Allowance of expenditure incurred in relation to exempted income during the assessment or otherwise would be prejudicial to the revenue that’s why Section 14A was introduced by the Finance Act 2001 with retrospective effect from 1st April 1962 in Chapter IV of the Income Tax Act 1961 which inter-alia provides for the disallowance of the expenditure incurred by an assessee in relation to the income which does not form part of his/her total income. Subsequently, Rule 8D was introduced by the Income Tax (Fifth Amendment) Rules 2008 with prospective effect from 24th March 2008 vide NOTIFICATION NO-45/2008, Dated:  24 March 2008 for computation of disallowance by the Assessing Officer subject to his satisfaction with the correctness of claim or no claim by an assessee. However, the above-mentioned provisions have left all with the ambiguity as there is lacuna in the provisions of section and the respective rule which results in many disputes and controversies between the assessing officers and assessees. The major two issues are discussed as follows:

First Issue

Whether this section along with the rule can be invoked even if the assessee has earned no exempt income in the relevant Previous Year

A. What Circular No. 5/2014 dated 11th February 2014 says? – Yes disallowance can be made.

The legislative intent is to allow only that expenditure which is relatable to earning of taxable 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.

Thus CBDT in exercise of its power under section 119 of the Act hereby clarifies that Rule 8D read with Section 14A of the Act provides for disallowance of expenditure even where taxpayer in a particular year has not earned any exempt income.

B. Ratio-Decidendi expressed by some of the recent judicial pronouncements after circular date that is 11th February 2014– No Disallowance can be made

1. CIT-vs- Corrtech Energy (P.) Ltd by Gujarat High Court dated 24th March 2014.

The Hon’ble Guj HC has endorsed the view taken by the Hon’ble Pb. & Hr. HC to the effect that section 14A cannot be invoked where the assessee has not earned income not forming part of total income.

2. CIT-vs- Lakhani Marketing INC by Punjab & Haryana High Court dated 2nd April 2014.

Tribunal deleted disallowance holding that unless and until, there is receipt of exempted income for concerned assessment years (dividend from shares) section 14A cannot be invoked and in instant case assessee was not in receipt of any dividend income during relevant year – Whether on facts Tribunal was justified in deleting disallowance under section 14A – Held, yes

3. Alliance infrastructure Projects Pvt. Ltd. vs. DCIT, ITAT Bangalore dated September 12, 2014

It has held that unless and until, there is receipt of exempted income for the concerned assessment years, we are of the view; Section 14A of the Act cannot be invoked.

Conclusion of first issue

By virtue of sub section 1 to section 119 the department is bound to follow such instructions or directions issued by CBDT, as a result of which AO are bound to disallow the expenditure under section 14A irrespective of the fact that no exempt income has been earned by the assessee in the concerned AY, to comply with the above mentioned circular. The aggrieved assessee will challenge the order of AO making disallowances under section 14A in higher authorities. The quasi-judicial and judicial authorities like Income Tax Appellate Tribunal and the different High Courts are not giving any weight to the circular in their respective orders. Even the orders issued after the circular date have given no reference of circular in it and as result which the decisions were in favour of assessee. Hence, it can be construed by the series of latest orders issued, that assessee will be remedied for the above discussed issue, if appealed and it can also be concluded that the above circular is only resulting in more litigations. The Income Tax Department should therefore take remedial measures to bring clarity in instructions to the assessing officers in line of the judicial pronouncement so that futile litigation by the department can be avoided.

The extract of Section 14A and Revised Rule 8D are as under for ready reference:

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 :

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.”

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 :

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

CA Hemant SharmaCA Hemant Sharma – Membership No. 535518

For feedback and queries please feel free to mail @ [email protected]

Read Other Article from the Author CA Hemant Sharma 

Republished with Amendments

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  1. ashish shaha says:

    If assessee took unsecured loan and invest in 2 different partnership firms equally. 1 of the firm has interest & share of profit and no income from 2nd firm.Does 14A disallowance restricted to 50% of interest paid on unsecured loan or whole interest amount

  2. Arun says:

    What if non-taxable income (Dividend from Mutual Funds) is earned during the year, but no such investment exist on first and last day of previous year ??
    Is there any case study in relation to such instance?

  3. CA Hemant Sharma says:

    Agreed Sanjeev Aggarwal I did not said in my article that the third limb is not in respect of expenses other than interest. However, the same is also in respect of interest expense as applied on other expenses. If assessee do not have other expenses in its profit and loss account or has minimal other expenses, then the computed amount of dis-allowance in third limb will be in respect of interest only , may be in respect of that interest which is directly attributable to investment yielding taxable income.
    This content of rule 8D needs to be clarified by the CBDT to avoid the confusions. The same is represented through my article.

  4. Sanjeev Aggarwal says:

    In second issue, disallowance in limb (iii) is not for interest disallownce. It is for other expenses debited in P&L account. Even if interest is zero ( for those assesseses who have not borrowed any money at all), Rule 8D (iii) is applied and disallowance is made by AO.

  5. CA Hemant Sharma says:

    In factual backdrop provided by CA Pranav judgement cited by venkat will apply and hence dis-allowance is justified
    However if business expediency is proved along with the fact that purpose of investment is not to earn interest income to the satisfaction of AO then disallowance can be challanged CASE EIH ASSOCIATED HOTELS

  6. CA Hemant Sharma says:

    The above cited judgments are latest and after the circular date
    Mr. Venkant thanks for initiating the discussion
    In the case cited by you the assessee has earned the exempt income which was not fullfilling the criteria of falling in issue 1 of my article as all in all the cases cited by me the assessee has not earned exempt incomeat all.

  7. Venkat says:

    See This Case Law

    [2012] 22 116 (Mum.)

    Assistant Commissioner of Income-tax-12(3), Mumbai


    Novel Enterprises*

    IT APPEAL NO. 1328 (MUM.) OF 2009
    JUNE 13, 2012

  8. CA PRANAV N SHAH says:

    A private limited company becomes a partner in the partnership firm and invests in fixed capital as well as current capital.
    The said company borrows substantial funds from a Bank by mortgaging its immovable properties and the diverts the borrowed funds to the partnership firm by way of current capital.
    The said company pays interest to the bank and in turn earns interest from the firm as well as share in the profit from the firm.
    The A O proposes to disallow interest expenditure of the said company U/ s 14A inspite of the fact that direct nexus can be established wrt funds borrowed and invested as well as interest paid and earned

    Whether this disallowance is justified ?
    Any decision in support of asesse’s claim .

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February 2021