Section 14A And Rule 8D Of Income Tax Act

By CA Mohammed S Chokhawala

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Updated on: May 6th, 2025

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3 min read

The tax laws of India treat certain income as not taxable, such as agricultural income, shares from a partnership firm, income of eligible charitable institutions, and tax-free interest. It is possible that taxpayers might have incurred certain expenditures in order to earn such income. For example, the interest on a loan to fund investment in tax-free bonds. 

There has been a debate between taxpayers and income tax authorities on whether expenditures earned on exempted income should be allowed or not. Taxpayers, for obvious reasons, have always contended that such expenses, too, should be allowed for deduction while arriving at taxable income. In contrast, the income tax department held on to the view that the income is already completely exempted from taxation. 

Therefore, any expenditure incurred to earn such income should not be allowed for deduction as it reduces tax on non-exempt income as well. The Apex Court of India, prior to the year 2001, had given its judgement partially in favour of the taxpayer’s view. The Supreme Court (SC) held that the principle of apportionment is not applicable in the case of composite and indivisible business.

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 exempt income.

Section 14A

As per Section 14A, the expenditure incurred by a taxpayer in relation to income that is not included in the total income as per the provisions of the Act should not be considered as a deduction while computing the total income of the taxpayer.

Is There a Method To Ascertain Expenses Associated With Exempt Income?

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

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

Rule 8D – Method To Determine Expenditure Incurred Towards Exempt Income

As per the present income tax laws (post amendment in June 2016), expenditure incurred in relation to earning exempt income is the aggregate of the following:

  • Any amount of expenditure which is directly related to exempt income and
  • An amount equal to 1 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.

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

Let's understand this by an example: Mr Rajesh took a loan of INR 20 lakh on 21 January 2021 @ 10% during the FY 2020-21. Therefore, his interest expenditure for the year on this loan is INR 2,00,000. He utilised this loan to invest INR 20 lakh in various avenues, the income from which is exempt from tax.

Monthly closing balances of this investment are INR 20,00,000 (January 2021), INR 15,00,000 (February 2021), and INR 5,00,000 (March 2021).

Rule 8D Disallowance

Particulars

Amount (in Rs)

Any amount of expenditure which is directly related to exempt income

2,00,000

January 2021– Rs 0 + Rs. 20,00,000/2 = Rs.10,00,000 
February 2021–  Rs. 20,00,000 + Rs. 15,00,000/2 = Rs.17,50,000 
March 2021 – Rs.15,00,000 + Rs.5,00,000/2 = Rs. 10,00,000

Annual Average of the above monthly averages= 10,00,000+17,50,000+10,00,000/ 3 = 12,50,000

12,500

Maximum disallowance under Section 14A read with Rule 8D (i.e., 2,00,000+12,500)

2,12,500

Key Points To Be Noted

  • Disallowance under Section 14A applies only with respect to expenditure which is already claimed to be a deduction. If the taxpayer has not claimed any deduction at all, there can not be a question of any disallowance.
  • The basic condition for the applicability of Rule 8D has to be satisfied, and AO must mandatorily show why he is not satisfied with the taxpayer’s computation and show the taxpayer’s computation to be incorrect based on the principle of natural justice and various case laws including the decision of SC.
  • For the purpose of Rule 8D, only investments relating to exempt income should be considered for the average and not the entire investment.

Section 14A and Rule 8D have been controversial provisions of the Income Tax Act, wherein there is no clarity on various things and utmost litigation even for something that may seem straight and simple.

Related Articles

  1. Section 10: Exemptions, Allowances And How To Claim It?

Frequently Asked Questions

Can disallowance be made claimed 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 judgements of high courts that disallowance cannot be attracted under Section 14A in the absence of exempt income.

Does exempt income for the purpose of this section include 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, and units in Special Economic Zone (SEZ).

Is this section applicable to shares held as stock in trade?

In this case, only dividend income would be exempted 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 dividends. This issue is settled by SC in its judgement pronounced in February 2018 (published in March 2018) in the case of Maxopp Investment Ltd. SC stated that even when shares are held as stock in trade, disallowance is attracted on expenditure apportioned towards exempt dividend income; expenditure apportioned towards business profit is allowed as deduction.

Is disallowance attracted on dividend income from Indian companies as the 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.

This is not relevant for the current FY as the income from dividends is also taxable.

What is the decision of the Supreme Court on 14A disallowance?

Accordingly, the issue stands approved by the Supreme Court that disallowance is to be restricted to the amount of exempt income.

Is there a penalty for non-compliance with Section 14A?

Non-compliance with Section 14A does carry a penalty. The tax authorities may impose fines and interest charges on a taxpayer who offends the terms of this section.

About the Author

I'm a chartered accountant, well-versed in the ins and outs of income tax, GST, and keeping the books balanced. Numbers are my thing, I can sift through financial statements and tax codes with the best of them. But there's another side to me – a side that thrives on words, not figures. Read more

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