Evolution of Section 14A & Rule 8D of Income Tax

Section 14A of the Income-tax Act read with Rule 8D of Income-tax Rules which provide for disallowance of expenditure incurred in relation to income which does not form part of the total income, had been subject matter of a number of controversies.

Various High Courts and Benches of the Income-tax Appellate Tribunal have on numerous occasions given decisions, which, have, at least for some time, resolved a few aspects of the matter. There have been occasions where different benches of the ITAT have taken different views on a particular issue or two High Courts have taken divergent views. This has led to creation of Special Benches at the ITAT and / or also made taxpayers await the final word on the subject by the Supreme Court.

Hence, it becomes imperative to update oneself with the currently prevailing section 14A/Rule 8D

The Finance Act, 2001 inserted section 14A in the Income-tax Act, 1961 with retrospective effect from 01.04.1962. Section 14A provides that expenditure incurred in relation to exempt income shall not be allowed as a deduction while computing total income. The Memorandum to the Finance Bill, 2001, explained the said provision as follows:

Objective behind insertion of section 14A

The object behind the insertion of section 14A in the said Act is apparent from the Memorandum explaining the provisions of the Finance Bill 2001 which is to the following effect:-

Explanatory memorandum of Finance Bill-2001 whereby object behind section 14A was presented, as under:

“Certain incomes are not includable 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.

It is proposed to insert a new section 14A so as to clarify the intention of the Legislature since the inception of the Income- tax Act, 1961, that no deduction shall be made in respect of any expenditure incurred by the assessee in relation to income which does not form part of the total income under the Income-tax Act.

The proposed amendment will take effect retrospectively from April 1, 1962 and will accordingly, apply in relation to the assessment year 1962-63 and subsequent assessment years.”

Background

Section 14A was introduced to overcome the judgement of Supreme Court in 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 deduction and the principle of apportionment would apply only for an indivisible business.

The assessee was a State Government corporation who derived its income from interest, letting out of warehouse and administration charges for procurement of foodgrains. It claimed deduction of expenditure amounting to Rs. 38.13 lakhs under section 37 of the Act. The ITO allowed only so much of the expenditure as could be allocated to the taxable income and disallowed the rest of it which was referable to the non-taxable income, being exempt under section 10 (29) of the Act. The Tribunal and the High Court confirmed the disallowance. Supreme Court laid down following principles:

(i) if the income of an assessee is derived from various heads of income, he is entitled to claim deduction permissible under the respective head, whether or not computation under each head results in taxable income;

(ii) if the income of an assessee arises under any of the heads of income but from different items, e.g., different house properties or different securities, etc., and income from one or more items alone is taxable whereas income from the other item is exempt under the Act, the entire permissible expenditure in earning the income from that head is deductible; and

(iii) in computing the “profits and gains of business or profession” when an assessee is carrying on business in various ventures and some among them yield taxable income and the others do not, the question of allowability of the expenditure under section 37 of the Income Tax Act, 1961, will depend on :

(a) fulfilment of requirements of that provision; and

(b) on the facts whether all the ventures carried on by him constituted one indivisible business; if they do the entire expenditure will be a permissible deductible but if they do not, the principle of apportionment of the expenditure will apply, because there will be no nexus between the expenditure attributable to the venture not forming an integral part of the business and the expenditure sought to be deducted as the business expenditure of the assessee. – [Rajasthan State Warehousing Corporation v. CIT (2000) 242 ITR 450 : 159 CTR 132 : 109 TAXMAN 145 (SC)]

Text of Section 14A

EXPENDITURE INCURRED IN RELATION TO INCOME NOT INCLUDIBLE IN TOTAL INCOME.

14A.(1) For the purposes of 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.

(2) The Assessing Officer shall determine the amount of expenditure incurred in relation to such income which does not form part of the total income under this Act in accordance with such method as may be prescribed, if the 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 in relation to income which does not form part of the total income under this Act.

(3) The provisions of sub-section (2) shall also apply in relation to a case where an assessee claims that no expenditure has been incurred by him in relation to income which does not form part of the total income under this Act :

PROVIDEDthat 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 already 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.

Position prior to the introduction of section 14A

Prior to the introduction of section 14A, the nature of the business was an important factor for determining the disallowance of expenditure incurred on earning exempt income. The businesses were broadly classified into two categories:

(1) Composite and indivisible business

Prior to introduction of section 14A, the law was that when an assessee has a composite and indivisible business i.e. the business has elements of both taxable and non-taxable income, the entire expenditure in respect of the said business is deductible and, in such a case, the principle of apportionment of the expenditure relating to the non-taxable income did not apply.

(2) Divisible business

Where the business was divisible, the principle of apportionment of the expenditure was applicable and the expenditure apportioned to the ‘exempt’ income or income not exigible to tax, was not allowable as a deduction.

Proportionate disallowance of expenses under section 14A as exempt income was incidental – Only expenses proportionate to earning exempt income could be disallowed under section 14A – Rule 8D is prospective in nature and could not have been made applicable in respect of assessment years prior to 2007 when this rule was inserted

It was held that the dominant object of investing in shares is irrelevant for interpreting the words ‘in relation to’ as contemplated in section 14A of the Income-tax Act, 1961. The Supreme Court has assented that section 14A has been introduced to bifurcate the expenditure between taxable and non-taxable income and to disallow the expenditure relatable to exempt income. The Supreme Court has also held that Rule 8D of the Income-tax Rules, 1961 (Rules) is prospective in nature and be applied from assessment year 2008-09. – [Maxopp Investment v. CIT (2018) 402 ITR 640 : 301 CTR 489 : 254 Taxman 325 : 91 taxmann.com 154 (SC)]

Where the business was divisible, the principle of apportionment of the expenditure was applicable and the expenditure apportioned to the ‘exempt’ income or income not exigible to tax, was not allowable as a deduction. The theory of apportionment of expenditure between taxable and non-taxable has been in principle widened under section 14A. – [CIT v. Walfort Share & Stock Brokers (P) Ltd. (2010) 326 ITR 1 : 233 CTR 42 : 192 TAXMAN 0211 : 41 DTR 233 (SC)]

Method for determining amount of expenditure in relation to income not included in total income [Rule 8D]

Income Tax Rules, 1962 were amended in 2008 by which Rule 8D was inserted to provide for the Method for determining amount of expenditure in relation to income not included in total income. Rule 8D was framed to give effect to the provisions of Section 14A(2) & (3) of Income Tax Act.

Text of Rule 8D

METHOD FOR DETERMINING AMOUNT OF EXPENDITURE IN RELATION TO INCOME NOT INCLUDIBLE IN TOTAL INCOME.

8D. (1) Where the Assessing Officer, having regard to the accounts of the assessee of a previous year, is not satisfied with—

(a) the correctness of the claim of expenditure made by the assessee; or

(b) the claim made by the assessee that no expenditure has been incurred,

in relation to income which does not form part of the total income under the Act for such previous year, he shall determine the amount of expenditure in relation to such income in accordance with the provisions of sub-rule (2).

(2) The expenditure in relation to income which does not form part of the total income shall be the aggregate of following amounts, namely:—

(i) the amount of expenditure directly relating to income which does not form part of total income; and

(ii) an amount equal to one per cent of the annual average of the monthly average of the opening and closing balances of the value of investment, income from which does not or shall not form part of total income :

PROVIDEDthat the amount referred to in clause (i) and clause (ii) shall not exceed the total expenditure claimed by the assessee.

Rule 8D do not have any retrospective application – It was prospective with effect from assessment year 2008-09

Rule 8D do not have any retrospective application and it is applicable prospectively from Assessment year 2008-09. It cannot be applied up to assessment years up to Assessment year 2007-08. As a result, till Assessment year 2008-09, disallowance cannot be made in accordance with Rule 8D but can be done as per the best judgment of the Assessing Officer in accordance with the spirit of section 14A which has application from 1961. – [CIT v. Essar Teleholdings Ltd. (2018) 401 ITR 445 (SC)]

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.

Evolution of Section 14A & Rule 8D

The sequence of insertion of section 14A & issuance of allied Circulars/Notifications since its inception: