Section 14A And Rule 8D Of Income Tax Act

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 us see an example of Rule 8D computation. Mr. A took a loan of Rs.15 lakh on 5 January 2023 at 10% during the FY 2023-2024. Therefore, his interest expenditure for the year on this loan is Rs.1,50,000. This loan was utilised for making an investment of Rs.15 lakh in various avenues; income from this is exempted from tax.

The monthly closing balances of this investment are Rs 10,00,000 (January 2023), Rs 12,50,000 (February 2023), and Rs 15,00,000 (March 2023  ). 

Rule 8D Disallowance

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.

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