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There are some heads of income which are considered tax-free or exempt for the purposes of the Income Tax Act (“Act”). On the other hand, the Act allows certain expenses incurred exclusively for earning income to be claimed as deductions i.e. these amounts can be deducted from the total income to arrive at the income liable to be taxed. However, Section 14A prohibits the expenditure incurred for earning exempt income to be claimed as a deduction.
Section 14A: Analysis
Section 14A disallows the expenditure incurred on earning exempt income to be claimed as a deduction. Sub-sections (2) and (3) of Section 14A empower the assessing officer to determine the expenditure incurred by applying the prescribed method if:
- the assessing officer is not satisfied with the correctness of the claim of the assessee, or
- the assessee states that no expenditure was incurred by him in relation to the exempt income.
Various issues have time and again arisen vis-à-vis, the applicability and operation of Section 14A. The key issues are listed below:
Can the disallowance under Section 14A be more than the expenditure claimed by the assessee?
Delhi ITAT in the decision of Gillette Group India Pvt. Ltd. v. ACIT, held that the disallowance cannot be more than the expenditure claimed. Section 14A read with Rule 8D allow only for such expenditure to be disallowed which is incurred for earning of exempt income.
Naturally, an application of this principle is that no disallowance can be made from expenses for making investments if no dividend has to be earned for such investments- a view that has been upheld by the Delhi High Court in Cheminvest Limited vs CIT.
Whether Rule 8D is prospective or retrospective in operation?
Rule 8D, as stated above, provides the method for determining the expenditure incurred on earning exempt income. Rule 8D was inserted with effect from March 24, 2008, and hence came into operation from 2008-09 onwards. Various judicial decisions have discussed whether Rule 8D is prospective or retrospective in operation.
Bombay High Court case: Godrej & Boyce Mfg. Co. v. DCIT
Notable judicial decisions:
If no expenditure is directly incurred in relation to the exempt income, can disallowance, be made under section 14A?
Section 14 disallows deductions of expenditure incurred ‘in relation to’ exempt income. Hence, it is pertinent to discuss the interpretation of the words “in relation to”. The Supreme Court in the decision of Maxopp Investment Ltd. while interpreting the words ‘in relation to’ stated that there should be a direct and proximate connection between the exempt income and the expense that is sought to be disallowed. If the expenditure incurred has no causal connection with the exempted income, then such expenditure could not be disallowed. In explaining the proximate connection test in relation to tax-free dividend income and corresponding interest expense on borrowed funds through which investment was made, the Supreme Court clarified that the dominant purpose of the investment was not relevant for the purpose of applicability of Section 14A. Ergo, whether investments were held for long term strategic purpose or for earning financial returns was deemed to be an irrelevant factor for determining the applicability of Section 14A. However, a distinction was made where shares are held as stock in the trade because in that case, where the Court held that expenditure should be apportioned between those which were made towards earning profit by trading in stocks and which were made towards earning a tax-free dividend. This was a reiteration of its earlier decision in CIT v. Walfort Share and Stock Brokers Pvt. Ltd. wherein it was held that a proximate cause for disallowance is required to attract the applicability of Section 14 and this proximate cause is the relation of the expenditure incurred and the exempt income. The Supreme Court of CIT v. Syntex Agro Securities Pvt. Ltd. and Godrej & Boyce Mfg. Co. also stress the need for a proximate cause between the expenditure incurred and the exempt income. Although after the Supreme Court decision in Maxopp, a Delhi ITAT judgement seems to have reopened the debate around legality of disallowance of expenditure made by traders holding investments as stock-in-trade. In the case of Nice Bombay Transport (P) Ltd vs ACIT, the Delhi ITAT has held that the import of paragraphs of 39 and 40 of the Supreme Court Judgement in Maxopp is that if a trader who held investment as stock-in-trade had no understanding whether he would earn dividend during the short period that he holds the shares and dividend is earned just by “quirk of fate”, then such expenditure for making such investment cannot be disallowed.
[ For more information, you may refer to the following cases: CIT v. Bharti Overseas Pvt. Ltd., CIT v. VOU Investment Pvt. Ltd., Joint Investments Pvt. Ltd. v. CIT, Principal Commissioner of Income Tax v. M/s UK Paints (India) Ltd., Controla & Switchgear Co. v. DCIT, Relaxo Footwears v. ACIT, New Delhi, Garware Wall Ropes Ltd. v. ACIT, M/S Dhanuka & Sons v. Commissioner of Income Tax(Central) and CIT v. Gujarat State Fertilizers & Chemicals Ltd. ]
If tax-free investments are made out of surplus funds, will Section 14A be applicable?
Another issue which arises with respect to Section 14A is its applicability to tax-free investments made out of surplus funds.
If the assessee is making tax-free investments out of his own surplus interest-free funds, then would this expenditure is disallowed? The Supreme Court in the decision of CIT v. Sintex Industries held that no disallowance of expenditure with respect to interest or administrative expenses may be done if the investment is made out of own interest-free surplus fund.
Various decisions of High Courts, including inter aliaDelhi, Bombay and Gujarat High Courts, held that, if sufficient funds are available with the assessee for making tax-free investments or if the funds available with the assessee far exceed the tax-free investment made, then disallowance under section 14A could not be made.
The following key takeaways arise out of the aforementioned analysis:
- Section 14A disallows expenditure incurred on a tax-exempt income. Such disallowance cannot exceed the expenditure incurred on such exempt income.
- Further, Section 14A cannot be applied to tax-free income earned out of one’s own surplus funds.
- In order for Section 14A to be applicable, there needs to be the proximate connection between the expenditure incurred and the exempt income.
- Rule 8D, used for determining the expenditure incurred on exempt income has prospective and not retrospective operation.
Analytics suggests, that a majority of cases pertaining to Section 14A are remanded to the file of the AO or to the tribunal for reconsideration. It also appears that almost 42% of the 14A cases which are decided quickly (i.e. within 2 years from the date of filing) result in a remand. Thus for quick disposal of these cases, it is important that all relevant legal principles from High Court and Supreme Court Judgements are quoted in detail before the AO. For more case laws on section 14A, you may refer to this link.
Written by Soumya Shekhar, | Legal content writer @ Riverus