Expenses incurred in relation to exempt income
(S.14A) |
SECTION 14A: DISALLOWANCE OF EXPENDITURE INCURRED IN RELATION TO
INCOME EXEMPT FROM TAX
Background
Section 14A is a disallowance provision. This section provides that while
computing the total income of any assessee, no deduction will be permitted in respect
of any expense incurred in relation to any income which is exempt from income
tax.
Position prior to the introduction of section 14A
Prior to the introduction of section 14A, the nature of the business was an
important factor for determining the disallowance of expenditure incurred on earning
exempt
income. The businesses were broadly classified into two categories:
– a composite
and indivisible business; or
– a
divisible business
The settled law at the material time was that, when an assessee has a composite
and indivisible business i.e. the business has elements of both taxable and
non-taxable income, the entire expenditure in respect of the said business is
deductible and, in such a case, the principle of apportionment of the expenditure
relating to the non-taxable income did not apply.
However, where the business was divisible, the principle of apportionment of the
expenditure was applicable and the expenditure apportioned to the 'exempt' income or
income not exigible to tax, was not allowable as a deduction.
Objective behind insertion of section 14A with retrospective
effect
The basic principle of taxation is to tax the net income, i.e. gross income minus
the expenditure and on the same analogy the exemption is also in respect of net
income. In other words, where the gross income did not form part of total
income, its associated or related expenditure also, could not be permitted to be
debited against other taxable income.
The stated intention of the Parliament, while introducing section 14A, was that it
should appear in the statute book, right from its inception that, expenditure
incurred in connection with income, which does not form part of total income is not
intended to be allowed as a deduction. By introducing this section
retrospectively, the Parliament was only acting on this intention.
It can be said that the insertion of section 14A with retrospective effect
reflects a serious attempt on the part of the Parliament not to allow deduction in
respect of any expenditure incurred by the assessee in relation to income, which does
not form part of the total income under the Act against the taxable income. It
is understood that in the case of an income like dividend income which does not form
part of the total income, any expenditure/deduction relatable to such (exempt or
non-taxable) income, even if it is of the nature specified in sections 15 to 59
cannot be allowed against any other income which is includable in the total income.
Chronology of amendments
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Amending Act/ Rule
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Amendment
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Impact
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Finance Act, 2001
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Section 14A inserted
(w r e f 1-4-1962)
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Provided for disallowance for expenses incurred in relation to income exempt
from income tax
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Finance Act, 2002
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Proviso to section 14A inserted
(w r e f 11-5-2001)
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Clarification that section 14A cannot be used to reopen / rectify completed
assessment
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Finance Act, 2006
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Sub-sections (2) and (3) inserted
(w e f 1-4-2007)
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Provided the methodology for computing the disallowance under section
14A
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IT (Fifth Amendment) Rules, 2008
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Rule 8D inserted
(w.e.f. 24-3-2008)
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Prescribes the mechanics for allocating expenses to exempt income
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Legislative history in brief
Allowance or disallowance of expenses incurred in relation to income / business
which were exempt from the levy of tax had always been a source of controversy and a
subject matter of dispute. The Government, with a view to put this controversy
to rest, brought section 14A in to the statute.
While making this amendment, the Government clarified that its intention, right
since the inception of the Income Tax Act, was to give a deduction only for those
expenses which would yield taxable income. Accordingly, section 14A was
inserted in to the statute by virtue of the Finance Act, 2001 with retrospective
effect from 1-4-1962.
Given the far reaching consequences of the amendment, there were concerns that
this amendment could also be used to re-open completed assessments, leading to
apprehension about the potential for abuse. With a view to curb any potential
abuse, the Government inserted a proviso (by virtue of the Finance Act, 2002),
clarifying that nothing contained in section 14A would empower the Assessing Officer
to either reassess under section 147 or pass an order enhancing the assessment or
reducing the refund already made or otherwise increasing the liability of the
assessee under section 154, for any assessment year beginning on or before the
1-4-2001. This ensured that all the concluded assessment, pertaining to
assessment years beginning on or before the 1-4-2001, would not be disturbed despite
the retrospective impact of section 14A.
Sub-sections (2) and (3) of section 14A were introduced subsequently by virtue of
the Finance Act, 2006, with effect from 1-4-2007. It is relevant to highlight
that although sub-sections (2) and (3) had been introduced with effect from 1-4-2007,
they remained inoperative due to technical reasons. A hurdle was created due to
use of the expression 'such method as may be prescribed' by the legislature.
The technical hitch was that, while sub-section (2) and (3) to section 14A provided
for computing the disallowance as per the method prescribed, the relevant method was
still not incorporated into the Income tax Rules. It is at this juncture that,
rule 8D was introduced [by virtue of the Income-tax (Fifth Amendment) Rules, 2008
notified by the Central Board of Direct Taxes by its notification No.45/2008, dated
24-3-2008].
Initially there was some controversy whether rule 8D could be applied prior to
24-3-2008, however, it is now a widely accepted position that that the method
prescribed under rule 8D applies prospectively.
Analysis of section 14A
Expenditure incurred in relation to income which does not form
part of the total income [Section 14A(1)]
Sub-section (1) of section 14A stipulates that for the purposes of computing total
income under Chapter IV (Computation of Total Income), 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 the said Act.
It is relevant to highlight that while an emphasis has been laid on the
expressions 'expenditure incurred' and 'in relation to', there have been many
disputes as to whether these words are required to be interpreted literally or a
purposive interpretation was required to be adopted. A literal interpretation
would mean that the expenditure must have actually taken place and that to in
relation to exempt income.
Relevance of the words ‘in relation to’
The need for a direct and proximate connection with the subject matter has been
the central point of debate on the applicability of section 14A to certain specific
instances. The judicial position in this regard is that, the expression 'in
relation to' appearing in section 14A is not to be given a narrow or constricted
meaning. The expression does not have any embedded object, it simply means 'in
connection with' or 'pertaining to'.
Given the above, if the expenditure in question has a relation or connection with
or pertains to exempt income, it is likely to be allowed as a deduction even if it
otherwise qualifies under the other provisions of the said Act. Further,
permissible deductions enumerated in sections 15 to 59 are likely to be allowed only
with reference to income which is brought to tax under one of the heads of
income.
Relevance of the word ‘expenditure incurred’:
The need for incurring of actual expenditure for earning exempt income has also
been a subject matter of dispute. The debate is whether the expression
‘expenditure incurred’ refers to actual expenditure and not to some
imagined expenditure. The judicial position in this regard is that, the
'actual' expenditure that is in contemplation under section 14A(1) is the 'actual'
expenditure in relation to or in connection with or pertaining to exempt
income. The corollary to this is that if no expenditure is incurred in relation
to the exempt income, no disallowance can be made under section 14A.
Determination of expenditure incurred in relation to exempt
income by the Assessing Officer [Section 14A(2)]:
Sub-section (2) of section 14A provides the manner in which the amount of
expenditure incurred in relation to exempt income is to be determined by the
Assessing Officer. Sub section (2) provides that if the Assessing Officer,
having regard to the accounts of the assessee, is not satisfied with the correctness
of assessee’s claim for the expenditure incurred in relation to exempt income,
then in such a case the Assessing Officer has to determine the quantum of
disallowance as per the method prescribed i.e. in accordance to Rule 8D of the Income
tax Rules.
It is relevant to highlight that the provisions of this sub-section come into
effect only if the Assessing Officer records a finding that he is not satisfied with
the correctness of the assessee’s claim for the expenditure incurred in
relation to exempt income. Therefore, the condition precedent for the Assessing
Officer entering upon a determination of the amount of the expenditure incurred in
relation to exempt income is that the Assessing Officer must record that he is not
satisfied with the correctness of the claim of the assessee in respect of such
expenditure.
Determination of expenditure incurred in relation to exempt
income by the Assessing Officer when assessee claims that no expenditure has been
incurred [Section 14A(3)]:
Sub-section (3) applies to cases where the assessee claims that no expenditure has
been incurred in relation to exempt income earned. It is highlighted that
sub-section (2) applies to situations wherein the assessee on his accord, asserts a
claim that some expenditure has been incurred for the purpose of earning exempt
income. As against this, sub-section (3) comes into play where the assessee
asserts that no expenditure has been incurred for earning exempt income. In
both cases, the Assessing Officer, has to record his satisfied or otherwise, with the
correctness of the claim of the assessee in respect of such expenditure or no
expenditure, as the case may be, before proceeding to determination of the amount of
expenditure in accordance rule 8D.
Thus, before rejecting the claim of the assessee with regard to the expenditure or
no expenditure, as the case may be, in relation to exempt income, the Assessing
Officer would have to indicate cogent reasons for the same.
Prescribed method of determining the quantum of expenditure incurred for earning
exempt income [Rule 8D]
This rule 8D comes into effect only when the Assessing Officer, having regard to
the accounts of the assessee of a previous year, records his dissatisfaction
about:
(a) the correctness of the claim
of expenditure made by the assessee; or
(b) the claim made by the assessee that
no expenditure has been incurred in relation to exempt
For this purpose, sub-rule (2) prescribed the method for computing the quantum of
expenditure attributable to earning exempt income. Sub-rule (2) provides that
the expenditure in relation to exempt income which shall be the aggregate of
following amounts, namely:—
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the amount of expenditure
directly relating to exempt income;
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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 ×
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 ;
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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. As is apparent from the above, the method for determining the expenditure in
relation to exempt income has three components.
a) The first component
being the amount of expenditure directly relating to exempt income.
b) The second component
being computed on the basis of the formula, applies to interest which is not directly
attributable to any particular income or receipt or expenses which are common to the
business as a whole. Essentially, the formula apportions the amount of interest
expense incurred, for common purposes i.e. earning taxable as well as exempt income,
during the previous year. The apportionment is in the ratio of the average
value of investment, income from which does not or shall not form part of the total
income, to the average of the total assets of the assessee.
c) The third component is
an artificial figure i.e. one half per cent of the average value of the
investment, income from which does not or shall not form part of the total income, as
appearing in the balance sheets of the assessee, on the first day and the last day of
the previous year.
In summary, the amount of expenditure in relation to exempt income has two aspects
- (a) direct and (b) indirect. The direct expenditure is straightaway taken
into account by virtue of clause (i) of sub-rule (2) of rule 8D. The indirect
expenditure is again split in two sub parts i.e. interest expenditure and other
expenditure. In case of (indirect) interest, the disallowance is computed
through the principle of apportionment, as indicated above. In cases other
indirect expenditure, a rule of thumb figure of one half per cent of the average
value of the investment, income from which does not or shall not form part of the
total income, is taken.
It is the aggregate of these three components which would constitute the
expenditure in relation to exempt income and it is this amount of expenditure which
would be disallowed under section 14A.
Summary of some of the leading judicial rulings on disallowance under section
14A
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Citation
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Key observations
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Commissioner of Income-tax, Mumbai v. Walfort Share & Stock Brokers (P.)
Ltd. [2010] 192 TAXMAN 211 (SC)
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The insertion of section 14A with
retrospective effect is the serious attempt on the part of the Parliament not
to allow deduction in respect of any expenditure incurred by the assessee in
relation to income, which does not form part of the total income under the Act
against the taxable income.
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Section 14A clarifies that expenses
incurred can be allowed only to the extent they are relatable to the earning of
taxable income.
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The basic principle of taxation is to tax
the net income, i.e., gross income minus the expenditure. On the same analogy
the exemption is also in respect of net income. Expenses allowed can only be in
respect of earning of taxable income. This is the purport of section 14A.
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The permissible deductions enumerated in
sections 15 to 59 are now to be allowed only with, reference to income which is
brought under one of the above heads and is chargeable to tax. If an income
like dividend income is not a part of the total income, the
expenditure/deduction though of the nature specified in sections 15 to 59 but
related to the income not forming part of total income could not be allowed
against other income includible in the total income for the purpose of
chargeability to tax.
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The theory of apportionment of expenditures
between taxable and non-taxable has, in principle, been now widened under
section 14A.
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For attracting section 14A, there has to be
a proximate cause for disallowance, which is its relationship with the tax
exempt income. In the absence of such proximate cause for disallowance,
section 14A cannot be invoked.
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Godrej & Boyce Mfg. Co. Ltd. v. Deputy Commissioner of Income-tax, Range
10(2), Mumbai [2010] 194 TAXMAN 203 (Bom.)
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Sub-section (2) of section 14A
prescribes a uniform method for determining the amount of expenditure incurred
in relation to income which does not form part of the total income only in a
situation where 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 an expenditure.
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The Parliament has provided an
adequate safeguard to the invocation of the power to determine the expenditure
incurred in relation to the earning of non-taxable income by adoption of the
prescribed method. The invocation of the power is made conditional on the
objective satisfaction of the Assessing Officer in regard to the correctness of
the claim of the assessee, having regard to the accounts of the assessee.
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Sub-section (2) of section 14A does
not authorise or empower the Assessing Officer to apply the prescribed method
irrespective of the nature of the claim made by the assessee. The Assessing
Officer has to first consider the correctness of the claim of the assessee
having regard to the accounts of the assessee. The satisfaction of the
Assessing Officer has to be objectively arrived at on the basis of those
accounts, after considering all the relevant facts and circumstances. The
application of the prescribed method arises in a situation where the claim made
by the assessee in respect of expenditure which is relatable to the earning of
income which does not form part of the total income under the Act is found to
be incorrect.
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In such a situation, a method has to
be devised for apportioning the expenditure incurred by the assessee between
what is incurred in relation to the earning of taxable income and that which is
incurred in relation to the earning of non-taxable income.
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Rule 8D which has been notified on
24-3-2008 would apply with effect from the assessment year 2008-09. The rule,
consequently, could not have an application in respect of the assessment year
2002-03 which was the year under consideration in the instant case.
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Even in the absence of sub-sections
(2) and (3) of section 14A and of rule 8D, the Assessing Officer was not
precluded from making apportionment. Such an apportionment would have to be
made in order to give effect to the substantive provisions of sub-section (1)
of section 14A which provides that no deduction would be allowed in respect of
expenditure incurred in relation to income which does not form part of the
total income under the Act. Consequently, de hors the provisions of
sub-sections (2) and (3) of section 14A and rule 8D, the Assessing Officer was
entitled to determine by the application of a reasonable method as to what
quantum of the expenditure incurred by the assessee would have to be disallowed
on the ground that it was incurred in relation to the earning of income which
does not form part of the total income under the Act. Undoubtedly, in
determining what would constitute a reasonable method for effecting the
disallowance, the Assessing Officer would have to give due regard to all the
facts and circumstances of the case.
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Commissioner of Income Tax vs. Winsome Textile Industries Ltd. (2009) 319
ITR 204 (P&H)
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Even if deduction under s. 36(1)(iii) is
ordinarily available in respect of borrowed funds utilised for the purpose of
business s. 14A carves out an exception insofar as any expenditure which is
relatable to the earning of dividend income not subject to tax is to be
disallowed.
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It is to be ascertained as to whether the
assessee has made the investment in purchase of shares out of borrowed funds or
invested its own funds. If the assessee has invested its own money in the
purchase of shares then there is no question of any disallowance in respect of
interest on borrowed funds under s. 14A. However, if the borrowed funds have
been utilised for purchase of shares of M/s Winsome Yarns Ltd., disallowance
under s. 14A shall have to be calculated even when investment has been made in
the course of business of the assessee and the assessee qualifies for deduction
under s. 36(1)(iii).
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Disallowance has got to be made under s.
14A if any expenditure relating to the earning of income which is not
chargeable to tax has been debited to the accounts by the assessee.
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CIT-vs- Hero Cycles 323 ITR 158 (P &H)
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The contention of the revenue, that
directly or indirectly some expenditure is always incurred, which must be
disallowed under section 14A, and the impact of expenditure so incurred cannot
be allowed to be set off against the business income which may nullify the
mandate of section 14A, could not be accepted
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Disallowance under section 14A requires
finding of incurring of expenditure. Where it is found that for earning
exempted income no expenditure has been incurred, disallowance under section
14A cannot stand.
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Maxopp Investment Ltd. v. Commissioner of Income-tax, New Delhi 247 CTR 162
(Del)
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The expression 'in relation to'
appearing in section 14A cannot be ascribed a narrow or constricted meaning.
The expression 'in relation to' does not have any embedded object. It simply
means 'in connection with' or 'pertaining to'. If the expenditure in question
has a relation or connection with or pertains to exempt income, it cannot be
allowed as a deduction even if it otherwise qualifies under the other
provisions of the said Act.
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While the expression 'expenditure
incurred' refers to actual expenditure and not to some imagined expenditure, it
is to be made clear that the 'actual' expenditure that is in contemplation
under section 14A(1) is the 'actual' expenditure in relation to or in
connection with or pertaining to exempt income. The corollary to this is that
if no expenditure is incurred in relation to the exempt income, no disallowance
can be made under section 14A.
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The requirement of the Assessing
Officer embarking upon a determination of the amount of expenditure incurred in
relation to exempt income would be triggered only if the Assessing Officer
returns a finding that he is not satisfied with the correctness of the claim of
the assessee in respect of such expenditure.
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Sub-section (3) is nothing but an offshoot
of sub-section (2) of Section 14A. Sub-section (3) applies to cases where the
assessee claims that no expenditure has been incurred in relation to income
which does not form part of the total income under the said Act. In other
words, sub-section (2) deals with cases where the assessee specifies a positive
amount of expenditure in relation to income which does not form part of the
total income under the said Act and sub-section (3) applies to cases where the
assessee asserts that no expenditure had been incurred in relation to exempt
income. In both cases, the Assessing Officer, if satisfied with the correctness
of the claim of the assessee in respect of such expenditure or no expenditure,
as the case may be, cannot embark upon a determination of the amount of
expenditure in accordance with any prescribed method, as mentioned in sub-
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section (2) of Section 14A of the
said Act. It is only if the Assessing Officer is not satisfied with the
correctness of the claim of the assessee, in both cases, that the Assessing
Officer gets jurisdiction to determine the amount of expenditure incurred in
relation to such income which does not form part of the total income under the
said Act in accordance with the prescribed method.
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Gillette Group India (P.) Ltd. v. Assistant Commissioner of Income-tax,
Circle 12(1) [2012] 22 taxmann.com 61 (Delhi)
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Justice Sam P. Bharucha v. Additional Commissioner of Income-tax-11(3),
Mumbai [2012] 25 taxmann.com 381 (Mum.)
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Section 14A has within its implicit notion
of apportionment in the cases where the expenditure is incurred for the
composite / indivisible activities in respect of which taxable and non-taxable
income is received. But 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, then principle of apportionment embedded in
section 14A has no application
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In order to disallow the expenditure under
section 14A, there must be a live nexus between the expenditure incurred and
the income not forming part of total income. A notional expenditure cannot be
apportioned for the purpose of earning exempt income unless there is an actual
expenditure in relation to earning the income not forming part of total income.
If the expenditure is incurred with an aim to earn taxable income and there is
apparent dominant and immediate connection between the expenditure incurred and
taxable income, then no disallowance can be made under section 14A merely
because some tax exempt income is received by the assessee.
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It is not the case of the revenue that the
assessee has used his official machinery and establishment for earning the
exempt income. The Assessing Officer has not given any finding of fact that any
of the expenditure that is incurred and claimed by the assessee is attributable
for earning the exempt income. In other words, the Assessing Officer has not
indicated that certain expenditure is not incurred for earning the professional
income, but is incurred in relation to dividend income or such expenditure is
incurred for inseparable and indivisible activities comprising professional as
well as the activities on which is exempt income has been earned by the
assessee. In the absence of any such instance of expenditure, finding of
Assessing Officer or any material to show that the expenditure incurred and
claimed by the assessee against the taxable income has any relation for earning
the exempt income, the provisions of section 14A cannot be applied
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CCI Ltd. v. Joint Commissioner of Income-tax, Udupi Range [2012] 20
taxmann.com 196 (Kar.)
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When no expenditure is incurred by the
assessee in earning the dividend income, no notional expenditure could be
deducted from the said income.
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Though the dividend income is exempted from
payment of tax, if any expenditure is incurred in earning the said income, the
said expenditure also cannot be deducted. But in this case, when the assessee
has not retained shares with the intention of earning dividend income and the
dividend income is incidental to its business of sale of shares, which remained
unsold by the assessee, it cannot be said that the expenditure incurred in
acquiring the shares has to be apportioned to the extent of dividend income and
that should be disallowed from deductions.
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Cheminvest Ltd. v. Income-tax Officer, Ward 3(3), New Delhi 2009] 121 ITD
318 (Delhi)(SB)
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The controversy raised in the instant case
was that the assessee had not earned or received any dividend in the year under
consideration and, therefore, no disallowance could be made by invoking the
provisions of section 14A. There was no force in the said contention of the
assessee. When the expenditure of interest is incurred in relation to income
which does not form part of total income, it has to suffer the disallowance,
irrespective of the fact whether any income is earned by the assessee or not.
Section 14A does not envisage any such exception.
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CIT vs Popular Vehicles And Services Ltd 325 ITR 523 (Ker)
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The share income from the partnership firm
which is the only consideration for advancing the loan to the firm does not
constitute income of the respondent u/s 10(2A) of the I.T. Act. Since the share
income from the firm does not constitute the part of taxable income of the
assessee, section 14A (1) applies which prohibits the deduction of any
expenditure incurred in relation to income not includible in total income
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Dharmasingh M. Popat v. Assistant Commissioner of Income-tax [2010] 127 TTJ
61(MUM.)
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** the key
observations have been reproduced verbatim from the ruling itself. While these
observations may serve as guiding principles, applicability to a case would need to
be evaluation on the basis of current judicial position, specific facts and
circumstances
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