The very intent of the section 14A of the income tax Act is that no expenditure shall be allowed as deduction, in computing the Total income of the Assessee, if such expenditure is incurred to earn an income, which is exempt under Income tax act. That is to say that no deduction shall be allowed in respect of the expenditure incurred in relation to the income which does not form part of the Total Income of the Act. The concept behind the insertion of section 14A of the income tax Act by the Finance Act 2001, with the retrospective effect from 1962, is that when the income, say, income from Agriculture or Dividend income, itself is exempt from Tax, the corresponding expenditure that shall be incurred for deriving such exempt income shall not be allowed as deduction against other taxable income logically and such expenditure can alone be deducted against such income, which is exempt from Tax.
The said section 14A has been provocative and was subject to various interpretations, with regard to the disallowance of such incurrence of expenses in relation to earning of exempt income. The issue involved is that whether such expenditure is to be disallowed, even if the exempt income is not earned during the previous year.
The Assessing Authorities make disallowances of expenses in respect of interest cost on loans borrowed for investment in the shares of companies along with other expenses, in relation to the earning of such exempt income, charged to Profit and loss account, by invoking Rule 8D, as the case may be, after placing due reliance on Department Circular 5/2014, on the contention that the said investments shall yield dividend income, which is exempt from tax. The said circular is depicted as below:
“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. Thus, in light of above , Central Board of Direct Taxes, in exercise of its powers under section 119 of the Act hereby clarifies 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.’’
Based on the above Circular, the Assessing Authorities disallowed the expenses by invoking Rule 8D read with section 14 A of the Income tax act on the ground that it is not necessary that the Assessee should have earned exempt income during the Financial Year to invoke Section 14 A of the Act and respective orders disallowing the impugned expenses u/s-143(3) of the Income tax Act were passed.
However, the Assessees challenged the impugned orders passed by the Revenue before the judiciaries and the most of the judgements were held in favour of the Assessees by the Hon’ITATs and Hon’ High courts, based on the contentions that the provisions of Section 14A shall be relatable to the earnings of actual income and cannot be on notional/hypothetical or anticipated/predicted income and the computation of total income for the purpose of section 5 of the Act is on the real income and there is no sanction in Law for the assessment of admittedly notional income, principally in the context of effecting a disallowance of expenses, particularly the interest cost on loans, in connection therewith, which eventually leads to imposition of an artificial method of computation on hypothetical and assumed/indeterminable income, which is contrary to law. Hence, the decisions were made in favour of the Assessees by the Hon’ Tribunals and Hon’ High Courts on the view that the provisions of section 14A read with Rule 8D of the Rules cannot be applicable in the absence of exempt income.
However, on further appeals by the revenue before the Hon’ble Apex court, the Apex court considered the issue in further detail by placing the legislative intent of the aforesaid circular 5/2014, with reference to the circular 14 of 2001,wherein, the very objective of the said circulars is to curb the practice of reducing the Tax liability on the taxable income which is forming part of the total income. It is imperative to note that Sec.14A clarifies the expenses incurred can be allowed only to the extent they are relatable to earning of taxable income, eventually, curbing the practice of claiming deduction of expenses incurred in relation to exempt income against taxable income, as laid down by the Hon’ble. Apex court in the case of CIT Vs Walfort Share Stock Brokers OP.Ltd  326 ITR 1(SC).
The Hon’ble ITAT in the case of Lally motors Pvt.Ltd., Vs Pr.CIT clarified by accentuating the basic principle that Sec 14A would be attracted on the expenditure duly incurred in relation to the earning of exempt income, not includible in the total income , even if such exempt income is not earned, as the legislative intent of the circular5/2014 which explains the logical basis of the provisions of Sec.14A with reference to the circular 14 of 2001, is to curb the practice of reducing the tax liability on taxable income by claiming such expenditure incurred on earning non-taxable income against the taxable income, leading to undue reduction of tax liability. Therefore, whether the exempt income is materialised or not, is not a relevant factor for invoking sec.14A of the act towards the disallowance of such expenditure incurred. The Hon’ble ITAT further reiterated that when the taxable income is added at netof relatable expenditure, the methodology/logic cannot be otherwise for exempt income.That is to further state that when the expenditure incurred for earning exempt income is charged against the taxable income, this not only violates the basic principle of taxation, it would also defeat the objective of sec.14A, as the said expenditure in relation to exempt income which was not earned, would get charged against the taxable income, consequently reducing the tax liability,as stated, which in turn, is contrary to the law, as clarified by the Hon’ble Apex court in the case of CIT v Wolfort share & stock brokers P Ltd326 ITR1 (SC), which was explained at length in the case of Godrej &Boyce MfgCo.Ltd V Dy CIT 328 ITR 81(Bom).
The Hon’ble Apex court in the case of CIT v Rajendra Prasad Mody  115 ITR 519 (SC) has patently explicated the fundamental principle of taxation with regard to allow-ability of an expenditure. The Hon’ble Apex court elucidated the principle that when an expenditure is incurred to earn taxable income, the excess of expenditure over the said taxable income or even Nil taxable income would get allowed under “Income from business or Income from other sources” as the case may be and eventually the allow-ability of an expenditure would not depend on whether it has resulted in an income (positive income) and it is just adequate to establish the fact that the expenditure stands incurred for the admissibility. By applying the same analogy, when the expenditure is incurred for earning exempt income, the claim of such expenditure should be reckoned/ confined only to income exempt from tax whether earned or not and consequently the same cannot be charged against the taxable income as per the logical basis in the wake of the aforesaid circulars pursuant to the intent behind Sec.14A. That is to say that when the assessee incurs expenditure (say interest cost on loan borrowed for agricultural operations) to earn agricultural income, which is exempt from tax, the excess of expenditure over such agricultural income or NIL agriculture income cannot be charged against business income or income from other sources. The objective behind this is torefrain the assessee from getting a double benefit, Viz., the benefit of the income being exempt from tax and the other by getting deduction on account of expenditure against taxable income, which is contrary to the Law of Taxation.
The Hon’ble Apex court in Max opp Investment Ltd & Ors V. CIT (in VA nos. 104-109 of 2015, dated February 12, 2018) has clearly delineated the real test that needs to be applied for invoking Sec 14A of the act. The Apex court expounded the test that if the expenditure incurred has no casual connection with the income exempt under tax, such expenditure shall be obviously treated as not related to income that is exempt from tax and such expenditure would be allowed as business expenditure. That is to state that due emphasis is given to the nature and characteristics of the transaction, wherein, the expenditure say “Interest cost” incurred on borrowed funds to make the investment for getting income which shall be brought under taxable net, then, such expenditure shall not be brought under the purview of Sec.14A. However, in that eventuality, the burden of proof lies on the assesse to justify the fact that the income which shall be generated on account of such investments shall be brought under taxable net.
The Hon’ble Supreme court in the case of Maxopp investments limited, supra, is in agreement with the view taken by the Hon’ble Delhi High Court with regard to the dominant purpose of making such investments in order to gain controlling interest of the investee company, is not a relevant factor, as the principle of apportionment of expenses between the expenses incurred in relation to earning taxable income and non-taxable income (Exempt income), in respect of divisible business, as entrenched and imbedded in Section 14A, is to be applied mandatorily, which is why, the section 14A, which was brought into force by the finance act 2001, but also made it retrospective from 1962, right from the inception of the income tax act and accordingly dismissed the appeal of the Assessee, confirming the addition of the interest cost incurred by the Assessee for the said investment. The Special Bench of the Hon’ble Tribunal in the said case also held that the investment in shares representing controlling interest does not amount to carrying on business and hence, interest expenditure incurred for acquiring shares was attracted by the provisions of section 14A of the Act.
The Hon’ Apex Court in the case of M/s. Max opp Investments Ltd., Vs CIT, (Supra) clearly explainsthe fact that the quality of the expenditure that determines its deducibility and not its quantum and ultimately, if the very purpose of the expenditure duly incurred by the Assessee, is to earn taxable income and the same, in turn, does not fall under the purview of Section 14A of the Act.
Therefore, it is axiomatic from the decision of the Hon’ble Apex Court, the expenditure incurred on induction of funds/investments shall be allowed as deduction, if the objective behind such investment shall yield income, which is taxable under the Act. For instance, the Assessee, say a doctor/Medical practitioner, by profession, incurs interest cost on borrowed funds for investments in Hospitals with an intention of earning consultancy income from such hospitals, which shall be brought under taxable net, then, such expenditure shall be allowed as business expenditure, in terms of professional or commercial expediency. In that eventuality, it is very much imperative for the Assessee to establish that the Assessee shall not earn such taxable income viz., consultancy income, in the absence of such investments.