Ms Paramita Biswas, IRS
(IT: 1993)
CIT (DR) 5, ITAT Delhi
pmb_irs@rediffmail.com
Paramita M. Biswas belongs to the 1993 Batch of IRS. At present she is posted as CIT(DR) at ITAT, Delhi. She is M.Sc. (Geography) from Calcutta University. She has worked as CIT(A) in Delhi, Addl. DIT in The Directorate of Recovery, CBDT, at Delhi and in Assessment and Investigation Wing as ACIT/ DCIT and DDIT in West Bengal and Dehradun
Ms Rakhi Vimal, IRS
(IT: 2002)
Addl. CIT, Sr. DR, ITAT, Delhi
rvdangi@hotmail.com
She is an IRS officer of 2002 batch. She has worked in various fields of the department from assessment charges ,investigation units to the Directorate of Systems. Presently she is working as Departmental Representative in the ITAT Delhi.
Mr. Satpal Gulati, IRS
(IT: 1993)
CIT-(DR) (ITAT)-8
(International Tax Bench) Delhi
satpalgulati@incometax.gov.in
Satpal Gulati IRS 1993 Batch Presently posted as CIT-DR (International Tax Bench)-ITAT Delhi Experience: Worked as AO and Range Head in assessment wing for 7 years, as DDIT in Investigation wing for 6 years, as Additional Director & CIT(CPC-TDS) in Systems Directorate for 8 years, as CIT(A) in International Taxation for 4 years. Special Achievement: -Won PM award as a team member of System Directorate for contribution in setting up CPC-TDS. Won e-governance Gold award for government process reengineering in rolling out CPC-TDS
Mr. Surender Pal, IRS
(IT: 1998)
CIT(DR(ITAT)-9(TP), Delhi
surender.pal@incometax.gov.in
Shri Surender Pal, CIT is from 1998 Batch of IRS. He is presently posted as CIT(DR) TP in ITAT, Delhi. He has Master’s Degree in Electronics & Communications Engineering from IIT, Roorkee. He has worked in the fields of assessment, Investigation and Administration in NWR and Delhi regions along with tenures in the CBDT and Systems.
Executive Summary
This Paper is on the Topic ‘Issues related to Section 14A’. Provisions of Section 14A and Rule 8D are invoked in a large number of cases. The tax laws of India treats certain income as not taxable such as agricultural income, dividend received from an Indian company, income of eligible charitable institution, and tax-free interest.
There has been a debate between the taxpayers and income tax authorities on whether the expenditure earned on exempted income should be allowed as expenditure or not. Section 14A and Rule 8D ever since they were brought on the statute book in 2001 and 2008 respectively have, on one hand been subject matter of litigation and on other hand undergone multiple changes through legislative amendments and judicial decisions of the Supreme Court, several High Courts and ITATs. Guidance for Assessing Officers on application of Section 14A and Rule 8D was therefore identified as one of the key areas, while listing topics for the Series of Technical Notes. This Paper covers important aspects such as recording of satisfaction before applying Section 14A& Rule 8D, disallowance of expenses under Section 14A in situation of no exempt income during the year, disallowance of expenses under Section 14A beyond exempt income, disallowance of interest element in situations of mixed funds, adding back of disallowance under Section 14A for book profit computation under Section 115JB etc. It is hoped that the Paper would be useful guidance for Assessing Officers and their supervisory authorities.
LEGISLATIVE EVOLUTION OF SECTION 14A & RULE 8D
Certain incomes are not includible while computing the total income, as these are exempt under various provisions of the Act. There have been cases where deductions are claimed in respect of such exempt income. This, in effect. means that the tax incentive given by way of exemptions to certain categories of income is being used to reduce the tax payable even on the non-exempt income by debiting the expenses incurred to earn the exempt income against taxable income.
Section 14A was introduced in the year 2001 with retrospective effect from 01.04.1962 to clarify the intention of the legislature with respect to expenses relating to earning of an exempted income. This was done after the Supreme Court decision in Rajasthan Warehousing Corporation [242 ITR 450 (2000)], held that in case of an indivisible business, some income wherefrom is taxable while some exempt, entire expenditure would be permissible deduction and the principle of apportionment would apply only for a divisible business.
With effect from 24.03.2008, Rule 8D was inserted which prescribes the mechanism for allocating expenses to exempt income. The important limbs of extant Rule 8D read as under:
- [Rule 8D(2)(i)]-Expenditure directly incurred to earn exempt income.
- [Rule 8D(2)(ii)]-The interest expense worked out on the basis of a prescribed formula (in the proportion of average value of investments yielding exempt income, to average value of total asset) which is not directly attributable to any exempt income.
- [Rule 8D(2)(iii)] – On presumptive basis, i.e. 0.5% of the annual average value of investments yielding exempt income
The table below summarises various amendments in respect of Section 14A of the Act:
Table 1
| Amending Act | Specific Amendment | Impact |
| Finance Act 2001 | Section 14A inserted (w.e.f. 01.04.1962) | Provided for disallowance for expenses incurred in relation to income exempt from income-tax. |
| Finance Act 2002 | Proviso to Section 14A insert- ed (w.e.f. 11.05.2001) | Clarification that Section 14A cannot be used to reopen/rectify completed assessment. |
| Finance Act 2006 | Sub-sections (2) and (3) insert-ed (w.e.f. 01.04.2007) | Provided the methodology for computing the disallowance under Section 14A. |
| I-T (Fifth Amendment) Rules 2008 | Rule 8D inserted (w.e.f. 24.03.2008) | Prescribes the mechanism for allocating expenses to exempt income. |
With a view to rationalize the formula in Rule 8D, a revised method for determining the amount of disallowance of expenditure on earning exempt income was notified by the CBDT on 2nd June, 2016 where Sub-Rule (2) which prescribes method of determining the expenditure in relation to exempt income was amended. Comparative summary of the new rule with the existing rule is as under:
- No change in Rule 8D(2)(i) which includes expenditure directly incurred to earn exempt income
- Existing Rule 8D(2)(ii) (the interest expense worked out on the basis of a prescribed formula which is not directly attributable to any exempt income) got deleted in the revised rule set
- New Rule 8D(2)(ii) introduced which provides for 1% of the annual average of the monthly averages of value of investments yielding exempt income. This rule is a replacement against the existing Rule 8D(2)(iii) with a modification where (a) rate of presumptive expenditure has been increased to 1% from 0.5%; and (b) as against annual average value of investment, the new rule provides for the annual average of the monthly averages of value of investments.
- New rule provides that the disallowance amount as computed under Rule 8D shall not exceed total expenditure claimed by the taxpayer. [Proviso to Rule 8D(2)] Thus, the new rule puts a cap on upper limit on disallowance as total expenditure claimed by taxpayer.
ISSUES EMANATING FROM JUDICIAL PRONOUNCEMENTS
A. Recording of Satisfaction before Making any Disallowance under Section 14A in the Assessment Order
A.1 In view of specific language of Sub-section (2) of Section 14A and Sub-rule (1) of Rule 8D, the recording of satisfaction is a necessary pre-requisite for invoking disallowance under Section 14A. Sub-section (3) of Section 14A provides that provisions of Sub-section (2) of Section 14A would apply where an assessee claims that no expenditure has been incurred in relation to exempt income. Rule 8D of the Income-tax Rules also uses the same language as in Sub-sections (2) and (3) of Section 14A of the Act. Accordingly, in cases where either the assessee claims that no expenditure has been incurred or where the assessee makes disallowance on the basis of his own calculations or determinations, Rule 8D can be applied by the Assessing Officer only if he is not satisfied as regards the correctness of claim of the assessee.
A.2 The Bombay High Court in the case of PCIT v/s. Reliance Capital Asset Management Ltd. [2017] 86 taxmann.com 200 (Bombay) held that where Assessing Officer had not commented upon correctness or otherwise of assessee’s working of expenditure in respect of income not chargeable to tax, the formula prescribed in Rule 8D(2)(iii) of the Income-tax Rules 1962 could not have been applied to work out disallowance under Section 14A of the Act. Department preferred SLP before Supreme Court which was dismissed due to low tax effect.
A.3 Delhi High Court in the case of Eicher Motors Ltd vs. CIT (2017) 398 ITR 51/ 250 Taxman 532 (Delhi) (HC) held that recording of satisfaction is mandatory. once this mandatory aspect was itself not fulfilled, the question of remanding the matter to the Commissioner (Appeals) and to call for a remand report from the Assessing Officer for the purposes of rectifying this jurisdictional defect would not arise.
A.4 Thus, in view of the language of Section 14A and various judicial pronouncements, AO needs to examine whether the taxpayer is able to justify the basis of its claim of amount to be disallowed or that no disallowance is required. In the scenario of not being satisfied with such claims of asseessee, AO needs to record his specific satisfaction describing the reasons thereof. Such satisfaction needs to be recorded in a speaking manner, clearly delineating the
facts and reasons for the same. The following points emanating from judicial precedents are relevant while recording satisfaction by the AO:
- Mere recording of satisfaction in a mechanical manner without discussing the exempt income and nature and source of expenditure in relation to the exempt income will render the case of the AO weak.
- Proximate cause between expenditure and exempt income is condition precedent for disallowance of expenditure. A proximate cause shall mean that the amount disallowed has a relationship with the exempt income. AO should address this aspect while recording satisfaction.
- Mere assertions that the Section is applicable and/ or assessee’s claim that no expenditure had been incurred is not acceptable are not sufficient. AO needs to elaborate upon the same.
- Satisfaction is to be recorded by the Assessing Officer and it cannot be substituted by recorded satisfaction of Commissioner of Income-tax (Appeals) – Arnav Gruh Ltd. vs. DCIT (2018) 168 ITD 518(Mum.) (Trib.)
A.5 In order to provide clarity to the Assessing Officers, the CBDT has issued a Standard Operating Procedure (SOP) on 10.01.2018 for applying provisions under Section 14A of the Income-tax Act. The focus of SOP is to guide the AO to carry out necessary due diligence by following step-wise process in order to record satisfaction while making disallowance under Section 14A of the Act. SOP factors in judicial position emerging on account of various decisions pronounced on the issue of recording the satisfaction by the AO while making disallowance under Section 14A. Various steps as per the SOP by the CBDT are listed in first column of the Table below. In the second column of the Table, documents to be referred to and related actions/ verifications are suggested for AO on the issue of making disallowance under Section 14A/ Rule 8D:
TABLE 2
| Step No. of SOP | Action to be Taken by AO as per SOP | Documents which may be Referred to by AO, for Verification/ Examination |
| 1 | Whether the assessee has investment or stock-in-trade which yield or are capable of yielding exempt income?
If yes, details be obtained and scru-tinised. |
|
| 2 | Reasons for making the investment be obtained to have insight into the nature of the transaction and the related expenditure |
|
| 3 | It may be summarized in the assess-ment order whether the assessee has received interest-free income during the year or has accrued interest-free income which has not been received during the year. |
|
| 4 | Identify all direct and indirect expendi-ture. |
|
| 5 | Scrutinize the correctness of claim of expenditure incurred to earn exempt income or the claim of no expenditure incurred to earn exempt income. |
|
| 6 | Recording of satisfaction by AO in the assessment order regarding the claim of expenditure in relation to income not includible in total income to bring on record relevant facts and reason for application of Rule 8D. |
|
| 7 | Computing disallowance as per Sub-Rule 2 of Rule 8D. |
|
| 8 | Ensuring that total disallowance does not exceed the total expenses debited by the assessee to the P&L account w.e.f. AY 2016-17. |
|
A.6 It is also pertinent to note that in those cases where the assessee is making a suo moto disallowance under Section 14A of the Act in the return, the AO must ask for working/computation of such disallowance. The AO has to objectively pinpoint the gaps in such working based on his analysis as discussed in SOP. In case, the assessee does not provide for such working for arriving at suo moto disallowance, recording to this effect must be made part of the satisfaction to be recorded in the order.
A.7 The Assessing Officer should specifically examine the direct expenses such as brokerage expenses, professional charges and manpower expenses which may throw light on expenses related to earning of exempt income on investments, to arrive at proper satisfaction. It is noteworthy that senior management including directors would be involved in deciding the timing and extent of surplus funds in the business and the duration for which the funds need to be invested in mutual funds etc. Thus, certain portion of salary of senior management is directly related to expenditure in relation to income not includible in total income. In case of exempt income from mutual funds, the Assessing Officer should call for complete statement of mutual funds which contain the details of person placing the order and other expenses before arriving at the satisfaction. There can be a situation where the mutual investments may be at zero value at the start and end of the year and therefore, the same may not be appearing in the balance sheet. Thus, the AO needs to specifically question about the mutual investments made and closed during the year.
A.8 Section 14A would take within its ambit not only direct expenses but also indirect expenses. The judicial position in this regard is that, the expression ‘in relation to’ appearing in Section 14A is not to be given a narrow or constricted
meaning. Thus, while recording satisfaction about the expenditure incurred in relation to exempt income as per assessee being not correct, the AO may also take note of indirect cost elements such as postage & telegram, printing & stationery, general administrative expenses, telephone expenses, audit fees, director sitting fees, miscellaneous expenses etc. The AO can invoke Rule 8D only after recording satisfaction as discussed above.
B. Whether in Absence of Exempt Income Earned/ Claimed during the Concerned Year, Disallowance could be made under Section 14A Read with Rule 8D.
B.1 A controversy has arisen in certain cases as to whether disallowance can be made by invoking Section 14A of the Act even in those cases where no income has been earned by an assessee which has been claimed as exempt during the financial year.
B.2 In this regard, Central Board of Direct Taxes, in exercise of its powers under Section 119 of the Act clarified vide Circular No. 5/2014 on 11th February 2014 that Rule 8D read with Section 14A of the Act provides for disallowance of the expenditure even where taxpayer in a particular year has not earned any exempt income. The clarification is based on the following:
- legislative intent is to allow only that expenditure which is relatable to earning of income and it therefore follows that the expenses which are relatable to earning of exempt income have to be considered for disallowance, irrespective of the fact whether any such income has been earned during the financial year or not.
- The above position is further clarified by the usage of term ‘includible’ in the Heading to Section 14A of the Act and also the Heading to Rule 8D of I-T Rules 1962 which indicates that it is not necessary that exempt income should necessarily be included in a particular year’s income, for disallowance to be triggered.
- Also, Section 14A of the Act does not use the word ‘income of the year’ but ‘income under the Act’. This also indicates that for invoking disallowance under Section 14A, it is not material that assessee should have earned such exempt income during the financial year under consideration.
- The above position is further substantiated by the language used in Rules 8D(2)(ii) & 8D(2)(iii) of I-T Rules.
B.3 However, Hon’ble Delhi High Court in the case of Cheminvest Ltd. vs. CIT (2015) 61 taxmann.com 118 (Del) dated 02.09.2015 held that Section 14A envisages that there should be an actual receipt of income which is not includible in total income; hence, Section 14A will not apply where no exempt income is received or receivable during relevant previous year. It has been noted by the Hon’ble High Court that decision of Hon’ble Supreme Court in the case of Rajendra Prasad Moody (115 ITR 519 (SC) was rendered in the context of allowance of deduction under Section 57(iii) of the Act, where the expression used is ‘for the purpose of making or earning such income’. Section 14A of the Act, on other hand, contains the expression ‘ín relation to income which does not form part of the total income’. The court held that the decision in Rajendra Prasad Moody cannot be used in reverse to contend that even if no income has been received, the expenditure incurred can be disallowed under Section 14A of the Act. In Cheminvest case, SLP before Supreme Court was not approved due to low tax effect.
B.4 Further, Hon’ble Delhi High Court in the case of CIT vs. Holcim India (P.) Ltd. (2014) 272 CTR 282 (Delhi) also held that there can be no disallowance under Section 14A in the absence of exempt income. This position has been followed by other courts as well, by following the aforesaid decisions of the Delhi High Court.
B.5 In PCIT vs IL&FS Energy Development Company Ltd. [2017] 84 taxmann.com 186 (Delhi) dated 16.08.2017, the Delhi High Court held that CBDT Circular No. 5/2014 dated 11.02.2014 cannot override express provisions of Section 14A, read with Rule 8D and where no exempt income was earned in relevant assessment year, merely because tax auditor had suggested in tax audit report that there ought to be such disallowance, it could not be a ground to make disallowance in terms of Section 14A, read with Rule 8D. In Redington (India) Ltd. vs. Addl. CIT [2017] 392 ITR 633/77 taxmann. com 257 (Mad.), a similar contention of the Revenue was negated. The court there declined to apply the CBDT Circular by explaining that Section 14A is ‘clearly relatable to the earning of the actual income and not notional income or anticipated income.’
B.6 Courts have decided the issue against the Department so far in other cases as below, mainly by following Delhi High Court decision in case of Cheminvest etc.:
- PCIT vs. Rattan India Infrastructure Ltd. (ITA no. 312 of 2018) dated 19.03.2018 Delhi High Court held that ‘having regard to the statutory mandate that there ought to be exempt income, as a pre-condition for disallowance, this Court is in agreement and follows the principles declared in Cheminvest Ltd. (supra) etc. and no question of law arises.’ The Supreme Court dismissed the revenue’s SLP in PCIT-7 vs. Rattan India Infrastructure Ltd. [SLP no. 44853/2018] (SC) dated 04.01.2019 on the ground of low tax effect, leaving the question of law open.
- CIT (Central-I), Chennai vs Chettinad Logistics Pvt. Ltd. [2017] 80 taxmann. com 221 (Madras) dated 13.03.2017 where it is held that Section 14A can only be triggered, if assessee seeks to square off expenditure against income which does not form part of total income under Act; Rule 8D only provides for a method to determine amount of expenditure incurred in relation to income, which does not form part of total income of assessee and it cannot go beyond what is provided in Section 14A. Thus, where no exempt income i.e., dividend, was earned in relevant assessment year by assessee, Section 14A cannot be invoked. Supreme Court dismissed Department’s SLP in CIT (Central) 1 vs. Chettinad Logistics (P.) Ltd. [2018] 95 taxmann.com 250 (SC) dated 02.07.2018 through a summary order, on delay as well as merits.
- CIT vs. GVK Project & Technical Services Ltd. (ITA No. 646 of 2018) [2019] 106 taxmann.com 180 (Del). The Supreme Court in PCIT vs. GVK Project and Technical Services Ltd. [2019] 106 taxmann.com 181 (SC) dated 03.05.2019 dismissed SLP of Department through a summary order, on delay as well as merits.
- PCIT vs. Oil Industry Development Board (ITA No. 197 of 2018) [2019] 103 taxmann.com 325 (Delhi). SLP of Department in PCIT vs. Oil Industry Development Board [2019] 103 taxmann. com 326 (SC) dated 08.02.2019 was dismissed.
- Commissioner of Income-tax– I vs. Corrtech Energy (P.) Ltd. [2014] 45 taxmann.com 116 (Gujarat) dated 24.03.2014 that where assessee did not make any claim for exemption of any income from payment of tax, disallowance under Section 14A could not be made.
- Redington (India) Ltd. vs. Additional Commissioner of Income-tax, Co. Range-V, Chennai [2017] 77 taxmann. com 257 (Madras) dated 23.12.2016 that provision of Section 14A is relatable to earning of actual income and not notional or anticipated income, hence, where there is no exempt income in a year, there cannot be a disallowance of expenditure in relation to an assumed income. In this case, SLP before Supreme Court was not approved due to low tax effect.
- CIT vs. Gujarat State Petronet Ltd. (ITA no. 543 of 2016) (Gujarat) dated 11.07.2016 holding that the sole question arising in the appeal was squarely covered by decision of that court in case of CIT vs. Corrtech Energy (P.) Ltd. reported in [2015] 372 ITR 97. SLP filed by revenue in this case before Supreme Court, vide SLP (C) No. 5147/2017, SLP (CC) No. 2919/2017 and Civil Appeal No. 9702/2018 was dismissed on 05.09.2018 by Supreme Court on the ground of low tax effect.
- Ballarpur Industries Ltd. (ITA No. 51 of 2016) (Bombay High Court, Nagpur Bench) dated 13.10.2016 the High Court decided the issue against revenue by following the judgment of Delhi High Court in the case of M/s. Cheminvest Ltd.
- Reliance Capital Asset Management Ltd. (ITA No. 487/2015) (Bombay) Revenue had challenged the order of ITAT by taking a ground of appeal that for invoking disallowance under Section 14A, it is not material that the assessee should have earned such exempt income during the financial year under consideration as per CBDT Circular No. 5/2014. The Bombay High Court, however, dismissed the appeal of revenue. SLP filed in this case before Supreme Court vide SLP (CC) No. 11379/2018 was dismissed on 07.09.2018 on the ground of low tax effect though question of law was kept open.
B.7. On this issue, SLP before Supreme Court is pending in certain cases namely: (a) SLP filed by the revenue before Supreme Court vide Dy. No. 12145/2018 in case of PCIT vs. IL&FS Energy Development Company Ltd. [2017] 84 taxmann.com 186 (Delhi), SLP filed vide Dy. No. 4145/2019 in case of PCIT-1, Chandigarh vs. Vardhman Chemtech (P.) Ltd. [2019] 102 taxmann.com 132 (Punjab & Haryana) and Dy. No. 28323/2019 against the order of High Court in PCIT vs. Apollo Infrastructure Projects Finance Co. Ltd. in TCA No. 567 of 2008 (Madras).
C. Whether Disallowance under Section 14A can Exceed the Quantum of Exempt Income
C.1 This aspect has been decided against the Revenue in the case of Caraf Builders & Constructions (P.) Ltd. [2019]101 taxmann. com 167 (Delhi). The court held that upper disallowance under Section 14A cannot exceed the exempt income of that year as held in Pr. CIT vs. McDonalds India (P.) Ltd. ITA 725/2018 decided on 22nd October, 2018, where the court followed the ratio and judgment of the Supreme Court in the case of Maxopp Investments Ltd.
vs. CIT [2018] 402 ITR 640/254 Taxman 325/91 taxmann.com 154 and the earlier judgments of the Delhi High Court in Cheminvest vs. CIT [2015] 378 ITR 33/234 Taxman 761/61 taxmann. com 118 and CIT vs. Holcim (P.) Ltd. [2015] 57 taxmann.com 28 (Delhi). Department’s SLP (Dy. No. 25130 of 2019) against the decision of High Court in PCIT-2 vs. Caraf Builders & Constructions (P.) Ltd. (2019) (101 taxmann. com 167) (Delhi), where this issue was involved, has been dismissed by the Supreme Court on 30.08.2019 in a summary manner and without any speaking order.
C.2 In the case of Principal Commissioner of Income-tax, Patiala vs. State Bank of Patiala (ITA No. 270 of 2016) (F/2) [2017] 88 taxmann.com 667 (Punjab & Haryana), the issue decided was that Assessment order could not be held to be erroneous under Section 263 where the Assessing Officer restricted disallowance under Section 14A to amount of exempt dividend income, even though he had computed disallowance under Rule 8D to be at a higher figure.
C.3 In the case of Principal Commissioner of Income-Tax, Patiala v. State Bank of Patiala (ITA No. 359 of 2017) [2018] 99 taxmann.com 286 (Punjab & Haryana), where the amount of disallowance under Section 14A was restricted to the amount of exempt income only and not at a higher figure, the High Court did not consider it appropriate to discuss the scope of Section 263 of the Act holding that the same has been rendered academic in view of the issue being answered in favour of the assessee. SLP against this High Court decision in ITA No. 359/2017 was dismissed by the Supreme Court on ground of delay and merits by a summary and non-speaking order in SLP(C) Diary No. 24323 of 2018 reported in [2018] 99 taxmann.com 286 (SC).
C.4 In the case of Indiabulls Capital Services Ltd. [2020]114 taxmann.com 647 (SC), Hon’ble Supreme Court has dismissed departmental SLP against High Court’s decision that disallowance calculated under Section 14A could not exceed amount of tax-free income. The court held that the question of law urged in respect of Section 14A in this case is squarely covered by the decision of this court in ACB India vs. Assistant Commissioner of Income Tax, [2015] 374 ITR 108 (Delhi). Furthermore, the disallowance calculated exceeded the amount of tax-free income and was therefore held to be contrary to the ruling in Cheminvest Ltd. vs. Commissioner of Income-tax [2015] 378 ITR 33 (Delhi).
D. Disallowance of Interest–Owned Funds vs. Borrowed Funds
D.1 The issue involved here is whether interest can be disallowed under Section 14A in cases where the assessee is unable to justify one-to-one use of borrowed funds for business purposes.
D.2 In this regard, it is relevant to note that Hon’ble Gujarat High Court in the case of PCIT vs. Sintex Industries (ITA No. 268/2017) held that where assessee had surplus funds against which minor investment was made, no question of making any disallowance of expenditure under Section 14A of the Act arose and therefore, there was no question of any estimation of expenditure under Rule 8D of the Income-tax Rules 1962. Hon’ble Supreme Court dismissed the SLP of the Revenue without discussing the facts or laying down any specific ratio.
D.3 Further, Income-Tax Appellate Tribunal – Delhi in the case of T&T Motors Ltd., DLF Ltd. and Oriental Bank of Commerce Ltd. followed the ratio decidendi laid down in the case of Hon’ble Bombay High Court in CIT vs. HDFC Bank Ltd. (2014) 366 ITR 505 (Bom) and held that the disallowance of interest in case of mixed funds is not appropriate. The relevant extracts in this regard are as under:
‘where assessee’s capital, profit reserves, etc., were higher than the investment in tax-free securities, it would have to be presumed that the investment made by the assessee would be out of interest-free funds available with the assessee and, consequently, no disallowance could be made under Section 14A of the Act. In view of the fact that the assessee’s share capital with reserves and surpluses is far in excess of the amount invested in securities fetching exempt income, there can be no question of disallowance of interest amounting to Rs. 8,22,725. The disallowance to this extent is deleted.’
D.4 In view of the above cited judicial decisions, onus is on AO to establish with evidence that interest bearing funds have been invested in the investments, which have generated the tax-exempt income. Mere satisfaction note unsubstantiated by underlying factors/ reasons may not stand the test of appeal. AO should not limit to the balance sheet for source of investment in the year of investment but should also look for cash flow statement. AO also needs to differentiate between cash flow on account of operating activities and finance/ investment activities. AO will need to examine cash-flow statement to ascertain whether on the date of investment, the assessee was having sufficient funds to source the investment yielding tax-free income, which would require thorough examination of balance sheet vis-a-vis the cash flow statement of the assessee. On such examination, the AO needs to establish that interest bearing funds have gone into making investments, which have generated the tax-exempt income. Accordingly, the AO may make necessary disallowance under Section 14A in such cases. It is relevant to add that while making aforesaid examination, the AO needs to be extra cautious particularly in respect of fresh investments made during the year irrespective of the fact as to whether exempt income has been earned on the same or not during the relevant year. This investigation in first year of investment(s) will set the base for making disallowance not only in the first year of investment but also in subsequent years till such investment is in existence. This assumes further significance because if the AO fails to investigate and pinpoint the sourcing of investment out of borrowed funds in the first year of the investment, which are capable of generating tax-free income, disallowance in subsequent years may also not hold good.
D.5 The AO must record in his order in case there is non-compliance at the end of the assessee in providing such details required for investigation. In a case where the assessee did not provide the requisite details, the Hon’ble Calcutta High Court, in the case of CIT vs. RKBK Fiscal Services (P.) Ltd. [2013] 214 Taxman 89 upheld the position that the onus to provide one-to-one correlation between the funds available and the funds deployed is on the assessee as separate accounts for the purpose of the exempt income have not been maintained. On this ground, the court confirmed the order under Section 263 of the Act with an observation that:
‘We are of the opinion that the Assessment Officer in its order dated 28th January, 2005 did not make provision for dis allowance of expenditure in terms of Section 14A of the I-T Act. The assessee has paid interest of Rs. 4,49,02,775 out of which only a sum of Rs. 1,33,51,132 was shown to be relatable to the non-taxable income….’
E. Whether Section 14A is Applicable to Investments Capable of Yielding Taxable Income/ Shares Held as Stock-in-trade/Investments Made in Group Companies/Investments Made Due to Commercial Expediency
E.1 In Maxopp Investment Ltd. vs. CIT [2018] 91 taxmann.com 154 (SC), Hon’ble Supreme Court held that while determining the disallowance, the dominant purpose or the intention while making the purchase of such investment is not relevant irrespective of whether shares are held to gain control or as stock-in-trade. Further, SC while defining the scope of the term ‘in relation to’ as used in Section 14A, further interpreted the dominant purpose test and upheld the principle of apportionment of expenses as that is the principle which is engrained in Section 14A of the Act. The Apex Court held that once a particular income itself is not to be included in the total income and is exempted from tax, there is no reasonable basis for giving benefit of deduction of the expenditure incurred in earning such an income.
E.2 With the above decision of Hon’ble SC, the issue is now settled. The AO may make disallowance irrespective of whether shares are held to gain control or as stock-in-trade because the dominant purpose or the intention while making the purchase of such investment is not relevant.
F. Whether Rule 8D is Prospective
F.1 Rule 8D were notified to come into force on March 24, 2008. The retrospective operation of Rule 8D was upheld by the Special Bench in the case of ITO vs. Daga Capital Management Private Limited (2008) 26 SOT 603 (Mum) on the ground that Rule 8D being in the nature of procedural law are applicable retrospectively. The same was also upheld in ACIT vs .Citicorp Finance (India) Limited [300 ITR 398(AT Mum)].
F.2 However, the Bombay High Court judgment in Godrej & Boyce Manufacturing Company Ltd. 234 CTR 1 decided that Rule 8D would only have prospective effect from AY 2008‐09. Bombay High Court observed in this regard, ‘unless expressly or by necessary implication, or contrary provision is made, no retrospective effect is to be given to any rule so as to prejudicially affect the interests of the assesse’.
F.3 It is only the prescription with regard to the method of determining such expenditure which is new and which will operate prospectively. The same was upheld by the Supreme Court in the judgment dated 31.01.2018 in the case of Essar Teleholdings Ltd. (CA No. 2165/2012) reported in [2018] 90 taxmann.com 2 (SC).
G. Whether Revision under Section 263 can be Invoked on the Issue of Disallowance under Section 14A of the Income-tax Act
G.1 The reopening of the case on account of making disallowance under Section 14A is barred in view of the proviso to Section 14A for any assessment year beginning on or before 1st April, 2001. However, the issue of revision of the
order involving Section 14A disallowance came up for consideration before the Hon’ble Delhi High Court in the case of Goetze India Ltd. (ITA No. 1179, 1366, 1979 and 2106 of 2010). The contention of the respondent-assessee in that
case was that in view of the proviso to Section 14A, the said provision could not have been invoked in a revision under Section 263 of the Act. The Court did not accept the contention of the respondent-assessee with an observation that the assessment order was made on 28th February, 2003, which is after Section 14A was enacted. The court noted that the Assessing Officer should have applied the said section and failure to invoke Section 14A had resulted in an order both erroneous and prejudicial to the interest of the revenue.
G.2 It flows from the above decision that as such there is no bar on revision under Section 263 on the issue of disallowance under Section 14A of the Income-tax Act.
H. Whether Disallowance under Section 14A is to be Added Back for the Purpose of Computing Book Profits under Section 115JB
H.1 The revenue has taken a position that Section 14A is applicable while computing book profit under MAT.
H.2. The above position has been contested by the assesse based on the decision of Hon’ble Supreme Court in the case of Apollo Tyres Ltd. wherein it is held that the Assessing Officer is not entitled to tinker with the book profits as determined as per provisions of Company’s Act unless the amount is specified in Clauses (a) to (h) of the Explanation.
H.3. Delhi High Court in the case of CIT vs. Goetze (India) Ltd. (2014) 361 ITR 505/97 DTR 169 (Delhi) (HC) decided the issue in favour of the Revenue and held that the AO can make disallowance under Section 14A while computing book profit under Section 115JB of the Income-tax Act 1961.
H.4. Further, the Delhi High Court in the case of Bhushan Steel Limited (ITA 593/2015) held that the ITAT has rightly held that this being in the nature of disallowance, and with Explanation to Section 115JB not specifically mentioning Section 14A of the Act, the addition was not justified. The court observed that this stand is consistent with the decision in Apollo Tyres Ltd. vs. Commissioner of Income-tax 255 ITR 273 (SC) which held that: ‘the Assessing Officer does not have the jurisdiction to go behind the net profit shown in the profit and loss account except to the extent provided in the Explanation to Section 115J.’
H.5 It may be relevant to add that the decision in the case of Bhushan Steel (supra) has been rendered without taking into consideration the decision in the case of Goetze (India) Ltd. (supra) of co-ordinate bench of equal strength.
H.6 In such a situation of two conflicting decisions of Delhi High Court, ITAT Delhi in the case of ACIT vs. Vireet Investment Pvt. Ltd. (2017) 165 ITD 27/ 154 DTR 241/ 188 TTJ 1 (SB) (Delhi) (Trib.) decided the issue in hand in favour of the assessee on this issue by following the decision of Hon’ble Supreme Court in the case of CIT vs. Vegetable Products Ltd. [1973] 88 ITR 192 which provides that where two reasonable constructions of a taxing provision are possible, that construction which favours the assessee must be adopted.
H.7 For the purpose of adding back disallowance of expenditure under Section 14A to the book profits, as per Clause (f) of Explanation 1 below Section 115JB, it is important that Clause (ii) of Explanation 1 below Section 115JB provides for reduction of exempt income under Section 10, 11 or 12 from the book profits being computed under Section 115JB. Disallowance of expenditure under Section 14A is in relation to income which does not form part of total income under the Act. Majority of such income would not be forming part of total income due to Sections 10, 11 or 12. Hence, expenditure disallowable under Section 14A should squarely fall under Clause (f) of Explanation 1 below Section 115JB. Further, the phrase ‘expenditure relatable to’ as used in Clause (f) of Explanation 1 to Section 115JB(2) is similar to the phrase in ‘in relation to’, used in Section 14A. Furthermore, the legislative intent regarding disallowance of expenditure relating to earning of exempt income was same, whether under normal provisions or
under the MAT provisions.
I. Whether Disallowance under Section 14A is Applicable in the case of Dividend Income Covered by Section 115-O
I.1 In the case of Godrej & Boyce Manufacturing Company Ltd. vs. DCIT [2017] 81 taxmann.com 111 (SC), the Supreme Court ruled in favour of Revenue and held that Section 14A of the Act would apply to dividend income on which tax is payable under Section 115-O with following observations:
- The dividend income under Section 115-O of the Act is a special category of income which has been treated differently by the Act making the same non-includible in the total income of the recipient assessee as tax thereon had already been paid by the dividend distributing company.
- The other species of dividend income which attracts levy of income tax at the hands of the recipient assessee has been treated differently and made liable to tax under the aforesaid provisions of the Act.
- In fact, if the argument is that tax paid by the dividend paying company under Section 115-O is to be understood to be on behalf of the recipient assessee, the provisions of Section 57 should enable the assessee to claim deduction of expenditure incurred to earn the income on which such tax is paid. Such a position in law would be wholly incongruous in view of Section 10(34) of the Act.
I.2 The dividend declared by a foreign company is not covered under Section 10(34) and therefore is not an exempted income. It becomes apparent that the provisions of Section 14A cannot extend to dividends received from investments made in the shares of foreign companies. The same was upheld in 2012-TIOL-453-ITAT-MUM and in ITO vs. Stides Acrolab Ltd 138 ITD 323 Mumbai ITAT.
I.3 It is to be noted that position on dividend distribution tax to be paid under Section 115-O and on exemption of DDT related dividend under Section 10(34) has got changed by Finance Act 2020 from AY 2021-22 onwards. Correspondingly, disallowance under Section 14A would not be required for that dividend income which is no longer exempt.
J. With Reference to Rule 8D(2)(iii), Whether ‘Average Value of Investment’ would Include all Investments or Investments Yielding Non-Taxable Income
J.1 Hon’ble Delhi High Court in the case of ACB India Ltd vs. ACIT (ITA No. 615/2014) (2015-374 ITR 108 Delhi) vide order dated 24.03.2015 held that as per Section 14A and Rule 8D(2)(iii) for computing the ‘average value of investment’, only the investments yielding non-taxable income have to be considered and not all investments.
J.2 Special Bench of ITAT Delhi in the case of ACIT vs Vireet Investment (P.) Ltd. [2017] 82 taxmann.com 415 (Delhi–Trib) (SB) held that disallowance under Rule 8D(2)(iii) of the Rules shall be computed only on those investments which yielded tax-free income during the year. There is no High Court decision so far on the issue of considering only the investments yielding tax-free income during the year for the purpose of computing ‘average value of investment’ as per Rule 8D.
J.3 In the case of ITO vs. LGW Ltd. (2016) 130 DTR 201 (Kol.) (Trib.), it is held that share application money cannot be included while working out average value of investment for the purpose of Rule 8D. This decision is on the ground that the share application money is only in the nature of an offer to buy shares made by the assesse and the right to claim dividend is not there till the offer is accepted by the company resulting in a concluded contract.
K. Whether the Expression ‘Expenditure Incurred’ in Section 14A Refers Only to Actual Expenditure
K.1 The Delhi High Court in the case of Maxopp Investment Ltd. vs. CIT [(2012) 347 ITR 272(Del)] observed: ‘While we agree that the expression “expenditure incurred” refers to actual expenditure and not to some imagined expenditure, we would like to make it clear that the “actual” expenditure that is in contemplation under 14A (1) of the Act is the actual expenditure in relation to or in connection with or pertaining to exempt income. The corollary to this is that if no expenditure is incurred in relation to the exempt income, no disallowance can be made under Section 14A of the said Act.’ A reference was also made to a similar finding by Punjab & Haryana High Court in the case of CIT-II vs. Hero Cycles Ltd. [ (323 ITR 518)]. A similar view was taken in Metalman Auto P. Ltd. [(336 ITR 434].
L. Whether Section 14A is Applicable with Respect to Income Exempted under Section 50 of the SIDBI Act 1989
L.1 In the case of Commissioner of Income Tax-3, Mumbai vs. Small Industries Development Bank of India (Bombay High Court) ITA No. 2108 of 2010, date of Order: 12.09.2012, the facts of the case are that the assessee was a statutory corporation established under the SIDBI Act 1989 which was engaged in the business of promotion, financing and development of small scale industries to meet the emerging challenges of the liberalized economy. The income of the assessee (SIDBI) was exempted from payment of income-tax by virtue of Section 50 of the SIDBI Act 1989.
L.2 The Assessing Officer disallowed the deduction on account of bad debts as claimed by the assessee and added the same to the income for the assessment year 2003-04 on the ground that for the assessment year 2001-02 and earlier the assessee was not chargeable to income tax. The High Court held that Section 14A of the Act would have no application to the present facts. The court observed that it is not the Revenue’s case that bad debts have been incurred in relation to income which does not form part of the total income. Further, the court noted that Section 50 of SIDBI Act 1989 only exempts payment of income-tax and it does not provide that such income of the SIDBI Bank will not be a part of the total income as in a case of income specified in Sections 10 and 10A of the Act.
M. Whether Section 14A is Applicable with Respect to Insurance Business
M.1 Pune ITAT in the case of Bajaj Alliance General insurance Co. Ltd. vs. Addl. CIT 38 Oriental Insurance Co. Ltd [130 TTJ 388 (Del.) (Trib.)] held that Section 14A of the Income-tax Act 1961 is not applicable to an insurance business as the same is governed under the specific provisions of Section 44 of the Income-tax Act 1961. A Bench of ITAT Delhi observed that the income of the insurance companies had to be computed under Section 44 read with Rule 5 of the First Schedule to Income-tax Act, which is a specific provision overriding Section 14A. Since, as per Section 44, no head-wise bifurcation of income was required to be made in case of insurance companies, Section 14A disallowance could not be made. ITAT observed:
‘It is not permissible to the Assessing Officer to travel beyond Section 44 and First Schedule of the Income-tax Act.’ This position has been upheld by the Mumbai Tribunal in Birla Sunlife Insurance Co. Ltd. [TS-23-ITAT-2010(Mum)].
CONCLUSION
As discussed in sub-paragraphs A.1 to A.8 of paragraph 2 of this paper, Assessing Officer should record a speaking satisfaction for invoking 14A and Rule 8D where he is not satisfied with correctness of assessee’s claim in respect of expenditure in relation to income not forming part of total income having regard to assessee’s accounts or with assessee’s claim of no expenditure having been incurred in relation to such income. AO may follow the CBDT issued Standard Operating Procedure for the AOs while invoking Rule 8D as per the provisions of Section 14A. Applicability of Rule 8D is not automatic.
As discussed at sub-paragraphs B.3 to B.7 of paragraph 2 above, courts have so far not upheld the disallowance of expenditure under Section 14A of the Act in cases where taxpayer has not earned any exempt income in that particular year. The principle emanating from such judicial precedents has also been followed by the courts while deciding the issue on (a) restriction of disallowance to the quantum of exempt income, and (b) taking average value of investments in Rule 8D by considering only such investments which have yielded tax-free income during the year. The aforesaid issues are yet to be decided on merit by the Apex Court. Accordingly, while making disallowance under 14A read with Rule 8D in cases having no exempt income during the year, the AO may follow the CBDT Circular No. 5/2014 dated 11th February 2014. Where disallowance under Section 14A read with Rule 8D exceeds the exempt income, the aforesaid CBDT Circular may be referred to. Lastly, while taking all investments capable of yielding income not includible in total income (including those not actually yielding such income during the year) for the purpose of computing disallowance under Rule 8D(2)(ii), the aforesaid CBDT Circular be referred to.
As per the SOP issued by the CBDT, it has been clarified that the total disallowance under Section 14A shall not exceed the total expenses debited by the assessee to the P&L account. Proviso to Rule 8D(2) be also referred to in this regard.
Onus is on AO to establish with evidence that interest bearing funds have been invested in the investments, which have generated the tax-exempt income. Mere satisfaction note unsubstantiated by underlying factors/ reasons may not stand the test of appeal. AO should not limit to the balance sheet for source of investment in the year of investment but should also look for cash flow statement. Further, in the case of mixed funds (own funds as well as borrowed funds) being utilized towards investment generating exempt income, AO needs to thoroughly examine the source of funds invested. As held by the Hon’ble Calcutta High Court in the case of CIT vs. RKBK Fiscal Services (P.) Ltd. [2013] 214 Taxman 89, where the assessee does not provide the requisite details, there is a failure on his part to discharge initial onus to provide one-to-one correlation between the funds available and the funds deployed, as separate accounts for the purpose of the exempt income have not been maintained.
The decision of Hon’ble SC in the case of Maxopp Investment Ltd. vs. CIT 402 ITR 640 (SC) has put to rest the controversy regarding the relevance of dominant purpose or the intention while making the purchase of such investment. Disallowance under Section 14A be made irrespective of whether shares are held to gain control or as stock-in-trade because the dominant purpose or the intention while making the purchase of such investment is not relevant.
For computing book profits under Section 115JB, while adding back expenditure disallowable under Section 14A under Clause (f) of Explanation 1 below Section 115JB, guidance in this paper in para H.7 may be useful.
Source- Taxalogue 3- April to June 2020
The url linked to the SOP dated 10.01.2018 takes us to CBEC SOP to be followed by exporters. Please update with correct link