Disallowance of expenditure related to income not includable in total income-Section 14A a new controversy

Deepak Kalani, FCA,DISA

After prescribing rules for determination of expenditure related to income not includable in total income now assessing officer is examining the issue in their assessment orders and disallowing the expenditure under section 14A without considering the entire facts .They simply putting the formula as prescribed under rule 8D of the Income Tax rules 2008 and work out the disallowance for making addition under section 14A even when the assessment year under consideration is prior to inserting the rules. In this article I have discussed the entire provision related to section 14A along with legal pronouncement and planning to resolve the issue.

Legal History

Section 14A was first inserted by Finance Act 2001 however same was inserted with retrospective effect from 01/04/1962 and section inserted was as under:-

14A. Expenditure incurred in relation to income not includible in total income.—For the purposes of computing the total income under this Chapter, 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 this Act.

Purpose for which the section was introduced, given in explanatory memorandum issued with the Finance Bill,2001 and same is as under :-

Certain incomes are not includible while computing the total income as these are exempt under various provisions of the Act. There have been cases where deductions have been claimed in respect of such exempt income. This in effect means that the tax incentive given by way of exemptions to certain categories of income is being used to reduce also the tax payable on the non-exempt income by debiting the expenses incurred to earn the exempt income against taxable income. This is against the basic principles of taxation whereby only the net income, i.e., gross income minus the expenditure, is taxed. On the same analogy, the exemption is also in respect of the net income. Expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income.

It is proposed to insert a new section 14A so as to clarify the intention of the legislature since the inception of the Income-tax Act, 1961, that no deduction shall be made in respect of any expenditure incurred by the assessee in relation to income which does not

form part of the total income under the Income-tax Act. The proposed amendment will take effect retrospectively from 1st April, 1962 and will accordingly, apply in relation to the assessment year 1962-1963 and subsequent assessment years.

However the section was being used by the assessing officer for reopening the assessment as section was retrospective effected till introduction of Finance Act 2002 when Government has realized his mistake and sub section 2 of 14A was inserted as under :-

Provided that nothing contained in this section shall empower the Assessing Officer either to reassess under section 147 or pass an order enhancing the assessment or reducing a refund already made or otherwise increasing the liability of the assessee under section 154, for any assessment year beginning on or before the 1st day of April, 2001.

There was another amendment by Finance Act 2006 in section 14A which has enlarged the scope of applicability of section 14A as previous section has not generated expected revenue or compliance up to the mark. The newly inserted section w.e.f.01/04/2007 is as under

(2) The Assessing Officer shall determine the amount of expenditure incurred in relation to such income which does not form part of the total income under this Act in accordance with such method as may be prescribed, if 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 expenditure in relation to income which does not form part of the total income under this Act.

(3) The provisions of sub-section (2) shall also apply in relation to a case where an assessee claims that no expenditure has been incurred by him in relation to income which does not form part of the total income under this Act.

The section was amended for the reason explained in explanatory statement for Finance Act 2006.Vide circular No.14/2006 dated 28-12-2006 in para 11 which is reproduced here:

11. Method for allocating expenditure in relation to exempt income

11.1 Section 14A of the Income-tax Act, 1961, provides that for the purposes of computing the total income under Chapter-IV of the said Act, 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 Income-tax Act. In the existing provisions of section 14A, however, no method of computing the expenditure incurred in relation to income which does not form part of the total income has been provided for. Consequently, there is considerable dispute between the taxpayers and the Department on the method of determining such expenditure.

11.2 In view of the above, a new sub-section (2) has been inserted in section 14A so as to provide that it would be mandatory for the Assessing Officer to determine the amount of expenditure incurred in relation to such income which does not form part of the total income in accordance with such method as may be prescribed. However, the Assessing Officer shall follow the prescribed method if, having regard to the accounts of the assessee, he is not satisfied with the correctness of the claim of the assessee in respect of expenditure in relation to income which does not form part of the total income. Provisions of sub-section (2), will also be applicable in relation to a case where an assessee claims that no expenditure has been incurred by him in relation to income which does not form part of the total income.

11.3 Applicability - From assessment year 2007-08 onwards

By this insertion the new controversies of disallowance begun as till date neither Government was serious nor there is a way of disallowance for assessing officer as no specific method has been prescribed for working out disallowance .Rules for determination of disallowance has been prescribed vide I.T. (5th Amend.) Rules, 2008, w.e.f. 24-3-2008 which are as under:-

8D. Method for determining amount of expenditure in relation to income not includible in total income.—

(1) Where the Assessing Officer having regard to the accounts of the assessee of the previous year, is not satisfied with—

(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 income which does not form part of the total income under the Act for such previous year, he shall determine the amount of expenditure in relation to such income in accordance with the provisions of sub-rule (2).

(2) The expenditure in relation to income which does not form part of the total income shall be the aggregate of following amounts, namely :—

(i) the amount of expenditure directly relating to income which does not form part of total income ;

(ii) in a case where the assessee has incurred expenditure by way of interest during the previous year is not directly attributable to any particular income or receipt, an amount computed in accordance with the following formula, namely :—

A X---

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 ;

(iii) 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.

3. For the purposes of this rule, the “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.

Rules prescribed as above are self explanatory and same is being applied by the Assessing officer where they found any exempted income in accounts of the assessee as in any case disallowance of .50% 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 can be made without making any other disallowance.

Scope

With the discussion of legal provision of section 14A the scope and applicability of section w.e.f.01/04/2007 are as under:-

1. Assessee must have exempted income which is not includable in his total income.

2. Assessee must have incurred expenditure in relation to earn income which is exempted under Income Tax Act.

3. Prescribed formula can be applied only where Assessing officer is not satisfied with account of assessee with regard to correctness of claim of expenses or assessee claims that no expenditure has been incurred .In other cases whatever expenses have been declared by the assessee with regard to earning exempted income is to be added for determination of total income. Meaning thereby that there must be account before the assessing officer for application of section 14A.

From perusal of the above it can be said that for applying formula there must be accounts of the assessee. If there is no accounts then the said disallowance can not be made as section says that for applying rule 8d assessing officer must not satisfy with account of the assessee with regard to correctness of claim of expenses. There are number of cases where no accounts are required under income tax act .Some examples are:-

1. Assessee declares income under presumptive income i.e.44AD, 44AE or 44AF etc.

2. Assessee earns income from Agriculture activity or only income which is exempted.

3. Income from partnership firm and Income of the assessee is below the limit prescribed under Income tax act for maintaining books of accounts

4. Turnover of the business of the assessee is below the limit as prescribed under Income tax act for maintaing books of accounts.

In the above cases assessing officer can not make any disallowance under section 14A if no balance sheet has been filed by the assessee. If assessee files balance sheet along with his return without the same is mandatory. The A.O. shall have power to make minimum disallowance of .50% of the Assets income of which exempted under the Income tax act as prescribed under rules and every balance sheet have some assets income of which is exempted under income tax act. Further under from 3CD a column has also been inserted w.e.f. 23/08/2006 vide Income Tax Ninth amendment rules 2006 regarding amount of disallowance under section 14A.Hence it is liability of tax auditor to give appropriate finding in this regard and after prescribing formula for determination of disallowance under section 14A the liability to disclose relevant facts has been enlarged.

Judicial Pronouncement

Only few cases has been decided by the High Courts and Tribunal Under the light of new provision of section 14A which has been inserted w.e.f.01/04/2007 along with rules for determination of disallowance under rule 8D however decision are relevant for assessment prior to assessment year 2007-2008 .I am highlighting some judgments of High court which deals with fundamental of section 14A

1. In case of Walfort Share and Stock Brokers P. Ltd reported in 310 ITR 0421 (Mumbai) it has been decided that What section 14A contemplates is the expenditure actually incurred for earning tax free income and not assumed expenditure or deemed expenditure and loss on sale of exempted assets can not be said to be expenditure incurred by the assessee for disallowance under section 14A

2. In recent case Commissioner of Income Tax verses Hero Cycle Limited it was held by the Hon’ble High Court that

“Whether, in a given situation, any expenditure was incurred which was to be disallowed, is a question of fact. Simply by saying 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, cannot be accepted. 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. “

The above finding clearly shows that first it is to establish that there is some expenditure incurred for earning exempt income by the assessing officer for imposition of section 14A. If no such finding by A.O. no disallowance is called for.

3. In case of Voltas Ltd v/s Asstt.CIT (17CPT130) it was held that where assessee has established that none of the funds have been utilized in investment in shares disallowance can not be justified on notional basis.

4. However the decision is contrary to the earlier decisions of Mumbai Tribunal special bench wherein ,in the case of Daga Capital Management Pvt. Ltd. Vs Income Tax officer Income Tax appellate Tribunal ,Mumbai Bench has decided that rules prescribed under rule 8D are retrospective in nature and decided the procedure for disallowance and held that:-

“When a clarificatory or explanatory or procedural provision is under consideration, the date of insertion loses its significance. It takes retrospective effect from the date when the substantive provision was inserted. So the relevant consideration is to understand the true nature of the amendment. If the new insertion or the amendment has the effect of imposing a new liability it is substantive in nature and ordinarily applies prospectively. If, however, it is either procedural or clarificatory in nature, it would be retrospective notwithstanding the fact that a particular date has been mentioned from which it would be applicable. Such clarificatory or procedural amendment would be fully applicable in the time anterior to the date from which it has been said to be applicable.No substantive liability is imposed by the Legislature through sub-sections (2) and (3) of section 14A. Sub-sections (2) and (3) lay down the procedure and mechanism for working out the expenditure in relation to income which is exempt from tax. Rule 8D of the Income-tax Rules, 1962, prescribes the method by which the Assessing Officer has to determine the disallowable expenditure as relatable to the exempt income in terms of sub-sec-tions (2) and (3). Thus, sub-sections (2) and (3) are procedural in nature and retrospective.

Further held that Under sub-section (1) of section 14A, the exercise of making dis-allowance starts with firstly tracing out the exempt income and then initiating the process of working out the expenditure incurred in relation to such exempt income. The expression "in relation to" in section 14A is to encompass not only direct but also indirect expenditure which has any relation to the exempt income. Thus, all direct and indirect expenses which have any relation with the income not chargeable to tax under the Act are disallowable under section 14A.

Same view has been upheld by the Cochin Bench of Income Tax Appellate Tribunal in case of Parry Agro Industries v/s ACIT.

Before these cases in case of Voltas Ltd v/s Asstt.CIT (17CPT130) it was held that where assessee has established that none of the funds have been utilized in investment in shares disallowance can not be justified on notional basis.

Though on the basis of tribunal decisions nothing can be concluded as same is to early for any conclusion still the controversy is very significant.

In a interesting case of Topstar Mercantile Pvt. Ltd v. ACIT (2009-TIOL-458-HC-MUM-IT) it has been held that when assessing officer is satisfied with submission made by assessee with regard to applicability of section 14A .Tribunal have no power to sent back the case for reconsideration under newly inserted rule 8D w.r.t. section 14A

CONCLUSION

Every assessee must have examine his balance sheet and computation of total income under the light of newly inserted section 14A otherwise he may have much more disallowance by assessing officer under newly inserted section even if he has incurred nominal expenses or not incurred any expenses. If assessee is individual he may have certain investment or assets in his balance sheet income of which is exempted under income tax act like PPF, LIC, Shares or even capital in partnership firm(profit from firm) or agriculture assets .If assessee has incurred some expenditure he must specifically mention in his profit and loss account under specific head like expenditure incurred for exempted income and while preparing income tax return he must add back the such expenditure according to section 14A.Further he must disclose exempted income under separate head .If he does so onus shifts on assessing officer to prove that expenditure are not correctly claimed for application of rule 8D for disallowance .Where assessee has not claimed any expenditure he must have all evidence or details of expenditure claimed in his profit and loss account that all expenses are related to earn taxable income otherwise subsection 14A3(3) will apply and adhoc deduction as per formula can be applied by the assessing officer which may cause more loss to him in compare to claiming certain expenditure in his profit and loss account for earning exempted income as minimum of .50% disallowance of assets can be made by the assessing officer .Further he may also review his balance sheet in light of section 14A like he may debit LIC/PPF in his capital account instead of disclosing the same in balance sheet to avoid adhoc disallowance under section 14A .Further such disallowance can not be applied without having accounts if assessee has filed return of income in which no books of accounts are required to be maintained then assessing officer has no power to disallow expenditure under any formula of rule 8d of income tax rule. In case of partnership firms and company Similar planning should be done as discussed in case of individual however there is limitation in case of firm or company to review balance sheet as same is also govern by other law for maintaining books of accounts. If any disallowance is made for interest expenses a case may be presented before the assessing officer that same should be allowed as a part of the cost of assets acquired out of borrowed funds as held by various High Courts. Even after prescribing formula for determination of quantum of deduction under section 14A still some clarification is required from the government in following points:-

1. In case of dividend under section 10(34) the exemption has been provided when same is being taxed u/s 115 O. The company is paying tax on dividend by way of dividend distribution tax .Is the same is truly exempted income for disallowance under section 14A.

2. In case of long term capital gain under section 10(38) exemption has been provided when STT is being paid on the sale purchases of securities or units and STT is part of tax hence same is not truly exempted income or assets.

3. Some assessing officer disallowing part of interest on the investment in partnership firm taking view that profit from firm is exempted however firm is paying tax on such profit .Whether it can be said the same is exempted income for the partners.

4. Agriculture income is not included in total income of the assessee and agriculture land is shown in balance sheet of the assessee whether any proportionate expenses or adhoc disallowance can be made of interest etc even same is being added for rate purpose for computing tax liability of the assessee.

5. Section 14A has been introduced for the object that the expenses incurred should be allowed only to the extent they are relatable to earning of taxable income. But as per formula without incurring any expenditure assessing officer can make minimum disallowance of .50 % of total assets income of which exempted. Is this not injustice for the tax payers

6. By applying this formula in some cases it may happen that disallowance comes more than the exempted income earned hence it should be restricted up to certain percentage of income.

7. It is not mentioned that whether any disallowance can be made when there is only exempted income like Trust or income earned as per section 10,10A,10B etc.

8. Whether any disallowance can be made if expenditure is not allowed in computation of total income or disallowed by the A.O. while completing the assessment.

9. Whether disallowance can be made for the investment on which no income is earned .

10. Definition of total assets has not been provided .Whether fictitious assets should be taken for computing total assets as no list has been provided what assets to be taken or what to be excluded.

Under Direct Tax Code similar law has been proposed vide section 17(1)(a) .The proposed section read as under :-

Following expenditure not allowed while computing total income under Direct Tax Code:-

Any expenditure attributable to income which does not form part of total income under this code and determined in accordance with the method as may be prescribed.

A suitable guidelines/circular must be issued by the government on the above mentioned para to avoid any litigation in this regard by keeping justice for taxpayers and this also must be considered while passing the new Direct Tax Code.