Sec 14A read with newly Amended Rule 8D of the Act

One of the most litigative issues in direct taxation faced by business entities pertains to disallowances made under section 14A of the Income Tax Act 1961 (IT Act) read with Rule 8D of the IT Rules. Here is the attempt from our side to simplify interpretation of Sec 14A of Income Tax Act, 1961 read with rule 8D of the Act by incorporating various High Court Judgements on said section. Rule 8D was amended by Finance Act,2016 to avoid litigations on disallowance of indirect expenditure in relation to interest. The position in the bare act in respect of Sec 14A read with rule 8D is as follows: 

"14A. Expenditure incurred in relation to income not includible in total income.-

(1) 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.

(2) The Assessing Officer shall 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 in relation to income which does not form part of the total income under this Act.

(3) 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:

Provided that nothing contained in this section shall empower the Assessing Officer either to reassess under section 147 or pass an order enhancing the assessment or reducing a refund already made or otherwise increasing the liability of the assessee under section 154, for any assessment year beginning on or before the 1st day of April, 2001.

8D. (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; and

ii) an amount equal to one per cent of the annual average of the monthly average of the opening and closing balances of the value of investment, income from which does not or shall not form part of total income.

Provided that the amount referred to in clause (i) and clause (ii) shall not exceed the total expenditure claimed by the assessee."

ISSUE 1: IN RELATION TO INCOME

Illustration 1: In Doypack Systems Pvt Ltd v. Union of India: AIR 1988 SC 782, the Supreme Court observed that the expressions "pertaining to", "in relation to" and "arising out of", used in the deeming provision, are used in the expansive sense.

The Supreme Court further observed as under:- "49. The expression "in relation to" (so also "pertaining to"), is a very broad expression which presupposes another subject matter. These are words of comprehensiveness which might both have a direct significance as well as an indirect significance depending on the context…"

"… In this connection reference may be made to 76 Corpus JurisSecundum at pages 620 and 621 where it is stated that the term "relate" is also defined as meaning to bring into association or connection with. It has been clearly mentioned that " relating to" has been held to be equivalent to or synonymous with as to "concerning with" and "pertaining to". The expression "pertaining to" is an expression of expansion and not of contraction."

ISSUE 2: WHICH DOES NOT FORM PART OF TOTAL INCOME UNDER THE ACT

Illustration 1: The Delhi High Court in the case of Cheminvest Limited held that there should be actual receipt of exempt income during the relevant year, for the purpose of disallowance of any expenditure incurred in relation to such income. Section 14A will not apply, if no exempt income is received during the relevant year. The expression"does not form part of total income" in Sec 14A of the Act, envisages that there should be an actual receipt of exempt income during the relevant year, for the purpose of disallowance of any expenditure in relation to such income.

The CBDT has clarified vide Circular No. 5/2014 that there will be disallowance of expenditure even in those cases where exempt income has not been earned during a particular year. However, CBDT circular is binding on tax authorities and not binding on Tribunal/Courts or even the taxpayer as held by the SC in the case of Hero Cycles Pvt Ltd.

Illustration 2: The Delhi High Court (HC) has recently held in the case of Holcim India Private Limited (the taxpayer) that the declaration of a dividend was not the shareholders prerogative as they could not insist on it. Furthermore, on declaration, a dividend was subjected to dividend distribution tax.

The HC also observed that the taxability of income to be earned in the subsequent year depended upon the nature of transaction entered into in the subsequent year. Also, the income which at present was exempt under section 10 of the Act may become taxable in subsequent years. The HC referred to other judgments wherein Courts had ruled that in the absence of any tax-exempt income during the year, the corresponding expenditure could not be disallowed. Considering the above, the HC held that the expenditure could not be disallowed under section 14A of the Act in the absence of any exempt income during the year.

ILLUSTRATION 3: CIT v. Winsome Textile Industries Ltd. [2009] 319 ITR 204 (PH)

This is the first decision of a high court where it has been expressly observed   that the provisions of section 14A cannot be invoked where the assessee had not earned any income not forming part of total income. In this case, the assessee was engaged in manufacture and sale of cotton yarn. During assessment proceedings, the Assessing Officer disallowed interest on the amount of investment in shares on the ground that since dividend income is exempt from tax u/s 10, the provisions of section 14A were applicable. Before the CIT(A), it was contended by the assessee that it had not claimed any income to be exempt from taxation and therefore, the provisions of section 14A cannot be invoked by the AO. 

However, the CIT(A) found that investment in shares was made in earlier years out of its own funds and therefore deleted the disallowance u/s 14A. The tribunal affirmed the order of the CIT(A) since there was no nexus between borrowed funds and the investment made in shares. On further appeal by the revenue, the hon’ble high court also affirmed the finding of the Tribunal considering the facts. But it is interesting to note the legal observations made by the high court in the last para of its decision. “In the present case, admittedly, the assessee did not make any claim for exemption. In such a situation, section 14A could have no application.”

ISSUE 3: Applicability where income has suffered economic taxation

Another important question which is often raised and will be litigated in times to come is whether Section 14A will have application when income has suffered economic taxation, for e.g. dividend which is subjected to Dividend Distribution Tax. In the case of Godrej and Boyce Mfg Co. Ltd v DCIT [TS-125-HC-2010(Bombay)-O], it was held in favour of the Revenue that tax is not paid on behalf of shareholder but is paid in respect of payer’s own liability. However, one wonders whether the amendment in Finance (No. 2) Act, 2014 in Section 115-O will be of any help. It is now provided that the amount of distributable profits shall be increased to such amounts as would after deduction of tax at the rate of 15% (excl. cess and surcharge) be equal to the net distributable profits. DDT is tax payable on distributable profits over and above the tax paid by the company on its profits. The Finance Minister in his Budget Speech stated that “In the year 2003, the tax liability on income by way of dividends was shifted from the shareholder to the company. The shareholder was required to pay tax on the gross dividends, but now the company pays tax on the dividend amount net of taxes.

Similarly, in the case of Mutual Fund, income distribution tax is paid on the income distributed net of taxes. I propose to remove this anomaly both in the case of the company and the Mutual Fund”. Considering the introduction of the provisions of grossing up of dividends and the fact that the Finance Minister himself acknowledges that DDT is tax paid by the company on behalf of the shareholders, the basis on which the judgement supra was rendered falls through. A plausible argument may be made by the assessee that no disallowance can be made u/s 14A in respect of expenditure incurred for earning dividends since the same has suffered tax by levy of DDT.

The R.V Easwar Committee for simplification of Income Tax Laws also recommended the same point to Finance Ministry. However it has not been considered in the newly amended Rule 8D and as such, will continue to be subject matter of litigation.

ISSUE 4: A.O has to record his reasons in writing for invoking Rule 8D.

Illustration 1: The Banglore bench of Income Tax Appellate Tribunal in the case of M/s Subramanya Constructions & Development Co. Ltd. held that AO is not justified in invoking Rule 8D(2)(iii) for a disallowance of indirect expenditure unless he recorded his dis-satisfaction of claim. It is essential such non-satisfaction has to be given with cogent reasons before invoking Section 14A. Doctrine of satisfaction no doubt, does not mean that an AO should presume what was in the mind of the assessee and express his approval or disapproval there on. However, once assessee say that it had incurred no expense covered by section 14A,  AO has to make a verification.

Illustration 2: The Delhi High Court in the case of CIT vs IP Support Services India Pvt. Ltd. has held that disallowance under section 14A read with Rule 8D (2) of the Rules cannot be made by the assessing officer without recording his satisfaction as to why “the voluntary disallowance made by the assessee was unreasonable and unsatisfactory”.

Illustration 3: CIT vs Hero Management Services Ltd(Delhi HC)

ISSUE 5: Meaning of Value Of Investment under section 14A read with Rule 8D

There are cases where an assessee earns exempt income during the relevant year only on some investments. In such cases, while computing ‘average value of investment’ under Rule-8D of the Rules, there has been a lot of debate as to whether those investments which have not yielded any exempt income should also be considered or not.

The Delhi High Court in the case of ACB India Ltd vs ACIT has held that for the purpose of Rule-8D, only those investments shall be considered which have actually yielded exempt income during the relevant previous year.Thus, it is not the total investment at the beginning of the year and at the end of the year, which is to be considered but it is the average of the value of investments which has given rise to the income which does not form part of the total income which is to be considered. Similar view was also taken by the Kolkata Bench of the Tribunal in the case of REI Agro Ltd vs DCIT.

ISSUE 6: Strategic/Business investments to be excluded while computing disallowance under section 14A

Numerous corporate assessees make investments in the shares of subsidiaries/associates companies with a view to acquire and retain controlling interest therein and not for the purpose of earning dividend and /or capital appreciation.  Such investments are made in larger business interest, on account of commercial expediency and not with the intent of earning dividend therefrom. The exempt income, if any, earned from such investments is always incidental to such shareholding.

Illustration 1: The Delhi High Court in the case of CIT v. Oriental Structural Engineers Pvt Ltd upholding the order of the lower authorities held that no disallowance can be made under section 14A of the Act in respect of strategic business investment made by an assessee with a view to retain controlling interest.

Illustration 2: The Madras High Court in the case of CIT vs RPG Transmissions Ltd held that Interest on borrowed funds utilized for investment in group companies for strategic business purpose was allowable under section 36(1)(iii).

ISSUE 7: CHANGES IN RULE 8D VIS-A-VIS ERSTWHILE OLD RULE FOLLOWING AMENDMENT BY FINANCE ACT,2016

The above compilation has been prepared to give glimpse of various issues involved in Section 14A.