Expense disallowed in relation to Exempt Income (Section 14A)

Expense disallowed in relation to Exempt Income (Section 14A) by CA. PRAMOD JAIN FCA, FCS, FCMA, DISA, MIMA LUNAWAT & CO.

Periods Before14 A Amended 14A Original 14A Rule 8 D

Background Rajasthan State Warehousing Corporation vs. CIT (2000) 242 ITR 450 (SC) S. 14A inserted by Finance Act, 2001 w.r.e.f. 1.4.1962. Memorandum explaining the introduction says: exemptions to certain categories of income are used to reduce the tax payable on non exempt income by debiting expenses incurred to earn the exempt income against taxable income. This is against the basic principle of taxation whereby only net income is taxed.expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income.

Section -14A For purposes of computing TI under this chapter, no deduction shall be allowed in respect of expenditure incurred by the assesseein relation to income which does not form part of TI under this Act. Provided that nothing contained in this section shall empower the AO either to reassess u/s 147 or pass an order enhancing the assessment or reducing a refund already made or otherwise increasing the liability of the assesseeu/s 154, for any AY beginning on or before 1.4.2001.

The Proviso Circular No. 11/2001, dated 23-7-2001 was converted into statutory provision by Finance Act 2002 w.r.e.f. 11.5.2001 The proviso to sec 14A bars reassessment but not original assessment -assessment done after insertion of section 14A- Honda SielPower Products Ltd. Vs. Dy. CIT [2011 ITRV SC 181]; (2011) 197 Taxman 415 (Delhi). AY 2000 01 Bar under Circular No.11 on reopening of concluded assessment would not operate where assessment was pending finalization after remand by first appellate authority in appeal filed by assessee- Catholic Syrian Bank Ltd. V. CIT [2011 ITRV HC KER 023]; (2010) 187 Taxman 185(Ker.)

The Proviso Where order of CIT under section 263 was passed earlier i.e. on 29/12/1999, the protection under the proviso is not available Mahesh G. Shetty& Ors. V. CIT [2011-ITRV-HC-KAR-053] Issue to invoke section 14A cannot be raised before the ITAT for the first time ACIT v. DeliteEnterprises (P.) Ltd. (2011)50 DTR 193 (MUM.) (Trib.)

Heads of Income The provisions of section 14A will apply to all income which is exempt whether the income is assessed under the head Other sources or under the head Business because there is nothing in Section 14A which restricts the operation of section to income of a particular nature only -InsaallahInvestments Ltd. V. ITO (2008) 23 SOT 130 (DEL Trib)

Expenditure Incurred Covers all forms of expenditure regardless of whether it is fixed, variable, direct, indirect, administrative, managerial or financial. KalpataruConstruction Overseas (P.) Ltd. v. Dy. CIT [2007] 13 SOT 194 (Mum. Trib.) Parry Agro Industries v. Asst. CIT 314 ITR (AT) 181(2009) (Cochin) Expenditure to be incurred actually and not notionally. AO should be in a position to pinpoint, with an acceptable degree of accuracy, the expenditure which was incurred by assessee to produce non-taxable income Asstt. CIT v. Eicher Ltd. [2006] 101 TTJ (Delhi Trib.) 369 Wimco Seedlings Ltd. vdy. CIT[2007] 107 ITD 267 (Del)(TM)

Expenditure in relation to Only expenditure which has been proved to be incurred in relation to earning of tax free income can be disallowed and section cannot be extended to disallow even expenditure which is assumed to have been incurred for earning tax free income. Common expenditure incurred cannot be broken artificially to apportion a part thereof to earning of tax free income on assumption that such part of common expenditure was incurred in relation to tax free income. DLF Ltd. v. CIT [2009] 27 SOT 22 (DELHI)

Allowances & Deductions Is depreciation covered u/s 14A?? Is 14A applicable on deductions under Chapter VIA?? HoshangD. Nanavativs. ACIT [2011-ITRV-ITAT-MUM-082] Vishnu Anant Mahajan vs. ACIT [2012-ITRV-ITAT-AHD-115] SB Applies to Partnership profits too Vishnu Anant Mahajan vs. ACIT [2012-ITRV-ITAT-AHD-115] SB CIT v. Popular Vehicles & Services Ltd. [2010] 189 Taxman 14 (Ker)

Nexus Nexus of interest expenditure directly or indirectly attributing to earn dividend income is necessary CIT vs. K. Raheja Corporation Pvt. Ltd. [2011-ITRV-HC-MUM-184] MindaInvestments Ltd. vs. DCIT [2010-ITRV-ITAT-DEL-097] ACIT vs. SIL Investment Ltd [2012-ITRV-ITAT-DEL-087] Justice Sam P Bharucha vs. Addl. CIT [2012-ITRV-ITAT-MUM-255] Ground that assesseeought not to have used own funds for tax-free investments is invalid. It was the prerogative of the assesseeto use its own fund in the manner in which it considers proper and the Revenue cannot dictate how the funds should be used CIT vs. Gujarat Power Corporation Ltd. [2011-ITRV-HC-GUJ-066] Godrej Industries Ltd. v. DCIT, [2011-ITRV-ITAT-MUM-096 ] Godrej Agrovet Ltd vs. ACIT [2010-ITRV-ITAT-MUM-086 ]

Mixed Funds Even if the assesseehad made investment in shares out of its own funds, the assesseehad taken loans on which interest was paid and all the money available with the assesseewas in common kitty, as held by this court in and, therefore, disallowance u/s 14A was Justified -CIT v. Abhishek Industries Ltd. [2006] 286 ITR 1 (P&H) Not justified - CIT vs. Lubi Submersibles Ltd. [2011-ITRV- HC-GUJ-191 ] AY 2001-02 Not Justified -Dy. CIT vs. Maharashtra Seamless Ltd. [2011-ITRV-ITAT-DEL-004]

Existence of exempt income No disallowance if no exempt income during yr Jt. CIT v. Holland Equipment Co. B.V. [2005] 3 SOT 810 (Mum.) AY 1995-96 ACIT v. Lafarge India Holding (P.) Ltd. [2008] 19 SOT 121 (Mum.) Disallowance even if no exempt income during yr CheminvestLtd. V. ITO 121 ITD 318 (2009) ITAT (Del)(SB)] No disallowance if tax-free investments are capable of taxable income Avshesh Mercantile P. Ltd. vs. DCIT [2012-ITRV-ITAT-MUM-140] Partnership Firm loss during the year interest paid. Disallowance u/s 14A? No CIT vs. Delite Enterprises [2012-ITRV-HC-MUM-138]

Statutory Compliances The expenses, if at all were expenses, they were incurred not for earning tax-free income but for maintaining the required SLR. The tax-free interest is only an incidence on fulfillment of SLR requirements. Then, section 14A has no application in this case. State Bank of Travancore Vs. Assit. CIT [2009] 318 ITR (AT) 171- (ITAT-COCHIN )

Interest capitalized Where the interest on borrowings made for investment in shares is capitalised, since in such a case interest paid is not in relation to exempt income, but as part of cost of share, such interest could not be disallowed u/s 14A -S. BalanV. Dy. CIT 120 ITD 469 (2009) ITAT(Pune) Interest paid on borrowed funds utilized for the purpose of investment in shares was not to be allowed as either an expenditure or as part of cost of acquisition of the shares, in view of the provisions of section 14A as the shares were not sold during the year-harish KrishnakantBhatt v. ITO [2004] 85 TTJ 872

Personal Tax Free Income Would personal Tax Free income like PPF Interest, dividend, etc come under 14A purview? The assesseeis maintaining separate books of account for the purpose of business. The tax-free investments are in his personal capacity. As the Assessing Officer has not disallowed any expenditure of personal nature out of the business income, the expenditure claimed in the business of share dealings cannot be correlated to the incomes earned in personal capacity that too on dividend, PPF interest and tax free interest on RBI bonds Accordingly, the estimation of expenditure out of business expenditure as being incurred for earning tax free income is not acceptable. Pawan Kumar Parmeshwarlalvs. ACIT [2011-ITRV-ITAT-MUM-006]

Applicability in case of Chapter VIA Expenditure incurred for earning of export income which is exempt u/s80hhc, cannot be held to be income which does not form part of total income. Such expenses cannot be disallowed u/s14a -CIT v. Kings exports 318 ITR 100 (2009) (Punj. & Har.) Section 14A could not be applied to provisions of Chapter VI-A where deductions are to be made in computing the total income and in no way that can be compared with the exempted income which does not form part of the total income-acit v. Tamil Nadu Silk Producers Federation Ltd. [2006] 103 TTJ (Chennai) 716]; ACIT vs. Bank of Madura [2011] 007 ITR (Trib) 139 ITAT [chen] Deduction of income derived by a co-operative society u/s 80P is not a case of exempt income but of deduction from income. Therefore provisions of sec.14a are not applicable in this case ACIT Vs. Kribhco 6 ITR 686 (2010) (ITAT Del)

Investment company In case of an investment company, where the business of the company is to invest its funds in the share of sister concerns and other companies and also deposit the money with group concerns on which interest is received, the infrastructure of the company is utilized for the purpose of carrying out its objects, i.e., investment in other concerns and also earning income on such investments. In such a case, assesseeis required to furnish details of expenditure incurred on salary of staff utilized for the object of assessee company, which would be disallowed otherwise it would be disallowed under section14a on estimate basis Dy. CIT V. Tata Investment Corporation Ltd. (2007) 295 ITR 330(Mum Trib)

Separate books? Section 14A authorisesao to make disallowance of expenditure incurred for earning tax free income, irrespective of whether assesseemaintained separate accounts or not with regard to expenditure incurred for earning non-taxable income. CIT v. The Catholic Syrian Bank Ltd. [ 2011 ITRV HC KER 023 ] Non maintenance of separate accounts by assessee with regard to expenditure incurred for earning non taxable income was not justification to claim immunity from operation of section14a. CIT v. DhanalakshmyBank Ltd, [2011] 10 taxmann.com 213(Ker.)

Section -14A Finance Act 2006 inserted s.ss (2) & (3) w.e.f. AY 2007 08: 1. For purposes of computing TI under this chapter, no deduction shall be allowed in respect of expenditure incurredby the assesseein relation to income which does not form part of TI under this Act. 2. The AO shall determine the amount of expenditure incurred in relation to such income which does not form part of the TI under this Act in accordance with such method as may be prescribed, ifthe AO, having regard to the accounts of the assessee, is not satisfied with the correctness of the claim of the assesseein respect of such expenditure in relation to income which does not form part of TI under this Act

Section -14A 3. The provisions of sub section (2) shall also apply in relation to a case where an assesseeclaims that no expenditure has been incurred by him in relation to income which does not form part of the total income under this Act 4. Provided that nothing contained in this section shall empower the AO either to reassess u/s 147 or pass an order enhancing the assessment or reducing a refund already made or otherwise increasing the liability of the assesseeu/s 154, for any AY beginning on or before 1.4.2001.

Rule 8 D Inserted vide notification No. S.O. 547(E) on 24-3-2008 Total 3 sub-rules. Sub-rule (1) Where the AO, having regard to the accounts of the assesseeof a P.Y., is not satisfied with (a) correctness of the claim of expenditure made by the assessee; or (b) the claim made by the assesseethat no expenditure has been incurred, in relation to income which does not form part of the total income under the Act for such P. Y., he shall determine the amount of expenditure in relation to such income in accordance with the provisions of sub-rule (2).

Rule 8 D Sub-rule (2). The expenditure shall be aggregate of following amounts (i.e., 1+2+3) namely: 1. Expenditure directly relating to income which does not form part of total income 2. In a case where the assesseehas incurred expenditure by way of interestduring the P.Y., 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 A = amount of expenditure by way of interest other than amount of interest included in clause (1) incurred during P.Y. B= 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, on the first day and the last day of the P. Y. C = average of total assets as appearing in the balance sheet, on the first day and the last day of the previous year.

Rule 8 D 3. An amount equal to 1/2% 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 P.Y. Sub-rule (3). 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.

Example of calculation u/r 8D Liabilities 31.3.13 31.3.12 Assets 31.3.13 31.3.12 Eq. Share capital 125 100 Fixed Assets 150 100 Loans for Investment in Shares & MF Balance Sheet as on 31 st March 2013 100 50 Shares 150 100 Other loans 400 350 Trade Receivable 60 50 Trade payables 200 150 Mutual Funds 190 150 Inventories 225 200 Cash and Bank 50 50 Total 825 650 Total 825 650 For the year ending 31 03 2013, assesseeearned dividend income Rs. 10 lacs, & interest on MF Rs. 15 Lacs. Interest paid on loans: For Investment in shares & MF Rs. 6 Lacs For other loans Rs. 28 Lacs

Example of calculation u/r 8D 1.Exp. directly related to exempt income= int. paid on loan for investment in shares & MF= 6 Lacs 2.Proportionate exp. of int.= exp by way of interest not directly related to exempt income X average value of invt. / average value of total assets A = 28 B = (150 + 100 + 190 + 150) / 2 = 295 C = (825 + 650) / 2 = 737.5 i.e( AX B/C)= 28 X 295 / 737.5 = 11.2 Lacs 3.½% of avgvalue of invt. = 295 X ½% = 1.475 Lacs Total Disallowance = 1+2+3 i.e., 6 + 11.2 + 1.475 = 18.675

Is 14A & 8D constitutionally valid? Special Bench in DagaCapital 117 ITD 169 (Mum) held that s. 14A(2) &(3)& Rule 8D are procedural in nature and have retrospective effect Several controversies settled in Godrej & Boyce Mfg. Co. Ltd. v. DCIT [2010-ITRV-HC-MUM-077]/ [2010] 328 ITR 81 (BOM.) The argument that dividend on shares / units is not taxfree in view of the dividend distribution tax paid by the payer u/s 115 O is not acceptable because such tax is not paid on behalf of the shareholder but is paid in respect of the payer s own liability. Once a proximate cause for disallowance is established which is the relationship of the expenditure with income which does not form part of the total income a disallowance u/s 14A has to be effected.

Is 14A & 8D constitutionally valid? S 14A is founded on a valid rationalethat the basic principle of taxation is to tax net income i.e gross income minus expenditure The AO cannot ipso facto apply Rule 8D but can do so only where he records satisfaction on an objective basis that the assessee is unable to establish the correctness of its claim Rule 8D inserted w.e.f24.3.2008 cannot be regarded as retrospectivebecause it enacts an artificial method of estimating expenditure relatable to tax free income. Applies w.e.f AY 2008-9 For the AYs where Rule 8D does not apply, the AO will have to determine the quantum of disallowable expenditure by a reasonable method having regard to all facts and circumstances Even though Rule 8D did not apply to AY 02-03, the AO had to consider whether disallowance could be made u/s 14A(1). Also, the principle of consistency would not apply as s. 14A had introduced a material change in the law

Nexus between expenditure & income After Rule 8D of S. 14A, is actual nexus between tax free income and expenditure required to be proved?? CIT v. Hero Cycles Ltd. [2010] 323 ITR 518 (P&H);[2009 ITRV HC P&H 11] Y CIT vs. WalfortShare and Stock Private Limited [2010] 326 ITR 1(SC); [2010 ITRV SC 070] DCIT vs. Allied Investments Housing P. Ltd. [2013 ITRV ITAT CHN 164] Justice Sam P Bharucha vs. Addl. CIT [2012 ITRV ITAT MUM 255] ACIT vs. Punjab State Co op & Marketing Ltd. [2011 ITRV ITAT CHD 230] AY 2007 08 S. 14A disallowance cannot exceed exempt income

Satisfaction of AO It is a pre requisite that before invoking Rule 8D, the AO must record his satisfaction on how the assessee s calculation is incorrect. AO cannot apply Rule 8D without pointing out any inaccuracy in method of apportionment or allocation of expenses. Onus is on AO to show that expenditure has been incurred by assessee for earning tax free income. Without discharging the onus, AO is not entitled to make an ad hoc disallowance DCIT vs. JindalPhoto Ltd. [2011 ITRV ITAT DEL 229] AY 2008-09 AY 2007-08 followed AO has to show how assesseeis wrong even if he claims no expenditure was incurred DCIT vs. Ashish Jhunjhunwala[2013 ITRV ITAT KOL 071]

MaxxopInvestment Ltd. vs. CIT Batch of 21 appeals decided on 14A read with Rule 8D [2011-ITRV-HC-DEL-253] The argument that if the dominant and main objective of the expenditure was not the earning of exempt income then, the expenditure cannot be disallowed u/s 14A is not acceptable. The expression in relation to cannot be given a narrow meaning and simply means in connection with or pertaining to. The expression expenditure incurred in s. 14A refers to actual expenditure and not to some imagined expenditure. If no expenditure is incurred in relation to exempt income, no disallowance can be made u/s 14A

MaxxopInvestment The AO cannot proceed to determine the amount of expenditure incurred in relation to exempt income without recording a finding that he is not satisfied with the correctness of the claim of the assessee. This is a condition precedent. Rule 8D comes into play only when the AO records a finding that he is not satisfied with the assessee smethod. Though s. 14A(2) &(3) were inserted w.e.f. 1.4.1962, Rule 8D was inserted on 24.03.2008. Accordingly, Rule 8D would operate prospectively. For periods prior to Rule 8D, the AO will have to adopt a reasonable method on the basis of objective criteria to determine the expenditure. However, here also, he will have to show why he is not satisfied with the correctness of the assessee sclaim

When can Rule 8D be applied? The satisfaction of AO as to incorrect claim made by the assesseeis sine qua non for invoking the applicability of Rule 8D. The satisfaction can be reached only when claim of the assesseeis verified. If the assesseeproves before AO that it incurred a particular expenditure in respect of earning the exempt income and the AO is satisfied, then there is no requirement to proceed with the computation under Rule 8D. Rule 8D is not automatic. The correct sequence for making any disallowance u/s14a is to, firstly, examine the assessee sclaim of having incurred some expenditure or no expenditure in relation to exempt income.

When can Rule 8D be applied? If the AO is satisfied with the same, then there is no need to compute disallowance as per Rule 8D. It is only when the AO is not satisfied with the correctness of the claim of the assesseein respect of such expenditure or no expenditure having been incurred in relation to exempt income, that the mandate of Rule 8D will operate. Auchtel Products Ltd vs. ACIT [2012-ITRV-ITAT-MUM-109]

Extent of disallowance Dividend Income 1 Cr; Exempt LTCG 5 Cr Expenses 25 Lacs; including interest 2 L Average investments 100 Cr How much should be disallowance? Gillette Group India Pvt. Ltd. vs. ACIT- [2012-ITRV-ITAT-DEL-66] Not exceeding exp incurred

Rule 8D(ii) ABC P. Ltd. engaged in business of running vehicles on hire: Investment in shares 100 L; Total Assets 1000 L Interest paid on borrowing for investments (income being tax free) -1L Interest paid on borrowing for vehicles put on hiring business 9 L. Total interest -10 L How much is interest disallowable u/r 8D(ii)?

Rule 8D(ii) In Godrej & Boyce Mfg Co Ltd328 ITR 81 (Bom)/[ 2010 ITRV HC MUM 077 ], the department took the stand, to defend the constitutional validityof Rule 8 D, that both, interest directly attributable to tax exempt income as well as interest directly relatable to taxable income would be excluded from the definition of variable A in Rule 8D(ii) formula. Accordingly, correct application of formula set out in Rule 8D(2)(ii) is, that interest expenses directly attributable to tax exempt income as alsodirectly attributable to taxable income have to be excludedfrom the computation of common interest expenses to be allocated u/r 8D(2)(ii) ACIT vs. Champion Commercial Co. Ltd. [2012 ITRV ITAT KOL 243]

Specific Expenditure Can expenditure specifically incurred for taxable income disallowed?? JCIT (OSD) vs. PilaniInvestment & Industries Corpn. Ltd. [2013-ITRV-ITAT-KOL-026] N ACIT vs. Best & Crompton Engineering Ltd [2013-ITRV- ITAT-CHN-100] REI Agro Ltd. vs. DCIT [2013-ITRV-ITAT-KOL-088]

No exempt income during year Rule 8D(2)(ii), numerator B average value of invest., income from which does not form or shall not form part of TI as appearing in the balance-sheet as on first day and in last day of the previous year. It is not total investment at beginning and at end of year, which is to be considered but it is average of the value of investments which has given rise to income which does not form part of total income which is to be considered. Rule 8D(2)(iii), what is disallowable is an amount equal to ½ percentage of the average value of investment the income from which does not or shall not form part of the total income The disallowance u/s 14A read with rule 8D is to be in relation to the income which does not form part of total income and this can be done only by taking into consideration invest. which has given rise to this income which does not form part of the total income. REI Agro Ltd. vs. DCIT [2013 ITRV ITAT KOL 088]

Stock-in-trade Is s. 14A / R 8D applicable on invest. held as stock in trade?? Yes D. H. Securities P. Ltd. vs. DCIT [2013-ITRV-ITAT-MUM-160] DagaCapital 117 ITD 169 (Mum)(SB) Esquire Pvt. Ltd. vs. DCIT [2012-ITRV-ITAT-MUM-204] JCIT vs. American Express Bank Ltd. [2012-ITRV-ITAT-MUM-174] No CCI Ltd 71 DTR (Kar) 141 [2012-ITRV-HC-KAR-075], Smt. Apporva Patni vs. Addl. CIT [2012- ITRV-ITAT-PUNE-282] EthioPlastic Pvt. Ltd. vs. DCIT [2012-ITRV-ITAT-AHD-283] DCIT vs. Gulshan Investment Co. Ltd. [2013-ITRV-ITAT-KOL-032] Esquire Pvt. Ltd. vs. DCIT [2012-ITRVITAT-MUM-204] Yatish Trading vs. ACIT [2011-ITRV-ITAT-MUM-071]

Stock-in-trade The argument that all expenditure has been incurred for share trading business and that there is no additional expenditure incurred for earning dividend is not acceptable because though the expenditure is incurred for purpose of the business of share trading, the said business yields taxable and non-taxable income If Rule 8D(2)(ii) which quantifies the interest on investments, income from which is not taxable, on a proportionate basis, is applied literally, it will lead to absurd results. Rule 8D(2)(ii) needs to be scaled down by bifurcating the expenditure so arrived at between the tax-free and the taxable incomes. Given that the dominant objective of the share holding is to earn share trading income, an ad hoc ratio of 20% toward tax-exempt dividend income will be reasonable. DCIT vs. Damani Estates& Finance Pvt. Ltd [2013-ITRV-ITAT- MUM-106]

Other points Can expenditure on acquiring shares out of commercial expediency disallowed?? CIT vs. Oriental Structural Engineers P. Ltd.[2013 ITRV HC DEL 163] N Does S. 14A/ Rule 8D apply to short-term investments? Sundaram Asset Management Co. Ltd. vs. DCIT [2013 ITRV ITAT CHN 099] N Interest paid 5 L, interest received 2 L. How much to be considered for Rule 8D? ITO vs. Karnavati Petrochmem Pvt. Ltd. [2013 ITRV ITAT AHD 105] net

MAT Section 115 JB provides for increasing the book profit by the amount of expenditure relatable to any income to which section 10 [other than 10(38)] applies and reducing the book profit by the amount of income to which section 10 [other than sec. 10(38)] applies. Now that the method is in place, the rigmarole of determining the amount of expenditure to be added and year of applicability of the prescribed method has to be undergone.

Tax Audit Para 17(l) of Form 3CD Amounts debited to the P & L A/c being.. Amount of deduction inadmissible in terms of section 14A in respect of the expenditure incurred in relation to income which does not form part of the total income

271 (1) (c) Penalty By applying the prescribed method under rule 8D, addition by way of disallowance of expenditure under section 14A is made, we have to ascertain whether or not the assesseehas furnished inaccurate particulars in the course of assessment proceedings. If the assesseeoffers an explanation which is not found by the AO to be false there is no need to invoke this penal provision. No Penalty if no disallowance is made in tax audit report also as there is difference of opinion. Dy. CIT vs. NalwaInvestments Ltd. [2011-ITRV-ITAT-DEL-114]

CA. Pramod Jain pramodjain@lunawat.com +91 9811073867 2014 CA. Pramod Jain,