Rule 8D – A Technical Study

Friends, there is no dearth of folk lore in this country. Many of these often constituted the subject matter of bed time stories with which our dear grandmas have rocked us to sleep. The stories were like ‘the standard formula movies’ we see now days. In these stories, there were always demons and gods. These demons always used to appease the gods by hard core penances to petition for boons. An angelic glow used to shine on these demons when their penances were culminating and at that historic moment, the dumb gods, propitiated by the demon’s worship, used to appear before the demons with a charming smile on their benign countenances and an ever ready raised hand in blessing. The boons sought by the demons were never in the interests of the grantors. Yet, the gods unfailingly granted the same and what happened there after is predictable history. The gods paid heavily through the noses for their extravaganza. Each demon became so powerful with the boon that he chased these very gods out of their heaven and usurped the throne there. This happened with not one demon, but with several demons in succession. There is a rule that “once bitten, twice shy”. But, this never seemed to register in the minds of gods. They continued to dole out boons like blank cheques to the demons , who ‘buttered’ them with penances and continued to kick them out of heavens.

This show goes on merrily even today. Rules created by an enactment continue to flout or challenge the enactments itself. But, this demonic aggression is not as easy as made out in the folk lore. Our Courts have been very clear in their perceptions that in the legal caste system, the rule cannot ever enjoy ascendancy over its peer, the enactment. The rule cannot be allowed to over step in contempt of this legal discipline. That a rule cannot over ride statutory provisions has thus been held by the Bombay High Court in the case of Inaroo Ltd. vs. CIT [1993] 204 ITR 312, 321 (Bom). A rule cannot travel beyond the Act {Gajraj Singh vs. State Transport Appellate Tribunal [1991] 1 SCC 650. 675 ; Addl. District Magistrate vs. Siri Ram [2000] 5 SCC 451, 458].

Rules are meant to play hand maids to the statutory provisions. A conflict between the statute and the rules is always to be resolved in favour of the former. {Union of India vs. Somasunderam Vishwanath [1989] 1 SCC 175, 180 {SC}. Rule is only a piece of subordinate legislation and therefore, ‘subordinate’ it must remain. This is the golden rule, which is unimpeachable even when the rule is founded by the law maker and not by delegated legislation. That a rule cannot enjoy the same force as the principal enactment has thus been well observed by the Gujarat High Court in its decision in the case of CIT vs. Satellite Engineering Ltd. {1928] as reported in 113 ITR 208, 223 {Guj}.

There are two ways in which the Court generally resolves a conflict between the statute and rule. The first is the surgical approach. When the rule is found to be ultra vires the statute empowering the rule, then the Court proceed to dissect the cancerous lump of rule from the body of law. The Court strikes down the rule and renders it dysfunctional.

But, it may so happen that the rule is not really ultra vires. Only, in a first glance impression, the rule may not appear to enjoy the confidence of the enactment. In such a case, the Court may proceed to take a curative approach. The Court will take a closer look at the wordings in the Rule and interpret it in the light of the purpose and objective of the enactment.

For example, in the case of All India Lakshmi Commercial Bank Officers Union vs. Union Bank of India [1984] 150 ITR 1,7 {Del}, the Delhi High Court noted that a Rule cannot travel beyond the main statute and must be read subject to the provisions of the Statute itself.

This guiding principle can also be seen followed by the Bombay High Court in the case of CIT vs. New Citizen Bank of India [1965] 58 ITR 468, 484 {Bom}. It is the Statute that must control the Rule and not vise versa.

Such purposeful interpretations have lend harmonies to both the enactment and the rule and enable both to prevail peacefully.

With these principles in mind, let us open the discussion on the subject matter of this article – Rule 8D of the Income Tax Rules 1962. At the end of this discussion, we shall come to the conclusion as to whether this Rule is demonic or benign.

In order understand this rule, let us first under the provisions of section 14 A, from whose parentage this rule has been derived.

This provides for disallowance of expenditure in relation to income not includible in total income.

Sub-section [1] provides that for 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 the Income Tax Act.

3.2 Sub-section [2] is pertinent for Rule 8D. This sub section enjoins on the Assessing Officer to determine the amount of expenditure incurred in relation to such income which does not form part of the total income under this Act in accordance with such method as may be prescribed, if the Assessing Officer, having regard to the accounts of the assessee, is not satisfied with the correctness of the claim of the assessee in respect of such expenditure [emphasis supplied in bold italics] in relation to income which does not form part of the total income under this Act.

Sub section [3] then provides that the provisions of sub-section (2) shall also apply in relation to a case where an assessee claims that no expenditure has been incurred by him in relation to income which does not form part of the total income under this Act.

Whereas sub section [1] has been brought on the statute book by Finance Act 2001 retrospectively with effect from 1-4-1962, sub sections [2] and [3] were subsequently introduced by Finance Act 2006 w.e.f. from 1-4-2007.

4. Now, let us proceed to have a look at our friend, Rule 8D.

Rule 8D :- “Method for determining amount of expenditure in relation to income not includible in total income.

(1) Where the Assessing Officer, having regard to the accounts of the assessee of a previous year, is not satisfied with –

(a) the correctness of the claim of expenditure made by the assessee; or
(b) the claim made by the assessee that no expenditure has been incurred, in relation to income which does not form part of the total income under the Act for such previous year, he shall determine the amount of expenditure in relation to such income in accordance with the provisions of sub-rule (2).

(2) 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 x B / C
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.”

(3) For the purposes of this rule, the ‘total assets’ shall mean, 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.”

At first glance, the new rule may appear fearsome and demonic But, this may not be so. We have seen above that there is enough authority to subdue a rule by interpreting the same is context of the statutory provision to which it is subordinate.

The first issue addressed in this article is whether the Assessing Officer is duty bound to determine the disallowance of expenditure by resorting to the method prescribed u/r 8D merely because he disagrees with the working of the disallowance or its correctness, when any other scientific working is still possible based on the information in book of accounts.

In short, even if the accounts are reliably maintained and a determination of disallowance of the expenditure is possible on some decent scientific method, whether a resort can be made by the Assessing Officer to the rule of thumb method prescribed in Rule 6D?

In the first place, the assessee, on his own, is not obliged to compute the disallowance as per the method prescribed in rule 8D.

The assessee is entitled to work out the disallowance by any scientific method based on the information in his accounts. The Rule 8D is meant for the Assessing Officer’s determination of the expenditure and not for the assessee.

The Assessing Officer has to be first dissatisfied with the correctness of disallowable expenditure calculated by the Assessing Officer. It is mandatory condition in section 14A that this dissatisfaction is reached “having regard to the accounts of the assessee”. Even Rule 8D agrees that the Assessing Officer should be dissatisfied “having regard to the accounts”. In short, he cannot disregard the accounts in making his inquiry whether the disallowance worked by the assessee is correct.

If, having regard to the accounts, he feels that the disallowance calculated by the assessee can be corrected by reworking it scientifically, he should not invoke the provisions of rule 8D. This is more particularly so, when the books of accounts provide the means to work out the disallowance correctly.

According to me, Rule 8D can be invoked only when it is not possible to work out the disallowance correctly having regard to the accounts, say due to the complexity involved in the accounts, unreliability in the accounts or lack of some vital information for determination of the disallowance

This interpretation, I feel, will assign due weightage and justice to the expression “having regards to the accounts”. Rule 8D is meant as measure of last resort only, i.e. when it is not possible to work out the disallowance correctly having regard to the accounts.

Even if the working of the disallowance made by the assessee is wrong, the Assessing Officer must take due regard to the accounts and find out whether the disallowance can be worked on basis of accounting principles. This, he is expected to do honestly and only when this possibility is exhausted, he must resort to the determination by Rule 8D.

The above interpretation will align Rule 8D with the provisions in section 14A.

The second issue addressed is whether this rule is retrospective, prospective or clarificatory in nature. This issue assumes significance from the point of view that the mode of calculation of the disallowance under section 14A is a hot bed of litigation before appellate authorities.

We observe that there is a prohibition in proviso to section 14A on reopening assessments u/s 147 or rectifying the assessment u/s 154 for Assessment Year 2001-02 and its prior years even if the Assessing Officer finds that if the computation of disallowance by the assessee is dissatisfactory having regard to the accounts of the assessee. But, at the same time, it may be noted that there is no express bar on applying rule 8D in pending proceedings such as in pending appellate proceedings before the Commissioner {Appeals} or before the Appellate Tribunal.

We have also seen above that rule 8D is a product of sub section [2] of section 14A. Whereas the main sub-section [1] introduced by the Finance Act 2001 with retrospective effect from 1-4-1962, the provisions in sub section (2) was introduced only later by the Finance Act 2006 and that too with effect from 1-4-2007.

A common misconception is that a provision is called ‘retrospective’ if it is brought on the statute with effect from a prior date. This is respectfully not entirely correct or half correct in my view. An amendment can also sometimes be clarificatory of an exiting position in law, which position may be implied in the existing law, but not express in its language. In such case, one may find amendment,[ though expressed by the Legislature to be brought on the statute with effect from a prior date] which is merely clarificatory and not retrospective. Such amendments are not considered as retrospective because the law expressed in the language of the amendments was already existing in the implied law.

A law has two aspects – substantative [i.e. that law which create or govern the rights of the person subjected to the law ] and procedural [i.e. the lesser essential section of law, which merely assists the substantive law by providing it a means or procedure for its administration] . The established code is that whereas a person can claim a vested right in law, he cannot do so in respect of a procedure in law.

In terms of Income Tax Act, if by virtue of amendment, a substantative right of the assessee is changed, then the amendment is said to be retrospective. In interpretation of taxing statutes, the general rule is that a substantative amendment is presumed to be prospective, unless stated to be otherwise by the Legislature. This is more particularly so when the amendment could risk the assessee with a new or additional burden of tax.

For example, the law that prevailed prior to the introduction of section 14A [1] was that if any expenditure was allowable because it was incurred for the purpose of business, no portion of the same can be disallowed on the ground that some portion of the income of this business was exempt from tax.

This existing substantative right to claim such expenditure was disturbed by the amendment brought by section 14A[1] w.e.f. from 1-4-1962. The assessee had all the time right to claim such expenditure by virtue of the law right from 1-4-1962 and this right which was vested in him was disturbed prejudicially by the Finance Act 2001, which introduced section 14A [1] w.e.f. from 1-4-1962.

The normal impact of any retrospective amendment in a taxing statute is two fold.

Firstly, this provision could have been applied to reopen any assessment of past year permissible u/s 147. This is because the amended law replaces the original law right from the date on which it takes retrospective effect.

The second impact would be that in any assessment or appeal, which were pending, this retrospective law can be applied even though the law at the time of the filing the return permitted such expenditure.

As regards section 14A, only, the degree of retrospective impact was curtailed by the proviso to this section so as to curb reopening powers u/s 147 and rectification powers u/s 154 for Assessment Years 2001-02 and prior years. This left the power to apply the provision of sub section 14A [1] in respect of pending assessment and appellate proceedings.

The general rule in construction of delegated legislation is that Rules are meant to be prospective in effect unless there is clear indication otherwise in the Statute that it is retrospective. {ITO vs. M.C. Ponnoose [1970] 75 ITR 174, 177 {SC} ; Bakul Cashew Co. vs. STO [1986] 159 ITR 565, 572 {SC}}

It may noted that while the Legislature brought the main provision in section 14A i.e. sub section [A] on the statute in 2001 with retrospective effect from 1-4-62, it preferred to keep its subsequent amendment of 2006 in sub-section [2] effective only from 1-4-2007. [i.e. A.Y. 2007-08 onwards]

Two views emerge in my mind. The first view is that since the sub-section [2] of section 14A has been brought by the Legislature on the statute w.e.f. from 1-4-2007, it is prospective and if it is prospective, the procedure derived from it in Rule 8D can only be prospective i.e. operating from A.Y. 2007-08 onwards. This will accord with the principle that a rule cannot extend beyond what its parent enactment extends.

The second view, which I am canvassing requires careful examination by the readers. To begin with, we have seen that Rule 8D concerns the Assessing Officer more than the assessee. Neither Section 14A [2] nor its Rule 8D prevents an assessee from working out his disallowance under Rule 8D scientifically in accordance with the material available in his books of accounts. If such a disallowance is worked out, the Assessing Officer is bound to accept it if it is fairly worked.

Even if the working is not satisfactory to the mind of the Assessing Officer, he is not bound to immediately resort to Rule 8D for determination of the disallowance.

He may calculate the disallowance on any fair scientific basis, taking due ‘regard to the accounts’ in reaching this state of dissatisfaction. If the accounts provide to the Assessing Officer an alternative means to compute the disallowance scientifically, he should proceed to so calculate the disallowance having regard to the accounts.

This power, the readers may appreciate, the Assessing Officer had even if sub section [2] was not on the statute because the power to ascertain the income properly is embedded in the assessment procedure of section 143 [3]. It is thus a possible view that neither sub Section [2] nor Rule 8D has changed the law in this respect.

Even without sub-section [2] of section 14A or Rule 8D, the Assessing Officer had power to estimate the disallowance if the books of accounts are not reliably kept so as to provide the material to compute the disallowance. This power is in the provisions of sections 143 [3], 144 and 145.

According section 14A [2] and Rule 8D it is only if the accounts cannot be “regarded” as the means to compute the disallowance i.e. when the accounts are not reliable, then the provisions of sub section [2] of section 14A and Rule 8D come in to play.

If, looked upon from this angle, it is possible to derive a consensus that Section 14 A [2] has only clarified an existing power of the Assessing Officer and no new law has been brought out. The only additional feature in section 14A [2] is that it provides a uniform procedure to work out the disallowance u/s 14A.

The power to impose a tax or an additional burden of tax lies with the taxing statute and not with the subordinate rules. An expectation from a rule is that there should be no new imposition of levy [Bimal Chandra Banerjee vs. State of M.P. [1971] 81 ITR 105, 110-111[SC}. Rule should not also enlarge the imposition of tax [Municipal Board vs. Bharat Oil Co [1990] 78 STC 453, 459-60 {SC}.

In my view, [which some readers may not share], the procedure in Rule 8D does not impose an additional burden of tax on the assessee. Rule 8D (2) provides the procedure for computation of disallowance.

Clause (i) disallows the amount of expenditure directly relating to income which does not form part of total income. This is surely not offensive. It accords with the accounting principle of matching expenditure with corresponding revenue.

As per clause (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, i.e. interest expenditure which is not directly attributable to either taxable income or exempt income a pro rata disallowance is made. Merely because this disallowance is worked on the basis of investment and not income or turnover does not invalidate the rule. If books of accounts are not reliable, then estimation on basis of investment values should not be faulted as totally insensitive.

As per clause (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 is disallowed to cover other indirect expenditure relating to exempt income. This is also not unreasonable in absence of reliable books of accounts.

Readers may note that in any estimation, there is bound to be some subjective element. But, a method of estimation need to be ideal to satisfy a Court. All that is required is that it should not be arbitrary or unconscionable.

These are the factors which I propose to the readers to take into account while judging Rule 8D.

Based on my views above, it appears to me that section 14A [2] neither brings any new law into existence nor imposes additional burden of tax on the assessee. It is not retrospective, but clarificatory in nature. If some thing is new, it is only a procedure in determination of the disallowance. An assessee cannot be said to have any vested right in a procedure of law. A retrospective operation is thus permissible for a procedure. It is therefore possible to take a view that this Rule 8D being procedural can be applied even in pending proceedings of assessment and appeals for Assessment Years even prior to Assessment Year 2007-08 .

In short, while section 14A [2] is clarificatory, Rule 8D being procedural, its retrospective application is permissible in pending proceedings.

This article opened with the story of gods and demons. After this discussion, I would ask the readers to look more kindly at Rule 8D. It may not be the demon that appeared in the folk lore, who ‘conned’ the god that granted the boon.

Article by Mr. CA Anant N. Pai,  a reputed Chartered Accountant, who is an expert in Tax