Income-tax Act, 1961 has so many complicated provisions.  I feel it is best to uncomplicate that which is complicated.  As Denzel Washington said in movie PHILADELPHIA, “All right, Mr. Laird, explain this to me like I'm a four-year-old, okay?” In that spirit, here is a fresh look at certain taxation provisions, from the eyes of a young tax practitioner. 

Section 14A – This section troubles most assessees.  For all those scrutiny cases, where there are capital gains transactions coupled with dividend received and interest payables, AOs inevitably make a disallowance u/s 14A.

What this section seeks to achieve is that all expenses relating to exempt income must be disallowed.  A plain reading of the section must surely convince a practical man that it is perfectly logical section and fits in the broader sense of things.  After all, certain incomes are privileged to be exempt under Section 10, and assessee’s should not take unfair advantage of claiming expenses related to earning such privileged income against other taxable income.

While the objective of the section is spelt out in the Act, the means to implement the section is spelt out in Rule 8D. 

As per the Rule, any expenses directly relatable to such income must be disallowed - usually there never are any, since you and I both know that you don’t pay anything to earn dividend! 

Further, interest attributable to exempt income must be disallowed in a proportion to Average Value of Non-taxable Investment / Average Value of total assets.  This is precisely where the problem lies.  Normally, what happens is that people buy and sell shares mainly for getting a profit on their investment.  The dividend income received is usually a meagre amount and is purely incidental income.  To put it differently, in most cases, shares are not purchased for earning dividend income. 


   Short term Capital gains during year on sale of shares (taxable) – Rs 100,

   Dividend Income (tax free) – Rs 5,

   Interest paid on loan to buy shares – Rs 15

Now, assuming that in above case, the shares constitute all total assets, then disallowance u/s 14A would be entire interest of Rs 15.  But, let us not forget, that actually, the assessee earned dividend income of Rs 5 only.  Now in such cases, disallowance u/s 14A of Rs 15 is more than the exempt income received of Rs 5, which is wholly against the spirit of the section.  The fact is that the shares were bought through a loan mainly for earning profit on share price (ie capital gains).  Hence, the AO if he wanted to disallow could at best disallow interest income in proportion of exempt income to taxable income ie Rs 15*5/100 = Rs 0.75. 

Further, there is another element of Rule 8D which blindly disallows ½% of Average Value of Non-taxable Investment.  I fail to understand where the makers of Rule 8D were coming from for this part of Rule 8D, which I am afraid violates all cannons of taxation, is completely illogical and quite plainly sticks a knife into honest assessee’s chest.


Keeping it simple, you can be taxed in respect of money’s earned over and above money’s spent. 

Section 14A, at first blush, looks like a section with honest intention.  However, Rule 8D gives license to AO to make unwarranted disallowances which are several times the amount of exempt income: in above example disallowance of Rs 15 vis a vis dividend of Rs 5.  How does the Godrej & Boyce decision affect anything?  To tell you the truth, I fail to understand the directions of the Hon’ble Bombay HC to remand to AO so as to disallow on ‘reasonable basis’.  This decision basically puts the ball in the court of the AO.

Looking at the broader picture, a man took loan to buy shares.  Undoubtedly, he should be taxed on profits earned from shares, and should be allowed deduction of interest spent.  However, with 14A, a significant part of interest is disallowed merely because he earned a meagre dividend income.

I can write similar articles with mathematical illustrations on Section 9, Section 68, Section 195 and Rule 10.  I would just like to conclude by saying that I am totally against DTC.  I look at DTC and think of FBT.  Instead of bringing in an entire new piece of legislation (who knows the new demons concealed therein), the law makers should focus on plastering and cementing the gaps in the current legislative framework (like Section 14A, Section 9, Section 68, Section 195 and Rule 10) so as to not cause undue hardship to honest assessee and moreover to ensure that a person is taxed only to extent of money’s earned over and above money’s spent.

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Ryan Saldanha
Category Income Tax   Report

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