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1. Introduction

The tax laws of India treats certain incomes for a taxpayer as not taxable such as agricultural income, dividend received from an Indian company, income of eligible charitable institution, tax free interest etc. It is quite possible for taxpayers to have incurred certain expenditures in order to earn any such income amongst others for eg: interest on loan to fund investment in tax free bonds, company shares. For quite a while, there has been a debate between the taxpayers and income tax authorities on whether expenditure earned on income which is exempt should be allowed or not.

Taxpayers, for obvious reasons have always contended that such expenses too should be allowed (deducted) while arriving at taxable income while department held on to the view that since the income is completely exempt from the taxation, any expenditure incurred towards earning such income should not be allowed as deduction as it will have effect of reducing tax on non-exempt income as well. The Apex Court of India prior to the year 2001 had given its judgment partially in favour of taxpayer’s view. The Supreme Court (SC) held that in case of composite and indivisible business principle of apportionment is not applicable.

Therefore, Section 14A was introduced in the year 2001 with retrospective effect from April 1962 to clarify the intention of the legislature with respect to expenses relating to earning of exempt income.

2. Section 14A

As per Section 14A, expenditure incurred by taxpayer in relation to income which does not form part of total income at all as per the provisions of the Act should not be allowed as deduction while computing total income of taxpayer.

Is there a method to determine expenditure incurred towards exempt income?

Yes, Section 14A has prescribed the method for determining the expenditure incurred towards earning exempt income under Rule 8D by income tax officer. However, method prescribed under Rule 8D can be applicable only in the following scenarios:

  • Where taxpayer claims that no expenditure has been incurred towards earning exempt income; or
  • Where taxpayer has already disallowed amount towards expenditure incurred in relation to earning exempt income, however, assessing officer is not satisfied that the claim of taxpayer is correct considering the accounts of taxpayer.

3. Rule 8D – method to determine expenditure incurred towards exempt income

As per the Income-tax law as it stands today (post amendment in June 2016), expenditure incurred in relation to earning exempt income is the aggregate of following:

  • Any amount of expenditure which is directly relating to exempt income; and
  • 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

However, any disallowance computed under this Rule cannot exceed total expenditure claimed by taxpayer.

Let us see an illustration on Rule 8D computation

Mr A has taken a loan on 5 January 2018 of Rs 15 lakhs @ 10% for the FY 2017-18. Therefore, his interest expenditure for the year on this loan is Rs 1,50,000. This loan was utilized for making an investment of Rs 15 lakhs in various avenues, income from which is tax exempt

Monthly closing balances of this investment is Rs 10,00,000 (January 2018), Rs 12,50,000 (February 2018), Rs 15,00,000 (March 2018).

Rule 8D Disallowance

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 – 1% of Rs 10,00,000 (See computation below)
Monthly average of Investment 2January 2018 – Rs 0 + Rs 10,00,000/2 = Rs 5,00,000
February 2018 – Rs 10,00,000 + Rs 12,50,000/2 = Rs 11,25,000
March 2018 – 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 2018) = Rs 10,00,000
10,000
Total disallowance under Section 14A read with Rule 8D 1,60,000

4. Key points to be noted

  • Disallowance under Section 14A is only with respect to expenditure which is already claimed to be a deduction. If taxpayer has not claimed any deduction at all, there can not be question of any disallowance
  • Basic condition for applicability of Rule 8D has to be satisfied and AO need to mandatorily show why he is not satisfied with taxpayer’s computation and show taxpayer’s computation to be incorrect based on principal of natural justice and various case laws including decision of SC
  • For the purpose of Rule 8D, only those investments relating to exempt income should be considered for the average and not the entire investment
  • However, Section 14A and Rule 8D had been one of the most controversial provisions of Income-tax Act wherein there is no clarity on various things and has utmost litigation even for something that may seem straight and simple. Following are few controversies that has arisen over the period more so due to different views adopted by various deciding forum:

1. Where disallowance can be made in the absence of exempt income in any FY?  Though there had been countless litigation on this issue, it seems to have been settled by various judgments of high courts which have held that disallowance can not be attracted under Section 14A in the absence of exempt income.

2. Whether exempt income for the purpose of this section includes profit linked deduction under Chapter VI -A? 
This includes deduction in respect of profits and gains of specific industries such as hotel business, small scale industrial undertaking, housing projects, export business, infrastructure development, units in Special Economic Zone etc

3. Whether this Section is applicable to shares held as stock in trade?
As only dividend income in such case would be exempt and gain on sale would be taxable business income based on dominant intention of taxpayer to hold shares as stock in trade and not to earn dividend? –  This issue is also settled by SC in its judgment pronounced in February 2018 (published in March 2018) in the case of Maxopp Investment Ltd. SC held that even when shares are held as stock in trade, disallowance is attracted on expenditure apportioned towards exempt dividend income and expenditure apportioned towards business profit is allowed as deduction.

4. Whether disallowance is attracted on dividend income from Indian companies as dividend income is actually not exempt but tax is collected from companies itself in the form of Dividend Distribution Tax (DDT) 
This issue has been a matter of debate before various courts/Tribunals which is now settled with the decision of SC in May 2017 in the case of Godrej & Boyce Manufacturing Company Limited where SC held that disallowance is attracted even when DDT is paid by companies

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