable income only.
Arjuna: Krishna, how taxpayer should calculate Disallowance u/s 14 A of Income Tax Act?
Krishna: Arjuna, department has not mentioned method for calculating disallowance, but taxpayer should calculate it appropriately by considering the income and expenditure. Government has given the procedure for calculating the disallowance in Rule 8D of Income Tax Rules for Assessing Officer. Taxpayer can also calculate the Amount of disallowance by following this method. The method is as follows: The Disallowance will be aggregate of the following three:
- Expenditure directly related to such Income.
- Expenditure by way of interest not attributable to any head of Income then calculation will be (A*B/C). where “A” is Interest Expenditure, “B” means average value of investment related to income which does not form part of total income and “C” means Average total assets of Taxpayer on first and last day of the year.
- 5% of average value of investment as stated in B above
Arjuna: Krishna, What are important points that taxpayer must consider while calculating disallowance u/s 14A?
Krishna: Arjuna, following are the important points arrived from various judgments of the courts on section 14 A:
- Where entire investment is made from the own funds or from interest free loan taken and tax free income is earned then provisions of section 14 A will not be applicable. For e.g. if taxpayer has own funds of R.s 10 Lakh and if he borrowed Rs. 10 Lakhs for business and if he invested Rs. 7 Lakhs from his own funds and earned tax free income then provisions of section 14 A will not be applicable and he can avail the deduction of interest of borrowed funds.
- When it is possible to determine actual expenditure of tax free income or if no expenditure has been incurred in relation to exempt income then principle of apportionment will not be applicable.
- Section 14 A signifies and implies both direct and indirect relationship between expenditure and exempt income.
- If taxpayer has made strategic investment and it does not have intention of earning tax free income then section 14A is not applicable. For e.g. investment made by holding company in subsidiary company.
Arjuna: Krishna, What one should learn from this?
Krishna: Arjuna, The taxpayer has to calculate and disallow the expenditure incurred on exempt income u/s 14A. The department has not mentioned how much disallowance should be made. But taxpayer should calculate it appropriately and take the decision. Further if required taxpayer should be able to justify the disallowance made. In life also it is same. Everyone have to take decisions. However, while taking decision all angles should be considered.
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Dear Mr. Shenoy,
The name of the section 14 A itself says Expenditure incurred in relation to exempt income is not deductible. So question of disallowance does not arise if there is no expenditure incurred for earning exempt income.
In your above article it is stated that if investment is made out of own funds and there are no borrowings then dis-allowance under section14A does not apply.
But the AO has dis-allowed 5% of average investment even in a case where the compaby has not borrowed even a single rupee and has not incurred any expenditure directly or indirectly for the investment. His argument is, as per Rule 8D it is the aggregate of Rule 8D (a)+(b)+(c) sub-clauses. And 5% of average investment is as per clause Rule 8D (c), hence it is mandatory to dis-allow at least 5% of average investment !!!
Can you please give your views ?
Allocation of expenditure pertaining to exempted income is tricky issue. The author has left it to the decision of the tax payer (or with his Accountant).
However, there will be always dispute in assessment between the AO and Asses see.
The real need is to have some standard guidelines from the professional bodies.
Cost Accounting has developed many tools for allocation (an apportionment) of expenses, which may be useful for setting such guidelines/standards.
CMA Suresh Pimple
Aurangabad