Expenditure related to exempt income

Every person whose total income of the previous year exceeds the maximum amount, which is not chargeable to income tax, is an assessee and chargeable to income tax in India at the rate or rates as may be prescribed in Finance Act and Income Tax for the relevant assessment year.  

We know that in India, income tax will be levied on the basis of the residential status of an assessee. In Income Tax Act, 1961, there are three types of assesses, based on their residential status, such as;

1. Resident and Ordinary Resident in India;
2. Resident but not Ordinary Resident in India;
3. Non-Resident.

The income of a Resident and Ordinary Resident in India from all over world or from any part of world will be taxable in India.

SECTION 14 of Income Tax Act, 1961 all income, for the purpose of Income -tax and computation of total are classified under following heads of income;

1. Income from Salary [Sections 15 to 17];
2. Income from House Property [ Sections 22 to 27];
3. Income from Profits and Gains from Business or Profession [Sections 28 to 44];
4. Income from Capital Gains [Sections 45 to 55A];
5. Income from other Sources [Sections 56 to 59].

The aggregate income of an assessee computed under aforesaid heads after applying clubbing and set off and carry forward losses’ provisions know as Gross Total Income.

From Gross Total Income assessee is allowed certain deductions under provisions of Chapter VI-A (i.e. from Sections 80C to 80U). The Gross Total Income less deductions are known as Total Income of Taxable Income.

There are some incomes, which are exempted under provisions of Income Tax Act, 1961. An assessee earning these types of income, is not required to pay any tax and same will be not included, while calculating tax liability of assessee. An assessee is not required to pay any tax on these types of incomes and hence any expenditure incurred for earning these types of income should not be allowed to be deducted from taxable profit of an assessee.

Section 14A:

As per Section 14A of the Indian Income Tax Act,1961 any expenditure incurred on earning an income that is already exempt and excludes the total revenue while computing the total income of the taxpayer should not be considered as a deduction.

Section 14A  of the Income Tax Act was introduced in the Finance Act, 2001 with retrospective effect from 01 April 1962 to disallow deduction with respect to the expenditure incurred by the taxpayer concerning income which does not form part of the total income under this Act.

However, there has always been a conflict between the taxpayers and the income tax authorities on whether to allow the expenditure earned on exempted income or not for tax computation. There has also been a different take on this section by the Honourable Supreme court as well, where the Court had held that where there was one unified business that gave rise to the expenditure and income, payment will be considered for tax computation. Judgment in two cases, i.e., CIT v. Indian Bank Ltd., (56 ITR 77) in 1964 and CIT v. Maharashtra Sugar Mills Ltd., (82 ITR 452) were passed by the Supreme Court.

Allocating Expenditure

The introduction of this Act has also introduced the method of allocating expenditure to exempt income. This was included in Rule 8D of the income tax rules, 1962. However, this rule 8D was amended on 02 June 2016 to provide for a revised method to allocate the expenditure to exempt income.

Let's discuss Rule 8D of Section 14A

As mentioned above, Rule 8D was introduced to pen down the method of determining the expenditure incurred concerning earning exempt income. There are two parts:

Rule 8D (1) 

Rule 8D (1) Lists down the rules for the assessment officer;

1. Where an Assessing Officer has satisfied with the correctness of the claim of expenditure or he is satisfied that no expenditure has been incurred for such exempt income, no further action is required by the AO in this regard;

2. Where Assessing Officer, having regard to the accounts of the assessee of a previous year, is not satisfied with

• the correctness of the claim of expenditure made by the assessee; or
• the claim made by the assessee that no expenditure has been incurred.

In relation to income which does not form part of total income under the Act for such previous year, he shall determine the amount of expenditure in relation to such income in accordance with Rule 8D (2) of the Income Tax Rules, 1962.

Rule 8D (2) [applicable w.e.f. 02/06/2016 as per Notification No. 43/206, dated 02/06/2026] lists down the nature of amounts put together that are determined to compute the expenditure incurred in earning the income, which does not form part of the total revenue. These are as follows:

• Any amount of expenditure that directly relates to income which does not form part of the total income;
• Any income arising by calculating one per cent (1%) of the annual average of the monthly average of the opening and closing balances of the value of the investment does not or shall not form a part of the total income.

Note: Both the above amounts to be considered should not exceed the total expenditure claimed by the assessee.                                

Interpretation 

It has also been observed that over the years, the interpretation of Section 14A has changed with the times and has been controversial to the extent that these controversies constitute a substantial portion of tax litigation in today’s time. 

Some of the noticeable recent decisions of the Honourable Supreme Court in matters of the tax computation as per Section 14A are mentioned below:

LET'S CONSIDER SOME JUDICIAL DECISIONS;

1. Canara Bank Vs. ACIT (2014) 52 Taxman 162(Kar):  where assessee bank earned tax free income in the form of dividends , interest on tax-free bonds, etc., and said income was directly credited to its bank account, it was held that since such incomes were directly credited to bank accounts of assessee by way of bank transfer the impugned disallowance by the tax authorities representing 2% of gross total income on account of expenditure incurred in realising said exempt income was to be deleted.

2. No disallowance of interest on borrowed funds if Assessing Officer does not shown nexus between borrowed funds and tax-free investments:

Hero Cycles Ltd. Vs. CIT (2010)323 ITR 518 (P&H)  No disallowance can be made under Section 14A of interest on borrowed funds where in case of mixed funds, it is not possible to ascertain whether the investment in tax free bonds is out of assessee own’s fund , the source of investment in the tax free bonds is identified , and Assessing Officer failed to establish any nexus between borrowed funds and the investments in tax free bonds. The AO has also ignored Cash Flow Statement of the assessee. Therefore, the apportionment on a pro rata basis was improper in the absence of anything brought by AO to rebut the assessee’s stand that investment in the tax-free bonds had been made out of the funds of own funds.

3. Gujarat Industrial Development Corporation Ltd. (2013)218 Taxman (Guj): where interest bearing borrowed funds were not used in investment, no interest could be disallowed under Section 14A.

4. Avon Cycles Ltd. Vs. CIT(2015)53 Taxman 297(P&H): where funds utilised by an assessee were mixed funds and part of it was invested in earning tax free dividend income, it was held that the interest paid on borrowed fund was also relatable to interest on investment made in tax free funds. Therefore, interest expenditure relatable to investment in tax free funds was to be computed under provisions of Rule 8D(2)(ii) of the Income Tax Rules, 1961.

5. Gujarat Apollo Industries Ltd. Vs. CIT (2015) 55 Taxman 158(Guj): if there was sufficient surplus fund at assessee’s disposal for making any investment and no nexus was established with expenditure incurred for earning exempt income, no disallowance could be made under Section 14A.

6. Hero Management Services Ltd. Vs. CIT(2014)360 ITR 68(Del): in order to invoke rule 8D of Income Tax Rules, 1962, the AO has to first record a finding that he was not satisfied with the correctness of the claim for expenditure made by the assessee in relation to income which did not form part of total income under the Act and as such if no satisfaction as required by Rule 8D had been recorded by the AO. No disallowance be made under Section 14A.

7. Disallowance cannot be made if the assessee has not incurred any expenditure to earn exempt income:

Hero Cycles Ltd. Vs. (2009)31 DTR 301(P&H):  disallowance under Section 14A requires finding of incurring expenditure. Where it is found that for earning exempted income no expenditure has been incurred, disallowance under Section 14A cannot stand.

8. Maxopp Investment Ltd vs. CIT – In this case, the Supreme Court took cognizance under the circumstance of applicability of section 14A in situations where shares are conducted to gain a controlling interest in group companies as stock-in-trade. Here the intention while making such investment or the dominant purpose is not relevant while determining the disallowance. It also held that the expenses incurred in earning dividends have to be apportioned appropriately and disallowed as Section 10(34) of the Act exempts dividend income made when shares are held in stock as stock-in-trade.

9. CIT v/s. Essar Teleholdings Ltd. – Here the prospective or retrospective operation of Rule 8D was in question, and the honourable Supreme Court held that Rule 8D was intended to operate prospectively and cannot be applied for Assessment Years before AY 2008-09.

10. Disallowance cannot be made if the assessee has no tax-free income in the year:

Lakhani Marketing Inc.Vs. CIT (2014) 49 Taxman 257(P&H):  from the reading of Section 14A of the Act, it is clear that before making any disallowance the following conditions are to exist;

• That there must be income taxable under the Act, and
• That this income must not form part of total income under the Act, and
• That there must be an expenditure incurred by the assessee, and
• That the expenditure must have a relation to the income which does not form part of the total income under the Act.

Therefore, unless and until, there is receipt of exempted income for the concerned Assessment Years (dividend from shares), Section 14A cannot be invoked.

Note: CBDT has issued Circular No. 5/2014 ,dated 11/02/2014 ,which clarifies as under CBDT , in exercise of its powers under Section 119 of the Act hereby clarifies that Rule 8D read with Section 14A of the Act provides for disallowance of the expenditure even where tax payer in a particular year has not earned any exempt income.

11. Kribhco Vs. CIT (2012) 75 DTR 265 (Del): the assessee is a co-operative society which claimed deduction under section 80P(2)(d). The AO applied provisions of Section 14A and disallowed 1/8 of the employees benefit and remuneration. In appeal the disallowance was deleted by CIT(Appeals) and Tribunal. On appeal to High Court, the Court held that deductions which are permissible and allowed under Chapter VI-A, do not result in exclusion of the income from the charging section. Chapter VI-A is a different from the exclusions/exemptions granted/stated in Chapter-III. The Court held that no disallowance under section 14A could therefore be made against the income which was entitled to deduction under Section 80P(2)(d).

Conclusion:

Disallowance of expenditure under provisions of Section 14A read with Rule 8D is the most debatable and disputed matter between assesses and the tax authorities. There are number of judicial decisions on various aspects of applicability of provisions of this section available today. The Assessing Officers generally disallowed genuine expenditure by invoking provisions of Section 14A. The AO should consider and prove nexus of expenditure and the income, while disallowing any expenditure under this section. Even CBDT has came with a circular mentioned above in which it is clarified that even if there is no exempt income during previous year under consideration, then also provisions of Section 14A read with Rule 8D will be invoked for determining Gross Total Income of an assessee.

Disclaimer:  

The entire contents of this document have been prepared on the basis of relevant provisions and as per the information existing at the time of the preparation. Although care has been taken to ensure the accuracy, completeness, and reliability of the information provided, author assume no responsibility, therefore. Users of this information are expected to refer to the relevant existing provisions of applicable Laws and take appropriate advice of consultants. The user of the information agrees that the information is not professional advice and is subject to change without notice. Author assume no responsibility for the consequences of the use of such information.