Section 14A Disallowance Cannot Exceed Exempt Income Earned: ITAT Delhi

Pragati Automotive Engineers Private Limited Vs ITO (ITAT Delhi)

The appeal before the Income Tax Appellate Tribunal (ITAT) related to Assessment Year 2017-18 and challenged the confirmation of a disallowance of ₹7,54,396 under Section 14A of the Income-tax Act, 1961 read with Rule 8D of the Income-tax Rules, 1962.

The assessee had filed its return declaring a total income of ₹200. The case was selected for limited scrutiny under CASS on the issue of expenses incurred for earning exempt income. During the relevant year, the assessee earned exempt income comprising dividend income of ₹2,07,642 and long-term capital gains of ₹55,473 exempt under Section 10(38), aggregating to ₹2,63,115. The assessee did not make any disallowance under Section 14A and contended that all expenses incurred were routine business and operational expenses such as audit fees, ROC expenses, bank charges, salaries, and employee benefit expenses related to taxable business operations. According to the assessee, no expenditure had been incurred for earning exempt income.

The Assessing Officer observed that exempt income had been earned without any corresponding disallowance. Applying Section 14A read with Rule 8D, the Assessing Officer computed a disallowance of ₹22,95,054.72, being 1% of the average value of investments of ₹22.95 crore. However, since the total expenditure claimed by the assessee was ₹7,54,396, the disallowance was restricted to that amount and added to the assessee’s income.

The assessee challenged the addition before the Commissioner of Income Tax (Appeals), arguing that no expenditure had been incurred for earning exempt income and that Rule 8D had been applied mechanically without recording the necessary satisfaction or establishing a nexus between the expenditure and exempt income. The assessee also contended that fixed deposits that did not generate exempt income had been included while computing the disallowance. The CIT(A) rejected these arguments and upheld the disallowance. The appellate authority observed that the assessee had substantial investments and that routine expenses such as salaries, audit fees, ROC fees, and office expenses were common in nature and could not be segregated from investment-related activities. The CIT(A) further held that the Assessing Officer had duly recorded satisfaction and had correctly restricted the disallowance to the actual expenditure incurred.

Before the Tribunal, the assessee relied on Delhi High Court decisions, including Joint Investments (P) Ltd. v. CIT and CIT-Central-1 v. RRPR Holding Pvt. Ltd., to argue that disallowance under Section 14A read with Rule 8D cannot exceed the exempt income earned during the year. The assessee therefore sought restriction of the disallowance to ₹2,63,115, being the total exempt income earned.

After considering the rival submissions and examining the record, the Tribunal noted that the assessee had earned aggregate exempt income of ₹2,63,115 and had incurred expenditure of ₹7,54,596. Although the Assessing Officer had computed a higher disallowance under Rule 8D and restricted it to actual expenditure, the Tribunal found merit in the assessee’s contention that the disallowance could not exceed the exempt income earned during the relevant year. The Tribunal held that the Delhi High Court decisions relied upon by the assessee were binding and applicable to the case. Accordingly, the Tribunal restricted the disallowance under Section 14A to ₹2,63,115. The Tribunal also noted that the Explanation inserted in Section 14A by the Finance Act, 2022 with effect from 1 April 2022 had been held to be prospective by the Delhi High Court in PCIT v. Era Infrastructure India Limited. The appeal was therefore partly allowed, and the disallowance was reduced from ₹7,54,396 to ₹2,63,115.

FULL TEXT OF THE ORDER OF ITAT DELHI

This appeal in ITA No. 281/Pun/2026 for Assessment Year: 2017-18 has arisen form the learned CIT(A)’s appellate order u/s 250 dated 31/12/2025 in DIN & Order No: ITBA/APL/S/250/2025-26/1084275093(1), which in turn has arisen from the assessment order dated 28.10.2019 passed by the AO u/s 143(3)of the Income Tax Act, 1961.

2. The assessee has raised the following grounds of appeal:

“1. That on the facts and circumstances of the case, the appellate order passed by the learned Commissioner of Income Tax (Appeals) (hereinafter referred as “Ld. CIT(A)”), by arbitrarily confirming addition of Rs. 7,54,396/- is bad both in the eyes of law and on facts.

2. That on the facts and in the circumstances of the appellant’s case, the Ld. CIT(A) erred both in law and facts in confirming the disallowance of expenses of Rs. 7,54,396/- under section 14A of the Act only on the assumption that application of provisions of section 14A read with Rule 8D is automatic and mandatory without appreciating the fact that no expenses were incurred in relation to earning exempt income.

3. That on the facts and in the circumstances of the appellant case, the Ld. CTT(A) erred both in law and facts in confirming the disallowance of expenses of Rs. 7,54,396/- under section 14A of the Income-tax Act, 1961 read with Rule 8D of the Income-tax Rules, 1962 without recording his satisfaction that as to why the claim of the appellant that no expenses has been incurred / claimed for earning exempt income is not correct

4. Without prejudice to the Ground of Appeal No. 1 to 3, the Ld. CTT(A) erred both in law and facts in confirming the disallowance of expenses of Rs 7,54,396/- under section 14A of the Income-tax Act, 1961 read with Rule 8D of the Income-tax Rules, 1962 without appreciating that the amount of disallowance under section 14A of the Act should be restricted to the extent of exempt income earned of Rs.2,63,115/-

5. That the grounds of appeal are independent and without prejudice to each other.

6. The appellant craves leave to add, amend or alter any of the grounds of appeal.”

3. Brief facts of the case are that the assessee filed its return of income declaring total income of Rs.200/- on 31.11.2017. The assessee’s case for A.Y.2017-18 was selected by Revenue for limited scrutiny under CASS . The reason being for said selection being “Expenses incurred for earning exempt income”. Statutory notices were issued by the AO u/s 143(2) and 142(1) of the 1961 Act, from time to time during the course of assessment proceedings. The assessee participated in the assessment proceedings, and submitted its replies/responses before the AO. The assessee company is stated to be engaged in the business of automotive engineers, dealers in all kind of automobiles etc. . During the year under consideration, the assessee has earned income from interest and profit on sale of shares. The AO observed that the assessee has earned exempt income to the tune of Rs. 2,07,642/- , while the assessee has not made any disallowance of the corresponding expenses u/s 14A of the 1961 Act. The assessee was asked by the AO to explain the same. The assessee submitted that it earned exempt income of Rs. 2,63,115/- , being Rs 2,07,642/- as dividend income and Rs.55,473/- as long term capital gains exempt u/s 10(38). It was submitted that the assessee paid taxes u/s 115JB of the 1961 Act. It was submitted that the assessee incurred total expenses (after considering add back of expenses) to the tune of Rs. 7,54,396/- which were all incurred for earning taxable income. These expenses are routine and operational expenses such as audit fee , ROC expenses, bank charges , employees benefit expenses for day to day business operations and were not incurred for earning exempt income. Thus, the same cannot be considered for disallowance u/s 14A. The AO invoked the provisions of section 14A of the 1961 Act r.w. Rule 8D and made disallowance to the tune of Rs.7,54,596/- , detailed as hereunder:

Notwithstanding of above, after considering Assessee Company replies and Provisions of Section 14 A of Income Tax Act 1961, read with Rule 8 D, disallowance of expenditures (in relation to Exempted Income claimed by Assessee company) of Rs.22,95,054/- is restricted to Expenditures claimed at Rs.7,54,396/- after disallowances of expenditures amounting to Rs.2,40,305/- in computation of Income. Resultantly, expenses disallowable u/s 14A of the Income-tax Act with Rule 8D is computed at Rs. 7,54,396/- and therefore disallowance of Rs. 7,54,396/- is made to the income of the assessee company.

4. After considering the submissions and facts of the case, the income of the assessee company is computed as under:

3.2. Thus as could be seen that the AO invoked the provisions of section 14A r. w. Rule 8D. The assessee has received exempt dividend income at Rs.2,07,642/- , while average value of investment made by the assessee was at Rs.22,95,05,471.50. The AO disallowed 1% of the average of the value of investment invoking Rule 8D of the Income-tax Rules,1961 which amounted to Rs. 22,95,054.72, but restricted the disallowance to the actual expenditure incurred and claimed by the assessee which was to the tune of Rs.7,54,596/- u/s 14A read with Rule 8D.

4. Aggrieved, the assessee filed first appeal with ld. CIT(A). The assessee contended before ld. CIT(A) that no expenditure has been incurred by the assessee company to earn exempt income of Rs. 2,63,115/- as the expenses claimed in the Profit and Loss Account are primarily salaries and routine administrative expenses which were wholly for taxable business operations. The assessee contended that the AO mechanically applied Rule 8D without recording mandatory satisfaction or establishing nexus between the expenses and exempt income . The assessee contended that even FDR on which no exempt income are earned are included while computing daisallowance u/s 14A read with Rule 8D. The Ld. CIT(A) dismissed the appeal of the assessee by confirming the addition made by the AO. The Ld. CIT(A) observed as that assessee has earned dividend income of Rs. 2,07,642/-and long term capital gain Rs.55,473/- which were claimed as an exempt income. The ld. CIT(A) observed that the assessee has investment of Rs. 21.20 crores as on 31.03.2017 and Rs. 24.69 crores as on 31.03.2017. The assessee has claimed expenses of Rs. 7,54,396/- . The ld. CIT(A) observed that the routine business expenses such as salaries, audit fees, ROC fees and office expenses are common in nature and cannot be segregated from the activities relating to investment. The ld. CIT(A) referred to decision in the case of CIT v. United General Trust Limited (200 ITR 488) and DCIT v. Viraj Profiles Limited (156 ITD 72). The ld. CIT(A) observed that the AO has duly recorded satisfaction. Since the assessee has incurred expenses of Rs. 7,54,396/- , and 1% disallowance u/r 8D works out much higher, the ld. CIT(A) observed that the AO has rightly restricted and disallowed Rs. 7,54,396/- u/s 14A r.w.r. 8D.

5. Still Aggrieved , the assesse filed second appeal before the Tribunal. At the outset, Ld. Counsel for the assessee submitted that the assessee has earned exempt income by way of dividend income of Rs.2,07,642/- and Rs. LTCG on sale of shares of Rs. 55,473/-u/s 10(38), which were claimed as an exempt income under the 1961 Act. The Ld. Counsel for the assessee relied upon the judgment and order of Hon’ble Delhi High Court in the case of Joint Investments (P) Ltd. v. CIT (59 com 295) and Judgment and order dated 22.12.2023 of Hon’ble Delhi High Court in the case of CIT-Central-1 v. RRPR Holding Pvt. Ltd. in ITA No. 808/2023 , and submitted that the disallowance u/s 14A read with Rule 8D cannot exceed the exempt income. Thus, prayers were made to restrict disallowance u/s 14A to the exempt income earned by the assessee.

5.2 The Ld. Sr. DR on the other hand, relied upon the decisions of the authorities below.

6. I have considered rival submissions and perused the materials available on record. I have enumerated facts in brief and contentions of both the parties in the preceding para’s of this order, and the same are not repeated. Short question which has arisen in this appeal is with respect to disallowance u/s 14A of the 1961 Act. The assessee has earned in aggregate exempt income of Rs. 2,63,115/- during the year under consideration. The assessee has incurred total expenditure to the tune of Rs. 7,54596/- which are stated to be incurred towards Salaries, Audit Fees, ROC Fees and other operational business expenses. The Average investment held by the assessee were to the tune of Rs. 22,95,05471.50. The AO applied Rule 8D of the 1962 Rules to quantify the disallowance which work out to be 1% of average investment i.e. Rs. 22,95,054.72, but the disallowance was restricted to actual expenditure incurred i.e. Rs. 7,54,596/-. The assessee has relied upon decision of Hon’ble Delhi High Court in the case of Joint Investments Private Limited(supra) and RRPR Holdings Private Limited(supra) to contend that the disallowance be restricted to the exempt income earned by the assessee i.e. to the tune of Rs. 2,63,115/-. The impugned assessment year under consideration is assessment year 2017-18. There is merit in the contention of the assessee , and the aforesaid judgments and orders of Hon’ble Delhi High Court are binding on this Tribunal. Thus, I restrict disallowance to Rs. 2,63,115/- u/s 14A. The amendment brought in Section 14A by insertion of Explanation by Finance Act , 2022 w.e.f. 01.04.2022 is held to be prospective by Hon’ble Delhi High Court in the case of PCIT v. Era Infrastructure India Limited in ITA No. 204/2022(448 ITR 674). The appeal of the assessee is partly allowed in the manner as indicated above. I order accordingly.

7. In the result, the appeal filed by the assessee is partly allowed as indicated above.

Order is pronounced in the Open Court on 14.05.2026