DISALLOWANCE OF EXPENDITURE INCURRED IN RELATION TO EXEMPTED INCOME

[Mr. M. GOVINDARAJAN]

Disallowance of expenditure on exempted income

Chapter III of the Income Tax Act, 1961 (‘Act’ for short) deals with the details of income which do not form part of income (Section 10 – Part A to Section 13B).  Section 14A was introduced by the Finance Act, 2001, with retrospective effect from 01.04.1962.  The purpose of introduction of Section 14A with retrospective effective was clarified by the Board in Circular No. 14/2001, as under-

"Certain incomes are not includible while computing the total income, as these are exempt under various provisions of the Act. There have been cases where deductions have been claimed in respect of such exempt income. This in effect means that the tax incentive given by way of exemptions to certain categories of income is being used to reduce also the tax payable on the non-exempt income by debating the expenses incurred to earn the exempt income against taxable income. This is against the basic principles of taxation whereby only the net income, i.e., gross income minus the expenditure, is taxed. On the same analogy, the exemption is also in respect of the net income. Expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income".

Section 14A(1)  of the Act provides that 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.

Assessing Officer to determine expenditure

Section 14A(2) of the Act provides that 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.

Section 14A(3) provides 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.

Procedure for determination of expenditure

Rule 8D of Income Tax Rules, 1962 provides the procedure for determining the expenditure in relation to exempted income.  Rule 8D (1) provides that where the Assessing Officer, having regard to the accounts of the assessee of a previous year, is not satisfied with-

•  the correctness of the claim of expenditure made by the assessee; or
• the claim made by the assessee that no expenditure has been incurred, in relation to income which does not form part of the total income under the Act for such previous year, he shall determine the amount of expenditure in relation to such income in accordance with the provisions of sub-rule (2).

Rule 8D (2) provides that 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.

Rule 8D (3) provides that 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.

Restriction on Assessing Officer

  The proviso to Section 14A provides 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.

Scheme of Section 14A

The scheme of Section 14A has within it the implicit notion of apportionment in cases where the expenditure is incurred for composite indivisible activities in which taxable and non taxable income is received when it is possible to determine the actual expenditure in relation to the exempt income or when no expenditure has been incurred in relation to the exempt income, the principle of apportionment embedded in Section 14A has no application.  The objective of Section 14A is not to allow the tax payable on the non exempt income to be reduced by deleting the expenditure to earn the exempt income.   Thus the expenses incurred to earn the exempt income cannot be allowed and the expenses shall be allowed only to the extent they are related to the earning of taxable income.   If there is expenditure directly or indirectly incurred in relation to the exempt income, it cannot be claimed against income which is taxable.

Disallowance even when there is no exempt income

  Circular No.5/2014, dated 11.02.2014 clarifies that Central Board of Direct Taxes, in exercise of its powers under section 119 of the Act hereby clarifies that Rule 8D read with section 14A of the Act provides for disallowance of the expenditure even where taxpayer in a particular year has not earned any exempt income.

Case laws

Section 14A led to many a litigation in the direct tax regime.  In this article some case laws with various issues are discussed. 

Invoking of Section 14A

  Section 14A could not be invoked where the assessee had not claimed any income of exempt as held in ‘Sumeru Soft Private Limited V. Income Tax Officer’ – 2016 (11) TMI 1297 - ITAT CHENNAI.  In this case the assessee contended that they had not earned any exempt income for the previous year 2011-12 and as such Section 14A cannot be invoked.  The Assessing Officer disallowed a sum of ₹ 2,20,841/- applying Section 14A read with Rule 8D(2)(iii).  The Assessing Officer held that the assessee had not used any borrowed funds for earning exempt income.  For making investment which could earn exempt income, the assessee would have incurred administrative cost.  The Tribunal observed that the assessee for the relevant previous year had not claimed any income exempt.  Even if the investment made by the assessee was capable of giving rise to any exempt income in future, the assessee had not earned any such income during the assessment year 2011-12.  The Tribunal held that Section14A could not be invoked where the assessee had not claimed any income of exempt.

  When the assessee has earned exempted income Section 14A may be invoked.  In ‘Deputy Commissioner of Income Tax V. Enercon India Limited’ – 2016 (3) TMI 1069 - ITAT MUMBAI the assessee was engaged in the business of manufacture, sales and trading of wind energy.  The assessee earned income which did not form part of the total income.  The Assessing Officer invoked the provisions of Section 14A read with Rule 8D and disallowed the expenditure in relation thereto.  The Commissioner (Appeals) deleted the disallowance.  The Commissioner (Appeals) held that the assessee’s own funds were far more than the investment in the subsidiary company.  The Tribunal dismissed the appeals filed by the Department.  The Tribunal held that admittedly the assessee’s own funds were far more than the investments made in the subsidiary companies and debentures.  The Commissioner (Appeals) had rightly deleted the disallowance on account of interest under Rule 8D (2)(iii).

  Section 14A cannot be invoked if the assessee does not earn any exempt income.In ‘Onkareshwar Properties Private Limited V. Assistant Commissioner of Income Tax’ – 2016 (10) TMI 840 - ITAT DELHI the Tribunal held that neither the Assessing Officer nor the Commissioner (Appeals) had pointed out any income earned by the assessee which was exempt.  Section 14A could not be invoked when no exempt income was earned.  Since the assessee had not earned any exempt income, the disallowance under Section 14A of the Act is not warranted.

Investments

  In ‘Deputy Commissioner of Income Tax V. Chennai Network Infrastructure Private Limited’ – 2016 (12) TMI 1247 - ITAT CHENNAI  the Tribunal held that if the investments were made in growth mutual funds yielding only capital gains or loss falling under the head ‘capital gains’ then the provisions of Section 14A were not applicable because the provisions of Section 14A deals with expenditure incurred in relation to income not includible in total income.  Since the Commissioner (Appeals) held only remitted the matter to the Assessing Officer for verifying the mode of investment and accordingly it was not necessary to interfere with the order on this issue.

  In ‘TAFE Motors and Tractors Limited V. Assistant Commissioner of Income Tax’ – 2016 (5) TMI 1128 - ITAT CHENNAI the Assessing Officer worked out the expenditure relating to income which does not form part of the appellant’s total income under Section 14A read with Rule 8D.  The Commissioner (Appeals) confirmed the order of the Assessing Officer.  The Tribunal held that the interest paid by the assessee on borrowing, which were used for specific purpose of computing the disallowance under Section 14A of the Act read with Rule 8D.  The investments which yielded taxable income could also not be considered while applying the formula specified in Rule 8D.  The Tribunal remanded the matter to the Assessing Officer for reconsideration.

  In ‘First Global Stock Broking Private Limited V. Deputy Commissioner of Income Tax’- 2016 (10) TMI 891 - ITAT MUMBAI  the appellant earned dividend of ₹ 15.60 lakhs.  The Assessing officer computed the disallowance under Section 14A read with Rule 8D(2)(iii) at ₹ 4,90,318/- only with reference to expenses which were equal to 0.5% of the average value of the investment, income from which did not for part of the total income, as appearing in the balance sheet of the assessee as on the first and last day of the previous year under consideration.  The Tribunal held that the investment out of which income was taxable could not be included for the purpose of computation of disallowance.  The Tribunal set aside the order of Commissioner (Appeals) and remanded to the Assessing officer for reworking the disallowance and to verify the contentions of the assessee that the investments made by it in the group concern, foreign entities the income which was eligible to tax was to be excluded while computing the disallowances under Rule 8D (2)(iii) which was in respect of 0.5% of the average value of investment, the income of which did not form part of total income.

Obligation of Assessing Officer

  In ‘Deputy Commissioner of Income Tax V. Joonktollee Tea and Industries Limited’ – 2016 (10) TMI 196 - ITAT KOLKATA the Assessing Officer disallowed an amount under Section 14A holding that the assessee must have incurred some expenditure for holding investment and for earning purely agricultural income.  The Assessing Officer disallowed ₹ 1 lakh under Rule 8D (2)(i).  The Assessing Officer also held that the assessee had incurred interest expenses proportionately to earn the exempt income and that it should be disallowed and worked out the disallowance under Rule 8D(2) (ii) and (iii).  The Commissioner (Appeals) deleted the addition holding that the Assessing Officer had made no attempt to establish linkages and nexus before the exempted income earned and expenditure incurred which was essential to invoke Section 14A read with Rule 8D.  The Tribunal held that the Assessing Officer has not recorded any satisfaction with reference to Section 14A read with Rule 8D.  Therefore the addition made by the Assessing Officer under Rule 8D(2)(ii) was to be deleted.  The addition under Rule 8D(2)(iii) was towards general and administrative expenses which a company normally incurs while making investment decision.  The Tribunal confirmed the addition made under Rule 8D(2)(i) and (iii).

  In ‘Alkyl Amines Chemicals Limited V. Assistant Commissioner of Income Tax’ – 2016 (11) TMI 382 - ITAT MUMBAI the assessee earned dividend of ₹ 1.15 crores and claimed exemption under Section 10(34) of the Act.   The assessee was directed to submit the details of expenses attributable to exempt income in terms of Section 14A read with Rule 8D.  The assessee submitted that no expenses were incurred for earning exempt income and as such no disallowance was called under Section 14A.  However the assessee submitted the working of disallowance to the tune of ₹ 1.13 lakhs.  The Assessing Officer rejected his submission.   He worked out the disallowance as ₹ 11.87 lakhs out of which disallowance for interest under Rule 8D(2)(iii) for indirect and administrative expenses at 5% of average investment worked out to ₹ 1,13,010/-.  The Tribunal observed that the assessee’s own funds were much higher than investments made which were capable of yielding exempt income.  The assessee contended that none of the loans were deployed towards investments made.  These were old investments.   No fresh investments were made during the assessment year.  The presumption shall apply that the assessee had invested its own fund towards making investment unless material to the contrary was brought on record by the Department.  The Department did not bring any incriminating hence, addition of ₹ 10,74,405/- was not sustainable.  The disallowance of ₹ 1,13,010/- towards administrative and other indirect expenses attributable to the earning of exemption is being dividend of ₹ 1.15 crores received by the assessee, was very reasonable and fair and to be sustained.

Obligation of the assessee

  In ‘Casby Logistics Limited V. Deputy Commissioner of Income Tax’ – 2016 (5) TMI 700 - ITAT MUMBAI the Tribunal imposes an obligation on the part of the assessee to prove that he had not incurred any expenditure relating to exempted income.   In this case the Tribunal held that Section 14A was applicable for the Assessment year and the disallowance had to be made in respect of income which had not form part of the total income.   It was for the assessee to show with cogent material that it had not incurred any expenditure in relation to earning the dividend or long term capital gains.  The Tribunal remanded the matter to the Assessing officer for de novo determination.

Disallowance could not more than exempt income

  In ‘Numbus Communications Limited V. Assistant Commissioner of Income Tax’- 2016 (5) TMI 166 - ITAT MUMBAI  the Assessing Officer disallowed a sum of ₹ 2 crores under Section 14A read with Rule 8D on the dividend received by the assessee.  The Tribunal held that all the investments were made in the subsidiary company as the strategic investment so as to get controlling interest in such subsidiaries.  The investment was not made for earning of any dividend.  The disallowance could not be more than exempt income.  The Assessing Officer was to restrict the disallowance to ₹ 7.24 lakhs.

  In ‘Pepsico India Holdings Private Limited V. Assistant Commissioner of Income Tax’ – 2016 (6) TMI 284 - ITAT DELHI  the appellant claimed exemption under Section 10(34) of ₹ 34,563/- as dividend income on shares in seven companies.  The Assessing Officer invoked the provisions of Section 14A read with Rule 8D and disallowed a sum of ₹ 6.04 crores rejecting the claim of the assessee that no expenditure was incurred to earn the income which did not form part of the total income.  The Commissioner (Appeals) confirmed the order.  The Tribunal, on appeal, held that the provisions of Rule 8D were applicable from the Assessment year 2008 – 09 only and disallowance could not be made for the assessment year prior thereto and the disallowance in case could not exceed the exempt income.  The Tribunal remanded the matter to the Assessing Officer to recompute the disallowance restricting it to the amount of dividend during the year.

Justification for disallowance

  In ‘Yama Finance Limited V. Income Tax Officer’ – 2016 (12) TMI 1246 - ITAT DELHI the Tribunal held that there is no evidence to relate expenditure incurred with exempt income and relate exempt income to investments yielding exempt income.  The disallowance is not justified.

Reduction of disallowance

  In some case the appellate authorities reduce the disallowance imposed by the Assessing Officer considering the facts and circumstances of the case.

  In ‘Brics Securities Limited V. Assistant Commissioner of Income Tax’ – 2016 (7) TMI 685 - ITAT MUMBAI the assessee is aggrieved against the order of Commissioner (Appeals), Mumbai for the assessment year 2008 – 09 in the matter of order passed under Section 143(3) of the Act.  The assessee is aggrieved for the disallowance under Section 14A made in respect of expenditure incurred for earning exempt income amounting to ₹ 28.97 lakhs.  The Tribunal held that the Assessing Officer has correctly computed the disallowance as per Rule 8D, in so far as the relevant assessment year under consideration is the assessment year 2008 – 09.  The Tribunal directed to reduce the disallowance by ₹ 14.03 crores being disallowance of expenses already offered by the assessee in the return of income.

Dividend income and interest

  In ‘Deputy Commissioner of Income Tax V. Phillps Carbon Black Limited’ – 2016 (10) TMI 323 - ITAT KOLKATA the assessee had earned dividend income and interest on tax free 6.75% US by bond which it had claimed as exempt from tax under Section 10 of the Act.  The assessee in computation of income has stated that no expenses was incurred for earning the exempt income and submitted no deduction shall be allowed.  The Assessing Officer worked out the disallowance expenditure including interest at ₹ 1.22 crores.  The Commissioner (Appeals) directed the Assessing Officer to restrict to 1%.  The Tribunal upheld the order of Commissioner (Appeals) as fair and reasonable.

Present position

  Vide Notification No. 43/2016, dated 02.06.2016 Rule 8D(2) has been substituted by the following new provisions (with effect from 02.06.2016) -

(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; and

(ii) an amount equal to one per cent of the annual average of the monthly averages of the opening and closing balances of the value of investment, income from which does not or shall not form part of total income:

               Provided that the amount referred to in clause (i) and clause (ii) shall not exceed the total expenditure claimed by the assessee.

The said Notification omits Rule 8D (3).

  By the Notification No. 43/2016, dated 02.06.2016, the procedure for determining the expenditure in relation to exempted income has been completely changed.  This will also lead to litigation whether the amount of expenditure is directly related to income which does not form part of total income or not.