Section 14A of Income Tax Act, 1961 – Controversial Provision

Section 14A was enacted vide Finance Act, 2001 w.r.e.f. 1-4-1962, so that net taxable income is actually taxed and no deduction is allowed against taxable income for expenditure incurred in earning exempt income. It was enacted to overcome the Supreme Court decision in the case of 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 as deduction. As per the Memorandum of Finance Bill, 2001, it was explained that “expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income.”

Section 14A was amended by the Finance Act, 2006, w.e.f. 1-4-2007 (A.Y. 2007-08). By this amendment Sub-section (2) and (3) were added in Section 14A to provide that AO shall determine the amount of expenditure incurred in relation to the exempt income in accordance with such method as may be prescribed by Rules. In exercise of the powers given in Section 14A (2) CBDT has issued Notification No. S.O. 547(E) on 24-3-2008 (299 ITR (ST) 88). This notification amends the Income-tax Rules by insertion of a new Rule 8D providing for a “Method for determining amount of expenditure in relation to income not includible in total income”. The Rule provides for disallowance of not only direct expenditure incurred for earning the exempt income but also for disallowance of proportionate indirect expenditure.

The constitutional validity of the provisions and that of Rule 8D has been upheld by the Bombay High Court in the case of Godrej & Boyce Mfg. Co. Limited v. CIT [2010] 328 ITR 81 (Bombay HC) observing that Rule 8D is applicable w.e.f. Assessment Year (AY) 2008-09 and subsequent years. A special leave petition against this judgment of the Bombay High Court is admitted and pending for final hearing before the Supreme Court in Appeal Civil No. 7019/2011.

Right from the inception of section 14A, it has been a subject matter of litigation between the taxpayers and tax collectors. Divergent views has been expressed by various benches of the Tribunals and High Courts. Some observations has also been made by the Supreme Court. The law on section 14A has evolved over the last 14 years and complex issues have arisen out of its application. We can summarize some of the recent issues dealt in the tribunals and courts as follows:

1. Establishment of nexus between the exempt income and related expenditure:

There can be different situations while making investment in tax-free/taxable securities

a. While making investment in the tax-free securities no expenditure has got incurred and investment has been made out of only capital raised over the years, reserves and surplus, no interest bearing loans and non-cash provisions.

b. There is a common pool of funds where overall investment in tax free securities has not exceeded the aggregate amount of shareholders’ funds, no interest bearing loans and non-cash provisions.

c. There is direct nexus between interest bearing funds and the taxable securities and it can be established that interest bearing funds has been used for earing taxable income.

Situation (a)

(i) In the case of CIT v. Hero Cycles Ltd. (ITA No. 331 of 2009) P&H High Court held that where it is found that for earning exempted income no expenditure has been incurred, disallowance under section 14A cannot stand.

(ii) The Delhi Tribunal in the case of Interglobe Enterprises Ltd. v. DCIT (ITA No. 1362 & 1032/DEL/2013) held that assessee had utilized interest free funds for making fresh investments and that too into its subsidiaries which were not for the purpose of earning exempt income but for strategic purposes only. No disallowance of interest is required to be made under rule 8D (i) & 8D (ii) as no direct or indirect interest expenditure has incurred for making investments. Strategic investment has to be excluded for the purpose of arriving at disallowance under Rule 8D (iii).

Situation (b)

(i) In the case of CIT v. HDFC Bank Limited (ITA No. 330 of 2012), Bombay High Court has held that no disallowance u/s 14A can be made in respect of interest paid on borrowing if assessee’s own funds and non-interest bearing funds exceeds investment in tax-free securities.

In principle, if there are funds available, both interest-free and over draft and/or loans taken, then a presumption would arise that investments would be out of the interest-free funds generated or available with the company if the interest-free funds were sufficient to meet the investment.

(ii) In the case of Reliance Utilities and Power Ltd (313 ITR 340(Bom), Bombay High Court has also held that Where an assessee has his own funds as well as borrowed funds, a presumption can be made that the advances for non-business purposes have been made out of the own funds and that the borrowed funds have not been used for this purpose. Accordingly, the disallowance of the interest on the borrowed funds is not justified.

(iii) In the case of CIT v. Suzlon Energy Ltd (Tax Appeal No. 223 of 2013), Gujarat High Court has held that where assessee had own interest free funds many times over the investment made in Indian subsidiaries and further, there was no direct nexus between interest bearing borrowed funds and such investment, no disallowance of interest expenditure could be made under section 14A.

Situation (c )

(i) In the case of ITO v. Narain Prasad Dalmia, ITAT Kolkata (ITA No. 1180/Kol/2011) has held that Rule 8D(2)(ii) is very clear that the expenditure on account of payment of interest would be covered in the said Rule only if it is not directly attributable to any particular income or receipt. If the assessee is able to demonstrate that the payment of interest is directly attributable to the assessee’s taxable business activity, it cannot be considered under Rule 8D(2)(íi) of the I.T. Rules and has to be excluded while computing the disallowance u/s 14A.

2. Investment in subsidiaries is for acquiring control interest / strategic investment.

(i) The Chennai Tribunal in the case of EIH Associated Hotels Ltd. v. DCIT has held that investments made by the assessee in the subsidiary company were not on account of investment for earning capital gains or dividend income. Such investments had been made by the assessee to promote subsidiary company into the hotel industry and were on account of business expediency and dividend therefrom is purely incidental. Therefore, the investment made by the assessee in its subsidiary is not to be reckoned for disallowance u/s 14A r.w. rule 8D.

(ii) CIT vs RPG Transmissions Ltd [2014] 48 taxmann.com 57, the Madras High Court has held that Interest on borrowed funds utilized for investment in group companies for strategic business purpose was allowable under section 36(1)(iii).

(iii) Recently in the case of ITO v. Pioneer Radio Training Services Pvt. Ltd. (ITA No. 4448/Del/2013) (Order Dated 19-1-2015), Delhi ITAT has held that (i) Expenditure (like audit fees) required to be incurred irrespective of income cannot be disallowed, (ii) investments in subsidiaries are not to earn dividend income and cannot be considered for disallowance.

3. Where no exempt income is earned during the relevant assessment year.

(i) CIT vs Shivam Motors Pvt Ltd ITA No.88/2014, (Order dt.05.05.2014) the Allahabad High Court has held that “As regards the second question, Section 14A of the Act provides that for the purposes of computing the total income under the 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 the Act. Hence, what Section 14A provides is that if there is any income which does not form part of the income under the Act, the expenditure which is incurred for earning the income is not an allowable deduction. For the year in question, the finding of fact is that the assessee had not earned any tax free income. Hence, in the absence of any tax free income, the corresponding expenditure could not be worked out for disallowance. The view of the CIT (A), which has been affirmed by the Tribunal, hence does not give rise to any substantial question of law.”

(ii) CIT vs Corrtech Energy Pvt Ltd [2014] 45 taxmann.com 116:  The Gujarat High Court has held that where assessee has not sought any exempt income, there cannot be any expense to be disallowed.

(iii) CIT v Lakhani Marketing, ITA No.970/2008 (Order dt.02.04.2014), the Punjab and Haryana High Court has held that when there was no dividend income and in such a situation, provisions of Section 14A of the Act has no applicability.

(iv) CIT v Delite Enterprises ITA No.110/2009, the Bombay High Court on an issue Whether on the facts and in the circumstance of the case and in law the Hon’ble Tribunal was right in deleting the disallowance made by the Assessing Officer of interest paid by the Assessee Company on borrowed funds amounting to Rs.241.10 lakhs overlooking the fact that the borrowed funds were used by the Assessee Company to invest in the Capital of another Partnership Firm and since profits derived by the Assessee Company from a Partnership firm were exempt from tax u/s.10(2A) of the Income-tax Act, the interest expense related to such tax free profits is to be disallowed u/s.14A of the Income Tax Act? It has been held that we find that there is no profit for the relevant assessment year.  Hence the question as framed would not arise.

(v) Alliance Infrastructure Project Pvt Ltd vs DCIT ITA Nos.220 & 1043 (Bang)/2013, (Order dated 12.09.2014) the ITAT Bangalore, relying on the decisions of above High Courts 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”.

(vi) ACIT vs M Baskaran [2014] 50 taxmann.com 138, the ITAT Chennai has held the disallowance cannot be made u/s.14A where assessee has not earned / received any exempt income during relevant year.

(vii) In the case of Bellwether Microfinance Fund Pvt. Ltd vs. ITO ITA No. 1743/Hyd/2013 the ITAT Hyderabad, had to consider whether in computing the figure of disallowance under Rule 8D(2)(i) and 8D(2)(iii), it was necessary that the investments had to have yielded income which was not chargeable to tax. HELD by the Tribunal:

Rule 8D (2)(i) Speaks of expenditure directly relating to income which does not form part of “total income”. In the context of s. 2(45) & s. 5, the expression ‘total income’ in Rule 8D (2)(i) Must relate to an income which is sought to be assessed. Therefore, only expenditure directly relating to income which is earned either on receipt basis or on accrual basis and which does not form part of total income of a particular assessment year can be disallowed under clause (i) of Rule 8D(2). However, while computing disallowance under Rule 8D(2)(iii), the average of the total investment of the assessee as appearing in the balance sheet on the first day and last day of the year irrespective of the fact whether it has yielded income or not can be considered for the purpose of disallowance.

Further, in Cheminvest Ltd. v. ITO [2009] 121 ITD 318 (Delhi ITAT) (SB), ITAT took a view that when the expenditure is incurred in relation to exempt income, it has to suffer disallowance irrespective of the fact whether any exempt income is earned by the assessee or not. This also prompted the CBDT to issue a Circular no. 5/2014 dated 11/02/2014 reiterating the view of the

Special Bench. However, Chennai bench of the Tribunal in ACIT vs M Baskaran (Chennai ITAT) as mentioned above held that the Delhi Special Bench decision of Cheminvest Ltd. (supra) and Circular no. 5/2014 dated 11/02/2014 (supra) are no more good law.

4. Whether when Capital gains on sale of investments are liable for tax, it can be considered that investment in shares is not a tax free investment.

(i) In the case of CIT v. Holcim India P. Ltd ITA No. 486/2014 & 299/2014, Delhi High Court held that S. 14A & Rule 8D disallowance cannot be made if there is no exempt income or if there is a possibility of the gains on transfer of the shares being taxable. HC has held that Income exempt under Section 10 in a particular assessment year, may not have been exempt earlier and can become taxable in future years. Further, whether income earned in a subsequent year would or would not be taxable, may depend upon the nature of transaction entered into in the subsequent assessment year. For example, long term capital gain on sale of shares is presently not taxable where security transaction tax has been paid, but a private sale of shares in an off market transaction attracts capital gains tax. It is an undisputed position that assessee is an investment company and had invested by purchasing a substantial number of shares and thereby securing right to management. Possibility of sale of shares by private placement etc. cannot be ruled out and is not an improbability. Dividend may or may not be declared. Dividend is declared by the company and strictly in legal sense, a shareholder has no control and cannot insist on payment of dividend. When declared, it is subjected to dividend distribution tax.

5. 14A & Rule 8D cannot be applied in a mechanical manner

(i) In the case of ACIT 11(2) vs. Iqbal M Chagala, Palloni Mansion ITA No. 877/Mum/2013, ITAT Mumbai, it has been held that 14A & Rule 8D cannot be applied in a mechanical manner. Disallowance cannot exceed expenditure claimed as a deduction

6. Disallowance while calculating MAT if there is no exempt income.

(i) In the case of Minda Sai Limited v. ITO (ITA No. 2974/Del/13), ITAT Delhi has been held that In the absence of exempt income, s. 14A disallowance cannot be added to s. 115JB book profits even if assessee has accepted s. 14A disallowance in the normal computation.

Further in the case of Wallfort Shares & Stock Brokers Ltd.  vs  I.T.O. the Hon’ble Supreme Court vide judgment dated 6^th July, 2010 (not yet reported) has held that “For attracting Section 14A, there has to be a proximate cause for disallowance, which is its relationship with the tax exempt income. Pay-back or return of investment is not such proximate cause, hence, Section 14A is not applicable in the present case. Thus, in the absence of such proximate cause for disallowance, Section 14A cannot be invoked.”

From the above discussion, it will be noticed that introduction of Section 14A (2) & (3) and further Rule 8D as prescribed by CBDT has complicated the calculation of the amount related to exempt income. It has given birth to a lot of anomalies as mentioned below which is required to be given attention immediately.

1. If the method prescribed under the New Rule 8D is applied the expenditure to be disallowed will be substantial and will have no relation to the actual expenditure incurred. In other words, in most cases, a notional amount will be disallowed which can be many times more than the actual expenditure.

2. In the case of dividend income, profit apportions to partner, long term capital gains (where STT has been paid etc. exemption has been granted not as an incentive but because the tax is levied at source. Therefore, there is no logic in disallowing expenditure u/s.14A in such cases where tax is collected at source. It is, therefore, suggested that the section should be suitably amended. Section 14A was introduced to cover cases where expenditure in relation to income such as agricultural income, tax free bonds, etc. which did not suffer any tax under the Income-tax Act, was being claimed. So the introduced section should be followed in its spirit for which it was enacted, should not be used just as a tax collection tool.