Section 14A read with Rule 8D of the Income Tax Act.

Section 14A and its necessity

The Act exempts certain income from tax, such as agricultural income, income received by charitable institutions, gratuity, pension, insurance claim amount etc. To earn such income, the taxpayers might have incurred certain expenditures—for example, the interest on a loan to undertake agricultural activities, etc.

The deduction of expenditure in relation to exempt income is a highly litigated subject matter, with both favorable and adverse judicial rulings in this regard. The taxpayers have always contended that such expenses should be allowed as a deduction. In contrast, the tax authorities have refuted such a claim, as the income is already exempt from taxation and allowance of such expenses would reduce the non-exempt income. This is against the basic principle of taxation, where only expenses that are relatable to the income are allowed as deductions.

To deal with such cases, Section 14A was introduced in the Act, which provides that the expenditure incurred in relation to income that does not form part of the taxable total income under this Act should not be allowed as a deduction against the total income of the taxpayer.

The section further provides an apparatus for the tax officer to undertake/determine the expenditure incurred by the taxpayer concerning the exempt income. This method is prescribed under Rule 8D of the Income-tax Rules, 1962 (“the Rules”). However, it is to be noted that Rule 8D can be invoked only in the following cases –

• Where the taxpayer claims that no expenditure is incurred in relation to exempt income earned by him
• Where the taxpayer has voluntarily disallowed a certain amount towards expenditure incurred in relation to exempt income. However, the tax officer is not satisfied with the taxpayer’s claim, considering the taxpayer’s books of accounts.

Only those expenses that are proved to be incurred in relation to the exempt income can be disallowed. Under the garb of this section, the tax officer cannot disallow such expenses which are assumed to have been incurred for earning such exempt income. Also, expenses incurred in common, towards both exempt and taxable income, cannot be artificially apportioned on the basis of such assumption that a part of these expenses would have been incurred towards earning exempt income.

Further, before invoking Rule 8D, the tax officer must clearly indicate the inaccuracy in the taxpayer’s calculation. The tax officer cannot arbitrarily apply Rule 8D without pointing out the inaccuracy in apportionment or allocation of expenses. The responsibility is on the tax officer to show that the assesses has incurred the expenditure for earning tax?free income.

Rule 8D – Mechanism provided to determine the expenditure in relation to exempt income

As per Rule 8D, expenditure in relation to the exempt income would be the aggregate of the following:

• The amount of expenditure which is directly related to such exempt income; and
• An amount computed as follows –
  - Compute the monthly average of opening and closing balances of the investment/ income which does not form part of the total income.
  - Compute the average of the monthly averages determined in point 1 above
  - Compute 1% of the annual average determined in point 2 above.

In any case, the amount of disallowance computed as per this Rule cannot exceed the total expenditure claimed by the taxpayer.

Let understand this by an example;
Mr A has taken a loan of INR 20 lakh on 23 January 2020 @ 10% during the FY 2020-21. Therefore, his interest expenditure for the year on this loan is INR 2,00,000. He utilized this loan for making an investment of INR 20 lakh in various avenues, income from which is exempted from tax.

Monthly closing balances of this investment is INR 20,00,000 (January 2020), INR 15,00,000 (February 2020), INR 5,00,000 (March 2020).

Rule 8D disallowance is computed as below:

Conclusion

• If the taxpayer earns no exempt income during a financial year, then there arises no question of disallowance of expenditure under this section [PCIT vs Ballarpur Industries Limited (Bombay High Court)]
• Disallowance under Section 14A can be made only with respect to the expenses claimed as a deduction. Thus, if the taxpayer does not claim a deduction of any such expense, then there is no question of disallowance of expenditure under this section. Further, the tax officer must also duly inform the taxpayer about his dissatisfaction with the computation provided by the taxpayer [Marg Ltd. vs Commissioner of Income Tax (2020) (Madras High Court)].
• The disallowance under Section 14A cannot exceed the exempt income [PCIT vs Caraf Builders & Constructions (P.) Ltd. (2019) (SC)]
• For computation under Rule 8D, only such investments must be considered, which earn an exempt income for the taxpayer and not all investments.
• One of the prerequisites for applying Rule 8D by the tax officer is that he must indicate the inaccuracy in the computation of disallowed expenditure provided by the taxpayer. Thus, the tax officer must mandatorily offer reasons why he is not satisfied with the taxpayer’s computation.
• For MAT computation, the amount of expenditure related to exempt income must be disallowed, .i.e. added back to the book profits. [K. B. Mehta Construction (P.) Ltd. vs DCIT (2020) (Ahmedabad Tribunal)]