CA Kamal Garg
Legal provisions and audit considerations w.r.t Section 14A: Section 14A of the Income Tax Act, 1961 is reproduced as below:
(1) For the purposes of computing the total income under this Chapter (i.e., Chapter IV) 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:
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 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.
Method for determining amount of expenditure in relation to income not includible in total income (Rule 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;
(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 A = amount of expenditure by way of interest other than the amount of interest included in clause (i) incurred during the previous year;
B = the average of 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 the last day of the previous year;
C = the average of total assets as appearing in the balance sheet of the assessee, on the first day and the last day of the previous year;
(iii) an amount equal to one-half per cent 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 the last day of the previous year.
(3) For the purposes of this rule, the ‘total assets’ shall mean, total assets as appearing in the balance sheet excluding the increase on account of revaluation of assets but including the decrease on account of revaluation of assets.
Clarification regarding disallowance of expenses under section 14A in cases where corresponding exempt income has not been earned during the financial year [Circular No. 5/2014, dated 11.2.2014]:
Section 14A provides that no deduction shall be allowed in respect of expenditure incurred relating to income which does not form part of total income. A controversy has arisen as to whether disallowance can be made by invoking section 14A even in those cases where no income has been earned by an assessee, which has been claimed as exempt during the financial year.
The CBDT has, through this Circular, clarified that the legislative intent is to allow only that expenditure which is relatable to earning of income. Therefore, it follows that the expenses which are relatable to earning of exempt income have to be considered for disallowance, irrespective of the fact whether such income has been earned during the financial year or not.
The above position is clarified by the usage of the term “includible” in the heading to section 14A [Expenditure incurred in relation to income not includible in total income] and Rule 8D [Method for determining amount of expenditure in relation to income not includible in total income], which indicates that it is not necessary that exempt income should necessarily be included in a particular year’s income, for triggering disallowance. Also, the terminology used in section 14A is “income under the Act” and not “income of the year”, which again indicates that it is not material that the assessee should have earned such income during the financial year under consideration.
In effect, section 14A read along with Rule 8D provides for disallowance of expenditure even where the taxpayer has not earned any exempt income in a particular year.
Chapter III, comprising sections 10 to 13B, deals with incomes which do not form part of total income. As per section 14A(1), for the purposes of computing the total income under Chapter IV, 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 Income-tax Act, 1961. Therefore, from a plain reading of section 14A, it is apparent that the intention of the section is to disallow expenditure in relation to income which does not form part of total income i.e., expenditure in relation to income exempt under section 10 to 13B. Therefore, the provisions of section 14A cannot be applied for disallowing expenditure relating to income for which deduction is available under Chapter VIA.
Illustration: Mr. X has provided the following information regarding his income and expenditure of the previous year 2014-15.
Income from business (computed) Rs. 5,00,000
Dividend income from Money Market Mutual Funds Rs. 1,25,000
Consultancy charges to Mutual Fund agent Rs. 15,000
Interest expenditure relating to both taxable and non-taxable income Rs. 2,25,000
Value of investments in mutual fund units as on first and last day of the previous year are Rs. 5,00,000 and Rs. 3,00,000 respectively.
Value of total assets as appearing in Balance Sheet as on first day and last day of the previous year are Rs. 50,00,000 and Rs. 70,00,000 respectively.
Mr. X claims that no expenditure was incurred by him for exempt income earned. The Assessing Officer is not satisfied with the correctness of the claim of the assessee in respect of expenditure in relation to exempt income. Compute the amount of expenditure incurred in relation to exempt income and resultant total income, assuming that Mr. W has no other income.
Recommendation: As per section 14A, expenditure incurred in relation to any exempt income is not allowed as deduction. However, if the Assessing Officer is not satisfied with the correctness of the claim of the assessee in respect of expenditure in relation to exempt income, or the claim made by the assessee that no expenditure has been incurred in relation to exempt income for such previous year, he shall determine the amount of expenditure in relation to such income in the manner provided in Rule 8D.
In this case, since the Assessing Officer is not satisfied with the correctness of claim of Mr. X, he shall determine the amount of expenditure in relation to exempt income in the manner provided in Rule 8D.
Dividend income of Rs. 1,25,000 from mutual fund is exempt under section 10(35). Therefore, dividend income represents exempt income of Mr. X.
Thus,
(A). The amount of expenditure directly relating to exempt income: Consultancy charges paid to Mutual Fund Agent = Rs. 15,000;
(B). Calculation of interest expenditure attributable to exempt income:
Interest expenditure incurred (x) [(Average value of investment in Mutual Fund Units as on the first and last day of the previous year) / (Average of total assets of the assessee as appearing in the Balance Sheet, on the first day and last day of the previous year)] = 2,00,000 (x) [{(5,00,000 (+) 3,00,000)/2}/ {(50,00,000 (+) 70,00,000}/2] = Rs. 15,000;
(C). Half per-cent of the average value of investment, income from which is exempt from tax i.e., ½% of the average value of investment in mutual funds = Rs. 4,00,000 x ½% = Rs. 2,000
Amount of expenditure in relation to exempt income [A + B + C] = Rs. 32,000
Computation of total income of Mr. X for the A.Y. 2015-16:
Income from business (computed) 5,00,000
Add: Amount of expenditure in relation to exempt income 32,000
Income from business / Total Income 5,32,000
Judicial Precedents:
(1) Section 14A & Rule 8D: Disallowance Cannot Exceed Total Expenditure [Gillette Group India Pvt. Ltd. v ACIT (ITAT-Delhi)]: In AY 2008-09, the assessee earned tax-free dividend income. Its’ total expenditure as per the P&L A/c was Rs.49 lakhs. The AO applied Rule 8D and made a disallowance under section 14A of Rs.2.37 crores which was reduced by the CIT (A) to Rs.1.78 crores. Before the Tribunal, the assessee claimed that even assuming that the entire expenditure had been incurred to earn the dividend, the disallowance under section 14A & Rule 8D could not exceed the expenditure incurred. HELD accepting the plea that Under section 14A read with Rule 8D, disallowance can be made for the expenditure incurred for earning of exempt income. From the assessee’s P&L A/c, it is evident that the total expenditure incurred was Rs.49 lakhs only which was claimed as a deduction. The disallowance under section 14A & Rule 8D cannot exceed the expenditure actually claimed by the assessee. Accordingly, the action of the AO & CIT (A) in making disallowance in excess of total expenditure debited to P&L A/c is unjustified.
(2) No section 14A Disallowance Whilst Computing Book Profits under section 115JA/JB [Quippo Telecom Infrastructure Ltd v ACIT (ITAT-Delhi)]: For AY 2007-08, the assessee invested Rs.10 crores in shares and units. The assessee claimed that it had incurred no expenditure to earn tax-free income though the AO & CIT (A) made a disallowance of Rs.19.58 lakhs under section 14A r.w. Rule 8D. Before the Tribunal, the assessee claimed that (i) Rule 8D could not apply to AY 2007-08 and (ii) No disallowance under section 14A could be made for purposes of computing book profits under section 115JB. HELD by the Tribunal that under the normal provisions of the Act, Rule 8D cannot apply till AY 2008-09 though the AO is at liberty to identify actual expenditure incurred to earn tax-free income & make disallowance. However, while computing book profit under section 115JB, no actual expenditure was debited in the profit & loss account relating to the earning of exempt income. S. 14A cannot be imported into while computing the book profit under section 115JB because clause (f) of Explanation to section 115JB refers to the amount debited to the profit & loss account which can be added back to the book profit while computing book profit under section 115JB of the Act. In Goetze (India) Ltd. v CIT 32 SOT 101 (Del) it was held that sub-section (2) & (3) of section 14A cannot be imported into clause (f) of the Explanation to section 115JA. Accordingly, it is held that no addition to book profit can be made on account of alleged expenditure incurred to earn exempt income while computing income under section 115JB.
The above article is contributed by CA Kamal Garg having professional and academic interests in IFRS, Accounts, Auditing and Corporate Laws arenas. He can be approached at [email protected]
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Very informative and useful article. Thank You.