Disallowance of expenditure u/s 14A of Income Tax Act against Exempt Income

Section 14A of the Income Tax Act disallows expenditure incurred in relation to income that does not form part of total taxable income. If an assessee claims no expenditure was incurred for exempt income, no disallowance arises. However, if the Assessing Officer (AO) doubts the correctness of the claim, disallowance must be computed under Rule 8D, which includes expenditure directly related to exempt income plus 1% of the annual average of monthly investments, capped at total expenditure claimed. Assessees usually calculate disallowance by maintaining separate records for specific expenditures or proportionately allocating common expenses based on fund or resource usage. AO may dispute the disallowance if proper workings or fund allocation are not provided. Since the 2022 amendment, Section 14A applies even if no exempt income is earned or exempt loss occurs. Careful documentation, verification by tax auditors, and maintaining working sheets are essential to substantiate claims or avoid disputes.

What does section 14A say:

No deduction shall be allowed for expenditure incurred in relation to income which does not form part of the total income.

In case, Assessee claims that he has not incurred any expenditure in relation to exempt income then, no disallowance u/s 14A shall attract.

In case, Assessing Officer is not satisfied with the correctness of the disallowance or claim made by assessee that he has not incurred expenditure in relation to exempt income, then AO shall determine the same as per rule 8D of the Income Tax Rules (However, AO should record the reasons for not satisfying with the method followed by the assessee).

What does Rule 8D say about calculation of Disallowance:

Total of:

1. Expenditure which is directly related to exempt income.

2. An amount equal to 1% of Annual average of monthly average of opening and closing investment amount.

However, disallowance u/s 14A shall not exceed the total expenditure claimed by the assessee.

Illustration for calculation of 1% disallowance:

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How assessee’s usually calculate the disallowance amount u/s 14A:

1. In case of specific expenditure incurred by assessee separate records may be maintained in respect of expenditure incurred for exempt income.

2. In case of common expenditure incurred by assessee for taxable income and exempt income, the same may be allocated proportionately based on Income ratio or resource ratio (in case of manpower/Bank Loan, etc).

Illustration:

Under which circumstances, AO may disagree with the disallowance made by Assessee:

1. Assessee has reported exempt income, but no disallowance was offered u/s 14A.

2. In case assessee not able to submit proper workings for the disallowance made u/s 14A.

3. Where assessee could not segregate the utilization of funds/resources/investment towards taxable income and exempt income.

 What are the precautions the assessee may adopt:

1. Must report the disallowance u/s 14A, when there is an exempt income if it applies.

2. Maintain proper working sheets duly verified by Tax Auditor along with supporting.

3. In case assessee claims that he has not incurred any expenditure for exempt income, then he must have proper backup to prove the same.

Whether disallowance attracts in case no exempt income is earned:

Yes, disallowance u/s 14A still attracts irrespective of earning exempt income or incurring exempt loss owing to amendment made in Finance Act,2022 (refer Explanation to section 14A).

Since, the legislative intent behind section 14A, is to allow the deduction of expenditure incurred for taxable income only. Hence Any expenditure incurred towards exempt income whether earned profit or incurred loss shall be disallowed.

Example: Exempt Loss incurred out of borrowed funds- then proportionate interest on such borrowings shall be disallowed u/s 14A.

 Whether disallowance attracts in all cases of exempt income:

No, disallowance u/s 14A will not attract merely on earning exempt income. If no expenditure is incurred in relation to exempt income, then disallowance u/s 14A does not arise. However, assessee must prove the same.

Example: Exempt income earned out of investment from assessee’s own funds- Since there is no expenditure incurred towards finance cost, no disallowance u/s 14A.