CIT vs. Hero Cycles (P & H High Court)

Even under Rule 8D of S. 14A, disallowance can be made only if there is actual nexus between tax-free income and expenditure

The assessee earned dividend income on shares which was exempt from tax. The AO took the view that the investment in shares was made out of borrowed funds on which interest expenditure was incurred and consequently made a disallowance u/s 14A. This was partly upheld by the CIT (A). On further appeal by the assessee, the Tribunal deleted the disallowance by noting that the assessee had proved that the investment in shares was made out of non-interest bearing funds. It held that unless there was evidence to show that the interest – bearing funds had been invested in the tax – free investments and the nexus was established by the Revenue, s. 14A could not be applied on mere presumption. The Revenue appealed to the High Court and claimed that in view of s. 14A (2) and Rule 8D (1) (b), a disallowance could be made even if the assessee claimed that no expenditure had been incurred in respect of the tax – free income. HELD, dismissing the appeal:

(i) If the investment in the shares is out of the non-interest bearing funds, disallowance u/s 14A is not sustainable;

(ii) The contention of the revenue that directly or indirectly some expenditure is always incurred which must be disallowed u/s 14A cannot be accepted;

(iii) Disallowance u/s 14A requires a finding of incurring of expenditure. If it is found that for earning exempted income no expenditure has been incurred, disallowance u/s 14A cannot stand;

(iv) The contention of the revenue even if the assessee has made investments in shares out of its own funds, the said own funds are merged with the borrowed funds in a common kitty and, therefore, disallowance u/s 14A can be made is also not justified.