Disallowances u/s.14A of Income-tax
Act
Background :
S. 14A has been inserted in Chapter IV of the Income
tax Act by the Finance Act, 2001, with retrospective effect from 1-4-1962.
This Section provides for disallowance of expenditure incurred in relation
to income which is not included in the total income of the assessee
(i.e. exempt income). The operative part of this Section reads as
under :
"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."
Proviso to the Section was added by the Finance Act,
2002 w.e.f. 11-5-2001. It provides that the A.O. cannot reopen the
assessment u/s.147 for any assessment year prior to A.Y. 2001-02 for this
purpose or pass any rectification order u/s.154 for prior years to
disallow any such expenditure.
In the case of CIT v. Indian Bank Ltd., (56 ITR
77), Supreme Court had decided in 1964 that the condition for
deductibility of an expenditure does not depend upon its quality of
directly or indirectly producing taxable income and, therefore, there was
no warrant for disallowing a proportionate part of the interest referable
to moneys borrowed for the purchase of tax free securities. This principle
was reiterated in the case of CIT v. Maharashtra Sugar Mills Ltd.,
(82 ITR 452). In this case 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 from which was exempt from tax.
Again, in the case of Rajasthan State Warehousing Corporation v.
CIT, (242 ITR 450) the above principle was once again reiterated by
the Supreme Court. In this case, it was held that if business is one and
indivisible, the expenditure cannot be apportioned and disallowed to the
extent it may relate to income which is exempt from income tax.
It may be noted that the explanatory memorandum issued
with the Finance Bill, 2001, gives the purpose for which the amendment is
made. This reads as under :
"Certain incomes are not includible while computing
the total income as these are exempt under various provisions of the Act.
There have been cases where deductions have been claimed in respect of
such exempt income. This in effect means that the tax incentive given by
way of exemptions to certain categories of income is being used to reduce
also the tax payable on the non-exempt income by debiting the expenses
incurred to earn the exempt income against taxable income. This is against
the basic principles of taxation whereby only the net income, i.e.,
gross income minus the expenditure, is taxed. On the analogy, the
exemption is also in respect of the net income. Expenses incurred can be
allowed only to the extent they are relatable to the earning of taxable
income.
It is proposed to insert a new S. 14A so as to clarify
the intention of the legislature since the inception of the Income-tax
Act, 1961, that no deduction shall be made in respect of any expenditure
incurred by the assessee in relation to income which does not form part of
the total income under the Income-tax Act."
From the above, it appears that only direct expenses
incurred for earning the income which is exempt will be covered by S. 14A.
Even in the decisions of the Supreme Court referred to above there is
nothing to infer that direct expenses incurred for earning exempt income
is allowable. Therefore, even in the absence of a provision contained in
the new S. 14A law was well settled. There is nothing in this Section to
suggest that indirect expenses will be disallowed.
In actual implementation of this provision, the
Income-tax Department has been taking the view that all items of income
(including dividend on shares and units of Mutual Funds etc. on which
Dividend Distribution Tax is paid) stated in S. 10 of the Income-tax Act
are governed by S. 14A. The intention of this legislation was to disallow
only direct expenses incurred for earning exempt income. In almost all
cases even indirect expenses are also being disallowed on proportionate
basis. In order to ensure uniform approach, S. 14A was amended by the
Finance Act, 2006, w.e.f. 1-4-2007 (A.Y. 2007-08). By this amendment
Ss.(2) and Ss.(3) were added in S. 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. The reasons for
making this amendment in S. 14A are explained in Paras 11.1 to 11.3 of
CBDT Circular No. 14/2006 of 28-12-2006.
New Rule 8D :
In exercise of the powers given in S. 14A(2) C.B.D.T.
has issued a 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". Reading this Rule it
is evident that the Rule provides for disallowance of not only direct
expenditure incurred for earning the exempt income but also for
disallowance of proportionate indirect expenditure. This is clearly
contrary to the main objective with which S. 14A was enacted.
Broadly stated, the new Rule 8D provides as
under :
(i) The method prescribed in the Rule is to be applied
only if the AO is not satisfied with :
(a) The correctness of the claim of expenditure
incurred for earning the exempt income made by the assessee or
(b) The claim made by the assessee that no expenditure
has been incurred for earning exempt income.
(ii) The method prescribed in the Rule states that the
expenditure in relation to income which does not form part of the total
income shall be the aggregate of the following
amounts :
(a) The amount of expenditure directly relating to
income which does not form part of total income.
(b) In the case of interest on borrowed funds which is
not directly attributable to any particular income or receipt, the amount
computed in accordance with this following formula :
A = Amount of interest, other than the amount of
interest which is directly attributable to the exempt income stated
in (a) above.
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
relevant accounting 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 relevant accounting year. The term ‘Total Assets’ means total
assets as appearing in the balance sheet excluding the increase on
account of revaluation of assets but including the decrease on
account of revaluation of assets.
(c) An amount equal to ˝ % 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 relevant accounting year.
2.3 From the above Rule, it will be noticed that
CBDT has, instead of prescribing a simple method, prescribed a
complicated formula. By applying this formula, in most cases,
expenditure which has no connection with earning the exempt income will
get disallowed. Some of the issues relating to this New Rule require
consideration :
(i) As stated in para 2.2(ii)(b) above, interest
which is directly attributed to borrowed funds used for the purpose of
earning taxable income or receipts will not be considered for
disallowance of proportionate interest u/s.14 A. Therefore, interest
on term loan taken for purchase of Plant & Machinery, Motor car
loan, amount borrowed for acquiring factory or office building or any
other business asset will not be considered for such
disallowance.
(ii) It is not mentioned that interest which is
disallowable u/s.43B or u/s.36(1)(iii) will also be excluded. But it
can be assumed that only such expenditure, which is otherwise
allowable in the computation of total income, will be considered for
disallowance u/s.14A.
(iii) In the above formula in para 2.2(ii)(b)
above while explaining the terms ‘B’ and ‘C’ there is a reference to
the average value of investments and total assets as per the Balance
Sheet of the assessee. It is not clear as to what figures shall be
adopted in the cases of non-corporate assessees, such as Individuals
and HUFs who do no maintain books of accounts.
(iv) In explanation to the term ‘B’ it is
stated that for considering average value of Investments, we have to
consider "Investment, income from which does
not or shall
not form part of the total income". This will mean that
even if there is no income from some or all of the investments, the
average value of these investments will enter the formula for
disallowance of proportionate interest. This will mean that in some
cases where there is no income from such investments and no exemption
from tax is claimed on any income, proportionate interest will be
disallowed. In some cases, if income from some investments is say only
Rs.1 lac on which exemption is claimed, but disallowance of
proportionate interest under the formula may work out to Rs.2
lacs.
(v) While explaining the term ‘C’ it is stated
that average of Total Assets as per Balance sheet should be taken. It
can be assumed that items like (a) Preliminary Expenses not written
off, (b) Deferred Revenue expenses, (c) Deferred Tax Assets, (d) Debit
Balance of Profit & Loss A/c. etc., which do not represent any
tangible or intangible asset, appearing in the Balance sheet of the
assessee will be excluded from Total Assets.
(vi) Similarly, current liabilities which are to
be deducted from current assets in the case of the company can be
added while working out the amount of Total Assets.
(vii) The formula given in para 2.2.(ii)(c) above,
states that amount equal to ˝% of the average value of investments,
income from which is exempt from tax, should also be disallowed
u/s.14A. This provision is not at all equitable. Such disallowance is
to be made with reference to average value of such investments from
which exempt income is received or not. This disallowance has no
relation to either the exempt income or to the expenditure claimed by
the assessee. In many cases the amount worked out may exceed the
exempt income or may exceed even the total expenditure (for taxable as
well as exempt income) incurred by the assessee. If we take the
illustration of a closely held Investment company it is common
knowledge that the administrative expenses are nominal as compared to
the value of the investments. In such cases, the amount to be
disallowed under the formula will far exceed the total expenses. It is
suggested that a very strong representation should be made for
deletion of this part of the New Rule. In any event, it should be
represented that the total disallowance under the formula should not
exceed 5% of the income for which exemption is claimed.
(viii) The validity of the New Rule 8D can be
challenged on the ground that S. 14A authorises CBDT to prescribe the
method for determination of expenditure incurred in relation earning
the exempt income, but the method prescribed by this Rule only
determines the notional cost for holding investments which may or may
not yield an exempt income. Such notional cost for holding the
investment has no relationship with the actual expenditure incurred
and claimed by the assessee. Therefore, the New Rule goes beyond the
authority given to CBDT by S. 14A.
As stated earlier, the above amendment giving power
to CBDT to prescribe the method for determination of expenditure to be
disallowed u/s.14A was made by the Finance Act, 2006 w.e.f. A.Y.
2007-08. Therefore, the above method, as now prescribed by New Rule 8D,
should apply to computation of income for A.Y. 2007-08 and onwards.
However, there are certain judicial pronouncements which suggest that
amendment made in S. 14A(2) and (3) made by Finance Act, 2006, is a
procedural provision and, therefore, the method for computation of
disallowable expenditure, whenever prescribed, will be applicable to all
pending assessments for earlier years also. Reference in this connection
may be made to the following decisions :
(i) ACIT v. Citicorp Finance (India) Ltd.,
108 ITD 457 (Mum.)
(ii) Kalpataru Construction Overseas (P) Ltd. v.
DCIT, 13 SOT 194 (Mum.)
(iii) DCIT v. Seksaria Biswar Sugar Factory
Ltd., 14 SOT 66 (Mum.)
(iv) Prakash Heat Treatment & Industries (P)
Ltd. v. ITO, 14 SOT 348 (Mum.)
(v) DCIT v. Smita Conductors Ltd., 16 SOT 251
(Mum.)
(vi) Narotamdas Bhau v. ACIT, 15 SOT 629
(Mum.)
(vii) Conwood Agencies (P) Ltd. v. ITO, 15
SOT 308 (Mum.)
Contrary view has been taken in the case of
Vidyut Investments Ltd. v. ITO, 10 SOT 284 (Delhi) where it is
held that S. 14A(2) and (3) will only apply w.e.f. A.Y. 2007-08 and
onwards.
3. What is Exempt Income u/s.14A :
As stated earlier, the objective behind enactment of
S. 14A was to disallow expenditure incurred in relation to any income
which is completely exempt from tax e.g. Agricultural Income.
Interest on Tax Free Bonds etc. However, in view of the wording of the
said Section "expenditure incurred by the assessee in relation to income
which does not form part of the total income under this Act", courts and
ITA Tribunal have given very wide meaning to the scope of disallowance
u/s.14A. Therefore, income listed in S. 10, S. 10A, S. 10AA, S. 10B, S.
10BA, S. 10C as well as Chapter VIA where 100% exemption is available
will get covered u/s. 14A for disallowance of direct and indirect
expenditure relating to such income. S. 14A does not make any
distinction between income which is completely exempt from tax and
income received after payment of tax (e.g. Dividend Distribution
tax, Tax payable by firms, etc.)
3.2 In this respect reference may be made to some of
the decisions wherein it is held that disallowance can be made u/s.14A
in respect of income from agricultural income, dividend on shares or
units of Mutual Fund, Share from Partnerships Firms, income exempt under
Chapter VIA, etc.
(i) Agricultural
Income : Haryana Land Reclamation &
Development Corp. v. CIT, 159 Taxman 271 (P & H).
(ii) Dividend on shares and units of mutual
funds : Wallfort Shares & Stock Brokers
Ltd. v. ITO, 96 ITD 1 (Mum.) (SB), Harish Krishnakant Bhatt v.
ITO, 91 ITD 311 (Ahd.), DCIT v. S. G. Investments &
Industries Ltd., 89 ITD 44 (Kol.), Muruti Udyog Ltd. v. DCIT,
92 ITD 119 (Del.), Shree Synthetics Ltd. v. CIT, 205 CTR 386
(MP), Escorts Ltd. v. ACIT, 102 TTJ 522 (Del.).
(iii) Share of Profit
from Firm : Sudhir Dattaram Patil v.
DCIT, 2 SOT 678 (Mum.), A. H. Baldota v. ACIT, 103 TTJ 517
(Mum.), Marezban Bharucha v. ACIT, 12 SOT 133 (Mum.).
(iv) Tax Free
Bonds : Punjab National Bank v. DCIT,
103 TTJ 908 (Del.).
(v) Chapter VIA
Income : Punjab State Co-operative Milk
Producers Federation Ltd. v. ITO, 104 ITD 408
(Chand).
In view of the above trend of judicial
pronouncements, it is possible that the disallowance may be made u/s.14A
for expenditure relating to long term capital gain on sale of shares or
redemption of units of Mutual Fund which is exempt u/s.10(38) as
Securities Transaction Tax (STT) is paid. Whether S. 14A can be invoked
for disallowance of expenditure relating to dividend on shares held as
stock-in-trade or not is a matter on which divergent views have been
expressed. Therefore, this matter has been referred to a Special Bench
of ITA Tribunal at Mumbai in the case of Daga Management Pvt. Ltd. and
its judgment is awaited.
4. To sum
up :
From the above discussion it will be noticed that
the New Rule 8D prescribed by CBDT will further complicate the working
of the amount disallowable u/s.14A. Hitherto some adhoc basis was being
adopted. Now, 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.
If we trace the history of this legislation it will
be noticed that S. 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. This was held to be allowable by the Supreme Court in certain
cases. It was only to deny such claim that this provision was
introduced.
In the explanatory memorandum issued with the
Finance Bill, 2001, while enacting S. 14A, it is stated that "the tax
incentive given by way of exemptions to certain categories of income is
being used to reduce also the tax payable on the non-exempt income by
debiting the expenses incurred to earn the exempt income against taxable
income". S. 14A was enacted to curb this tendency.
In the case of dividend income, the scheme of the
Income-tax Act is to collect tax at 15% plus applicable surcharge at the
time of distribution. It is for this reason that tax is not levied in
the hands of the investor. Similarly, the firm is required to pay tax at
30% plus applicable surcharge. For this reason, the balance of profit
apportioned to partners is exempted in the hands of the partners.
Similar exemption is given u/s.10(38) in respect of
long term capital gains on which STT is paid. This exemption is 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 or CBDT should clarify that S. 14A should not
be invoked where income is received by the assessee after payment of tax
under the Income-tax Act.
Article by P. N. Shah ,
Chartered
Accountant
