CA Ashish Chadha has analyzed all the recent judgements of the Supreme Court and the High Courts on the topic of how the AO should record his satisfaction before making disallowance u/s 14A of the Income-tax Act, 1961 read with Rule 8D. The author has explained the salient points of the important judgements, some conflicting with each other, in a succinct manner
There have been various controversies surrounding the interpretation and application of Section 14A of the Income-tax Act, 1961 (‘Act’), which have been subject to extensive litigation. The most recurrent and significant issue being that of recording of satisfaction by the Assessing Officer (‘AO’) as to the incorrectness of claim made by an assessee. Recently, there have been various judicial decisions rendered by the High Court(s) and the Supreme Court, whereby much needed clarity has evolved regarding such controversies.
The provisions of sub-section (2) and (3) to Section 14A, which empower the AO to compute disallowance as per the provisions of Rule 8D of the Income-tax Rules, 1962 (‘Rules’) with effect from Assessment Year (‘AY’) 2008-09, provides that the disallowance under Rule 8D can be computed, only if the AO, having regard to the accounts of the assessee, is not satisfied with the claim of the assessee regarding the expenditure claimed to have been incurred/ not incurred in relation to the exempt income.
In this context, it is vitally important to make reference to the provisions of Section 14A of the Act. These provisions read as under:
“14A. (1) 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.
(2) 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 in accordance with such method as may be prescribed, if the Assessing Officer, having regard to the accounts of the assessee, is not satisfied with the correctness of the claim of the assessee in respect of such expenditure in relation to income which does not form part of the total income under this Act.
(3) The provisions of sub-section (2) shall also apply in relation to a case where an assessee claims that no expenditure has been incurred by him in relation to income which does not form part of the total income under this Act:
Provided that nothing contained in this section shall empower the Assessing Officer either to reassess under section 147 or pass an order enhancing the assessment or reducing a refund already made or otherwise increasing the liability of the assessee under section 154, for any assessment year beginning on or before the 1st day of April, 2001.”
As per the provisions of sub-section (1) of Section 14A of the Act, the AO is empowered to not allow the assessee any deduction with regard to any such expenditure which has been incurred by the assessee in relation to income which does not form part of its total income, i.e. the income which is exempt. The provisions of sub-section (2), which was inserted by the Finance Act, 2006 with effect from 01 April, 2007 further provides that if the AO is not satisfied with the correctness of claim of assessee in respect of expenditure in relation to exempt income, the AO is to determine the amount of such expenditure incurred in accordance with the method as prescribed.
At this point in time, it will be appropriate to allude to Rule 8D, which was introduced in the Rules with effect from 24 March, 2008 and provides for a mechanism of computing the expenditure to be disallowed by the AO under Section 14A. Sub-section (3) further states that the provisions of sub-section (2) are also applicable in a scenario where the assessee claims that no expenditure has been incurred in relation to earning of exempt income. This means that even after the introduction of the computation mechanism provided for in Rule 8D from AY 2008-09 and onwards, it is only if the AO, having regard to the accounts of the assessee, reaches to a finding/ satisfaction that the claim of assessee regarding expenditure incurred in relation to exempt income is incorrect, that he can compute the disallowance under Section 14A as per the provisions of Rule 8D.
The Supreme Court of India in the case of Maxopp Investment Ltd. v. Commissioner of Income tax [2018] 402 ITR 640 has also come to a conclusion that the language of Section 14A(2) makes it clear that before applying the theory of apportionment, the AO needs to record its satisfaction that having regard to the accounts of the assessee, the suo motu disallowance made by assessee under Section 14A was not correct. The Apex Court has further stated that if the assessee in its return of income has himself apportioned certain expenditure or claims to have incurred no expenditure in relation to exempt income, in that eventuality, the AO will have to record its satisfaction to this effect, after examining the nature of loan taken by assessee for purchasing shares/ making investments and the nexus thereof with the actual investments made from which the income derived will not be included in the total income.
A similar view has also been taken by the Supreme Court of India in the case of Godrej & Boyce Manufacturing Company Ltd. v. Deputy Commissioner of Income-tax [2017] 394 ITR 449, analyzing the current provisions of Section 14A and the earlier prevailing provisions of this section.
The Apex Court has held that sub-sections (2) and (3) of Section 14A read with Rule 8D of the Rules merely prescribe a formula for determination of expenditure incurred in relation to income which does not form part of the total income under the Act, in a situation where the AO is not satisfied with the claim of assessee. The Court was of the view that whether the determination of disallowance is to be made on application of formula prescribed under Rule 8D or in the best judgment of the AO, what the law postulates is the requirement of a satisfaction of the AO that having regard to the accounts of the assessee, as placed before him, it is not possible to generate the requisite satisfaction with regard to the correctness of the claim of the assessee. The Court concluded that it is only thereafter that the provisions of Section 14A(2) and (3) read with Rule 8D of the Rules or a best judgment determination, as earlier prevailing, would become applicable.
Very recently, the High Court of Delhi in the case of Principal Commissioner of Income Tax v. Vedanta Ltd. [2019] 102 taxmann.com 95, referring to the decision of Apex Court in Godrej & Boyce Manufacturing Company Ltd. (supra) has held that Rule 8D cannot be invoked and applied unless AO records his dissatisfaction regarding the correctness of claim made by assessee in relation to expenditure incurred to earn exempt income.
The High Court of Gujarat in the case of Principal Commissioner of Income-tax v. Shreno Ltd. [2018] 409 ITR 401 has further gone to the extent to lay down that the fact that assessee availed of mixed funds, i.e. interest free as well as interest bearing funds, and utilized them for making investments in securities earning tax free income, will not make the application of Section 14A read with Rule 8D automatic.
The High Court in this case has further referred to the judgment of Supreme Court in the case of Maxopp Investment Ltd. (supra), where the major issue to be decided was whether disallowance of expenditure under Section 14A of the Act would be applicable in a case where shares or stocks of a company were purchased for the purpose of gaining control over the company and incidentally tax free dividend income was generated. The Court, after considering the decision of the Apex Court has concluded that no portion of the judgment can be seen as fundamentally changing the understanding and interpretation of Section 14A read with Rule 8D.
The High Court of Delhi in the case of Eicher Motors Ltd. v. Commissioner of Income-tax [2017] 398 ITR 51 has further analyzed the provisions of Rule 8D of the Rules and has concluded that Rule 8D(1) also requires the AO to mandatorily record his satisfaction that the claim made by assessee that “no expenditure has been incurred to earn exempt income” is incorrect, having regard to the accounts of the assessee. The Court concluded that where the AO made disallowance under Section 14A read with Rule 8D in respect of exempt dividend income earned by assessee without recording his satisfaction based on accounts of assessee, the disallowance made was to be deleted.
The High Court of Delhi in the case of Principal Commissioner of Income-tax v. U. K. Paints (India) (P.) Ltd. [2017] 392 ITR 552 has held that the AO cannot re-compute the disallowance under Section 14A by invoking the provisions of Rule 8D without elucidating and explaining as to why the assessee’s voluntary disallowance is unreasonable and unsatisfactory.
The High Court of Punjab & Haryana in the case of Punjab Tractors Ltd. v. Commissioner of Income-tax [2017] 393 ITR 223 has also affirmed this position stating that sub-section (2) of Section 14A does not ipso facto enable the AO to apply the method prescribed by Rule 8D straightaway without considering whether the claim made by the assessee in respect of expenditure incurred in relation to income which does not form part of the total income is correct.
This principle was also laid down by the High Court of Delhi back in the year 2014 in the case of Commissioner of Income-tax v. Taikisha Engineering India Ltd. [2015] 370 ITR 338, whereby the Court held that it is only when the voluntary disallowance made by assessee under Section 14A is found to be unsatisfactory on examination of accounts of assessee that the AO is entitled and authorized to compute the disallowance under Section 14A read with Rule 8D.
The above judgment of Taikisha (supra) was also followed by the High Court of Delhi in the case of Joint Investments (P.) Ltd. v. Commissioner of Income-tax [2015] 372 ITR 694, wherein it was again decided by the High Court that where assessee declared tax exempt income and voluntarily disallowed certain expenditure under Section 14A, the AO is not justified in re-computing the disallowance in the absence of giving any reason as to why assessee’s claim for disallowance under Section 14A had to be rejected considering the accounts of assessee.
The High Court of Delhi in the case of Commissioner of Income Tax v. I. P. Support Services India (P.) Ltd. [2015] 378 ITR 240, referring to its decision in the case of Taikisha (supra) has again reiterated that the premise of the AO that invocation of Section 14A is automatic and comes into operation as soon as the dividend income is claimed as exempt is erroneous.
In this background, it is, however, pertinent to note that the Act merely provides for the AO to record his satisfaction regarding the claim of assessee in relation to expenditure incurred to earn income which does not form part of total income, and does not specify any particular manner in which such satisfaction ought to be recorded by an AO. In this context, it is of paramount importance to refer to the judgment of High Court of Gujarat in the case of Devarsons Industries (P.) Ltd. v. Assistant Commissioner of Income Tax [2017] 84 taxmann.com 244, wherein it has been held that where the AO gave detailed reasons for making disallowance under Section 14A in respect of exempt dividend income and long-term capital gain earned by assessee discarding assessee’s theory that to earn the income assessee incurred no expenditure whatsoever, mere fact that AO did not arrive at the satisfaction in a particular manner (which as per the taxpayer would have been a correct manner) while making the disallowance under Section 14A, would not per se destroy the mandate of Section 14A.
In this regard, it is also crucial to refer to the judgment of High Court of Delhi in the case of Indiabulls Financial Services Ltd. v. Deputy Commissioner of Income-tax [2017] 395 ITR 242, wherein the Court has reached to a conclusion that where the AO has carried out an elaborate analysis and has thereafter followed the steps enacted in the statute in determining the amount of expenditure incurred for earning tax exempt income, the fact that he did not record his dissatisfaction about assessee’s calculation of disallowance, could not be a ground for rejection of the stand taken by the AO.
The above judgments of High Courts in the case of Devarsons (supra) and Indiabulls (supra) stamp out that though the recording of satisfaction of the AO regarding the claim of assessee after considering the accounts of the assessee is necessary, there is neither any specific or particular manner in which such satisfaction should be recorded nor any specific or particular manner in which the dissatisfaction of AO with claim of assessee prescribed under the scheme of the Act. All that is required under the Act is the recording of satisfaction by the AO before proceeding with making any disallowance under Section 14A, which may be based upon the understanding and analysis of the tax law by the AO, considering the accounts of the assessee. The various decisions mentioned hereinabove do shift the onus on the AO, however, these judgments do not carve out any specific manner in which the onus has to be dispensed off with by the AO.
All the above decisions of the Supreme Court and the High Court(s) definitely provide a sigh of relief to the taxpayers regarding the disallowance made by tax authorities under Section 14A in the absence of recording of satisfaction, but the principles laid down by the High Courts in the cases of Devarsons (supra) and Indiabulls (supra) are still needed to be tested before the Supreme Court, which may entail further litigation on this aspect
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