The tax laws of India treats certain income as not taxable such as agricultural income, dividend received from an Indian company, income of eligible charitable institution, 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 and company shares. There has been a debate between the taxpayers and income tax authorities on whether the expenditure 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 towards earning 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 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 of exempt income.
2. Section 14A
As per Section 14A, the expenditure incurred by a taxpayer in relation to income that excludes total income as per the provisions of the Act should not be considered as deduction while computing the total income of the taxpayer.
Is there a method to determine expenditure incurred towards exempt income?
Yes, Section 14A has prescribed a method for determining the expenditure incurred towards earning exempt income under Rule 8D by income tax officer. However, the method prescribed under Rule 8D can be applicable only in one of the following scenarios:
- Where taxpayer claims that no expenditure has been incurred towards earning exempt income.
- Where taxpayer has already disallowed amount towards expenditure incurred in relation to earning exempt income. However, the assessing officer is not satisfied that the claim of taxpayer is correct, considering the accounts of the taxpayer.
3. 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 following:
- Any amount of expenditure which is directly relating to exempt income; and
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 of Rs.15 lakh on 5 January 2018 @ 10% during 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 lakh in various avenues; income from this is exempted from tax.
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
|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 must mandatorily show why he is not satisfied with taxpayer’s computation and show 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 those 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 have utmost litigations even for something that may seem straight and simple. Following are a few controversies that have come up over the period, more so due to different views adopted by various deciding forum:
1. 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.
2. 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).
3. 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.
4. 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.