Budget Expectations: Need to Amend Section 14A To Reduce Tax Litigations

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  • Last Updated on 25 January, 2021

Introduction to Section 14A under Income Tax Act:

 

The rules of accounting play an important role in an accurate calculation of the income which is chargeable to tax during the year. One such important rule is the ‘Matching Concept’ which is an accounting principle whereby an entity is required to recognize the revenue and its related expenses, incurred in the same accounting period. The purpose behind this concept is to avoid misstatement of earnings and to calculate the actual profitability of the organization for a certain period.

This matching concept is highly relevant under Income-tax Act as different set of rules and rates of taxes have been prescribed for calculation of the taxable income under different heads of income, for instance, Capital Gains, Business Profits, Residuary Income, etc. An expense is matched with its corresponding revenue so that any expense incurred to earn an exempt income is not claimed against the taxable income.

Under Section 14A of the Income-tax Act, specific and general expenses are disallowed if such expenses were incurred to earn an exempted income. Prior computation of income, if taxpayer has not disallowed the expenditures in relation to an exempted income, the tax officer would necessarily re-calculate such expenditures to disallow the same.

Right from its introduction, the section has always been a matter of controversy and dispute. Be its applicability or the computation of such disallowance. 
 
We have identified some of the disputable matters under Section 14A and offer our recommendations on how CBDT can possibly bring some certainty in this provision.

1. No Exempt Income, No Disallowance:

Taxpayers and the Department are often at loggerheads on the matter of disallowance of an expense under Section 14A even if a no tax-free income is generated during the year. CBDT  has clarified that all expenses pertaining to an exempted income will be disallowed, notwithstanding the fact that no such income has been earned during the financial year. However, various courts have held that Section 14A disallowance couldn’t kick in when there is no exempted income earned by assesse.

The Delhi High Court  and the Madras High Court  has already expressed a clear disagreement with the CBDT’s circular and held that where there is no exempt income in relevant year, there cannot be a disallowance of expenditure under section 14A.
 
So, it is recommended that an amendment should made to Section 14A to clarify that disallowance under Section 14A shall be restricted to the extent of exempted income earned during the financial year.

2. No Disallowance from Dividend Income:

Dividend Distribution Tax (DDT) is the tax paid by a domestic company in respect of the dividend paid by the company to its shareholders. Dividend is considered as a tax free income to a shareholder, even though it has actually suffered the economic taxation. In other words, even after the dividend income has been subjected to the dividend distribution tax yet it is categorized as an exempted income. Therefore, it is suggested that no such disallowance should be invoked under Section 14A for the expenses incurred in respect of the investments which are earning dividend income for the taxpayers. Dividend income is already taxed at the rate of 20.357% so any further disallowance would be perverse and unreasonable for the investors.  

You can also read: Some Income Tax rules need to be updated

3. No Disallowance if MAT is applicable:

Minimum Alternative Tax (MAT) is the minimum amount of income-tax that every company is required to pay during a financial year. It is levied on the book profit which is computed after making prescribed adjustments in the net profit as reported in the financial statement. As of now, the provisions of MAT do not prescribe the adjustments for any disallowance made under Section 14A, but the tax officers often add back the disallowance under section 14A while computing the book profits. The Special Bench of Delhi Tribunal in the case of ACIT v. Vireet Investment (P.) Ltd. [2017] 82 taxmann.com 415 (Delhi – Trib.) (SB) held that while computing book profit under Section 115JB, provisions of Section 14A can’t be imported as any amount of expenditure computed by applying Rule 8D is an artificial or notional expenditure that is not debited in the profit and loss account. Therefore, it can’t be added back to compute the book profit. Hence, it is recommended that an amendment should be made to clarify that any expenditure disallowed under Section 14A shall not be added back while computing the book profit.

4. Disallowance for the Depreciation of Assets:

As we already know that section 14A disallows the specific and general expenses incurred by the taxpayers to earn an exempted income. Now, the matter or contention is if these attributed expenses also cover the depreciation of the fixed assets, for instance computers, office appliances, etc. that has been used in the process of earning the exempt income. In Hoshang D. Nanavati v. ACIT [2012] 25 taxmann.com 141 (Mum.-Trib.), it was held that the disallowance under Section 14A cannot cover depreciation in, as-much-as what is disallowed under section14A, is only expenditure and not allowance. Depreciation is in the nature of allowance and, thus it cannot be the subject matter of disallowance of an expense under section14A. An amendment can be suggested to Section 14A for plugging in this gap by overcoming the above judicial precedents.

Conclusion:

It is expected the Union Budget 2018 might introduce some necessary amendments to section 14A in order to reduce tax litigations arising out of it and, bring in certainty and clarity in the disallowance regime of Section 14A under IT Act. 
 

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