Section 14A was enacted vide Finance Act, 2001 w.r.e.f. 01.04.1962, so that net taxable income is actually taxed and no deduction is allowed against taxable income for expenditure incurred in earning exempt income. Further, it was enacted to overcome the Supreme Court decision in the case of Rajasthan State Warehousing Corporation v. CIT (2000) 242 ITR 450 (SC) wherein it was held that in case of an indivisible business, some income wherefrom is taxable while some exempt, entire expenditure would be permissible as deduction. As per the Memorandum of Finance Bill, 2001, it was explained that expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income. 

Applicability of Section 14A

Section 14A applies in the following cases:

(i) The assessee claims that there is no expenditure incurred  for earning such exempted income.

(ii)  The assessee has incurred the expenses to earn the exempted income, and such expenses are disallowed by  the taxpayer.

(iii)   The Assessing Officer is not satisfied with the correctness  of the amount claimed for expenditure incurred.

(iv)    The assessee has invested to earn exempted income. 

For computing the total income under this Chapter, no deduction shall be allowed in respect of Expenditure incurred by the assessee in relation to income which does not form part of the total income under this Act. [Section 14A(1)]

Assessing Officer shall determine the amount of Expenditure incurred in relation to exempt income in accordance with such method as may be prescribed under Rule 8D in following cases……

Section 14A(2) Section 14A(3)
If Assessing Officer, having regard to the accounts of the assessee, is not satisfied with the correctness of the claim of the assessee in respect of such expenditure. where an assessee claims that no expenditure has been incurred by him in relation to income not forming the part of the total income under this Act.

Proviso to Section 14A

PROVIDED THAT nothing contained in this section shall empower the Assessing Officer either to reassess under section 147 or pass an order enhancing the assessment or reducing a refund made or otherwise increasing the liability of the assessee under section 154, for any Assessment year beginning on or before the 1st day of April, 2001.

Expectations from the Assessing Officer

(i)   Recording of satisfaction

Memorandum to the Finance Act 2006 explaining introduction of sub-sections (2) and (3) in section 14A of the Act, states as under:

“However, the Assessing Officer shall be required to adopt the prescribed method if, having regard to the accounts of the assessee, he is not satisfied with the correctness of the claim of the assessee in respect of expenditure in relation to income which does not form part of the total income”

The invocation of sections 14A(2)/(3) read with Rule 8D is thus made conditional upon the objective satisfaction of the Assessing Officer about the correctness of the assessee’s claim, having regard to the accounts of the assessee. The Assessing Officer has to arrive at the decision in good faith and on relevant considerations. If the Assessing Officer is not satisfied with the correctness of the assessee’s claim, he must record the reasons for his conclusion. Resort cannot be had to the provisions of Rule 8D in the absence of such finding.

Assessing Officer failed to satisfy himself about correctness of assessee’s claim, impugned disallowance was to be deleted 

Allowing the appeal of the assessee the Tribunal held that; since, in instant case, Assessing Officer failed to satisfy himself about correctness of assessee’s claim, impugned disallowance was to be deleted. (Related Assessment year : 2010-11) – [Associated Law Advisers v. ITO (2017) 167 ITD 695 (ITAT Delhi)]

 (ii)   Onus to prove incurrence of expenditure

The onus to prove that interest bearing funds were used or expenditure was incurred, lies squarely on the shoulders of the revenue. Thus, if the Assessing Officer is able to refer to relevant material while recording satisfaction that borrowed funds were used to earn interest- free income, he may legitimately disallow such a claim. The Assessing Officer however cannot by recording general observations, particularly where the assessee has denied using interest- bearing funds, proceed to infer that interest-bearing funds may have been used to earn exempted income. Section 14A being in the nature of an exception, has to be construed strictly and only where the Assessing Officer records satisfaction, on the basis of clear and cogent material, shall an order be passed under section 14A, disallowing such a claim.

Disallowance of expenditure under section 14A – Exempt income – Interest – Where the assesse is able to establish the nexus disallowance can be made under Rule 8D(2)(i) and not under Rule 8D(2)(ii)

Assessee company was engaged in share broking business. On examination of return of assessee, Assessing Officer noticed that assessee had disclosed dividend income and claimed same as exempt from taxation but did not make any disallowance under section 14A ,invoking rule 8D(2)(ii), he computed disallowance. Tribunal held that workings furnished by assessee for interest disallowance were not examined at all by Assessing Officer and assessee was able to prove nexus between borrowings and investments, and assesse was able to prove nexus between borrowings and investments , interest disallowance was required to be made under Rule 8D(2)(i) and not by invoking rule 8D(2)(i).  (Related Assessment year : 2008-09) – [ITO v. Reliance Share & Stock Brokers (P) Ltd. (2015) 67 SOT 73 : (2014) 51 taxmann.com 215  (ITAT Mumbai)]

In the case of CIT v. Deepak Mittal, the High Court has laid down that when consistent case / version of the assessee was that he had not incurred any expenditure for earning exempt income, the Assessing Officer, in terms of section 14A(2) of the Act, was to proceed further to collect the relevant material or evidence, to determine the expenditure relating to such exempt income. It was also held that application of rule 8D by the Assessing Officer as a substitute for section 14A(2), is not permissible in law.

 As per the aforesaid judgement, in the case of Deepak Mittal, the High Court has held that in a case where no expenditure has been incurred by the assessee in earning the exempt income, there can not be any disallowance of expenditure under section 14A, r.w.r. 8D of the Income-Tax Rules, 1962 (the Rules). It was further held by the High Court that when consistent case / version of the assessee, despite notice given by the Assessing Officer to give details of the expenditure incurred on earning exempt income in the nature of dividend, was that he had not incurred any expenditure on earning such income, the Assessing Officer, in terms of section 14A(2) of the Act, was to proceed further to collect such material or evidence to determine expenditure, if any, incurred by the assessee. The Assessing Officer, however, relying on rule 8D of the Rules, applied as a formula applicable to an assessee, who had incurred expenditure by way of interest, which is not directly attributable to any particular income or receipt. Such was not the case in the case of the present assessee and therefore, there was clearly a wrong application of rule 8D, as a substitute for section 14A(2) of the Act, which is not permissible in law. – [CIT v. Deepak Mittal (2014) 361 ITR 131 (2013) 219 Taxman 314 (P&H)].

Onus is on Assessing Officer to show how assessee’s claim is incorrect. Assessing Officer has to show direct nexus between expenditure & exempt income. Disallowance cannot be made on presumptions [Rule 8D]

Assessing Officer made a disallowance of Rs. 58 lakhs under section 14A read with Rule 8D. The assessee claimed that the disallowance was not permissible on the grounds that (i) the Assessing Officer had not recorded any satisfaction as to the correctness of the assessee’s claim that it had not incurred expenditure of more than 2% of the dividend income earned, (ii) it had not made any fresh investment during the year and the dividend was received from an unlisted company out of an investment made in an earlier year & (iii) the Assessing Officer had not pointed out any direct nexus between the interest expenditure incurred and the exempt income earned during the year. The CIT(A) accepted the claim & restricted the disallowance to Rs. 50,000 On appeal by the department to the Tribunal HELD dismissing the appeal: (i) A disallowance under section 14A read with Rule 8D cannot be made without recording satisfaction as to how the assessee’s calculation of section 14A disallowance is incorrect. It is a prerequisite that before invoking Rule 8D, the Assessing Officer must record his satisfaction on how the assessee’s calculation is incorrect. The Assessing Officer cannot apply Rule 8D without pointing out any inaccuracy in the method of apportionment or allocation of expenses. Further, the onus is on the Assessing Officer to show that expenditure has been incurred by the assessee for earning tax-free income. Without discharging the onus, the Assessing Officer is not entitled to make an ad hoc disallowance. A clear finding of incurring of expenditure is necessary. No disallowance can be made on the basis of presumptions, (ii) the mere fact that some interest expenses were incurred cannot be the reason for disallowance unless the nexus between the expense and the exempt income is established, (iii) the assessee did not make any fresh investment during the year which could generate exempt income in forthcoming years, (iii) the exempt income earned during the year comprised of dividend received from an investment made in an earlier year, (iv) the interest expenditure of the year is not directly related to the earning of exempt income & (v) the Assessing Officer has not pointed out any direct nexus between the interest expenditure incurred and the exempt income earned during the year. (Related Assessment year : 2009-10) – [DCIT v. Allied Investment Housing (P) Ltd. – Date of Judgement : 07.11.2013 (ITAT Chennai)]

KEY NOTE

(i)    Assessing Officer should concentrate on investments in the balance sheets which would result in incomes not includible in taxable income; for e.g. tax free bonds, equities held as investments, PPF, LIC investments, capital in partnership firm or agriculture assets, etc.

(ii)  Assessing Officer to write detailed reasons, backed by facts, to disagree with explanation of assessee, before Assessing Officer proceeds for making disallowance under section 14A.

(iii) Assessing Officer to call for fund-utilization/cash flow statement & independently call loan approval documents from banks/Financial Institution to arrive at/rule out one-to-one nexus of borrowed funds with investments income from which is claimed as exempt.

(iv)  Always check the current status of SLPs/Appeals pending before Hon‘ble Supreme Court or High courts. 

Where there is no actual receipt of exempt income – CBDT clarifies that disallowance under section 14A will be attracted even if no exempt income is earned during the financial year

The Central Board of Direct Taxes (CBDT) issued Circular No. 5/2014 dated 11.02.2014, through which it has taken a view that disallowance of expenditure for earning exempt income under section 14A read with Rule 8D would be attracted even if the corresponding exempt income has not been earned during the financial year, thereby superseding a few decisions rendered in this regard.

CBDT Circular No. 5/2014, Dated : 11.02.2014

Subject: – Clarification regarding disallowance of expenses under section 14A of the Income-tax At in cases where corresponding exempt income has not been earned during the FY -regarding.

Section 14A of the Income-tax Act, 1961 (`Act’) provides for disallowance of expenditure in relation to income not “includible” in total income.

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.

2.The matter has been examined in the Board. It is pertinent to mention that section 14A of the Act was introduced by the Finance Act, 2001 with retrospective effect from 01.04.1962. The purpose for introduction of section 14A with retrospective effect since inception of the Act was clarified vide Circular No. 14 of 2001 as under:

“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 have been 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 also the tax payable on the non-exempt income by debiting the expenses incurred to earn the exempt income against taxable income. This is against the basic principles of taxation whereby only the net income, i.e., gross income minus the expenditure, is taxed. On the same analogy, the exemption is also in respect of the net income. Expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income”.

Thus, 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.

3. 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 Income Tax 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.

4. The above position is further substantiated by the language used in Rule 8D(2(ii) & 8D(2)(iii) of Income Tax Rules which are extracted below:

“(ii) in a case where the assessee has incurred expenditure by way of interest during the previous year which is not directly attributable to any particular income or receipt an amount computed in accordance with the following formula, namely:-

 A*B/C Where……….

B= the average of value of investment, income from which does not or shall not form part of total income as appearing in the balance sheet of the assessee, on the first and last day of the previous year :

(iii) an amount equal to one-half percent 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 ’tile last day of the previous year.”

(Emphasis added)

5. 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.

6. This may be brought to the notice of all concerned.

Disallowance under section 14A cannot exceed assessee’s exempt income

The assessee earned dividend income of Rs.1,13,72,545 which was exempt from tax. The Assessing Officer disallowed interest and administrative expenditure in relation to the exempt income in a sum of Rs.4,22,72,425/- of the Act. The Tribunal confirmed the disallowances. On appeal court held that the disallowance under section 14A read with rule 8D could not exceed the assessee’s exempt income. The disallowance under section 14A was to be limited to the extent of the dividend income earned by the assessee which was exempt from tax. (Related Assessment year : 2008 -09) – [Nirved Traders (P) Ltd. (2020) 421 ITR 142 (Bom)]

Disallowance under section 14A cannot exceed exempt income earned – Tribunal restricting disallowance to extent offered by assessee is held to be proper

Dismissing the appeal of the revenue the Court held that the disallowance of expenditure incurred to earn the exempt income could not exceed the exempt income earned. The ratio of the decisions in the cases of Cheminvest Ltd. v. CIT (2015) 378 ITR 33 (Del) and CIT v. Holcim India (P) Ltd. (I. T. A. No. 486 of 2014 decided on 05.09.2014(Del) would include a facet where the assessee’s exempt income was not nil, but had earned exempt income which was more than the expenditure incurred by the assessee in order to earn such income. The order of the Tribunal which restricted the disallowance of the expenditure to the extent voluntarily offered by the assessee was not erroneous. (Related Assessment year : 2009-10) – [CIT v. HSBC Invest Direct (India) Ltd. (2020) 421 ITR 125 (Bom)]

No Section 14A disallowance if there is no exempt income in that year

As per Section 14A of the Act, the purposes of computing the total income under Chapter, no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income which does not form part of the total income under the Act. Hence, what Section 14A provides is that if there is any income which does not form part of the income under the Act, the expenditure which is incurred for earning the income is not an allowable deduction.

In the given case, there was no tax-exempt income in the relevant previous year, hence ITAT hold that no disallowance under section 14A could have been made, on the facts of this case and in the year before us. ITAT, therefore, uphold the plea of the assessee and delete the disallowance of Rs 80,51,200 sustained by the CIT(A). The grievance of the assessee is thus upheld and grievances of the Assessing Officer are dismissed as infructuous. (Related Assessment Year : 2013-14) – [DCIT v. JSW Limited – Date of Judgement : 14.05.2020 (ITAT Mumbai)]

Assessing Officer cannot reject the disallowances offered by the assessee, without adducing any reasons
In this case, the assessee had offered amounts as disallowance claiming them to be expenditure for tax exempt income. The assessing officer merely proceeded to reject such amount as expenditure and straightaway applied rule 8D without adducing any reasons. It was held that Unless the assessing officer rejected the explanation or the rationale which induced the assessee to offer particular amount as expenditure with some reasoning, the mere rejection per se cannot be accepted. – [PCIT v. Moonstar Securities Trading and Finance Co. (P) Ltd. (2019) 263 Taxman 459 : 105 taxmann.com 274 (Del)]

KEY NOTE :  SLP of revenue is dismissed, PCIT v. Moonstar Securities Trading and Finance Co. (P) Ltd. (2019) 263 Taxman 458 (SC)

It is not possible to disallow amount under section 14A in a mechanical way so as to exceeds the actual administrative expenditure claimed 

It was held that disallowance rule cannot be applied in a mechanical way and under no circumstances an Assessing Officer can attribute expenses for earning tax free income in excess of total administrative expenditure incurred by assessee. – [PCIT v. Adani Agro (P) Ltd (2018) 91 taxmann.com 29 (Guj)] 

Disallowance of expenditure – Exempt income –Explanation offered cannot be rejected arbitrarily by the Assessing Officer

Dismissing the appeal of the revenue the Court held that, explanation of assessee and amount offered to tax under said section could not have been rejected by Assessing Officer in arbitrary manner. – [PCIT v. Hero Corporate Service Ltd. (2019) 262 Taxman 30 : 103 taxmann.com.199 (Del)]

KEY NOTE :  SLP of revenue is dismissed , PCIT v. Hero Corporate Service Ltd. (2019) 262 Taxman 29 (SC)

 The disallowance of expenditure under section 14A cannot exceed the amount of tax-free dividend

The income from dividend had been shown at Rs. 1,11,564/- whereas disallowance under Section 14A read with Rule 8D of the Rules worked out by the Assessing Officer came to Rs. 4,09,675/-. Thus, the Assessing Officer disallowed the entire tax exempt income which is not permissible as per settled position of law. The window for disallowance is indicated in section 14A, and is only to the extent of disallowing expenditure “incurred by the assessee in relation to the tax exempt income”. The disallowance under section 14A read with Rule 8D as worked out by the Assessing officer is not in accordance with law and as such working is not sustainable. (Related Assessment year : 2009-10) – [PCIT v. Empire Package Pvt. Limited – Date of Judgement : 12.01.2016 (P&H)]

Disallowance of expenditure – Exempt income – Effect of Rule 8D

Aassessee to prove it had sufficient funds to finance tax-exempt investments and that no disallowance would arise on basis of general pool of funds hypothesis. Matter remanded to Assessing Officer to allow assessee opportunity to show why disallowance under section 14A(1) should not be worked out following, proportionate method. (Related Assessment years : 2005-06 to 2008-09) – [Hercules Hoists Ltd. v. ACIT (2013) 59 SOT 43 : 22 ITR 527 (URO)(ITAT Mumbai)]

Onus on assessee to prove that he had not incurred any expenses relating to income not forming part of total income

Assessing Officer had disallowed a sum of Rs.3,05,423/- by applying provisions of section 14A read with rule 8D. On Appeal the Commissioner (Appeals) reduced the disallowance to Rs. 1 lakh on the ground that there is no precise finding given by the Assessing Officer. On appeal Tribunal held that onus lay on assessee to prove that he had not incurred any expenses relating to income not forming part of total income. Since assessee did not file any details of expenditure incurred by him, the order of Commissioner (Appeals) was set aside and that of Assessing Officer restored. (Related Assessment year : 2009-10) – [ACIT v. Joe Marcelinho Mathias (2013) 156 TTJ 777 : 143 ITD 132 : 92 DTR 331 (ITAT Panji)]

 Assessing Officer must examine the accounts closely and determine if at all any expenditure could be ascribed to the tax exempt dividend/interest earned by the assessee. If the tax exempted income was earned without the interference of any employee the question of attributing any expenditure cannot arise at all – Duty of Assessing Officer to examine accounts of assessee and determine whether any expenditure could be ascribed to exempt income — Matter remanded 

Sub-rule (1) categorically and significantly states that the Assessing Officer having regard to the account of the assessee and on not being satisfied with the correctness of the claim of expenditure made by the assessee or claim that no expenditure was incurred in relation to income which does not form part of the total income under the Act, can go on to determine the disallowance under subrule (2) to Rule 8D of the Rules. Sub-rule (2) will not come into operation until and unless the specific precondition in sub-rule (1) is satisfied. Thus, section 14A (2) of the Act and rule 8D (1) in unison and affirmatively record that the computation or disallowance made by the assessee or claim that no expenditure was incurred to earn exempt income must be examined with reference to the accounts, and only and when the explanation/ claim of the assessee is not satisfactory, computation under subrule (2) to rule 8D of the Rules is to be made. Allowing the appeal the Court held that; Duty of Assessing Officer to examine accounts of assessee and determine whether any expenditure could be ascribed to exempt income. Matter remanded. – [Pradeep Khanna v. ACIT (2017) 399 ITR 146 (Del)]

Assessing Officer cannot blindly apply the Rule 8D, without elucidating and explaining why assessee’s voluntary disallowance was unreasonable and unsatisfactory

Dismissing the appeal of the Revenue the Court held that, the Assessing Officer cannot blindly apply the Rule 8D, without elucidating and explaining why assessee’s voluntary disallowance was unreasonable and unsatisfactory. (Related Assessment year : 2006-07) – [PCIT v. U.K. Paints (India) (P) Ltd. (2017) 244 Taxman 309 (Del)]

Shipping company – Tonnage tax scheme – Assessing Officer has to exam one accounts of assessee first and then if he is not satisfied with correctness of claim, only he can invoke rule 8D – Satisfaction is mandatory – When no expenditure was incurred for earning exempted income – Disallowance can not be made

Since the Assessing Officer embarked upon computing disallowance under rule 8D without considering the assessee’s claim, the disallowance under section 14A could not stand. The assessee had not directly incurred any expenditure for earning the exempt income and the Assessing Officer had not recorded any satisfaction with reference to the accounts of the assessee or claim that no expenditure was incurred. The assessee offered most of the income under the tonnage tax scheme and the remaining expenditure was for earning taxable non-tonnage tax income. Therefore, the question of invocation of rule 8D for disallowing the expenditure under section 14A on presumptive basis does not arise. (Related Assessment year : 2008-09) – [Raj Shipping Agencies Ltd. v. Add. CIT (2014) 146 ITD 277 : (2013) 24 ITR 249 (ITAT Mumbai)]

Circular No. 11/2001, dated 23.07.2001, was issued by CBDT so as to direct that the assessments where the proceedings have become final before the first day of April, 2001 should not be re‐opened under section 147 of the Act to disallow expenditure incurred to earn exempt income by applying the provisions of newly inserted section 14A of the Act. The same view has been expressed in CIT v. PNB Finance & Industries Ltd (2010) TIOL – 801-HC –DEL –IT.

CBDT Circular No. 11/2001, dated 23.07.2001

Subject : Clarification regarding restriction on re-  opening of completed assessments on account of provisions of section 14A

1. The Finance Act, 2001 has inserted section 14A in the Income-tax Act, 1961 wherein it was specifically provided that no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income which does not form part of total income under the Act. The amendment takes effect from 01.04.1962.

2. Section 14A was introduced retrospectively in order to clarify and state the position of law that any expenditure relatable to income which does not form part of total income cannot be set off against other taxable income. This section was not introduced with prospective effect, as that would have implied that before the introduction of the said provisions, expenditure incurred to earn exempt income was allowable.

3. Instances of reopening of old assessments, which had attained finality, after insertion of section 14A in the Act, have come to the notice of the Board. Reopening of past completed assessments, having attained finality, on the basis of newly inserted provisions of section 14A is likely to cause hardship to a large number of taxpayers and would result in increasing avoidable litigation.

4. The Board have considered this matter and hereby directs that the assessments where the proceedings have become final before the first day of April, 2001 should not be re-opened under section 147 of the Act to disallow expenditure incurred to earn exempt income by applying the provisions of newly inserted section 14A of the Act.

The proviso to section 14A bars reassessment but not original assessment on the basis of retrospective amendment. – [Honda Siel Power Products Ltd. v. DCIT (2011) 197 Taxman 415 (Del)]

Bar under Circular No. 11 dated 23.07.2001 on reopening of concluded assessment would not operate where assessment was pending finalization after remand by first appellate authority in appeal filed by assessee. – [Catholic Syrian Bank Ltd. v. CIT (2010) 187 Taxman 185 (Ker.)]

Heads of Income

The provisions of section 14A will apply to all income which is exempt whether the income is assessed under the head “Other sources’ or under the head “Business” because there is nothing in Section 14A which restricts the Lunawat & Co operation of section to income of a particular nature only – [Insaallah Investments Ltd. V. ITO (2008) 23 SOT 130 (ITAT Delhi)]

At para 42, Hon’ble Court has considered the decision of Punjab & Haryana High Court in the case of Avon Cycles Ltd., Ludhiana.It has been stated that the assessee had paid total interest of ₹ 2.92 lakh out of which interest paid on term loan raised for specific purpose totals to ₹ 1.70 crore and balance interest paid by the assessee was ₹ 1.21 crore.  In view of provisions of Rule 8D(2)(ii) of Income-tax Rules, the Tribunal had upheld the disallowance of ₹ 10,49,851/- which was determined with reference to interest of ₹ 1.21 crore only after excluding interest on loans raised for specific purpose. High Court had dismissed the appeal filed against the order of ITAT observing that after examining the Balance Sheet of the assessee and finding of fact, there was no question of law. The Hon’ble Supreme Court also after going through the record and applying the principle of apportionment has dismissed the appeal. What is important to be noted is that the apportionment as per Rule 8D(2)(ii) of Income-tax Rules had been made and upheld only with reference to balance interest of ₹ 1.21 crore. The position that amount of disallowance of ₹ 10,49,851/- was determined with reference to interest expenditure of ₹ 1.21 crore is quite clear on the basis of relevant order of ITAT, Chandigarh Bench, which was the subject matter before the High Court and the Supreme Court in ITA No.1143/Chd/2011 dated 17.01.2013. As per the facts average amount of investments was ₹ 18.685 crore and average of total assets was ₹ 215.34 crores and on that basis proportionate disallowance out of total expenditure of ₹ 1.21 crore related to the average investment worked out to ₹ 10,49,851/-.

Accordingly, it is stated that any expenditure incurred which is relatable to specific loans taken for business activities is to be excluded for the purpose of determining the proportionate disallowance on account of interest as per Rule 8D(2)(ii) of Income-tax Rules. – [[Maxopp Investment Ltd. v. Commissioner of Income Tax (2018) 402 ITR 640 (SC)]

In the judgment of Maxopp Investment Ltd. v. CIT  vide para 32, the Hon’ble Court has held that “if an expenditure incurred has no casual connection with the exempted income, then such an expenditure would obviously be treated as not related to the income that is exempted from tax, and such, expenditure would be allowed as business expenditure. To put it differently, such expenditure would then be considered as incurred in respect of other income which is to be treated as part of the total income.” Accordingly, the first condition to apply provisions of section 14A of the Act is that the assessee must have incurred expenditure which can be said to be related to exempt income. – [Maxopp Investment Ltd. v. CIT (2018) 402 ITR 640 (SC)]

 No disallowance on account of interest expense if borrowed funds have not been used for investments

The Court vide para 38 of the judgment in the case of Godrej & Boyce Manufacturing Co. Ltd. v. DCIT held that in the absence of any basis disclosed by the Assessing Officer establishing a reasonable nexus between the expenditure to be disallowed and dividend income received and also in the absence of any basis that any part of the borrowings of the assessee had been diverted to earn tax free income despite the availability of surplus or interest free funds available disallowance cannot be made. – [Godrej & Boyce Manufacturing Co. Ltd. v. DCIT & Anr. (2017) 394 ITR 449 (SC)]

For disallowance under section 14A – Expenditure should be actually incurred

In the decision in the case of Godrej & Boyce Manufacturing Co. Ltd. v. DCIT, (para 36), the Hon’ble Court has observed that “what cannot be denied is that the requirement for attracting the provisions of Section 14A(1) of the Act is proof of the fact that the expenditure sought to be disallowed/ deducted had actually been incurred in earning the dividend income. – [Godrej & Boyce Manufacturing Co. Ltd. v. DCIT & Anr. (2017) 394 ITR 449 (SC)] 

Interest expenditure on loans taken for specific business purpose is not to be considered for the purpose of apportionment

The Hon’ble Supreme Court in the case of Godrej & Boyce Manufacturing Co. Ltd. v. DCIT was considering the circumstances wherein it has been held in earlier years that no disallowance was to be made since the borrowed funds had not been used for the purpose of investments. In assessment year under consideration there was no increase in the amount of investments. In the circumstances view was taken that the expenditure under reference was not related to earning of dividend income and the assessee was entitled to exemption of full amount of dividend income. In the case of Maxopp Investment the Hon’ble Supreme Court in para 42 has discussed the decision of Punjab & Haryana High Court in the case of Avon Cycles Ltd., Ludhiana. It has been stated that the assessee had paid total interest of ₹ 2.92 lakh out of which interest paid on term loan raised for specific purpose totals to ₹ 1.70 crore and balance interest paid by the assessee was ₹ 1.21 crore. In view of provisions of Rule 8D(2)(ii) of Income-tax Rules, the Tribunal had upheld the disallowance of ₹ 10,49,851/- which was determined with reference to interest of ₹ 1.21 crore only after excluding interest on loans raised for specific purpose. High Court had dismissed the appeal filed against the order of ITAT observing that after examining the Balance Sheet of the assessee and finding of fact, there was no question of law. The Hon’ble Supreme Court also after going through the record and applying the principle of apportionment has dismissed the appeal. What is important to be noted is that the apportionment as per Rule 8D(2)(ii) of Income-tax Rules had been made and upheld only with reference to balance interest of ₹ 1.21 crore. The position that amount of disallowance of ₹ 10,49,851/- was determined with reference to interest expenditure of ₹ 1.21 crore is quite clear on the basis of relevant order of ITAT, Chandigarh Bench, which was the subject matter before the High Court and the Supreme Court in ITA No.1143/Chd/2011 dated 17.01.2013. As per the facts average amount of investments was ₹ 18.685 crore and average of total assets was ₹ 215.34 crores and on that basis proportionate disallowance out of total expenditure of ₹ 1.21 crore related to the average investment worked out to ₹ 10,49,851/-.

Accordingly, it is stated that any expenditure incurred which is relatable to specific loans taken for business activities is to be excluded for the purpose of determining the proportionate disallowance on account of interest as per Rule 8D(2)(ii) of Income-tax Rules. – [Godrej & Boyce Manufacturing Co. Ltd. v. DCIT & Anr. (2017) 394 ITR 449 (SC)]

In case own funds are more than the investments no disallowance on account of interest is to be made

The Hon’ble Supreme Court in the case of Godrej & Boyce Manufacturing Co. Ltd. v. DCIT has specifically taken note of the fact in that case investments were only of ₹ 125.54 crore whereas own funds of the company were of ₹ 280.64 crore which was interest free funds in the form of share capital and reserves. In the circumstances it was held by the Supreme Court that the fact that any part of the borrowings of the assessee had been diverted to earn tax free income despite the availability of surplus or interest free funds available remains unproved by any material whatsoever. Therefore, no disallowance for interest was to be made. – [Godrej & Boyce Manufacturing Co. Ltd. v. DCIT & Anr. (2017) 394 ITR 449 (SC)]

Position accepted in earlier years need to be followed in subsequent years

The Hon’ble Court also held in the case of Godrej & Boyce Manufacturing Co. Ltd. v. DCIT that though the principle of res judicata would not apply to assessment proceedings under the Act, the need for consistency and certainty and existence of strong and compelling reason for a departure from a settled position has to be spelt out. In this case since position had been examined and accepted by the Tribunal in earlier years the Hon’ble Court held that different view could not be taken. – [Godrej & Boyce Manufacturing Co. Ltd. v. DCIT & Anr. (2017) 394 ITR 449 (SC)]

Section 14A is applicable even where the motive of the assessee in acquiring the shares is to obtain controlling interest in a company and not to earn dividends

The question arose whether section 14A applies to a case where the motive of the assessee is to acquire controlling interest in a company and not to earn dividends. The Tribunal followed the judgement of the Special Bench in ITO v. Daga Capital Management (P) Ltd (2009) 312 ITR (AT) 1 and held that section 14A is applicable even where the motive in acquiring the shares was to obtain controlling interest in the companies. The Tribunal upheld in principle the applicability of section 14A but remanded the matter to the Assessing Officer to ascertain from the facts of the case as to how much interest bearing borrowings was utilized to acquire shares in the companies. (Related Assessment year : 2004-05) – [United Breweries Limited v. DCIT – Date of Judgement : 31.05.2016 (Karn)]

 Disallowance under section 14A cannot be made if the assessee has no tax-free income in the year

From the reading of section 14A of the Act, it is clear that before making any disallowance the following conditions are to exist:-

(a) That there must be income taxable under the Act, and

(b) That this income must not form part of the total income under the Act, and

(c) That there must be an expenditure incurred by the assessee, and

(d) That the expenditure must have a relation to the income which does not form part of the total income under the Act. Therefore, unless and until, there is receipt of exempted income for the concerned assessment years (dividend from shares), section 14A of the Act cannot be invoked.  (Related Assessment year : 2001-02) – [CIT v. Lakhani Marketing Inc. (2014) 272 CTR 265 : 226 Taxman 45 (Mag.) (P&H)]

Section 14A & Rule 8D cannot be applied in a mechanical mannerDisallowance cannot exceed expenditure claimed as a deduction

The assessee was assessed to income of Rs. 12.62 crore. The assessee had investments of Rs. 32.71 crore. The investment transactions were managed by investment advisers and the assessee paid portfolio management services (PMS) fees which were debited to his capital account. The demat expenses and security transaction tax (STT) was also debited to the capital account. The assessee claimed that the expenses relating to salary, telephone and other administrative expenses were incurred by him for his professional income and not for earning tax-free income. However, the Assessing Officer rejected the claim and made a disallowance of Rs. 16.35 lakhs, being 0.5% of the average investments under Rule 8D(2)(iii). The CIT(A) deleted the disallowance on the ground that it was without establishing any nexus. On appeal by the department to the Tribunal HELD dismissing the appeal. (Related Assessment year : 2009-10) – [ACIT 11(2) v. Iqbal M Chagala, Palloni Mansion – Date of Judgement : 30.07.2014 (ITAT Mumbai)]

Author Bio

Qualification: Post Graduate
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Location: FARIDABAD, Haryana, IN
Member Since: 12 Apr 2020 | Total Posts: 24
Born on 27 June, 1958 in Narnaul, Haryana joined Income-tax Department in the year 1983 and retired as Income Tax Officer on 30.06.2018. Have so far author of 21 books on Income Tax and also writer of his own blog https://ramduttsharma.blogspot.com/. Previlliged to be recipient of first-ever Finance View Full Profile

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