Section 14A of Income Tax Act 1961

Section 14A of Income Tax Act 1961

·        Introduction

The Finance Act, 2001 has inserted section 14A in Chapter IV of the Income-tax Act, 1961 wherein it was specifically provided that no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income which does not form part of total income under the Act. Section 14A was introduced retrospectively in order to clarify and state the position of law that any expenditure relatable to income which does not form part of total income cannot be set off against other taxable income.

·        Circular No. 11/2001, dated 23/7/2001

The proceedings those have become final before the first day of April, 2001 should not be re-opened under section 147 of the Act to disallow expenditure incurred to earn exempt income by applying the provisions of section 14A of the Act.

·        Amendment through Finance Act, 2006

With effect from 1^st April, 2007 amendment was done by addition sub-section 2 & 3 to section 14A. As per section 14A (2), the Assessing Officer (AO) 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 (AO), 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. It is provided in section 14A (3) that 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 (AO) 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.

·        Purpose of the Amendment

Circular No.14/2006, dated 28/12/2006 (Point 11) has stated that, in the existing provisions of section 14A, however, no method of computing the expenditure incurred in relation to income which does not form part of the total income has been provided for. Consequently, there is considerable dispute between the taxpayers and the Department on the method of determining such expenditure. Taking this into consideration, a new sub-section (2) has been added in section 14A so as to provide that it would be mandatory for the Assessing Officer (AO) to determine the amount of expenditure incurred in relation to such income which does not form part of the total income in accordance with such method as may be prescribed.

·        Insertion of Rule 8D

The Central Board of Direct Taxes (CBDT) vide Notification No. 45/2008, dated 24/3/2008 has laid out the method for determining amount of expenditure in relation to income not includible in total income.

As per Rule 8D (2), the expenditure in relation to income which does not form part of the total income shall be the aggregate of following amounts, namely:-

(i) The amount of expenditure directly relating to income which does not form part of total income;

(ii) In a case where the assessee has incurred expenditure by way of interest during the previous year which is not directly attributable to any particular income or receipt, an amount computed in accordance with the following formula, namely:-

 A X B

        C

 Where, A = Amount of expenditure by way of interest other than the amount of interest included in clause (i) incurred during the previous year;

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 previous 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 previous year;

(iii) An amount equal to one-half per cent 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 previous year.

It is given in Rule 8D (3), for the purposes of this rule, the 'Total assets' shall mean, 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.

·        Analysis of Sec. 14A & Rule 8D

The basic principle of taxation states that only the Net Income (Gross Income-Related Expenditure) is taxed. Expenditure which has a bearing on exempt income should not be considered in the computation of total income as otherwise this would result in double advantage to the assessee. Although the purpose of this section seems logical, but it has been patched up in a piecemeal manner by way of insertion, substitution, addition of sub sections, proviso and Board’s circulars with the result that there is sufficient room for different interpretations as regards the effective year of applicability of the provisions and the determination of the amount expenditure to be disallowed. Section 14A does not make any distinction between income which is completely exempt from tax [e.g. Agriculture income] and income received after payment of tax [e.g. Dividend income received after payment of Dividend Distribution Tax (DDT)]. Situations might arise where expenditure by way of interest may be incurred indivisibly both for earning taxable and exempt income, as it happens in the case of a business enterprise where a part of working capital loans may be deployed in tax free bonds or shares of companies, the interest/dividend from which is exemptible under the provisions of section 10. The decisions in the earlier case laws on the subject were in favor of the assessee.

1.     The decision of Supreme Court in CIT vs. Indian Bank [56 ITR 77] did not accord with disallowance of proportionate expenditure. The condition for deductibility of 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.

2.     The same view was followed in CIT vs. Maharashtra Sugar Mills limited [82 ITR 452]. 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 of which was exempt from tax.

3.     In the case of CIT vs. Rajasthan State Warehousing Corporation [242 ITR 450 (2000), the Supreme Court reversing the decision of the High Court held that in view of the fact that income from various ventures was earned in the course of one indivisible business, apportionment of the expenditure and allowing deduction of only that proportion of it which was referable to taxable income was unsustainable.

Formula stated in Rule 8D for calculating disallowance under section 14A is complicated. While explaining the term B & C [in rule 8d (ii)], it has not made clear as to what figures shall be adopted in the cases of non-corporate assessees, such as Individuals and HUFs who do not maintain books of accounts. The method of determining such expenditure that is stated above seems arbitrary and not equitable. In a case where there is no income at all but only loss is incurred, this ad hoc addition to income by way of disallowance under the notification would cause unwarranted hardship. 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. Nowhere in act or rule is mentioned that disallowance shall not exceed exempted income.

·        Case laws

AOs have not been paying any attention to the aforesaid provision and they have been indiscriminately applying the prescribed method laid down under rule 8D(2) in all the cases, where disallowance under section 14A of the Act, is sought to be made. In view of the aforesaid approach of the AOs, gross injustice continues to be done in a number of cases, where the provisions of section 14A are found to be applicable. In this context, it may also be noted that regarding the interpretation of section 14A, there is a plethora of case-law rendered by various Benches of the Income-Tax Appellate Tribunal (ITAT), as also some High Courts and the Supreme Court. In the aforesaid legal precedents, there has often been a divergence of views expressed by the various legal fora. There continues to be a lot of confusion, in relation to the correct interpretation of the provisions of this section. Two peculiar cases are given below:-

1.     CIT v. Hero Cycles Ltd., 323 ITR 518 (P & H)

In this case, the assessee was engaged in manufacturing of cycles and parts of two-wheelers in multiple units. It earned dividend income, which was exempted under section 10(34) and 10(35). The AO made an inquiry whether any expenditure was incurred for earning this income and as a result of the said inquiry addition was made by way of disallowance under section 14A(3), which was partly upheld by the CIT(A).  The AO made enquiry whether any expenditure was incurred for earning this income and as a result of the enquiry made, addition by way of disallowance under section 14A(3) was made. The aforesaid disallowance was partly upheld by the CIT(A).The matter went to Punjab and Haryana High Court.

Honorable High Court held that the expenditure on interest was set-off against the income from interest and the investment in the shares and funds were made out of the dividend proceeds. In view of this finding of fact, disallowance under section 14A was not sustainable. It was also held that the contention of the Revenue that directly or indirectly some expenditure was always incurred, which must be disallowed under section 14A and the impact of expenditure so incurred could not be allowed to be set-off against the business income, which may nullify the mandate of section 14A could not be accepted.

2.     CIT v. Kribhco (2012) 75 DTR 265 (Delhi) (High Court)

The assessee is a co-operative society and is engaged in marketing of fertilizers and purchase and processing of seeds. The assessee claimed deduction under section 80P(2)(d) on dividend income received from NAFED and co-operative bank. The Assessing Officer applied provisions of section 14A and disallowed 1/8 of the employees benefit and remuneration. In appeal the disallowance was deleted by Commissioner (Appeals) and Tribunal.

The High Court observed that section 14A is not applicable for deductions, which are permissible and allowed under Chapter VIA. Income which qualifies for deductions under section 80C to 80U has to be first included in the total income of the assessee and then allowed as a deduction. However, income referred to in Chapter III do not form part of the total income and therefore, as per section 14A, no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to such income which does not form part of the total income.

Section 14A has come into light these days after 2 judgments :-

1)    Karnavati Petrochmem Pvt. Ltd. vs. The Income-tax Officer

2)     Sundaram Asset Management Co. Ltd. vs. Deputy Commissioner of Income Tax

·        Conclusion

Section 14A has been subject of litigation. Therefore a few issues need to be addressed by the law makers to avoid litigation. It is hoped that the section would be suitably amended or CBDT would clarify this issue in order to remove ambiguity. 

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This Article has been shared by Saurabh Wagle. He can be reached at saurabh.wagle@gmail.com

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