An analysis of Section 14A with Rule 8D
Simplicity and taxation laws cannot go hand in hand. The more attempt is made to simplify the tax laws, more complicated it becomes. One such provision is section 14A which has been brought in the statue book very recently in 2001. However, it was made applicable retrospectively from 1961 i.e., from the birth of Income Tax Act-1961. This may be the section with highest number of disputes and litigation in its fold as of now. Different High Courts and various benches of theITAT have given decisions which is contravening with each other. Pronouncement by Supreme Court has given finality to few issues.
Section 14A of the Income-tax Act read with Rule 8D of Income-tax Rules provides for disallowance of expenditure incurred in relation to ‘income which does not form part of the total income’. Before discussing further about issues involved, let us have a look at the provision and rule thereto.
Section 14A of the Income Tax Act-1961 reads as under:
Expenditure incurred in relation to income not includible in total income.
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 prescribed17, 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.
Rules 8 prescribed u/s 14A reads as under:
Rule 8D: Method for determining amount of expenditure in relation to income not includible in total income.
(1) 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).
[ (2) The expenditure in relation to income which does not form part of the total income shall be the aggregate of following amounts, namely:—
the amount of expenditure directly relating to income which does not form part of total income; and
an amount equal to one per cent of the annual average of the monthly average 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.]
[It may be noted that above Rule 8D was amended on 02.06.2016 so as to provide for a revised method for determining the amount of disallowance of expenditure on earning exempt income].
To understand the logic of section 14A, it is important ot visit the explanatory memorandum of Finance Bill-2001 whereby object behind section 14A was presented, as under:
“Certain incomes are not includable 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 debiting 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. It is proposed to insert a new section 14A so as to clarify the intention of the Legislature since the inception of the Income – tax Act, 1961, that no deduction shall be made in respect of any expenditure incurred by the assessee in relation to income which does not form part of the total income under the Income-tax Act. The proposed amendment will take effect retrospectively from April 1, 1962 and will accordingly, apply in relation to the assessment year 1962-63 and subsequent assessment years.”
Evolution of Section 14A & Rule 8D thereof:
Here is a short compilation of the birth and development of Section 14A and rule 8D since its inception:
- FA-2001 has inserted section 14A in the Income Tax Act-1961 w.e.f. 01.04.1961.
- FA-2002 has inserted a provision whereby section 14A cannot be used to reopen and rectify any earlier cases.
- FA-2006 inserted sub-section (2) and (3) to section 14A w.e.f 1 April 2007 thereby enabling to notify the method to compute the amount of disallowance u/s 14A
- Fifth Amendment Rule, 2008 was done to insert Rule 8D w.e.f. 24 March 2008 providing the formula for apportioning expenses related to exempt income.
- FA-2016- Amendment to Rule 8D whereby disallowance is restricted to 1% of the average monthly value of investments yielding exempt income, but not exceeding the actual expenditure claimed.
ISSUES & JUDICIAL PRNOUNCEMENTS:
There are numerous issues arisen not only during the course of assessment and reassessment proceedings but also at all appellate forum from CIT (A) to ITAT to HC to SC. There are controversial judgement and differential interpretation as well. Though some of the issues are well settled by the Apex Court, still there are many issues which are a matter of litigation.
Let us have a look at some of the issues related to section 14A read with Rule 8D of Income-tax Rules:
A] Supreme Court in Commissioner of Income-tax v. Essar Teleholdings Ltd. (2018) 401 ITR 445 (SC)
Rule 8D don’t have any retrospective application
Rule 8D don’t have any retrospective application and it is applicable prospectively from A.Y. 2008-09. It cannot be applied up to assessment years up to A.Y. 2007-08. As a result, till AY 2008-09, disallowance cannot be made in accordance with Rule 8D but can be done as per the best judgment of the AO in accordance with the spirit of section 14A which has application from 1961.
B] Supreme court in Godrej & Boyce Manufacturing Co. Ltd. v. Dy. CIT & Anr. (2017) 394 ITR 449 (SC);
- For disallowance, expenditures should have to be actually incurred. The key observations were as under:
“what cannot be denied is that the requirement for attracting the provisions of Section 14A(1) of the Act is proof of the fact that the expenditure sought to be disallowed/ deducted had actually been incurred in earning the dividend income. Again in the judgment of Maxopp Investment (supra) vide para 32, the Hon’ble Court has held that “if an expenditure incurred has no casual connection with the exempted income, then such an expenditure would obviously be treated as not related to the income that is exempted from tax, and such, expenditure would be allowed as business expenditure. To put it differently, such expenditure would then be considered as incurred in respect of other income which is to be treated as part of the total income.”
Without any expenditure being actually incurred to earn exempt income, there will not be any application of section 14A.
- Satisfaction of AO is necessary before invoking Rule 8D r.w.s. 14A.
Hon’ble supreme Court observed in its Para 37 that
“whether such determination is to be made on application of the formula prescribed under Rule 8D or in the best judgment of the Assessing Officer, what the law postulates is the requirement of a satisfaction in the Assessing Officer 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. 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.”
- No disallowance towards interest expense can be done if borrowed funds is actually not used for investments
Hon’ble court at Para 38 of the judgment categorically noted against the disallowance if there is
i) absence of any reasonable or direct nexus between the expenditure intended to be disallowed u/s 14A & exempt income and
ii) absence of the fact that any part of the borrowings is diverted in investment to earn tax free income despite the availability of surplus or interest free funds,
- If own funds exceeds the amount of investment then no disallowance towards interest can be done u/s 14A:
The Hon’ble Supreme Court carefully noted that investments by assessee company was only of ₹125.54 crore whereas own funds of the company were of ₹ 280.64 crore which was interest free funds in the form of share capital and reserves.
In the circumstances it was held by the Supreme Court that the fact that any part of the borrowings of the assessee had been diverted to earn tax free income despite the availability of surplus or interest free funds available remains unproved by any material whatsoever. Therefore, no disallowance for interest was to be made.
- 14A disallowance to apply if the dividend is subject to taxation u/s 115-O:
It is held that section 14A of the Act would apply only to dividend income on which tax (i.e., Dividend Distribution Tax) is payable under section 115-O. Since the liability to pay DDT U/s 115-O in respect of the dividend is on the dividend paying company and the shareholder / assessee has no connection with the same, it will be treated as exempt in the hand of the recipient and so will attract section 14A disallowance.
C] Supreme Court in Maxopp Investment Ltd. v. Commissioner of Income Tax (2018) 402 ITR 640 (SC)
- Before applying the theory of apportionment, the AO needs to record satisfaction that having regard to the kind of the assessee, suo motu disallowance under Section 14A was not correct.
Apex court makes following observation in its judgement at Para 41 with regard to invoking of section 14A:
“having regard to the language of Section 14A(2) of the Act, read with Rule 8D of the Rules, we also make it clear that before applying the theory of apportionment, the AO needs to record satisfaction that having regard to the kind of the assessee, suo motu disallowance under Section 14A was not correct. It will be in those cases where the assessee in his return has himself apportioned but the AO was not accepting the said apportionment. In that eventuality, it will have to record its satisfaction to this effect. Further, while recording such a satisfaction, nature of loan taken by the assessee for purchasing the shares/making the investment in shares is to be examined by the AO.”
- Nexus of loan vis a vis investment towards investment offering exempt income is necessary.
Apex Court at Para 41 while upholding that recording of satisfaction is pre condition for invoking section 14A has made following comment:
“further, while recording such a satisfaction, nature of loan taken by the assessee for purchasing the shares / making the investment in shares is to be examined by the AO.”
- Borrowing for the purpose of investment is a pre-condition for section 14A applicability.
No disallowance was to be made if borrowed funds had not been used for the purpose of investments yielding exempt income.
At para 42, Hon’ble Court has considered the decision of Punjab & Haryana High Court in the case of Avon Cycles Ltd., Ludhiana.It has been stated that the assessee had paid total interest of ₹ 2.92 lakh out of which interest paid on term loan raised for specific purpose totals to ₹ 1.70 crore and balance interest paid by the assessee was ₹ 1.21 crore. In view of provisions of Rule 8D(2)(ii) of Income-tax Rules, the Tribunal had upheld the disallowance of ₹ 10,49,851/- which was determined with reference to interest of ₹ 1.21 crore only after excluding interest on loans raised for specific purpose. High Court had dismissed the appeal filed against the order of ITAT observing that after examining the Balance Sheet of the assessee and finding of fact, there was no question of law. The Hon’ble Supreme Court also after going through the record and applying the principle of apportionment has dismissed the appeal. What is important to be noted is that the apportionment as per Rule 8D(2)(ii) of Income-tax Rules had been made and upheld only with reference to balance interest of ₹ 1.21 crore. The position that amount of disallowance of ₹ 10,49,851/- was determined with reference to interest expenditure of ₹ 1.21 crore is quite clear on the basis of relevant order of ITAT, Chandigarh Bench, which was the subject matter before the High Court and the Supreme Court in ITA No.1143/Chd/2011 dated 17-1-2013. As per the facts average amount of investments was ₹ 18.685 crore and average of total assets was ₹ 215.34 crores and on that basis proportionate disallowance out of total expenditure of ₹ 1.21 crore related to the average investment worked out to ₹ 10,49,851/-.
Accordingly, it is stated that any expenditure incurred which is relatable to specific loans taken for business activities is to be excluded for the purpose of determining the proportionate disallowance on account of interest as per Rule 8D(2)(ii) of Income-tax Rules.
- Disallowance cannot exceed the exempt income:
Hon’ble Apex court has opined that the amount of disallowance cannot exceed the amount of exempt income. Hon’ble Court expressed that
“the view of the CIT(A) was clearly untenable and rightly set aside by the ITAT. Therefore, on facts, the Punjab & Haryana High Court has arrived at a correct conclusion by affirming the view of the ITAT, though we are not subscribing to the theory of dominant intention applied by the High Court”.
As of now, theory that disallowance cannot exceed the amount of exempt income stands approved by the Supreme Court
- Primary or dominant purpose for which investment is done is irrelevant for the purpose of section 14A:
Key conclusions drawn by the court is that if an income is considered exempt, expenses incurred for earning such dividend income have to appropriately apportioned and disallowed accordingly.
It is worth to find the observation of the High court on the issue as under:
“we are of the opinion that the dominant purpose for which the investment into shares is made by an assessee may not be relevant. No doubt, the assessee like Maxopp Investment Limited may have made the investment in order to gain control of the investee company. However, that does not appear to be a relevant factor in determining the issue at hand. Fact remains that such dividend income is not-taxable. In this scenario, if expenditure is incurred on earning the dividend income, that much of the expenditure which is attributable to the dividend income has to be disallowed and cannot be treated as business expenditure. Keeping this objective behind Section 14A of the Act in mind, the said provision has to be interpreted, particularly, the word ‘in relation to the income’ that does not form part of total income.” Similarly, in the case of State Bank of Patiala wherein shares had been held as stock-in-trade the Hon’ble Court vide para 38 has disagreed with the judgment of Punjab & Haryana High Court observing that “at the same time, we do not agree with the test of dominant intention applied by Punjab & Haryana High Court, which we have already discarded.”
Further rejecting ‘the dominant intention theory’ of holding the shares as stock-in-trade is not relevant, court observed that
“where shares are held as stock-in-trade, the main purpose is to trade in those shares and earn profits therefrom. However, we are not concerned with those profits which would naturally be treated as ‘income’ under the head ‘profits and gains from business and profession’. What happens is that, in the process, when the shares are held as ‘stock-in-trade’, certain dividend is also earned, though incidentally, which is also an income. However, by virtue of Section 10(34) of the Act, this dividend income is not to be included in the total income and is exempt from tax. This triggers the applicability of Section 14A of the Act which is based on the theory of apportionment of expenditure between taxable and non-taxable income as held in Walfort Share and Stock Brokers P Ltd. case. Therefore, to that extent, depending upon the facts of each case, the expenditure incurred in acquiring those shares will have to be apportioned”.
“depending upon the facts of each case, the expenditure incurred in acquiring those shares will have to be apportioned”.
Assessee’s submission with regard to the business needs for making the investment for avoiding disallowance u/s 14A is outrighly rejected by the judiciary.
D] PCIT v/s. Sintex Industries  93 taxmann.com 24 (SC)- Whether disallowance permissible when assessee failed to justify one to one use of borrowed capital:
Question before the Supreme Court was whether interest can be disallowed under section 14A in cases where the assessee is unable to justify one-to-one use of borrowed funds for business purposes but has sufficient Owned Funds (viz., share capital and free reserves).
It was decided in favor of Assessee by holding that assessee had surplus funds against which minor investment was made, no question of making any disallowance of expenditure under section 14A of the Act arose and therefore, there was no question of any estimation of expenditure under Rule 8D of the Income-tax Rules, 1962.
It may be recalled that the Bombay High in the case of HDFC Bank Ltd.  67 taxmann.com 42 (Bombay) as well as in the case of Reliance Utilities & Power Ltd.  178 Taxman 135 (Bombay) has also given broad guidelines on the issue whereas the Supreme court in above case has decided the issue under above specific facts of the case wherein investments were minor as compared to the funds available). In my view, applicability of above case has to be case specific and not generalized.
It is held ruled in favour of Revenue and held that section 14A of the Act would apply to dividend income on which tax is payable under section 115-O since the liability to pay tax under section 115-O in respect of the dividend is on the dividend paying company and the shareholder / assessee has no connection with the same
E] PCIT Vs. Adani Agro (P.) Ltd  91 taxmann.com 29 (Gujarat) – Is it possible to disallow amount u/s 14A in a mechanical way so as to exceeds the actual administrative expenditure claimed
It was held by the Gujarat High Court has held that disallowance rule cannot be applied in a mechanical way and under no circumstances an Assessing Officer can attribute expenses for earning tax free income in excess of total administrative expenditure incurred by assessee.
F] PCIT v/s. Reliance Capital Asset Management Ltd.  86 taxmann.com 200 (Bombay)- Recording of satisfaction as a key pre-requisite for invoking provision of section 14A
Where AO has not commented upon correctness or otherwise of assessee’s working of expenditure in respect of income not chargeable to tax, the formula prescribed in Rule 8D(2)(iii) of the Income-tax Rules, 1962 could not have been applied to work out disallowance under section 14A of the Act. In short, it can be concluded that no disallowance is warranted if taxpayer is able to justify its basis for disallowance.
Most of the controversy arising in section 14A has been settled. Let us hope that any more retrospective amendment is not carried out so as to nullify the verdict of the Apex court so far.