Complete Guide To The Law Of Disallowance U/s 14A And Rule 8D

Dr. K. Shivaram & Rahul Sarda

Complete Guide To The Law Of Disallowance U/s 14A And Rule 8D

Dr. K. Shivaram, Senior Advocate And Rahul Sarda, Advocate
Section 14A And Rule 8D enjoy the dubious distinction of being amongst the most contentious provisions in the Income-tax Act, 1961. There is a bewildering deluge of judgements from various Courts and Tribunals. The authors have done the admirable task of cataloging all the important judgements under their respective propositions in an easy-to-retrieve format

1. Introduction – Legislative history of section 14A

Section 14A of the Income-tax Act, 1961 (the “Act”) was Legislature’s response to a host of judicial decisions which did not differentiate between expenditure incurred for earning taxable income and for earning exempt income for the purpose of allowability of expenditure as deduction. To overcome the Supreme Court decision in the case of Rajasthan State Warehousing Corporation v. CIT [2000] 242 ITR 450 (SC) wherein it was held that in case of an indivisible business, some income wherefrom is taxable while some exempt, entire expenditure would be permissible deduction and the principle of apportionment would apply only for an indivisible business.

As a result of these decisions, section 14A was enacted vide Finance Act, 2001 w.r.e.f. 1-4-1962, so thatnet taxable income is actually taxed and no deduction is allowed against taxable income for expenditure incurred in earning exempt income. As per the Memorandum Explaining Provisions of Finance Bill, 2001, “expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income.”- [2001] 248 ITR (St.) 162, 196.

Sub-sections (2) and (3) of this section were introduced later which along with Rule 8D of the Income-tax Rules, 1962 (the “Rules”), prescribe a method of determining expenditure incurred for earning exempt income.

The constitutional validity of the provisions and that of Rule 8D has been upheld by the Bombay High Court in the case of Godrej & Boyce Mfg. Co. Limited v. CIT [2010] 328 ITR 81 (Bom.) (HC) observing that Rule 8D is applicable w.e.f Assessment Year (AY) 2008-09 and subsequent years. A special leave petition against this judgment of the Bombay High Court is admitted and pending for final hearing before the Supreme Court in Appeal Civil No. 7019/2011.

2. Basic issues and controversies

In practice, it would not be uncommon to see a situation arise where no incremental expenditure has been incurred for earning exempt income or where the amount of expenditure that is actually incurred would not have been any lesser than is even inabsence of exempt income. In such a situation, the application of rigours of section 14A may seem harsh and unjustified.

While on one hand, the kind of controversies and problems arising out of section 14A seem to have become more complex, on the other, even the most basic issues keep coming up time and again. The following are some of such basic controversies:

2.1 Non-recording of satisfaction of the Assessing Officer – Mechanical application of Rule 8D

A plain reading of the provisions of section 14A(2)/ (3)suggests that the disallowance can be made only if the Assessing Officer is satisfied that the amount claimed by the assessees incurred for earning exempt income is not correct. Furthermore, such satisfaction is to be arrived at from the accounts of the assessee. This position is also clear from the Memorandum explaining provisions of Finance Bill, 2006 – [2006] 281 ITR (St.) 178, 190.

The following are some important decisions wherein the above proposition was laid down:

  • Maxopp Investment Ltd. &Ors. v. CIT [2011] 347 ITR 272 (Del.) (HC) – The requirement of the AO embarking upon a determination of the amount of expenditure incurred in relation to exempt income would be triggered only if AO returns a finding that he is not satisfied with the correctness of the claim of the assessee in respect of such expenditure [AY 1998-99 to 2005-06];

A similar view was also taken in the following cases by the Income-tax Appellate Tribunal (the “Tribunal”/ ITAT):

  • CIT v. Hero Management Service Ltd. [2014] 360 ITR 68 (Del.) (HC) [AY 2007-08];
  • Kodak India Pvt. Ltd. v. ACIT[2013] 155 TTJ 697 (Mum.)(Trib.)[AY 2008-09];
  • JK Investors (Bombay) Limited (Mum.) (Trib.) (www.itatonline.org) [AY 2008-09];
  • Auchtel Products Limited v. ACIT[2012] 52 SOT 39 (Mum.) (Trib.) [AY 2003-04, 2007-08, 2008-09];
  • Priya Exhibitors Pvt. Ltd. v. ACIT [2012] 54 SOT 356 (Del.) (Trib.) [AY 2008-09];
  • DCIT v. REI Agro Ltd. (Kol.)(Trib.)(www.itatonline.org)[AY 2009-10]. This decision has been upheld by the Calcutta High Court in GA 3022 of 2013 dated 23/12/2013 (www.itatonline.org);
  • ACITv. Iqbal M. Chagla (Mum.) (Trib.) (www.itatonline.org) [AY 2009-10].

2.2Assessing Officer to show how Assessee’s computation is incorrect

In many cases, assessees offer a suo motu sum as disallowance u/s 14A. The principles of natural justice require that the Assessing Officer to first show how such computation is incorrect before proceeding tore-compute the disallowance. Such a view has been taken in the following cases:

  • Kalyani Steels Ltd. v. Addtl. CIT (Pune) (Trib.)(www.itatonline.org)[AY 2008-09];
  • Priya Exhibitors Pvt. Ltd v. ACIT[2012] 54 SOT 356 (Del.) (Trib.) [AY 2008-09].

Therefore, it becomes imperative on the Assessing Officer to first show how the suo motu disallowance, if any, offered or the claim that no expenditure is incurred for earning exempt income is incorrect and to record satisfaction as regards incorrectness of the claim of the assessee. If the same is not done, assessees would be well advised to mention this in the Statement of Facts and take specific grounds in the Grounds of Appeal to be filed before the First Appellate Authority, if they prefer an appeal.

2.3Expenditure must be claimed as deduction

Section 14A is a “disallowance” provision and not an “addition” provision. This means before invoking it, the impugned expenditure must be claimed as deduction in the first place. This is based on the simple proposition that what has not been claimed as deduction cannot be disallowed. A similar view was taken in the following case:

  • CIT v. Hero Cycles Ltd. [2010] 323 ITR 518 (P&H) (HC) – Where it is found that for earning exempted income no expenditure has been incurred, disallowance u/s 14A cannot stand [AY 2004-05];
  • Modern Info Technology P. Ltd. v. ITO (Del.)(Trib.)(www.itatonline.org) [AY 2009-10];
  • Relaxo Footwears Ltd. v. ACIT[2012] 50 SOT 102 (Del.)(Trib.) [AY 2008-09].

As a corollary to this proposition, the disallowance computed in accordance with Rule 8D cannot also exceed the total expenditure claimed as deduction, as was held in the case of:

  • Iqbal M. Chagla (supra) – Disallowance of Rs. 16.35 lakhs as against expenditure of Rs. 13 lakhs claimed by the assessee in P&L account is not justified. 

2.4 Nexus of expenditure with exempt income

In the following decisions, it was held that there should be a proximate relationship between the expenditure and exempt income:

  • CIT v. Hero Cycles Ltd. (supra) – In the absence of nexus ofexpenditure incurred and the income generated, disallowance cannot be made [AY 2004-05];
  • Justice Sam P. Bharucha v. Addtl. CIT [2012] 53 SOT 192 (Mum.) (Trib.) (URO) [AY 2008-09];
  • DCIT v. Allied Investments Housing P Ltd.(Chennai)(Trib.) (www.itatonline.org) [AY 2009-10]

3. Recent issues andcontroversies in section 14A

The law on section 14A has evolved over the last 14 years and complex issues have arisen out of its application. Following are some of the recent issues that have arisen in this provision:

3.1 Disallowance in absence of exempt income

The intention of section 14A is to disallow expenditure incurred in relation to income which does not form part of total income (i.e. exempt income). Therefore, it seems only logical that unless there is exempt income in a particular year, section 14A should not trigger for that year. However, the Delhi Special Bench of the Tribunal, in Cheminvest Ltd. v. ITO [2009] 121 ITD 318 (Del.) (Trib.) (SB), took a view that when the expenditure is incurred in relation to exempt income, it has to suffer disallowance irrespective of the fact whether any exempt income is earned by the assessee or not. This also prompted the Board to issue a Circular no. 5/2014 dated 11/02/2014 reiterating the view of the Special Bench.

However, subsequently, in the following cases, various High Courts have taken a view that unless there is exempt income in a year, no disallowance u/s 14A can be made for that year:

  • CIT v. Lakhani Marketing, ITA No. 970/2008 (www.itatonline.org) (P&H)(HC);
  • CIT v. Shivam Motors (P) Ltd., ITA No. 88/2014 (www.itatonline.org) (All.)(HC);
  • CIT v. Cortech Energy Pvt. Ltd., TA No. 239 of 2014 (www.itatonline.org) (Guj.) (HC);
  • CIT v. Delite Enterprises, ITA No. 110/2009(www.itatonline.org)(Bom.)(HC).

Following the above High Court decisions, the Chennai bench of the Tribunal in ACITv. M. Baskaran (Chennai) (Trib.) (www.itatonline.org) held that the Delhi Special Bench decision of Cheminvest Ltd. (supra) and Circular no. 5/2014 dated 11/02/2014 (supra) are no more good law.

Thus, the current legal position is that no disallowance u/s 14A should be made for a year in the absence of exempt income.

3.2 Applicability to income for which deductions available under Chapter VI-A/ profit-linked exemption provisions

Allowability of expenditure incurred for earning income for which deductions are available under Chapter VI-A by virtue of which no tax is payable (either in whole or in part) on them is discussed, among others, in the following cases:

  • Punjab State Co-operative Milk Producer Federation Ltd. v. ITO [2007] 104 ITD 408 (Chd.) (Trib.) – Section 14A is applicable even in respect of the incomes which are excluded from total income by virtue of deductions under Chapter VI-A [AY 2002-03].

Contrary view

  • Infosys Technologies Ltd. v. JCIT [2007] 109 TTJ 631 (Bang.) (Trib.) – Section 14A would not be applicable to a deduction u/s 80G as it is limited in its operation to Chapter IV only whereas deduction u/s 80G falls under Chapter VI-A and donation made does not constitute expenditure [AY 1998-99];
  • ACITv. Tamil Nadu Silk Producers Federation Ltd. [2007] 105 ITD 623 (Chennai)(Trib.) [AY 1996-97, 1997-98 and 1999-2000].

In our opinion, the decision of Bangalore Tribunal and Chennai Tribunal is better view because albeit in both situations (i.e. exempt income and income deductible under Chapter VI-A), the assessee would not have to pay tax, one of the fundamental differences between exempt income and income for which deduction is available under Chapter VI-A is that while the former type of income does not even enter the computation, the latter income enters the computation but is deductible under special provisions and section 14A deals only with the former type of income. Such a view is supported by the following decisions:

  • CIT v. King Exports [2009] 319 ITR 100 (P&H) (HC);
  • CIT v. KRIBHCO [2012] 349 ITR 618 (Del.) (HC)

3.3Applicability to shares held as stock-in-trade

Shares in a company can be held either as capital assets (i.e. as investment) or as stock-in-trade. If the same are held as stock-in-trade, their sale is not exempt from tax. The only exempt income from such shares can be in the form of dividend.

In the latest case of D. H. Securities Pvt. Ltd. v. DCIT [2014] 146ITD1 (Mum.) (TM), the Third Member bench of the Tribunal held that section 14A r.w. Rule 8D disallowance can be made in respect of tax-free securities held as stock-in-trade. This view was taken following the decisions in ITO v. Daga Capital Management (P) Ltd. [2009] 117 ITD 169 (Mum.) (SB). The Bombay High Court has admitted an appeal against the Special Bench decision in case of Daga Capital Management (P) Ltd. (supra) vide order dated 1/7/2009 in Income Tax Appeal No. 989 of 2009 while the appeal against the decision in D. H. Securities Pvt. Ltd. (supra) is pending admission before the Bombay High Court in ITXA/1233/2014.

However, in the case of DCIT v. Damani Estates & Finance Pvt. Ltd [2014] 41 taxmann.com 462 (Mum.) (Trib.), since share trading was found to be the dominant objective of the assessee and shares were held as stock-in-trade, disallowance of interest was restricted to 20% of the amount computed u/R 8D(2)(ii).

3.3.1 Authors’ views

The Tribunal, in D. H. Securities Pvt. Ltd. (supra) followed the jurisdictional High Court in the case of Godrej & Boyce Mfg. Co. Limited (supra) while coming to the conclusion that section 14A is applicable to shares held as stock-in-trade as well. However, this was not the issue before the jurisdictional High Court. A judgement ought to be read as a whole and the observations from the judgment have to be considered in the light of the questions which were before the Court [CIT v. Sun Engineering Works (P) Ltd. [1992] 198 ITR 297 (SC)]

In view of the decisions of non-jurisdictional High Courts {CCI Ltd. v. JCIT [2012] 206 Taxman 563 (Kar.) (HC) & CIT v. Smt. Leena Ramachandran [2011] 339 ITR 293 (Ker.) (HC)} on the issue, the same ought to have been followed as was done in the following cases {See: Nanubhai D. Desai v. ACIT [2014] 104 DTR 1 (Ahm.) (Trib.) (SB)}:

  • DCIT v. M/s India Advantage Securities Ltd. (Mum.) (Trib.) (www.itatonline.org) [AY 2008-09];
  • Vivek Mehrotra v. ACIT(Mum.) (Trib.) (www.itatonline.org) [AY 2008-09].

Considering that this issue is affecting a large number of assessees, it is desirable that the Bombay High Court decides the appeal in case of Daga Capital Management (P) Ltd. (supra) at the earliest to bring some certainty on the issue.

3.4Investment in shares of foreign companies

Dividend received on shares held in foreign companies is not exempt from tax in India as such companies are not required to pay dividend distribution tax in accordance with section 115-O. Also, the profit/ gain on their sale are also not exempt from tax u/s 10. Thus, such shares (whether held as investment or stock-in-trade) neither earn nor are capable of earning exempt income for the holder. Therefore, section 14A should not apply in such cases as was held in the following cases:

  • CIT v. Suzlon Energy Ltd. [2013] 354 ITR 630(Guj.) (HC)
  • Birla Group Holdings Ltd. v. DCIT [2007] 13 SOT 642 (Mum.) (Trib.)
  • ITOv. Strides Acrolab Ltd. [2012] 138 ITD 323 (Mum.) (Trib.)

Similarly, dividend on preference shares is also taxable. Hence, interest incurred for making investment in preference shares is also allowable –ACITv. Tellicherry Co-op Hospital Society Ltd., ITA No. 404/Coch/2013, dated 4/4/2014 (Coch.) ITAT) [AY 2008-09].

3.5Investment in mutual funds or in short term investments

Sundaram Asset Management Co. Ltd. v. DCIT [2013] 145 ITD 17 (Chennai) (Trib.) – Held, some of the investments made by the assessee are short term. Since assessee was paying capital gains tax on short term investments, Rule 8D will not apply on them and the AO was directed to recompute disallowance u/s 14A read with Rule 8D after excluding short term investments [AY 2008-09].

As regards units in a mutual fund, they are normally held as investment and not stock-in-trade. Whether the provisions of section 14A can be applied in such cases would depend on the nature of mutual fund units. In case of investment in liquid fund or debt fund mutual funds, since both the gains from sale and dividend are taxable, section 14A should not be applicable.

3.6Considering only those investments which derive exempt income

Sarabhai Holdings Pvt. Ltd. v. ACIT, ITA No. 2328/Ahd/2012, dated 11/4/2014 (Ahd.)(Trib.)–Only average of value of investment from which exempt income has been earned is to be considered and not total investment at beginning of year and at end of year in disallowing administrative expenses [AY 2009-10].

3.7Investment due to commercial expediency – whether a relevant factor

EIH Associated Hotels Ltd. v. DCIT (Chennai)(Trib.) (www.itatonline.org) – Investments made by the assessee in the subsidiary company were not on account of investment for earning capital gains or dividend income. Such investments had been made by the assessee to promote subsidiary company into the hotel industry and were on account of business expediency and dividend therefrom is purely incidental. Therefore, the investment made by the assessee in its subsidiary is not to be reckoned for disallowance u/s 14A r.w.r. 8D [AY 2008-09].

Other decisions on the issue: CIT v. Oriental Structural Engineers Pvt. Ltd. (Del.) (HC) (www.itatonline.org), JM Financial Ltd. v. ACIT (Mum.) (Trib.)(www.itatonline.org) [AY 2009-10].

3.8Investment in subsidiary and for acquiring controlling interest/ strategic investment

Interglobe Enterprises Ltd. v. DCIT(Del.)(Trib.)(www.itatonline.org) [AY 2008-09 & 2009-10] – Assessee had utilized interest free funds for making fresh investments and that too into its subsidiaries which were not for the purpose of earning exempt income but for strategic purposes only. No disallowance of interest is required to be made under rule 8D (i) & 8D (ii) as no direct or indirect interest expenditure has incurred for making investments. Strategic investment has to be excluded for the purpose of arriving at disallowance under Rule 8D (iii).

Other favourable decisions on the issue: Garware Wall Ropes Ltd. v. ACIT(Mum.)(Trib.)(www.itatonline.org) [AY 2009-10].

3.9Applicability to profit share from partnership firm

Share in partnership firm is exempt from tax u/s 10(2A). Therefore, expenditure incurred for earning such exempt income may be disallowed as deduction.In the following decision,among others, this view was taken:

  • Vishnu Anant Mahajan v. ACIT[2012] 137 ITD 189 (Ahd.) (SB) – Any expenditure incurred in earning the share income will have to be disallowed [AY 2006-07].

The contrary decisions on the issue viz., Shri Sudhir Kapadia v. ITO and Hitesh D. Gajaria v. ACIT are no more good law on this issue.

3.10Whether net interest can be considered for computing disallowance under

Rule 8D(2)(ii)

ITO v. Karnavati Petrochem Pvt. Ltd.(Ahm.)(Trib.) (www.itatonline.org) – As the interest income was more than interest expense and the assessee was having net positive interest income, the interest expenditure cannot be considered for disallowance u/s 14A and Rule 8D [AY 2008-09].

Sitsons India (P) Ltd. v. ACIT [2014] 63 SOT 37 (Mum.)(Trib.) (URO) – On facts, the interest income was held tobe received from bank deposit, while interest payment is made to directors and not against any bank loan. Hence, in the absence of any nexus, the contention of netting off interest was rejected [AY 2008-09].

4. Other complex issues

4.1 Section 14A and presumptive taxation

4.1.1 Tonnage tax scheme

Varun Shipping Company Ltd. v. ACIT[2012] 134 ITD 339 (Mum.) (Trib.) –When income of the assessee from the business of operating ships is computed as per the special provisions of Chapter XII-G, any expenditure other than the expenditure incurred for the purpose of the said business cannot be said to have been allowed and consequently no addition to income so computed can be made by way of disallowance u/s 14A on account of expenditure incurred by the assessee in relation to earning of exempt dividend income.If at all the assessee has claimed any such expenditure in computation of profits of business of shipping, the same are to be taken as disallowed when the income of the said business is finally computed in accordance with the provisions of Chapter XII-G and no separate disallowance on account of such expenditure u/s 14A can be made [AY 2008-09].

4.1.2 Insurance business

Oriental Insurance Co. Ltd. v. ACIT[2010] 130 TTJ 388 (Del.) (Trib.) – In case of an insurance company, it is not permissible to the AO to travel beyond section 44 and Schedule I and make disallowance by applying section 14A.

4.1.3 Authors’ views

In our view, this analogy can also be applied when an assessee offers income u/s 44AD, 44AE and 44AF.

4.2 Interest capitalised and not claimed as deduction

When interest cost is capitalised and not claimed as deduction, same cannot be considered for disallowance u/s 14A – ITO v. M/s Arihant Advertising Pvt. Ltd, ITA No. 2750/Del/2011, dated 21/9/2012 (Del.)(Trib.)[AY 2007-08].

4.3 Power of enhancement when the matter is set aside by the Tribunal to the file of the Assessing Officer

While the First Appellate Authority has the power of enhancement, the Tribunal does not have such powers {See Mcorp Global (P) Ltd. v. CIT [2009] 309 ITR 434 (SC)}. Therefore, once a matter has been set aside by the Tribunal to the Assessing Officer, the assessee cannot be put in a worse off situation than he was earlier – Kellogg India Pvt. Ltd. v. ACIT (Mum.) (Trib.) (www.itatonline.org).

Thus, once a matter is set aside by the tribunal to the file of the Assessing Officer for redeterminationof the amount of disallowance u/s 14A, the Assessing Officer has no power of enhancement.

4.4 Can a method other than the one prescribed under Rule 8D be adopted if the same results in better estimation of expenditure incurred for earning exempt income

The objective of section 14A and Rule 8D are that net income is actually taxed. In our view, this objective should always be kept in mind while computing the disallowance. A reasonable disallowance, if results in more accurate estimation of such expenditure should be adopted. Similarly, if computation in accordance with Rule 8D results in manifestly unreasonable disallowance, the same should, in our view, be eschewed. In the case of Ramkumar Venugopal Investments Pvt. Ltd. v. ACIT (Mum.)(Trib.)(www.itatonline.org) [AY 2009-10], the Tribunal restricted the disallowance as computed by the lower authorities under Rule 8D(2)(ii) and (iii) to 5% and 10% of the amounts respectively as the same resulted in a better and fair estimation of the expenditure to be disallowed u/s 14A. The decision in the case of Damani Estates & Finance Pvt. Ltd. (supra) also merits consideration in this regard.

However, in the case of Joint Investment Pvt. Ltd. v. ACIT, ITA No. 785/Del/2013dated 06/06/2014 (Del.) (Trib.) [AY 2009-10], the Tribunal held that the word “shall” in section 14A(2) makes it mandatory for the Assessing Officer to determine the amount of expenditure incurred in relation to exempt income as per the prescribed method i.e. Rule 8D.

5. Interplay between section 14A and other provisions

5.1 Revision of assessment u/s 263

CIT v. Hotz Industries Ltd. [2014] 49 taxmann.com 267 (Del.) (HC)

Once inquiries were conducted and a decision was reached by the AO, it cannot be said that it was a case of no inquiry and in exercise of power u/s 263, the CIT must reach a finding that, finding of AO was erroneous, not because no inquiries were conducted, but because final finding was wrong and untenable.

Decisions in favour of the assessee

CIT v. Galileo India (P) Ltd. [2014] 220 Taxman 115 (Mag.) (Del.) (HC) – The CIT passed order u/s 263 and recorded that the AO should have conducted further inquiries and correct disallowance should have been made u/s 14A read with Rule 8D. Held, an order is not erroneous, unless the CIT holds and records reasons why it is erroneous [AY 2006-07].

DLF Ltd. v. CIT [2009] 27 SOT 22 (Del.) (Trib.) – There being no specific finding by CIT to the effect that any particular expenditure was incurred for earning dividend income exempt under s. 10(33), he was not justified in his revisional jurisdiction under s. 263 in asking the AO to make enquiry and find out of common expenses, which could be disallowed under s. 14A on proportionate basis [AY 2002-03]. This decision is upheld in CIT v. DLF Ltd. [2013] 350 ITR 555 (Del.) (HC).

Similar view was taken in CIT v. L and T Infrastructure Development Projects Ltd [2013] 357 ITR 763 (Mad.) (HC).

Decisions in favour of the Revenue

CIT v. RKBK Fiscal Services P Ltd [2013] 358 ITR 228 (Cal.) (HC) – Revision of order u/s 263 on account of no disallowance being made by AO u/s 14A was valid.

CIT v. Goetze (India) Ltd. [2014] 361 ITR 505 (Del.) (HC) – Revision order u/s 263 was held justified as the AO made error in computing income u/s.115JA and also failed to apply s.14A [AY 2000-01 to 2001-02].

Jammu & Kashmir Bank Ltd. v. ACIT[2009] 118 ITD 146 (Amr.)(Trib.) – AO having allowed exemption under ss. 10(15), 10(23G) and 10(33) without even considering the applicability of s. 14A, his order was erroneous as also prejudicial to interests of Revenue, hence rightly set aside by CIT in exercise of revisional jurisdiction. The total investment for earning such income must be more than 300 crores. An enquiry and examination was required to be made by the AO at the time of completing the assessment as regards disallowance under s. 14A [AY 2002-03].

5.2 Reassessment u/s 148

CIT v. P.G. Foils Ltd. [2013] 356 ITR 594 (Guj.) (HC) – The AO reopened assessment by issuing notice u/s 148 recording three reasons. Two of such reasons pertained to extent of earnings exempt from Income-tax, which Revenue contended should have been disallowed u/s 14A. The CIT(A) as well as the Tribunal held that both issues were examined by AO in original assessment. Held, CIT (A) noted that AO had raised several queries with respect to those issues. Thus, Tribunal correctly held that any attempt on part of AO to re-examine such issues would only amount to change of opinion [AY 2008-09].

CIT v. Dhanalakhsmi Bank Ltd. [2013] 357ITR448 (Ker.) (HC) – By virtue of proviso to s. 14A, there is no justification to make reassessment u/s 147 for any AY prior to AY 2001-02.

Reckitt Benckiser Healthcare India Ltd. v. ACIT[2013] 216 Taxman 209 (Guj.)(HC) – Since the entire issue pertaining to disallowance of expenditure under s. 14A was scrutinized by Assessing Officer during original assessment proceedings, reopening of assessment to make disallowance of such expenditure on basis of formula provided in rule 8D would amount to change of opinion, and hence, bad in law [AY 2007-08].

Similar issue was decided in favour of the assessee in ACITv. Sterling Infotech Ltd. [2013] 59 SOT 19 (Chennai) (Trib.) (URO) [reopening beyond four years].

5.3 Computation of book profits u/s 115JB

CIT v. Goetze (India) Ltd. [2014] 361 ITR 505 (Del.) (HC), Time Technoplast Ltd. v. Addtl. CIT, ITA No. 8126, 7576/M/2011, dated 2/1/2014 (ITAT Mumbai), Godrej Consumer Products Limitedv. Addtl.CIT[2014] 159 TTJ 21 (Mum.)(Trib.), ITO v. RBK Share Broking (P) Ltd. [2013] 60 SOT 61 (Mum.)(Trib.)(URO), Dabur India Ltd. v. ACIT [2013] 145 ITD 175 (Mum.) (Trib.) etc. – Amount of expenditure disallowable u/s 14A was to be added back while computing book profit under clause (f) of explanation (1) to section 115JB. The Bombay High Court has admitted an appeal on the issue whether disallowance u/s 14A is to be added back for the purpose of computing book profits u/s 115JB – CIT v. Garware Wall Ropes Ltd., ITA No. 1327 of 2013dt. 26/11/2014.

5.4 Section 14A and section 10B

Sandoz P. Ltd. v. DCIT [2013] 145 ITD 551 (Mum.) (Trib.) – Provisions of section 14A are not attracted in the case of the unit suffering losses eligible for deduction u/s 10B and further the assessee is entitled to set off of loss of STP unit u/s 10B against other business income [AY 2008-09].

5.5 Penalty u/s 271(1)(c)

Sunash Investment Co. Ltd. v. ACIT[2007] 14 SOT 80 (Mum.) (Trib.) – When Assessee claimed deduction of interest on borrowed funds which were invested in the financing business as well as purchase of shares of group companies under bona fide belief that such interest was deductible in entirety in view of some judicial pronouncements, it cannot be said that the assessee is guilty of concealment or furnishing of inaccurate particulars of income. Held, penalty under s. 271(1)(c) was not leviable [AY 1998-99].

CITv. Liquid Investment and Trading Co. [ITA 240/2009 dated 5/10/2010 – Delhi HC] – Disallowance u/s 14A of the Act was a debatable issue. Also, High Court had admitted the appeal of the assessee on quantum. Hence, penalty was not leviable.

Skill Infrastructure Ltd. v.ACIT[2013] 157 TTJ 565 (Mum.)(Trib.) – Disallowance u/s 14A does not call for penalty.

6. Relevant factors to be pointed out by assessee against invocation of section 14A and Rule 8D

In the case of AFL Private Limited [2013] 60 SOT 63 (Mum.) (Trib.), it was held that onus to prove that expenditure has been incurred for the purpose of earning taxable income is on the assessee. A similar view was taken in the case of CIT v. Deepak Mittal [2014] 361 ITR 131 (P&H) (HC).

In any case, the onus to substantiate claims made in the return of income is always on the assessee.

The fact whether a particular expenditure is incurred in relation to exempt income or in relation to taxable income is essentially a question of fact. In the case of Addtl. CIT v. M/s Dhampur Sugar Mills Pvt. Ltd., ITA No. 220 of 2014 dt. 5/11/2014, the Allahabad High Court held that in light of Tribunal’s finding that interest expenditure was attributable to taxable business, the same cannot be considered for disallowance under Rule 8D(2)(ii). Therefore, the submission against disallowance under these provisions should be on facts. The following factors may be pointed out by the assessee before the Assessing Officer against the disallowance:

  • Establishing nexus of loans with taxable income/ business can help minimise disallowance under clause (ii) of Rule 8D(2) – CIT v. Ms. Sushma Kapoor [2009] 319 ITR 299 (Del.) (HC), ITO v. Narain Prasad Dalamia[2014] 30 ITR (T) 619 (Kol.) (Trib.), ACIT v. Best & Crompton Engineering Ltd. [2013] 60 SOT 53 (Chennai) (Trib.) (URO) etc.
    • In case of secured loans from banks, this can be done with the help of “purpose of loan clause”in loan agreements. Interglobe Enterprises Ltd. v. DCIT (supra) – One of the factors that found favour with the Tribunal was that most of the interest bearing loans were vehicle loans and not for making tax-free investment.
    • In case of unsecured loans from non-institutional lenders, it is advisable that the assessee enters into a loan agreement and mentions the purpose of taking loan in the agreement and utilizes the loan for that purpose;
    • Apart from the above, sufficiency of own funds for the purpose of making investments would be an important factor – CIT v. HDFC Bank Ltd. [2014] 366 ITR 505 (Bom.) (HC)
      • Other decisions on sufficiency of own funds/ interest-free funds:

CIT v. Torrent Power Ltd. [2014] 363 ITR 474 (Guj.) (HC), DIT v. BNP Paribas SA [2013] 214Taxman 548 (Bom.) (HC), CIT v. UTI Bank Ltd. [2013] 215 Taxman 8 (Mag.) (Guj.) (HC),CITv. Reliance Utilities & Power Ltd. [2009] 313 ITR 340 (Mum.)(Trib.), Sharekhan Financial Services (P) Ltd. v. ACIT, ITA No. 5861/M/2011, dated 20/8/2014 [AY 2008-09]etc.

    • If some portion of interest is already disallowed under some other provisions of the Act such as section 36(1)(iii) or section 40(a)(ia), the assessee may request for exclusion of the such interest from computation of disallowance under Rule 8D(2)(ii).
  • Against the disallowance of administrative expenditure under Rule 8D(2)(iii), the assessee must give submissions in respect of each item of expenditure and establish how it was incurred for the purpose of taxable income/ business only.
  • Reasonable bifurcation of expenditure such as electricity expenses, salary, etc. as incurred towards exempt income and taxable income (depending on facts of each case) can be given.
  • An individual-assessee may establish nexus of expenditure incurred for earning exempt income with drawings to show that such expenditure has not been claimed as expenditure.
  • Separation of accounts for taxable business and other business.

In the case of Iqbal M. Chagla (supra), it was held that since the assessee had not claimed any expenditure in its P&L account as incurred for earning exempt income,the onus was on the Assessing Officer to prove that the expenditure incurred undervarious heads were related to earning of exempt income. This decision of the Tribunal is contrary to that in the case of AFL Private Limited(supra). However, after discharging the initial onus in the manner stated above, the burden of proof may shift on to the Assessing Officer and the decision in the case of Iqbal M. Chagla (supra) should come to the aid of the assessee.

7. Authors’ views

In recent times, it is seen that injudicious invocation of these provisions has become a cause of serious harassment for tax payers resulting in increased litigation.

While the purpose of introducing the provisions of section 14A was to ensure that net income is actually taxed and no expenditure incurred for earning exempt income is claimed as deduction from business income,the blanket application of this section read with Rule 8D oftenresults in a situation wherein even expenditure incurred for earning taxable income is disallowed.It is not uncommon to see a notional/ estimated disallowance computed by the Assessing Officer exceeding the amount of exempt income by multifold times or the disallowance so computed exceeding the total expenditure of the assessee.

The purpose of introduction of sections 10(34), 10(35) and 10(38) was to promote investment into Indian companies (directly or via mutual funds) by exempting dividends and capital gains upon their sale in certain circumstances, However, considering the amount of disallowance u/s 14A that can follow the receipt of such exempt income, an assessee would only be constrained to observe that the Assessing Officer takes by one handwhat the Legislature has given by the other.

It is the need of the hour for the Legislature to step in and carry out necessary amendments to prevent misuse of the provisions of section 14A of the Act. While in cases where the Assessing Officer is able to demonstrate nexus ofexpenditure with non-taxable business of the assessee, the actual amount of such expenditure (irrespective of the amount) should be disallowed u/s 14A, in cases where Rule 8D is appliedby the Assessing Officer for want of satisfaction with the correctness of the claim of the assessee as regards such expenditure, the introduction of the following proviso inRule 8D may curtail litigation in this regard:

Provided that wheresuch expenditure determined in accordance with sub-rule (2)exceeds the amount of income which does not form part of the total income under the Act, then, such excess shall be ignored.

Disclaimer: The contents of this document are solely for informational purpose. It does not constitute professional advice or a formal recommendation. While due care has been taken in preparing this document, the existence of mistakes and omissions herein is not ruled out. Neither the author nor itatonline.org and its affiliates accepts any liabilities for any loss or damage of any kind arising out of any inaccurate or incomplete information in this document nor for any actions taken in reliance thereon. No part of this document should be distributed or copied (except for personal, non-commercial use) without express written permission of itatonline.org
Reproduced with permission from the Chamber’s Journal of October 2014 and updated with decisions after the date of publication

14 comments on “Complete Guide To The Law Of Disallowance U/s 14A And Rule 8D
  1. P.C.Yadav says:

    Excellent Article

  2. RISHI RAJPOOT says:

    Whether a Limited company have invested in shares with own funds, and there is no expenditure has been claimed in p&l and no any income earned from dividend in relevant year, i.e. (no any expenditure & no any Income) can A.O. disallowed the 0.5% u/s 14A of Income Tax Act, 1961.
    Please reply and if you have any judgment of any court please share at rajpootrishi@gmail.com

  3. CA DEV KUMAR KOTHARI says:

    My view in brief:
    Section 14A should not be applied in case of dividend, share in profit of firm and long-term capital gains on which security transaction tax has been levied.
    Thanks to authors:
    Thanks for elaborate article by learned authors.
    addition by me for consideration by authors and readers:
    I would like to add that, as far as my reading goes, a vital point has been missed in all judgments that S.14A was to cover such income which are not at all taxable like agricultural income( Maharastre Sugar case), Tax free interest (Indian Bank case ) and income which is exempt and not even taxed indirectly(RAjasthan Warehousing case) and not income which are taxed under simplified taxation scheme in case of shares and units(dividend tax is imposed u/s 115O and 115R) partners share in profit (taxed in hands of firm) and taxation by way of Security Transaction Tax.
    Crucial wordings and aspects:
    We find two sets of wordings in the sub-section (1) these are given in first column and in second column significance is discussed:
    Words uses Significance
    total income under this Chapter, This expression is used in relation to total income of assessee which is computed as per provisions of the Chapter IV that is Sections 14- 59.

    which does not form part of the total income under this Act.
    Here ‘total income under this Act’ means any income on which tax is not imposed under the entire Act whether directly or indirectly.
    The Assessing Officer shall determine the amount of expenditure incurred in relation to such income which does not form part of the total income under this Act
    The AO can determine disallowable expenditure only when any ‘income does not form part of total income under the Act’ and not merely when any income is not included in total income of assessee.
    We find use of first expressions ‘total income under this chapter’ which is used in relation to ‘total income of assessee’ which is to be computed under Chapter IV.
    We find that the second expression ‘total income under this Act’ used in sub-section (1) and (2) both, this expression means chargeable or taxable income under the entire Income-tax Act.
    If it was intended only in relation to the assessee whose income is to be computed, then similar expression could have been used that is ‘which does not form part of total income under this chapter or ‘which does not form part of total income of assessee’ instead of words ‘which does not form part of the total income under this Act.
    The Income tax Act is a self contained and integrated code. As per scheme of the Act, some incomes are taxable in hands of the recipient of income whereas some incomes are taxable in hands of person who pays or distribute income. When a tax is finally collected (that is not in nature of tax deducted or collected on behalf of recipient of income) at distribution stage, then the income in respect of which such tax is collected is nothing but tax on income. Therefore, it cannot be said that such income does not form part of total income under this Act.
    Once it is found that dividend forms part of ‘total income under this Act’, and a taxable income is computed, and tax is imposed and collected, then S.14A will not at all be applicable in relati)on to such income which has already been include in taxable income in some other scheme of imposing tax on income.
    Similar is case in relation to share in profit of firm which is exempt in hands of partner, because tax has been paid by the firm. Other income of partner received from the same firm by way of interest, salary etc. is taxable in hands of partner as it is allowed to the firm as expenditure. Therefore, it can be said that the share in profit of the firm which has suffered tax in hands of the firm is not an income which does not form part of total income under the Income Tax Act. Therefore, S. 14A will not be applicable in respect of the same.
    Above aspect has not been considered so far:
    On reading of reported judgments and on discussion in groups and tax authorities, it is found that the above aspect has not been considered and even contended in any reported case, so far our reading could cover reported judgments.

    Probability of taxable and exempted income:
    Furthermore when the same investment has yielded or can yield taxable income and exempted income ( in hands of recepient) and when probability or earning taxable income are greater then S.14A should not be applied.
    Exempt income in true sense:
    An income can be considered as exempt only if tax in not collected on it in any manner. If a tax on income is collected directly or indirectly and such tax is not refundable of adjustable against any other liability of tax on income, then tax has been finally collected and the related income has suffered tax under the I.T.Act and it is not an exempt income or income not chargeable to tax.
    Dividend – in old scheme tax was paid by shareholders, wherein a large portion of dividend was exempt from tax for several reasons. The additional tax payable by companies and mutual funds, on distribution made all dividends taxable and tax collected from companies and mutual funds are finally collected tax. Only as a consequence to tax on distribution exemption for dividend is granted in computation of shareholders. Therefore, it is wrong to say that dividend referred to in section 115 O is not part of taxable income, in the overall context of tax on income or ‘total income’ in the Act. Shares and units of mutual funds are purchased mainly to earn gains by way of appreciation and dividend is merely incidental. Average yield by way of dividend is about 1%, therefore, no one will invest in shares merely to receive dividend. Merely because dividend is earned and it is excluded from income of shareholder that too because tax is already paid by the company, section 14A should not be applied to disallow interest and other expenses incurred in connection with purchasing and holding shares and units of mutual funds, which is also a systematic and organized activity and share are capital assets of such business activity just like land, building , furniture and plant and machinery used in any business sale of which also results profit or gains or loss under the head ‘capital gains’.
    Chargeable income -Total income:
    In the Income-tax Act, 1961 the expression ‘total income’ is used to mean ‘taxable income’ or ‘chargeable income’. In section 14A also the expression ‘ which does not form part of total income under this Act’ is used , this can mean only such income on which no tax at all is chargeable under the Act for example, agricultural income, or interest on some tax free bonds etc. and not such income which are taxed in some other manner or in hands of some other person. Once income tax is levied in any manner under the Act, it cannot be said that ‘it is does not form part of total income under the Act’, though it may not be included in particular hands. Thus, tax paid on income whether directly or indirectly under any provisions of the Income-tax Act, or any Finance Act is tax on income. Once a tax is levied on any income, in any manner by the Central Government, it is a tax on income and nothing else. Under our Constitution the Central Government is empowered to impose tax on income (other than agricultural income). The tax can be imposed and collected in any suitable manner provided it is tax on income.
    Tax on distributed profits S. 115-O:
    As per sub-section (1) tax imposed is additional income-tax, as per sub-section (4), the tax paid by the company at the time of distribution of profits, shall be treated as the final payment of tax in respect of the amount of dividend declared, distributed or paid and no further credit of such tax shall be claimed by the company or by any other person in respect of the amount of tax so paid.
    As per sub-section (5) no deduction under any other provision of the Act shall be allowed to the company or a shareholder in respect of the amount which has been charged to tax under sub-section (1) and the amount of tax paid thereon.
    Similarly, in respect of divided distributed by some mutual funds similar provisions are made in section 115 R.
    From these provisions it is clear that the dividend paid by the company, UTI or Mutual Fund which is subjected to tax at the time of distribution is not to be allowed as an expenditure to the company or the mutual find and the tax paid by the company, UTI or mutual fund as the case may be is treated as final payment of tax for which no further credit or refund can be claimed or allowed to any one:- in particular the company or its shareholders and the mutual fund and its unit holders.
    Dividend distribution tax (DDT) and Security Transaction Tax (STT) are nothing but tax on income:
    From the provisions of S. 115O and 115 R it is clear that the tax paid by the company or mutual fund is an additional income-tax collected from the person who distribute dividend. Fifth proviso to S. 48 also prescribes that Security Transaction Tax (STT) shall not be allowed while computing capital gains. STT is not an allowable deduction against business income vide S.40 (a) (ib) till assessment year 2008-09 however a tax rebate is allowed. From A.Y. 2009-10 STT will be allowed as deduction from business income however tax rebate shall not be allowed. All these provisions clearly shows that DDT and STT are nothing but income-tax. Therefore, in the overall context of the income-tax Act, 1961 dividend as well as long term capital gains which are exempted u/s 10 are already taxed in other manner and the tax imposed as DDT or STT is income tax levied and collected in an easy and convenient manner.

  4. vswami says:

    IMPROMPTU

    wprt “The constitutional validity of the provisions and that of Rule 8D has been upheld by the Bombay High Court in the case of Godrej & Boyce Mfg. Co. Limited v. CIT …. A special leave petition against this judgment of the Bombay High Court is admitted and pending for final hearing before the Supreme Court in Appeal Civil No. 7019/2011.”

    So far as known, there has been no update on further development, if any, in the mentioned proceedings.
    Be that as it may, now that the SC has,-as per independent understanding,-in Hero Cycles’ case, effectively clipped the scope for related controversies to be perpetuated (ref. http://itatonline.org/archives/hero-cycles-p-ltd-vs-cit-supreme-court-s-361iii-law-on-when-interest-expenditure-on-loans-diverted-to-sister-concerns-and-directors-can-be-allowed-as-business-expenditure-explained/#comment-2405)by basing its opinion on the sweeping ground of well settled principle of “commercial expediency”, one wonders,- does not the issue of constitutional validity of the entire scheme of the enactment (Sec 14A and the Rule)automatically pale into insignificance, for all practical purposes!

    < Over to eminent tax experts (within and without the FM) for deliberation, and enlightenment of the common readers.

  5. B. M. Kothari ( Former Member, ITAT) says:

    In a recent decision,the Hon,ble Bombay Tribunal (per Hon’ble Shri Rajendra A.M.) in the case of DCIT Vs. Shri Rajeev G. Kalathil Millennium Mumbai (ITA No. 6727/Mum/2012 for AY 2009-10 order dated 20.08.2014) have decided a similar issue .. In this case the AO made an addition of Rs. 13,69,417/- on the basis of sales made by Hawala Dealer reported in the official website of Sales Tax Department. The facts of the aforesaid case are exactly identical. The Hon’ble tribunal in para 2.4 has held as under:
    The facts have been mentioned in para 2.1 of the said order, which is reproduced below:

    “2.1.First ground of appeal is about deleting an addition of Rs.13,69,417/- on account of non genuine purchases..During the course of assessment proceedings ,notices u/s.133(6)of the Act were sent to some of the sundry creditors on random basis..However ,notice in the cases of M/s D K. Enterprises (DKE)and N B Enterprises(NBE)were returned back by the postal authorities with the “Not Known” remarks..Therefore ,he was asked give correct addresses or in the alternative to explain as to why the purchases of Rs.5,05,259 from NBE and Rs. 8,64,158/- from DKE totaling to Rs.13,69,417 should not be treated as bogus purchase. He was also asked to submit sample bills of those parties..The assessee submitted a letter dated 05-12- 2011 as under:

    ” ….. we tried to communicate them but there is no response at all from parties. Further our
    person visited at parties’ places as per address on our record, but parties are not available on respective places. Please find enclosed herewith letters from our banker stating the payment details to respective parties in subsequent year …”

    The sample bills submitted contained TIN numbers of the vendors..The same were verified in the Maharashtra sales tax department official website http://www.mahavat.gov.in.The website had specifically put up the name of NBE with TIN number as ‘Hawala Dealer’ who issued bill without delivery of goods..As regards DKE ,the website search did not yield any results for the TIN numbers shown in the bills..The AO concluded that the TIN number shown in DKE bill itself was bogus..After considering the submissions of the assessee ,the AO held that same was not acceptable ,that merely payment to parties through banking channel did not prove the genuineness of purchase or genuineness of expenses made by the assessee..He made an addition of Rs.13.69 lakhs (Rs.5.05 lakhs +Rs.8.65 lakhs)to the total income of the assessee.”.

    On these facts the Tribunal held as under in para 2.4:

    “2.4.We have heard the rival submissions and perused the material before us..We find that AO had made the addition as one of the supplier was declared a hawala dealer by the VAT Department We agree that it was a good starting point for making further investigation and take it to logical end..But ,he left the job at initial point itself..Suspicion of highest degree cannot take place of evidence..He could have called for the details of the bank accounts of the suppliers to find out as whether there was any immediate cash withdrawal from their account..We find that no such exercise was done. .Transportation of good to the site is one of the deciding factor to be considered for resolving the issue..The FAA has given a finding of fact that part of the goods received by the assessee was forming part of closing stock..As far as the case of Western Extrusion Industries. ITA/6727/Mum/2012/RGK4 (supra)is concerned ,we find that in that matter cash was immediately withdrawn by the supplier and there was no evidence of movement of goods..But ,in the case before us ,there is nothing, in the order of the AO, about the cash trail..Secondly ,proof of movement of goods is not in doubt. Therefore ,considering the peculiar facts and circumstances of the case under appeal, we are of the opinion that the order of the FAA does not suffer from any legal infirmity and there are not sufficient evidence on file to endorse the view taken by the AO..So, confirming the order of the FAA, we decide ground no.1 against the AO.”

  6. GSA says:

    Thanx Sanjeev ji

  7. SHYAM GITE says:

    Pl Send me a copy

  8. Sanjeev Aggarwal says:

    Dear GSA,

    Recently, the Ahmedabad Special Bench of Income- tax Appellate Tribunal (the Tribunal) in the case of Shri Vishnu Anant Mahajan v. Assistant Commissioner of Income Tax (ITA No. 3002/AHD/2009) held that the share of profit received by a partner from a firm, which is exempt in the hands of such partner under Section 10(2A) of the Income-tax Act, 1961 (the Act), attracts the provisions of Section 14A of the Act. The Tribunal further held that the depreciation cannot be considered as an expenditure which can be disallowed under the provisions of Section 14A of the Act.

  9. CA R.B.POPAT says:

    SIR THANKS FOR SHARING.

  10. GSA says:

    Hi

    Would depreciation qualify as ” expenditure’ ? I am talking of a case where the assessee earns income from a partnership firm but uses a personal asset too for the business and obviously claims depreciation on it ..Thanx

  11. Sanjeev Aggarwal says:

    Sir, Can u please share apleal citation admitted in Bombay High Court on the issue of addition of disallowance u/s 14A in Book Profit?

  12. Sanjeev Aggarwal says:

    Effort by Dr.Shivaram and Shri Sarda is laudable. Iti is informative and lucid. As an assessee suffering for last many years on this issue, I have read lot of material on the subject. One point is that CIT v. Goetze (India) Ltd. [2014] 361 ITR 505 (Del.) (HC) seems to be only High Court judgement on the issue of addition of 14A in Book Profit. However, I may point out that the said judgement is not speaking. The order merely says ” The council of the assessee fairly concedes that disallowance u/s 14A is to be added back to the book profit”. Why the assessee conceded without arguments, in may opinion, may be because amount involved was only 88 thousand odd rupees. The Company Goetze is a big company and it was not a significant amount for them. The Court order did not mention any arguments or counter arguments or any conclusion on the issue. Therefore, I do not think this order is serious one.

  13. Shivaram effort is indeed very good.

    if there are conflicting judgements, then what is favorable to tax payer would be considered by competent court is a well known principle of law as two sets of judging one !upports the accused/defendant or the taxpayer/weaker person is taken into account, court never bothers whether govt gets revenue or not as that is not he concern of court, any where all over globe!

  14. Vinay says:

    Thanks for sharing detailed study on the issue.
    Can you please guide on following issue.
    when partner has brought capital into firm. This fund is raised by unsecured loan an has paid interest on such loan. Now can he claim that interest against interest received from firm straight away ?
    Whether he has to disallow interest in proportion of share of profit received (which is exempt)?

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