Disallowance of expenditure relating to exempt income – Section 14A r/w/r 8D of ITR, 1962 – Condition precedent for disallowance – Proximate relationship between expenditure and exempt income – Onus to establish such proximity on Department – A.O. must give a clear finding with reference to the assessee’s accounts how expenditure related to exempt income

Disallowance of expenditure relating to exempt income – Section 14A r/w/r 8D of ITR, 1962 – Condition precedent for disallowance – Proximate relationship between expenditure and exempt income – Onus to establish such proximity on Department – A.O. must give a clear finding with reference to the assessee’s accounts how expenditure related to exempt income

The assessee was a miner and exporter of mineral ores. For the A.Y. 2009-10 the A.O. computed disallowance u/s 14A read with rule 8D at 0.5% on the average investment. He rejected the assessee’s claim that it did not incur any expenditure to earn the dividend income, that it invested the surplus funds through bankers and other financial institutions and all the forms were filled up by them, and that it only issued cheques. He was of the view that without devoting time and without analysing the nature of the investment, the assessee could not have invested in the mutual funds.

The Commissioner (Appeals) partly allowed the appeal. The Tribunal allowed the assessee’s appeal and deleted the disallowances.

On appeal by the Revenue, the Bombay High Court upheld the decision of the Tribunal and held as under:

‘i)    Section 14A inserted by the Finance Act, 2001 with retrospective effect from 1st April, 1962 aims to disallow expenditure incurred in relation to income which did not form part of the total income and has to be read with Rule 8D of the Income-tax Rules, 1962 which provides the method of calculation of the disallowance. Section 14A statutorily recognises the principle that tax is leviable only on the net income. The profits and gains of business or profession are taxed after deducting expenditure from income. In that regard, there is no need for the assessee to establish a one-to-one correlation between income and expenditure. Rule 8D provides the methods for determining the amount of expenditure in relation to income not includible in the total income and comes into play once an expenditure falls within the mischief of section 14A.

ii)    The onus is on the Revenue to establish that there is a proximate relationship between the expenditure and the exempt income. The application of section 14A and rule 8D is not automatic in each and every case, where there is income not forming part of the total income. Though the expenditure u/s 14A includes both direct and indirect expenditure, that expenditure must have a proximate relationship with the exempted income. Before rejecting the disallowance computed by the assessee, the A.O. must give a clear finding with reference to the assessee’s accounts as to how the other expenditure claimed by the assessee out of the non-exempt income is related to the exempt income. There must be a proximate relationship between the expenditure and the exempt income and only then would a disallowance have to be effected.

iii)   The Tribunal was right in deleting the additions made by the A.O. u/s 14A read with rule 8D. The Tribunal had found that the A.O. had only discussed the provisions of section 14A(1) but had not justified how the expenditure incurred by the assessee during the relevant year related to the income not forming part of its total income and had straightaway applied Rule 8D. There must be a proximate relationship between the expenditure and the exempt income and only then would a disallowance have to be effected. There was no valid reason to interfere with the Tribunal’s well-reasoned order.’