COMPILATION OF PRONOUNCEMENTS U/S 14A OF THE INCOME-TAX ACT,1961.
Legislative history and purpose of Sec. 14A
Section 14A has been inserted in Chapter IV of the Income-tax Act by the FinanceAct 2001, with retrospective effect from April 1, 1962. This Section provided fordisallowance of expenditure incurred in relation to income which is not included inthe total income of the assessee. The retrospective amendment follows the positionin law as laid down by the Supreme Court in CIT vs Indian Bank Ltd. ((56 ITR 77)),CIT vs Maharashtra Sugar Mills Ltd. [TS-3-SC-1971] and Rajasthan StateWarehousing Corporation vs CIT [TS-7-SC-2000]. It aims to prevent misuse of theserulings by certain assesses to reduce the tax payable on taxable income by adjustingthe expenditure incurred in relation to income which does not form part of the totalincome under the Act.
Purpose of Sec. 14A
In practice, in certain cases, it was noticed that there was misuse of the abovementioned principle in adjusting expenses relating to exempt income against thetaxable income to reduce the tax liability. The introduction of Sec 14A was meant tocurb the said practice. Accordingly, Sec 14A was inserted by Finance Act, 2001 so
as to clarify the intention of the Legislature since the inception of Income-tax Act1961, that no deduction shall be made in respect of any expenditure incurred by theassessee in relation to income which does not form part of the total income. Further,the amendment will apply retrospectively from AY 1962-63 onwards.
The basic principle of taxation is to tax the net income, i.e. gross incomeminus the expenditure. On the same analogy, the exemption too, is in respectof the net income. Expenses allowed can only be in respect of earning of taxableincome. This is the purport of Sec. 14A.
- In this section, the first phrase is 'for thepurposes of computing the total income under this chapter' which makes it clear thatvarious heads of income, as prescribed under Chapter IV, would fall within Sec. 14A.
- The next phrase is 'in relation to income which does not form part of total incomeunder the Act'. It means that if certain income does not form part of the total income,then the related expenditure is outside the ambit of the applicability of Sec. 14A.
Analysis of Sec 14A(1)
The two expressions in this sub-section which have been a matter of judicial debateare 'incurred by the assessee' and 'in relation to' income which does not form part ofthe total income.
Meaning of terms used in Sec. 14A
Delhi High court in the case of Maxopp Investment Ltd. vs CIT [TS-668-HC-2011(Del)] observed, “While we agree that the expression ‘expenditure incurred’refers to actual expenditure and not to some imagined expenditure, we would like tomake it clear that the 'actual' expenditure that is in contemplation u/s 14A(1) of the
act is the actual expenditure in relation to or in connection with or pertaining toexempt income. The corollary to this is that if no expenditure is incurred in relation tothe exempt income, no disallowance can be made u/s 14A of the said Act.” Areference also was made to a similar finding by Punjab & Haryana High Court in the
case of CIT-II vs Hero Cycles Ltd. (323 ITR 518). A similar view was taken inMetalman Auto P Ltd. (336 ITR 434) (P&H HC).
However, the Delhi HC held that the phrase 'inrelation to' is of wide import and found 'the context (in Sec14A) does not
suggest that a narrow meaning ought to be given to the said expression'.
Accordingly, the expression 'in relation to' does not imply any dominant andimmediate purpose in the earning of exempt income and it will be understood in thenormal, natural sense without any restriction. Also, the expression 'in relation to'does not have any embedded object. It simply means 'in connection with' or
'pertaining to'. Accordingly, if the expenditure in question has a relation orconnection with or pertains to exempt income, it cannot be allowed asdeduction even if it otherwise qualifies under other provisions of the Act.
What constitutes exempt income?
Yet another issue is what constitutes exempt income. If a particular income likedividend has already been taxed u/s 115-0 of the Act, can it be called exemptincome or income not forming part of the total income? Courts and Tribunals havegiven very wide meaning to the scope of disallowance u/s 14A. Accordingly, income
covered in Sections 10, 10A, 10AA, 10B, 10BA, 10C as well as Chapter VIA, where100% exemption is allowable, will get covered u/s 14A for disallowance ofexpenditure relating to such income.
Reassessment / revision / rectification & Sec. 14A disallowance:-
The proviso to Sec.14A inserted by Finance Act, 2002 makes it clear that nothing inSec.14A empowered the assessing officer to either reassess u/s 147, or pass anorder enhancing the assessment or reducing the refund already made or otherwiseincreasing the liability of the assessee u/s 154, for any assessment year before 1stApril 2001.
Scope of Sub-Sections (2) and (3) of Section 14A and Rule 8DAnalysis of Sec. 14(2) and 14A(3)
Sub Section (2) provides the manner in which the Assessing Officer is to determinethe amount of expenditure incurred in relation to income not forming part of the totalincome. However, the Assessing officer would be called upon to do so only in theevent of his dissatisfaction with the correctness of the assessee’s claim in respect ofthe expenditure.
Sub-Section (3) is nothing but an offshoot of sub-section (2). It applies to caseswhere the assessee claims that no expenditure has been incurred in relation to theincome which does not form part of the total income. Under both sub-sections (2)and (3), the Assessing Officer gets jurisdiction to determine the amount of
expenditure incurred in relation to such income not forming part of the total income,only when he is not satisfied with the correctness of the claims of the assessee.
Effective date for applicability
Rule 8D was introduced on March 24, 2008 by CBDT vide Notification No. 45/2008,dated March 24, 2008 to take effect from AY 2008-09. It would be seen from thelegislative history and developments as described above that sub-sections (2) and(3) of Sec 14A remained empty shells and inoperative till A.Y.2008-09. Though they
were introduced with effect from April 1, 2007, in the absence of Rule 8D,subsections (2) and (3) lacked the 'prescribed method' for operationalization.
The operation of Rule 8D has been held to be prospectiveboth by Bombay HC in the case of Godrej & Boyce Mfg. Co. Ltd. and Delhi HC in thecase of Maxopp Investment Ltd. Bombay HC observed in this regard, 'unlessexpressly or by necessary implication, or contrary provision is made, noretrospective effect is to be given to any rule so as to prejudicially affect the interestsof the assessee. The Rules were notified to come into force on March 24, 2008.
From the above it is clear that, in effect, the provisions of sub sections (2) and (3) ofSection 14A would be workable only with effect from the date of introduction of Rule8D. This is so because prior to that date, there was no prescribed method and subsections
(2) and (3) of Sec.14A remained unworkable.
The only requirement was that such rejection must be for cogent
reasons and the AO was free to adopt any reasonable and acceptable method. Inaddition, the Assessing Officer will not have suomoto rights to resort to Rule 8D. It isimperative on part of the Assessing Officer to invoke Rule 8D, only if he isdissatisfied with the correctness of the quantum of disallowance admitted by the
assessee, or where the assessee claims that no expenditure has been incurred withrespect to exempt income. Rule 8D, as already stated, would apply from assessmentyear 2008-09. 'Even prior to the assessment year 2008-09, when Rule 8D was notapplicable, the assessing officer had to enforce the provisions of sub section (1) ofsec.14A.
Computation of disallowance
Rule 8D has three components.
- The first component is the amount of expendituredirectly relating to income not forming part of total income (Direct expenditure).
- Thesecond component is computed on the basis of the formula given therein. In thecase of interest expenditure which is not directly attributable to any particular incomeor receipt, the formula essentially apportions the amount of expenditure by way ofinterest (other than the amount of interest included in direct expenses as above),incurred during the previous year 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 averageof the total assets of the assessee.
- The third component is an artificial figure namely, a half percent 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 balancesheets of the assessee, on the first day and the last day of the previous year. It is theaggregate of the three components which would constitute the expenditure inrelation to exempt income and it is the amount of expenditure which would bedisallowed under section 14A of the Act.
There is a view that the method prescribed by Rule 8D seeks only to determine thenotional cost for holding/maintaining investments which may or may not yield anexempt income. It is a moot point whether such a notional cost has any truck with theactual expenditure incurred and claimed by the assessee. Also, one half percent ofthe average value of investment, referred as third component supra, is a rule of thethumb figure and its artificiality may tweak the expenditure to be disallowed
disproportionately, out of sync with the earning of the exempt income. Thisdisallowance may not have any relation, either to the exempt income or to theexpenditure claimed by the assessee. To that extent, it will be inequitable, and willrender the Rule 8D as being in excess of Sec.14A.
Compilation of rulings on Sec.14A:-
This compilation lists rulings delivered in the last 3 years on various issues in the context of Sec. 14A.
Sr.No:-1 Issue Case laws
Applicability of Sec14A to differentclasses ofassessees
Oriental Insurance Co. Ltd [130 TTJ 388 (Del.) (Trib.)]
A Delhi bench of ITAT held that Sec 14A was not applicable to insurance companies. ITAT observed that theincome of the insurance companies had to be computed u/s 44 read with Rule 5 of the First Schedule to IncomeTax Act, which is a specific provision overriding Sec 14A. Since, as per Sec 44 no head-wise bifurcation ofincome was required to be made in case of insurance companies, Sec 14A disallowance could not be made.
ITAT observed, “…it is not permissible to the Assessing Officer to travel beyond s. 44 and First Schedule of the
Income-tax Act.”
Birla Sunlife Insurance Co. Ltd [TS-23-ITAT-2010(Mum)]
Following Delhi ITAT decision in Oriental Insurance Co [130 TTJ 388 (Del.) (Trib.)], a Mumbai bench of ITAT heldthat Sec 14A disallowance was not attracted in case of a life insurance company due to the special provisionsrelating to their taxation (Section 44 read with Rule 5 of the First Schedule to the Act) .
Varun Shipping Company Ltd [144 TTJ 286 2011(Mum)]
A Mumbai bench of ITAT held that Sec. 14A was not applicable to a shipping company subject to tonnage tax.ITAT observed that as the income of the shipping business was computed as per the tonnage tax scheme, onlythose expenses, which pertained to the shipping business, were deemed to have been allowed. Thus, it could not
be said that the expenses in relation to earning dividend income were included in such expenses. Accordingly,ITAT held that the separate disallowance u/s 14A was not applicable and no addition on that account could bemade to the income from the shipping business computed under the tonnage tax scheme.
Sr.No:-2
Relevance ofpurpose ofinvestment forapplicability of Sec.14A
Dividend earned onshares held as stockin trade
CCI Ltd [TS-226-HC-2012 (Kar)]
Karnataka HC held that the disallowance u/s 14A was not applicable on shares held as stock in trade. HC heldthat the dividend income was incidental to the business of share trading and the expenditure was not incurredwith an intention to earn dividend. Since dividend was earned on unsold portion of shares, no expenditure could
be disallowed u/ 14A.
Yatish Trading Co. P Ltd [(2011)129 ITD 237 (Mum)]
Interest incurred for share trading activity could not be disallowed u/s 14A, as the earning of dividend was onlyincidental to the share trading activity. Simply because shares purchased for trading incidentally resulted in somedividend, it would not change the nature, character and purpose of the interest expenditure. In order to disallowexpenditure u/s 14A, there must be live nexus between the expenditure and earning of income. Disallowance of
administrative expenses on the basis of ratio of dividend income to taxable income was set aside. In case oftransactions of purchase and sale of shares, a reasonable basis of apportionment of expenditure could be thevolume and the nature of transactions. There could not be parity or equal basis for the apportionment of
administrative expenses between delivery based and non-delivery based transactions, and trading andinvestment activity.
Yogesh J Shah [(2010)(46 SOT 183)(Mum)(URO]
Mumbai ITAT held that it was not necessary that dividend should be earned out of intended activity so as to applydisallowance u/s 14A. When the assessee had incurred expenditure for an activity which had resulted into anexempt income, the disallowance u/s 14A was applicable. Rule 8D was not applicable for the relevant AY and theissue of determination of exact disallowance u/s 14A was remitted back to the AO.
Sr.No:-3
Strategic investmentswhere earning ofdividend income is not
the motiveInvestments forbanking business.
Maxopp Investment Ltd [203 taxman 185 (Del)]
Sec. 14A disallowance applicable to the interest paid on the borrowings used for strategic investments, eventhough earning of dividend income is only incidental.
Smt. LeenaRamachandran [(2011) 339 ITR 296 (Ker)]
The assessee was engaged in trading in goods. She acquired controlling interest of a company engaged inleasing of articles by way of purchasing its shares. The shares were acquired with borrowed capital. Shecontended that the company leased articles similar to the ones she was trading in and hence, the acquisition wasfor business purpose. The AO disallowed the interest paid on borrowed capital, which was more than thedividend earned during the year on the said investment. HC held that entire interest was disallowable u/s 14A, asthe entire funds were utilized for acquisition of shares. HC held that the only benefit derived from investment wasdividend, which was exempt from tax and accordingly, the AO was right in invoking provisions of Sec. 14A.
State Bank of Travancore [124 ITD 332 2011(KER)]
The assessee made investments in tax free bonds for meeting SLR requirements. The assessee had borrowedfunds for making investments. HC held that even though the investment was made for meeting SLRrequirements which was essential for the assessee’s banking business, the interest and other expenditureincurred on borrowings for investment was disallowable u/s 14A.
Applicability of Sec.14A when no exemptincome earnedduring relevant year
Cheminvest Ltd [121 ITD 318 2009(DEL)]
Delhi Special Bench held that Sec. 14A disallowance had to be made in respect of interest on loans, which wereutilized for investment in shares, even though no dividend income was earned on those shares during therelevant year.
Siva Industries & Holding Ltd [TS-438-ITAT-2011(CHNY) and TS-317-ITAT-2012(CHNY)]
Relying on the Special Bench ruling in Cheminvest Ltd, Chennai ITAT held that the disallowance u/s 14A wasapplicable, even though the assessee did not earn any exempt income in AY 2007-08. ITAT noted that whiledisposing the appeal for the earlier year, the ruling of the Special Bench in Cheminvest was not considered byITAT and hence, that ruling was incorrect. In the earlier year, ITAT had held that the disallowance for interestpaid on loans borrowed for making investment in shares was not applicable, as the assessee did not earn anydividend from such investment.
Technopack Advisors P Ltd [(2012) 50 SOT 31 (Delhi)(URO)]
Even if the investment in shares did not yield any dividend in the year under consideration, the disallowance u/s14A on the expenditure incurred for earning income was disallowable, notwithstanding the fact that no suchincome was earned.
Relaxo Footwear Ltd [(2012) 50 SOT 102 (Delhi)]
Even if the assessee had not earned any income which was not includible in the total income, the provisions ofsection 14A could still be invoked to disallow the expenditure relatable to the income not includible in the totalincome. Since the AO did not consider the claim of the assessee that no expenditure was incurred for earningexempt income before invoking provisions of Rule 8D, the matter was restored to AO for fresh consideration inview of the Bombay HC ruling in Godrej & Boyce.
Applicability of Sec.14A disallowance to
share of profit frompartnership firm
Popular Vehicles & Services Ltd [(2010)325 ITR 523 (Ker)]
The assessee borrowed funds from banks, which were diverted to partnership firms, in which it was a partner.HC noted that the assessee did not receive any interest from those firms. The only benefit derived was share ofprofit, which was exempt u/s 10(2A). HC sustained the disallowance of interest by invoking provisions of Sec.14A.
Vishnu AnantMahajan[TS-396-ITAT-2012(Ahd)]
An Ahmedabad Special Bench of ITAT held that Sec. 14A disallowance is applicable to partners’ share in thefirm’s profit, which is exempt u/s 10(2A). ITAT SB held that profit from firm is not included in the total income ofthe partner by virtue of exemption provisions of Sec. 10(2A). ITAT held that a partnership firm is not a passthroughvehicle and the firm and partners are separately assessable to tax, despite the position of law under thePartnership Act that the firm is a compendium or collective name of the partners.
Non-maintenance ofseparate books ofaccounts does notprovideimmunityfrom applicability ofSec 14Adisallowance priortointroduction ofRule 8D
Catholic Syrian Bank Ltd. & Ors. (2011) 237 CTR 164 (Ker)
The assessee bank did not maintain separate accounts for the expenditure incurred towards interest paid onfunds borrowed for investments in securities, bonds and shares which yielded tax free income. In the absence ofseparate accounts, the Assessing Officer made proportionate disallowance of interest attributable to the fundsinvested to earn tax free income, based on the average cost of deposit in the year under consideration.A division bench of Kerala HC held that the amendment introducing sub-sections (2) and (3) in Sec 14A wasclarificatory only. The main clause of Section 14A was applicable for all periods, which authorized thedisallowance of the expenditure incurred for earning tax free income, irrespective of whether the assesseemaintained separate accounts or not. However, with regard to administrative expenses, HC held that there wasno precise formula for proportionate disallowance. Therefore, no disallowance was called for, for proportionateadministrative cost attributable to earning of tax free income until Rule 8D came into force.