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:
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
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.
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
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 Rule 8D provides the method for computation of disallowance by the AO in case he is not satisfied with the correctness of the claim of expenditure made by the assessee or the claim made by the assessee that no expenditure has been incurred in relation to income which does not form part of the total. The second limb of method of computation and the resultant figure of disallowance which deals with the interest expenditure in certain cases are unfair on the part of assessee as the resulting disallowance of interest exceeds the actual unallocated interest expenditure and allocated interest expenditure towards the income not forming part of total income one of which is discussed with the help of illustration produced after Rule 8D:
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|
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.
Illustration explaining the issue in computation of disallowance in certain specific case
Suppose total interest expenditure incurred by the assessee is Rs. 600 crores. Out of which Rs. 100 crores interest is directly attributable to the Income which does not form part of total income and interest of Rs. 300 crores is directly attributable to the income forming part of total income as the borrowing is for the specific purpose the income from which is taxable. The balance interest of Rs. 200 crores is general interest expenditure incurred for both types of income. Average investment for exempt income is Rs. 5000 crores and average total assets are Rs. 10000 crores. Now AO invokes rule 8D and compute the disallowance amount as follows:.
For (i) Directly attributable interest expenditure to exempt income that is Rs. 100 crores
(ii) As the assessee has incurred Rs. 200 crore as interest expenditure which is not directly attributable to any income taxable or exempt hence the formula given above will be applied
A = Rs. 500 crores that is interest other than (i)
B = Rs. 5000 crores average investment for exempt income
C= Rs. 10000 crores average total assets
By applying formula amount for (ii) comes out is Rs. 250 crores (500*5000/10000)
(iii) One-half per cent of the average of the value of investment the income from which is exempt 0.5% of Rs. 5000 crores = Rs. 25 crores
Now in above case total disallowance comes out to Rs. 375 crores (100+250+25) which is more than the total interest minus interest directly attributable to taxable income that is Rs. 300 crores (600-300) which is totally unfair on the part of the assessee as the disallowance is more than the remaining interest which in not attributable to any income and the interest which is directly attributable to the income which does not form part of total income taken together.
Conclusion of second issue
Thus to weed out above discussed hardship on the assessee part the legislature needs to insert an explanation or proviso to amend the law and restrict the disallowance amount to the extent of interest not attributed and interest directly attributed to the exempt income taken together that is Rs. 300 crores (200+100) in above illustration.
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