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Section 14A – Disallowance of Expenditure Incurred on Exempt Income

Last Update Date : August 12, 2018

According to section 14A, expenses incurred by a tax payer about the income which does not form a part of the total taxable income as per the provisions of Income Tax Act, 1961 is not allowed as a deduction while computing his / her taxable income.

section 14A

What is Disallowance of Expenses?

The income tax department doesn’t levy tax on certain incomes in India, such as agricultural income, tax-free interest, dividend earnings from Indian companies, etc. There is a possibility of assesses incurring expenses on such incomes, e.g., interest paid on loan taken to invest in tax-free bonds. Thus, for a long time, there has been a debate between the officers of IT department and the tax payers regarding the disallowance of such expenditure. While the tax payers have been insisting on the deduction of such expenditures, the IT department has staunchly held the disallowance of expenses, as the income is completely exempt of tax and by deducting expenditure incurred on such income, it will result in reduced tax liability on non-taxable income as well.
Eventually, the court passed a judgement favouring both the sides partially and threw light upon its decision regarding the treatment of expenses incurred on exempt income.

Provisions of Section 14A

Sec 14A was introduced by the Finance Act 2011, having a retrospective effect from 1962. The provision disallows the expenses incurred towards earning of income exempt from tax.

The section applies to the occurrence of one if more of the following events

  • If the assessee has incurred expenses to earn income which does not form a part of the total taxable income
  • If assessee claims that expenditure has been incurred, but the ASSESSING OFFICER is not satisfied with the explanation of the assessee having regarded the accounts of the assessee
  • If the assessee claims that he has not incurred any expenditure

Process of Applying Section 14A

If the assessee has in fact incurred expenditure for earning tax-free income, then subsection 1 of section 14A is applied. Subsection 2 is applied when assessee claims the amount incurred about exempt income and subsection 3 is when the assessee claims that there is no expenditure incurred.

Subsection 2 of Section 14A

If the assessee claims that the amount of expenditure is incurred about exempt income then the Assessing Officer needs to verify the correctness of this claims having regards the books of accounts of the assessee. The Assessing Officer needs to clarify the expenses in the books of accounts. Post verification if the Assessing Officer is satisfied then he shall disallow the expenses u/s 14A. If the assessee’s claim does not convince the Assessing Officer, then he must record his dissatisfaction and start with the application of rule 8D for calculating the disallowance amount.

Subsection 3 of Section 14A

If the assessee claims that he has incurred no expenditure about the tax-free income then Assessing Officer can directly apply rule 8D to determine the expenditure to be disallowed u/s 14A. In this case, the Assessing Officer is not required to record his dissatisfaction.

Chronology of Amendments

The laws written are difficult to interpret and many times tax payers and experts end up finding loopholes in the statements of laws. This gives them the freedom to interpret in a way which gives them an advantage. Thus, to avoid these loopholes and keep both the tax payers and the income tax officers satisfied with their demands, department of income tax introduced a lot of amendments in the section. Following is summary of the changes made in this section.

Amending Act / Rule Amendment Impact
Finance Act, 2001 Section 14A inserted

w.e.f. 1 April 1962

Provides for disallowance of expenditure incurred to earn tax-free income
Finance Act, 2002 Provision of section 14A inserted w.e.f. 11 May 2001 Stating that section 14A cannot be used to reopen and rectify any earlier cases
Finance Act, 2006 Subsection (2) and (3) inserted w.e.f 1 April 2007 Provided a method to compute the amount of disallowance u/s 14A
Fifth Amendment Rule, 2008 Rule 8D inserted w.e.f. 24 March 2008 Provides the mechanics for allotting expenses to exempt income
Finance Act, 2016 Amendment to Rule 8D Disallowance will be limited to 1% of the average monthly value of investments yielding exempt income, but not exceeding the actual expenditure claimed.

Rule 8D of Income Tax Rules

8D(1) where the Assessing Officer, having regarded the accounts of the assessee, is not satisfied by

  • The correctness of claim made by assessee regarding the amount of expenditure incurred on tax-free income
    Or
  • The claim made by the assessee that no income has been incurred on exempt income for the previous year

Then he shall determine such value of expenditure following the lines of subsection (2) of rule 8D, which says
8D(2) the expenditure incurred to earn the income not forming part of total taxable income is the aggregate of the following two

  • The amount of expenditure directly relating to income which does not form part of total income and,
  • An amount equal to one percent of the annual average of the monthly average of opening and closing balance of the value of the investment, income from which does not or shall not form part of total income.

Let’s see an illustration of computation under Rule 8D

Ms Manisha has taken a loan on 2nd of January 2018 for Rs 20 lakhs at 12% for the FY 2017-18. Therefore, interest expenditure on loan is Rs 2,40,000. The loan was used to invest funds in tax-free infrastructure bonds approved by the government.

Monthly closing balances of the investment are Rs 12,00,000 (January 2018), Rs 13,50,000 (February 2018), Rs 15,50,000 (March 2018)

PARTICULARS AMOUNT

(in Rupees)

Any amount of expenditure directly relating to exempt income  2,40,000
Amount equal to 1% of the annual average of monthly average of opening and closing balances of the value of investment whose income is or shall be exempt – 1% of

 

Monthly average of investment

January 2018 – 0 + 12,00,000/2 = Rs 6,00,000

 

February 2018 – 12,00,000 + 13,50,000/2 = Rs 12,75,000

 

March 2018 – 13,50,000 + 15,50,000/2 = Rs 14,50,000

Annual Average of the above monthly averages = Rs 6,00,000+12,75,000+14,30,000/3 = 11,08,333

11,083
Total disallowance under section 14A read with rule 8D 2,51,083

Section 14A Applicability

Dividend Income

Case study: Godrej and Boyce Manufacturing company ltd v/s Deputy CIT and Another Civil Appeal no. 7020 of 2011
Court’s decision – section 14A applicable but does not affect this case as ASSESSING OFFICER not successful in linking expenditure disallowed and exempt income earned.

It may be wrong to say that dividend referred to sec 115O is not a part of taxable income as companies pay the DDT and mutual funds on the dividend distributed thus making it taxable. The only difference is that it is collected in the beginning and hence exempted in the hands of the receiver of the dividend.

Interest and other expenses incurred for purchasing and holding of shares and units of mutual funds

Shares and units of mutual funds are purchased mainly to ears capital gains by way of appreciation, dividend being incidental. In the view of the probability of earning taxable income being many times higher than earning exempt income in case of shares, to say that investment is made and expenses like carrying costs are incurred to earn exempt income. Long-term capital gains are exempt from tax, but they are already taxed under the Securities Transaction Tax, and hence they shouldn’t be treated as exempt income.

Disallowance cannot be made if there does not exist exempt income

Case study: ACIT v/s M. Baskaran 152 ITD 0844 (Chennai).
Also, disallowance of expenditure is towards exempt income and not exempt investment. Crores of investment yielding no exempt income attract no disallowance as the criteria for computing the disallowance is exempt income and not the investments.

Investment in subsidiaries

Case study: EIF associated Hotels LTD v/s DCIT I.T.A. No. 1503/ Mds/2012
The investment made in subsidiaries out of borrowed funds is deemed to be used for business, and no disallowance under the provision could be made on such interest expenditure.

Foreign

Foreign dividends are taxable in India. That is the income forms part of the total income and hence the disallowance u/s 14A is not applicable to the foreign dividend.

Key Points to be Noted

  • Disallowance u/s 14A is only concerning expenditure which is already claimed to be a deduction. If tax payer has not claimed any deduction at all, there is a question of any disallowance.
  • Assessing Officer must justify the incorrectness of the claim made by the assessee and show the tax payers computation to be incorrect.
  • For the applicability of Rule 8D, only those investments to be considered for the average, which is about the exempt income and not the entire investment.
  • Section 14A and Rule 8D had been one of the most controversial decisions of the Income Tax department and there is still no clarity on various things and has utmost litigation even for that may be straightforward.

Exempt Income

An income is considered exempt only if the tax is not collected on it in any manner. If the tax is collected directly or indirectly on an income and such tax not refundable or adjustable against any liability of tax on income, then such income is said to have suffered taxation, under the Income Tax Act, 1961. In IT Act the expression ‘total income’ is used to mean total taxable income or chargeable income. In section 14A, the expression used is ‘which does not form part of the total income under this Act’. This can mean that income on which no tax is chargeable at all under the act or such income which is taxed in some other manner or in the hands of some other person.

Section 14A with rule 8D has been one of the most arguable and debatable decisions of the Income Tax Department. With every new case, there is a variation in the court’s decision. Section 14A has also gone through amendments made by the Income Tax Department to satisfy the tax payers as well the Assessing Officers of the department.

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