By CA.P.Vedagiri, FCA, Chennai
1.1 As per well settled law and also according to canons of taxation only that expenditure which is relatable to taxable income should be deducted in computing the total income. Expenditure which has a bearing on exempt income should not be considered in the computation of total income as otherwise this would result in double advantage to the assessee. For example when agricultural income itself is exempt from taxation, there is no justification to consider expenditure on agricultural activities in the computation of total income. Likewise there is no legitimacy for claiming deduction of interest on moneys borrowed for capital contribution in a partnership in the assessment of the partner, since the share of profit from the firm is exempt from tax. To assert this position categorically section 14A was brought on the statue book to the effect that for the purpose of computing the total income, no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income which does not form part of total income under the provisions of the Income tax Act, 1961.
1.2 A note worthy feature of this new provision is that it has been patched up in a piecemeal manner by way of insertion, substitution, addition of sub sections, proviso and Board’s circular with the result that there is sufficient room for different interpretations as regards the effective year of applicability of the provisions and the determination of the amount expenditure to be disallowed.
The need and the rationale for specific provision
2.1 Situations might arise where expenditure by way of interest may be incurred indivisibly both for earning taxable and exempt income, as it happens in the case of a business enterprise where a part of working capital loans may be deployed in tax free bonds or shares of companies, the interest/dividend from which is exemptible under the provisions of section 10. The decisions in the earlier case laws on the subject were in favor of the assessee.
2.2 In the case of Rajasthan State Warehousing Corporation v CIT [242 ITR 450 (2000), the Supreme Court reversing the decision of the High Court held .that in view of the fact that income from various ventures was earned in the course of one indivisible business, apportionment of the expenditure and allowing deduction of only that proportion of it which was referable to taxable income was unsustainable.
2.3 Supreme Court decision in CIT V Indian Bank [56 ITR 77] did not accord with disallowance of proportionate expenditure. This view was followed in CIT vs Maharashtra Sugar Mills limited (82 ITR 452). It was held that no part of managing agency commission can be disallowed on the ground that it partly relates to managing sugarcane cultivation, the income of which was exempt from tax.
2.4 The Memorandum explaining the rationale behind the insertion of new section states that the claim of expenditure in respect of exempt income will reduce tax payable on non-exempt income and expenditure can be allowed only to the extent they are relatable to taxable income.
Exempt income and deductions from total income:
3.1 Section 10 lists out income which do not form part of total income, like agricultural income, share of income of a partner from the firm, interest on notified bonds arising to a non-resident, interest on tax –free bonds, income by way of dividend, long-term capital gains from transfer of equity shares in a company or units of an equity oriented fund, through a Recognized Stock Exchange (RSE). The expenditure for earning those items of income should not find a place in the computation of total income.
3.2 Sections 10A, 10AA, 10B, 10 BA, allows for a deduction of the profits as specified in the respective sections in the computation of the total income. Similar is the case with respect to sections 80IA, 80IAB, 80IB, 80IC, 80ID, 80IE, 80JJA & 80JJAA. The provisions of section 14A will have no application to income referred to in these sections for the reason that income is ascertained after setting off against gross receipts, the expenses incurred for earning the income. The profits as ascertained will be considered and deduction allowed from the total income on so much of the profits as provided for in the respective sections.
3.3 Some payments or contributions referred to in Chapter VIA will have the effect of reducing the taxable income, as they are deductible from the gross total income. This deduction may be contrasted with exclusion of certain income, in that, the deduction reduces the taxable income whereas exclusion eliminates the exempt income from tax purview.
4.1 The sequence of insertion of section 14A & issuance of allied circulars/notifications
i. Section 14A was introduced by the Finance Act 2001 effective from 01.04.1962
ii. Circular No 11/2001 was issued dated 23-7-2001
iii. A proviso to section 14A was inserted by the Finance Act, 2002 with effect from 11-5- 2001)
iv. The Finance Act, 2006 revamped the Section 14A adding sub sections (2) & (3) with effect from 1st April, 2007.
v. Rule 8D was added by Notification 45/2008 dated 24th March, 2008
GLIMPSES OF THE NEW PROVISION
Expenditure incurred in relation to income not includible under total income, to be ignored
5.1 Section 14 A inserted in Chapter IV of the Income Tax Act, by the Finance Act, 2001, with retrospective from 1-4-1962 is intended to safeguard the interest of Revenue on account of wrong claim of expenditure relating to exempt income against taxable income.
5.2 The Finance Act, 2006 revamped the Section 14 A adding sub sections (2) & (3) with effect from 1st April, 2007.The provisions can be summed up as under
(1) For computation of total income under Chapter IV no deduction shall be allowed in respect of expenditure incurred in relation to income which does not form part of total income of the assessee
(2) If the AO is not satisfied with the correctness of claim of the assessee in respect expenditure relating to exempt income, the AO shall determine such expenditure in accordance with such method as may be prescribed
(3) The provision of sub section (2) shall apply where the assessee claims that no expenditure has been incurred with respect to exempt income.
5.3 As per Circular No 11/2001dated 23-7-2001, assessments where the proceedings have become final before 1-4-2001 should not be re-opened under section 147 to disallow expenditure incurred to earn exempt income by applying the provisions of newly inserted section
5.4 The proviso inserted by the Finance Act, 2002 with effect from 11-5- 2001, provides that the A.O cannot reassess under section 147 or pass an order enhancing assessment or reducing a refund already made or otherwise increase the liability of the assessee under section 154, for any assessment year beginning on or before the 1-4-2001.
Determination of such expenditure as prescribed
Notification 45/2008 dated 24th March, 2008 is given below (See Rule 8D)
Expenditure to be disregarded shall be the aggregate of the following:
6.1 The amount of expenditure in relation to income which does not form part of total income shall be the aggregate of the following:
i) the expenditure which directly relate to income which does not form part of total income
ii) in a case where the expenditure incurred by way of interest is not directly relatable to any particular income or receipt, an amount computed in accordance with the following formula, namely = A x B divided by C
A is the amount of interest other than that directly attributable to income referred to in (i) above
B is the average value of investment, the income from which does not or shall not form part of the total income, as appearing on the first day and last day of the previous year
C is the average of the total assets appearing in the Balance Sheet of the assessee on the first day and last day of the previous year. Total assets shall exclude increase on account of revaluation of assets but include decrease on account of revaluation of assets. [Stated in simple terms, the impact of revaluation shall be ignored]
iii) An amount equal to ½% of the average of the value of investment, the income from which does not or shall not form part of total income, as appearing in the Balance sheet on the first day and last day of the previous year.
Certain critical issues
7.1 The method prescribed for disregarding expenditure related to exempt income
For disallowing expenditure related to exempt income, the method of determining such expenditure especially the one under (iii) above seems arbitrary and not equitable. For, in a case where there is no income at all but only loss is incurred, this ad hoc addition to income by way of disallowance under the notification would cause unwarranted hardship. At times the disallowance may be more than the exempt income itself, going by the method prescribed. Investment held in group companies for control purposes should be viewed from a different angle rather than mere dividend income. For, the benefits accruing from the shares so held is far more than the dividend, which make the holding company to have more economic power and increase synergy in the group. Also there is nothing in the section to suggest that indirect expenses will have been disallowed. Section 14A is on the expenditure relatable to exempt income and not on indirect expenditure which has no nexus to the earning of income.
Average of total assets in the formula given above would, it looks, would include debit balance in P& L account and miscellaneous expenses/ Deferred Revenue Expenses to be written off. Also Current assets may be taken at gross value without netting off against current liabilities. This would inflate the denominator in the formula given in (ii) above.
Averages used for value of assets and investment are not always infallible. Peak level investment or asset can sharply tilt the average. To iron out distortions, time-weighted averages could be used.
7.2 AO not to have suo motto right to resort to Rule 8D: It looks imperative on the part of the AO to resort to application of Rule 8D only if he is not satisfied with the correctness of the quantum of disallowance admitted by the assessee and where the assessee claims that no expenditure has been incurred with respect to exempt income.
7.3 Whether the “prescribed method” is retrospective or Prospective: The “Prescribed method” was announced by notification dated 24-3-2008, though sub sections (2) & (3) empowering AO to compute the disallowance of expenditure by the prescribed method were inserted by the Finance Act 2006 with effect from 1-4-2007, AY 2007-08. The notification comes into effect from the date of its publication. The AY for which the prescribed method is applicable would be 2008-09. However the considered view is that the prescription of method being a procedural formality the applicability would be from AY 2007-08.
The special bench in the case of ITO vs. Daga Capital Management Private limited (2008) 26 SOT 603 (Mum) held that the provisions of sub section (2) & (3) being in the nature of procedural law are applicable retrospectively.
In ACIT v Citicorp Finance (India) Limited [300 ITR 398(AT Mum)] it was held that the provisions of sub sections (2) & (3) are procedural in nature and therefore section 14A will apply to all pending matters.
However in the case of Wimco Seedlings limited v Dy CIT (Del) (TM) it was observed that the Assessing Officer is given the authority to determine the expenditure to be disallowed by the prescribed method only from the Assessment Year 2007-08, the year from which year the sub sections came in to force.
7.4 Whether the Rule apply to other indirect expenditure: The Rule extends (besides interest) to disallowing other expenses or indirect expenses as was held in the case of ITO vs. Daga Capital Management Private limited (2008) 26 SOT 603 (Mum)..
7.5 Dividend earned by an assessee who holds shares as stock in trade: It may also be observed that earning of dividend on shares held as stock in trade cannot be treated as a separate venture other than the business of trading in shares and therefore no disallowance will be called for under this Rule in view of Supreme Court decision in CIT vs. Indian Bank [56 ITR 77] and Rajasthan State Warehousing Corporation v CIT [242 ITR 450 (2000). However under the changed circumstances, the importance of this decision gets diluted.
7.6 Where there is no specific borrowing for investment: A manufacturing company having suppliers’ credit facility only, has the practice of investing or parking surplus money on a regular basis in mutual funds (dividend plan) and gets dividend income credited to its bank account. Such dividend income does not form part of total income under section 10 (34). Since there was no specific loan used for investment, except the cash flows generated from operations by way of profits, no identifiable cost could be attributed for the investment. Even opportunity cost could not be imputed, assuming that the source of investment being borrowed funds. The disallowance of indirect expenditure at 0.5% of the average investment would cause unwarranted hardship.
At times, it is possible that the assessee could have taken various types of loans for different purposes. It is not open to the AO to presume that a portion of some of these loans could be used for investment in shares of companies including group companies. The ITAT in Faze Three Exports Limited v Addl. CIT(Mum) (2008), noted that the presumption of lower authorities that the assessee could have used a portion of the loan taken for business purposes, for investments as well was unwarranted. The ITAT also further observed that the assessee could demonstrate that funds owned by it was much more than the loans taken and investment made and allowed the appeal by the assessee. Under these circumstances disallowance of a part of interest cost as per section 14A is not possible.
7.7 Where there is no income received as dividend: In Shree Shyamkamal Finance & Leasing Company private limited, v ITO, the ITAT (Mum) (2006) observed that as the assessee did not receive any income as dividend in the relevant assessment year 2002-03, there could be no income which could be termed as income which did not form part of total income under the Act, and therefore the provisions of section 14A were not applicable. However the validity of this decision for future reference may not be acceptable to the Department for the reason that interest cost is always there whether income is received or not on the money borrowed for investment, supposed to yield tax free income like dividend.
7.8 Loss in a transaction covered by section 10 (38): A trader in shares and securities transfers/sells shares through RSE and incurs a loss. Since section 10(38) exempts income from transfer of capital assets being shares in a company and units of equity-oriented funds, transacted through RSE, a question may arise whether the trader in shares could claim the expenditure relatable to the such transactions in the computation of his income from business or profession and whether the loss could be adjusted against any other income in the same year or carried forward. Shares and securities constitute stock in trade for a trader in shares. Stock in trade is excluded from the definition of capital asset under section 2(14) and therefore 10(38) may not apply. Consequently section 14A is uncalled for. Adjustment of loss/Carry forward of loss is sustainable.
But in the case of ITO vs Daga Capital Management Private limited (2008) 26 SOT 603 (Mum) the Special bench took the view that the provisions of section 14A were applicable with respect to dividend income earned by the assessee engaged in the business of dealing in shares and securities, on the shares held as stock in trade when earning of such dividend income was incidental to trading in shares.
7.9 Whether loss on sale of capital asset being shares to which section 10(38) applies can be adjusted against any other long term capital gain: Views may be split as to whether the loss sustained in a transfer of capital asset to which exemption under section 10(38) applies, could be adjusted against any other long term capital gain in the same assessment year or carried over for set off in future. Section 10 starts with the words “In computing the total income of any person, any income falling within any of the following clauses shall not be included”. “Any income” referred to here means that neither income nor loss should be taken into account in the computation of total income. Logically the loss on sale of shares referred to in section 10(38) shall not be eligible for adjustment or carry over since it is outside the scope of computation of total income.
7.10 Investment and the loan taken for investment are not recorded in the books of account: If the loans taken for investment as well as the income from investment are not recorded in the books of accounts, it appears that the method prescribed for computation of the expenditure to be disallowed may not be relevant. Hopefully the prescribed method may be reviewed and the hardship caused averted.
7.11 Whether addition on account of applying section 14A attracts penalty under section 271 (1)(c) : Only when there is concealment of income or the particulars of income furnished are inaccurate, the provisions of this section is attracted. By applying the prescribed method under rule 8D, addition by way of disallowance of expenditure under section 14A is made, we have to ascertain whether or not the assessee has furnished inaccurate particulars in the course of assessment proceedings. If the assessee offers an explanation which is not found by the Assessing Officer to be false there is no need to invoke this penal provision. By offering correct explanation, the assessee enables the AO to quantify the amount of disallowance. Having cooperated with the AO in the assessment proceedings in this manner, the assessee cannot be faulted for furnishing inaccurate information or explanation. Under these circumstances section 271(1)(c ) will have no role to play. However the assessee should not give room for any misgivings. He should place before the AO all the records and documents besides furnishing correct information.
7.12 14A in the context of MAT: Section 115 JB provides for increasing the book profit by the amount of expenditure relatable to any income to which section 10 [other than 10(38)] applies and reducing the book profit by the amount of income to which section 10 [other 10(38) applies. Now that the “method” is in place, the rigmarole of determining the amount of expenditure to be added and year of applicability of the “prescribed method” has to be undergone.
As could be seen from the above discussions a few issues need to be addressed by the law makers to avoid litigation. The disallowance of assumed indirect expenses on a percentage basis would nullify the exemption itself. It is preferable to keep expenses of exempt income under separate cost code and demonstrate that no such expenditure has been taken into account in the computation of total income, so as to avoid recourse to Rule 8D.
It is advisable to compute the total income taking into cognizance the expenditure to be disregarded with respect to exempt income as provided for under this rule.