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Method for Determining Expenditure Incurred Towards Earning Income Not Forming part of Total Income - Section 14A and Rule 8D

There are certain incomes which do not form part of Total Income. In other words, such incomes are exempt from tax. For example- agricultural income, tax free interest etc. In respect of such income it is also possible that the assessee may have incurred certain expenditure. Would such expenditure be allowed? This has been a topic of debate between the Assessee and the Income Tax Authorities for a long time.

To put an end to such discussion, section 14A was introduced.

Section 14A and Rule 8D of the Income Tax Act

Section 14A

As per section 14A of the Income Tax Act, 1961, no expenditure incurred by the assessee shall be allowed in respect of such income which does not form part of total income under the Income Tax Act.

Method of Determining Expenditure Incurred Towards Income not forming Part of Total Income

Section 14A read with Rule 8D, also prescribes the method for determining the expenditure incurred towards earning income not forming part of Total Income. Such expenditure shall be determined only in the following scenarios-

  1. The Assessing Officer, having regards 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.
  2. The assessee claims that no expenditure has been incurred by him, in relation to the income which does not form part of the Total Income.
 

However, section 14A shall not 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. 

Rule 8D 

Rule 8D prescribes the method of determining the expenditure in relation to income which does not form part of the total income. Such expenditure shall be the aggregate of following amounts:—

  1. the amount of expenditure directly relating to income which does not form part of total income; and
  2. 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 so determined shall not exceed the total expenditure claimed by the assessee.

Let us understand clearly through an example-

Apeksha has taken a loan of Rs.15 lakh on 1January 2021 @ 10% during the FY 2020-21. Therefore, her interest expenditure for the year on this loan is Rs.1,50,000. This loan was utilized for making an investment of Rs.15 lakh in various avenues; income from this is exempted from tax.

Monthly closing balances of this investment is Rs 10,00,000 (Jan 2021), Rs 12,50,000 (Feb 2021), Rs 15,00,000 (Mar 2021)

 

Calculation of disallowance under Rule 8D

Particulars

Amount (in Rs)

Any amount of expenditure which is directly relating to exempt income

1,50,000

Amount equal to 1% of annual average of monthly average of opening and closing balances of value of investment whose income is or shall be exempt is 1% of Rs 10,00,000 (See computation below)

10,000

Monthly average of Investment

 

Jan 2021 – Rs 0 + Rs 10,00,000/2 = Rs 5,00,000

 

Feb 2021 – Rs 10,00,000 + Rs 12,50,000/2 = Rs 11,25,000

 

Mar 2021 – Rs 12,50,000 + Rs 15,00,000/2 = Rs 13,75,000

 
   

Annual Average of the above monthly averages= Rs 5,00,000 + Rs 11,25,000 + Rs 13,75,000 / 3 (Loan was borrowed only in January 2021) = Rs 10,00,000

 

Total disallowance under Section 14A read with Rule 8D

1,60,000

Note: The maximum amount of disallowance is subject to the expenditure claimed by the assessee.  

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