By P. N. Shah, Chartered Accountant
Article
1. Background :
1.1 S. 14A has been inserted in Chapter IV of the Income tax
Act by the Finance Act, 2001, with retrospective effect from 1-4-1962. This
Section provides for disallowance of expenditure incurred in relation to income
which is not included in the total income of the assessee (i.e. exempt
income). The operative part of this Section reads as under :
“For the purposes of computing the total income under this
chapter, no deduction shall be allowed in respect of expenditure incurred by
the assessee in relation to income which does not form part of the total
income under this Act.”
1.2 Proviso to the Section was added by the Finance Act, 2002
w.e.f. 11-5-2001. It provides that the A.O. cannot reopen the assessment u/s.147
for any assessment year prior to A.Y. 2001-02 for this purpose or pass any
rectification order u/s.154 for prior years to disallow any such expenditure.
1.3 In the case of CIT v. Indian Bank Ltd., (56 ITR
77), Supreme Court had decided in 1964 that the condition for deductibility of
an expenditure does not depend upon its quality of directly or indirectly
producing taxable income and, therefore, there was no warrant for disallowing a
proportionate part of the interest referable to moneys borrowed for the purchase
of tax free securities. This principle was reiterated in the case of CIT v.
Maharashtra Sugar Mills Ltd., (82 ITR 452). In this case it was held that no
part of managing agency commission can be disallowed on the ground that it
partly relates to managing sugarcane cultivation, the income from which was
exempt from tax. Again, in the case of Rajasthan State Warehousing
Corporation v. CIT, (242 ITR 450) the above principle was once again
reiterated by the Supreme Court. In this case, it was held that if business is
one and indivisible, the expenditure cannot be apportioned and disallowed to the
extent it may relate to income which is exempt from income tax.
1.4 It may be noted that the explanatory memorandum issued
with the Finance Bill, 2001, gives the purpose for which the amendment is made.
This reads as under :
“Certain incomes are not includible while computing the
total income as these are exempt under various provisions of the Act. There
have been cases where deductions have been claimed in respect of such exempt
income. This in effect means that the tax incentive given by way of exemptions
to certain categories of income is being used to reduce also the tax payable
on the non-exempt income by debiting the expenses incurred to earn the exempt
income against taxable income. This is against the basic principles of
taxation whereby only the net income, i.e., gross income minus the
expenditure, is taxed. On the analogy, the exemption is also in respect of the
net income. Expenses incurred can be allowed only to the extent they are
relatable to the earning of taxable income.
It is proposed to insert a new S. 14A so as to clarify the
intention of the legislature since the inception of the Income-tax Act, 1961,
that no deduction shall be made in respect of any expenditure incurred by the
assessee in relation to income which does not form part of the total income
under the Income-tax Act.”
1.5 From the above, it appears that only direct expenses
incurred for earning the income which is exempt will be covered by S. 14A. Even
in the decisions of the Supreme Court referred to above there is nothing to
infer that direct expenses incurred for earning exempt income is allowable.
Therefore, even in the absence of a provision contained in the new S. 14A law
was well settled. There is nothing in this Section to suggest that indirect
expenses will be disallowed.
1.6 In actual implementation of this provision, the
Income-tax Department has been taking the view that all items of income
(including dividend on shares and units of Mutual Funds etc. on which Dividend
Distribution Tax is paid) stated in S. 10 of the Income-tax Act are governed by
S. 14A. The intention of this legislation was to disallow only direct expenses
incurred for earning exempt income. In almost all cases even indirect expenses
are also being disallowed on proportionate basis. In order to ensure uniform
approach, S. 14A was amended by the Finance Act, 2006, w.e.f. 1-4-2007 (A.Y.
2007-08). By this amendment Ss.(2) and Ss.(3) were added in S. 14A to provide
that AO shall determine the amount of expenditure incurred in relation to the
exempt income in accordance with such method as may be prescribed by Rules. The
reasons for making this amendment in S. 14A are explained in Paras 11.1 to 11.3
of CBDT Circular No. 14/2006 of 28-12-2006.
2. New Rule 8D :
2.1 In exercise of the powers given in S. 14A(2) C.B.D.T. has
issued a Notification No. S.O. 547(E) on 24-3-2008 (299 ITR (ST) 88). This
notification amends the Income-tax Rules by insertion of a new Rule 8D providing
for a “Method for determining amount of expenditure in relation to income not
includible in total income”. Reading this Rule it is evident that the Rule
provides for disallowance of not only direct expenditure incurred for earning
the exempt income but also for disallowance of proportionate indirect
expenditure. This is clearly contrary to the main objective with which S. 14A
was enacted.
2.2 Broadly stated, the new Rule 8D provides as under :
(i) The method prescribed in the Rule is to be applied only if the AO is not satisfied with :
(a) The correctness of the claim of expenditure incurred for earning the exempt income made by the assessee or
(b) The claim made by the assessee that no expenditure has been incurred for earning exempt income.
(ii) The method prescribed in the Rule states that the expenditure in relation to income which does not form part of the total income shall be the aggregate of the following amounts :
(a) The amount of expenditure directly relating to income which does not form part of total income.
(b)In the case of interest on borrowed funds which is not directly attributable to any particular income or receipt, the amount computed in accordance with this following formula:
A*B/C
A = Amount of interest, other than the amount of interest which is directly attributable to the exempt income stated in (a) above.
B = The average of value of investment, income from which does not or shall not form part of the total income, as appearing in the balance sheet of the assessee, on the first day and the last day of the relevant accounting year.
C = The average of total assets as appearing in the balance sheet of the assessee, on the first day and the last day of the relevant accounting year. The term ‘Total Assets’ means total assets as appearing in the balance sheet excluding the increase on account of revaluation of assets but including the decrease on account of revaluation
of assets.
c) An amount equal to 1h % of the average of the value of investment, income from which does not or shall not form part of the total income, as appearing in the balance sheet of the assessee, on the first day and the last day of the relevant accounting year.
2.3 From the above Rule, it will be noticed that CBDT has, instead of prescribing a simple method, prescribed a complicated formula. By applying this formula, in most cases, expenditure which has no connection with earning the exempt income will get disallowed. Some of the issues relating to this New Rule require consideration:
i) As stated in para 2.2(ii)(b) above, interest which is directly attributed to borrowed funds used for the purpose of earning taxable income or receipts will not be considered for disallowahce of proportionate interest u/s.14 A. Therefore, interest on term loan taken for purchase of Plant & Machinery, Motor car loan, amount borrowed for acquiring factory or office building or any other business asset will not be considered for such disallowance.
ii) It is not mentioned that interest which is disallowable u/s.43B or u/s.36(1)(iii) will also be excluded. But it can be assumed that only such expenditure, which is otherwise allowable in the computation of total income, will be considered for disallowance u/s.14A.
iii) In the above formula in para 2.2(ii)(b) above while explaining the terms ‘B’ and ‘C’ there is a reference to the average value of investments and total assets as per the Balance Sheet of the assessee. It is not clear as to what figures shall be adopted in the cases of non-corporate assessees, such as Individuals and HUFs who do no maintain books of accounts.
iv) In explanation to the term ’12’ it is stated that for considering average value of Investments, we have to consider “Investment, income from which does not or shall not form part of the total income”. This will mean that even if there is no income from some or all of the investments, the average value of these investments will enter the formula for disallowance of proportionate interest. This will mean that in some cases where there is no income from such investments and no exemption from tax is claimed on any income, proportionate interest will be disallowed. In some cases, if income from some investments is say only Rs.1lac on which exemption is claimed, but disallowance of proportionate interest under the formula may work out to Rs.2 lacs.
v) While explaining the term ‘C’ it is stated that average of Total Assets as per Balance sheet should be taken. It can be assumed that items like (a) Preliminary Expenses not written off, (b) Deferred Revenue expenses, (c) Deferred Tax Assets, (d) Debit Balance of Profit & Loss AI c. etc., which do not represent any tangible or intangible asset, appearing in the Balance sheet of the assessee will be excluded from Total Assets.
vi) Similarly, current liabilities which are to be deducted from current assets in the case of the company can be added while working out the amount of Total Assets.
vii) The formula given in para 2.2.(ii)(c) above, states that amount equal to 1/2% of the average value of investments, income from which is exempt from tax, should also be disallowed ul s.14A. This provision is not at all equitable. Such disallowance is to be made with reference to average value of such investments from which exempt income is received or not. This disallowance has no relation to either the exempt income or to the expenditure claimed by the assessee. In many cases the amount worked out may exceed the exempt income or may exceed even the total expenditure (for taxable as well as exempt income) incurred by the assessee. If we take the illustration of a closely held Investment company it is common knowledge that the administrative expenses are nominal as compared to the value of the investments. In such cases, the amount to be disallowed under the formula will far exceed the total expenses. It is suggested that a very strong representation should be made for deletion of this part of the New Rule. In any event, it should be represented that the total disallowance under the formula should not exceed 5% of the income for which exemption is claimed.
The validity of the New Rule 8D can be challenged on the ground that S. 14A authorises CBDT to prescribe the method for determination of expenditure incurred in relation earning the exempt income, but the method prescribed by this Rule only determines the notional cost for holding investments which mayor may not yield an exempt income. Such notional cost for holding the investment has no relationship with the actual expenditure incurred and claimed by the assessee. There-fore, the New Rule goes beyond the authority given to CBDT by S. 14A
2.4 As stated earlier, the above amendment giving power to CBDT to prescribe the method for determination of expenditure to be disallowed u/ s.14A was made by the Finance Act, 2006 w.e.f. AY. 2007-08. Therefore, the above method, as now pre-scribed by New Rule 8D, should apply to computation of income for AY. 2007-08 and onwards. However, there are certain judicial pronouncements which suggest that amendment made in S. 14A(2) and (3) made by Finance Act, 2006, is a procedural provision and, therefore, the method for computation of disallowable expenditure, whenever pre-scribed, will be applicable to all pending assessments for earlier years also. Reference in this connection may be made to the following decisions:
(i) ACIT v. Citicorp Finance (India) Ltd., 108 ITD 457 (Mum.)
(ii) Kalpataru Construction Overseas (P) Ltd. v. DCIT, 13 SOT 194 (Mum.)
(iii) DCIT v. Seksaria Biswar Sugar Factory Ltd., 14 SOT 66 (Mum.)
(iv) Prakash Heat Treatment & Industries (P) Ltd. v. ITO, 14 SOT 348 (Mum.)
(v) DCIT v. Smita Conductors Ltd., 16 SOT 251 (Mum.)
(vi) Narotamdas Bhau v. ACIT, 15 SOT 629 (Mum.)
(vii) Conwood Agencies (P) Ltd. v. ITO, 15 SOT 308 (Mum.)
Contrary view has been taken in the case of Vidyut Investments Ltd. v. ITO, 10 SOT 284 (Delhi) where it is held that S. 14A(2) and (3) will only apply w.e.f. AY. 2007-08 and onwards.
