UNDERSTANDING SECTION 14A IMPACT WITH CASE LAWS PART - II.

The Income tax department (ITD) now a days become very harsh to the assessee in respect of disallowance made under section 14A read with rule 8D. The  ITD applies rule 8D blindly on the assessee  and making un-necessarily additions causing hardship to innocent assessee. The first part of the article published last year had provided number of tips in respect of handling assessment in respect of section 14A. Further, there are number of decisions comes out  during the one year and given below the summary of the same which will help you during the assessments and appeals.

·         ITAT Delhi in the case of Continental Carriers Pvt. Ltd. vs. ACIT decided that In the light of Godrej & Boyce Mfg. Co. Ltd. (2010) 328 ITR 81 (Bom.) it was held that the plea of the assessee based on Minda Investments Ltd. that the disallowance should be deleted cannot be accepted as in the later decisions similar matters have been restored to the file of the Assessing Officer and according to rule of precedence, later decision passed by similar strength of the Bench has to be followed in preference to the earlier decision.

·         In order to disallow expenditure u/s 14A, there must be a live nexus between the expenditure incurred & income not forming part of total income. Refer, Yatish Trading Co v ACIT.

·         The protection of proviso to section 14A w.r.t. A.Y. 2001-02 & earlier years was inserted w.e.f. 11/05/2001. Thus, where order of CIT under section 263 was passed earlier i.e. on 29/12/1999, the protection under the proviso is not available. Refer, Mahesh G. Shetty & Ors. 51 DTR 104.

·         Issue of disallowance under section 14A, cannot be raised for the first time before the Tribunal where the provision of section 14A, was not invoked against the assessee by the Assessing Officer while making disallowance of interest expenditure under section 36(1)(iii) and CIT(A) also at no stage considered the application of section 14A. Refer, ACIT vs. Delite Enterprises (P) Ltd, 50 DTR 193.

·         Gujarat High Court in the case of CIT vs. Gujarat Power Corporation Ltd, decided that  the assessee has sufficiently explained that a majority of the investment in the tax-free security was made before the borrowing. The assessee had demonstrated that it had other sources of investment and that no part of the borrowed fund could be stated to have been diverted to earn tax free income. As borrowed funds were not used for earning tax-free income, applying section 14A was not justified.

·         It was held that section 14A permits a disallowance of “expenditure incurred by the assessee” and not of “allowance admissible” to him. There is a distinction between “expenditure” and “allowance”. The expression “expenditure” does not include allowances such as depreciation allowance. Accordingly, depreciation cannot be the subject matter of disallowance under section 14A (ratio of Nectar Beverages 314 ITR 314 (SC) followed); Similarly, it was further held that the deduction under section 80D is not expenditure for earning tax-free income but is a permissible deduction from gross total income under Chapter VIA. Refer, Hoshang D. Nanavati vs. ACIT, Mumbai ITAT.

·         Where borrowed funds were utilized for business purposes and investment in shares is made out of own funds, then disallowance under section 14A of interest on borrowed fund was not permissible. CIT vs. Hero Cycles Ltd. 323 ITR 518 (P&H) (A. Y. 2005-06). Refer, Godrej Industries Ltd. vs. Dy. CIT.

·         No disallowance under section 14A when no dividend was received. Refer, Siva Industries & Holdings Ltd, Chennai ITAT.

·         During the course of assessment proceedings , the Assessing Officer made a query in respect of disallowance under section 14A of the Income tax Act ,however no disallowance was made . Revenue had not challenged the non applicability of section 14A. Tribunal gave direction to consider applicability of section 14A. The direction of Tribunal was quashed. Refer, Topstar Mercantile P. Ltd v Asst CIT, 334 ITR 374.

·         No s. 14A disallowance of interest on borrowed funds if AO does not show nexus between borrowed funds & tax-free investment  CIT V RAJEHA CORPORATION In AY 2000-01 the assessee had investments in shares & mutual funds of Rs. 20 crores on which it earned tax-free dividend of Rs. 13.35 lakhs. The assessee also had borrowed funds on which it claimed deduction of interest of Rs. 8.70 crores. The AO disallowed interest of Rs.2.79 crores on the ground that it was relatable to earning tax-free dividend. The Tribunal deleted the disallowance on the ground that the investments had been made out of the assessee’s own funds and not out of the borrowed funds. The department filed an appeal before the High Court. HELD dismissing the appeal: 

Counsel for the Revenue could not point as to how interest on borrowed funds to the extent of Rs.2.79 crores was attributable to earning dividend income which are exempt u/s 10(33) of the Act. Therefore, in the absence of any material or basis to hold that the interest expenditure directly or indirectly was attributable for earning the dividend income, the decision of the Tribunal in deleting the disallowance of interest made u/s 14A cannot be faulted.

·         No S. 14A disallowance in absence of nexus between investment in tax-free securities & borrowed funds. S. 14A disallowance cannot exceed exempt income 

In AY 2007-08, the assessee received dividend of Rs. 4 lakhs in respect of investment in shares made in earlier years. No investments were made during the year. It was claimed that the investment in the earlier years was made out of reserves & surplus and that there was no expenditure incurred during the year to earn the dividend. The AO held that as in the earlier years, the assessee had borrowed funds, s. 14A applied. He applied the rate of interest paid on the borrowings and disallowed Rs. 12.73 lakhs. This was deleted by the CIT (A). On appeal by the department, HELD dismissing the appeal. Refer, ACIT vs. Punjab State Coop & Mktg.  

·         Investments in shares were made by the assessee from own funds , no disallowances were made in earlier years. No disallowance can be made for the relevant year. ( A.Y. 2005‐06). Refer, G.D. Metsteel (P) Ltd v Asst CIT, 47 SOT 62.

·         If the investment in tax free income yielding securities is made from interest free funds , no disallowance can be made under section 14A.(A.Y. 2001‐02). Refer, CIT v LubiSummersibles Ltd, ACAJ Vol 35 Part 5 August‐2011 P. 319)

·         In the case of Dhanuka and Sons v. CIT (Cal), 339 ITR 319, it was decided that disallowance of section 14A is justified if dividend income had earned.

·         Similar view was given in the case of CIT v. Smt. Leena Ramachandran, 339 ITR 296, where it was held that interest expenditure in relation to income not forming part of total income where borrowed funds utilised for acquisition of shares in company of which assessee acquired controlling interest and Acquisition of shares in form of investment and only benefit is dividend income, hence, Assessee not entitled to deduction of interest .

·         In the case of CIT v. Reliance Industries Ltd, 339 ITR 632 it was held that No expenditure in fact incurred in earning dividend income and hence, No disallowance permissible.

·         The Delhi High Court in the case of Maxopp Investment had to consider two issues: (a) whether interest paid on funds borrowed to acquire “trading shares” is hit by s. 14A given that the profits there from are assessable to tax as “business profits” and the dividend is incidental and (b) whether Rule 8D has retrospective operation. HELD by the Court:

(i) 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”. If the expenditure has a relation or connection with or pertains to exempt income, it cannot be allowed as a deduction even if it otherwise qualifies under the other provisions of the Act;

(ii) 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 the exempt income, no disallowance can be made u/s 14A (Hero Cycles Ltd 323 ITR 518 referred).

(iii) 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. While rejecting the claim of the assessee with regard to the expenditure or no expenditure in relation to exempt income, the AO will have to indicate cogent reasons for the same;

(iv) Rule 8D comes into play only when the AO records a finding that he is not satisfied with the assessee’s method. 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. (Godrej and Boyce Mfg. Co. Ltd 328 ITR 81 (Bom) followed);

(v) 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’s claim (argument that Rule 8D exceeds the mandate of s. 14A left open).

·         In the case of CIT v. Metalman Auto P. Ltd, 336 ITR 434, it was held that disallowance cannot be made on the basis of presumption.

·         Assessee bank borrowed certain funds, which were invested in purchase of tax free bonds for meeting SLR requirement of RBI. Assessing Officer disallowed the interest under section 14A. The Tribunal deleted the disallowance. On appeal High Court held that the object or purpose of investment does not affect operation of section 14A in as much as any expenditure incurred for earning tax free income is not an allowable expenditure, therefore, even though purchase of tax free bonds was for meeting SLR requirements, interest and other expenses incurred on borrowals for investment in tax free bonds was to be disallowed. Refer, CIT v. State Bank of Travancore, 203 Taxmann 639.

·         Assessee claimed that no expenditure was incurred for earning for earning tax free income. Assessing Officer held that some expenditure must have been incurred to earn said income and he estimated 1 percent of tax free income and disallowed Rs. 42,130 under section 14A. Commissioner (Appeals) by applying Rule 8D retrospectively, disallowed Rs. 10.29 lakhs. Assessee before Tribunal challenged applicability of Rule 8D. The Tribunal held that Rule 8D was not applicable, however, went into  reasonableness of estimation and quantification before Tribunal, estimation as made by Assessing Officer was to be up held. (A. Y. 2004-05). Refer, Dy. CIT v. Philips Carbon Black Ltd., 133 ITD 189.

·         Mumbai ITAT in the case of Bunge Agribusiness (India) (P) Ltd. v. Dy. CIT, 64 DTR 201 held that If there were funds available, both interest free and interest bearing, then a presumption would arise that interest free funds have been generated for investments and no disallowance of interest could be made under section 14A. (A. Y. 2004-05).

·         On facts of the assessee, assessment proceedings initially completed under section 143(1). Subsequently Assessing Officer initiated reassessment proceedings in course of which he made certain disallowance under section 14A. Since notice under section 148 was issued to make an assessment at first instance, Assessing Officer was justified in dealing with issue arising under section 14A. Bar stated in proviso to section 14A does not operate in a case of first assessment. (A. Y. 1999-2000). Refer, ACIT v. Tube Investments of India Ltd. 133 ITD 79.

The assessee should make fair calculation of section 14A disallowance based on the actuals and accordingly disallow the same at the time of filing of return of income or else at the time of assessment atleast. This will help assessee from the unjustified disallowance under section 14A read wilth rule 8D.  Justify your disallowance computation before the ITD.  

Hope the above small summary on section 14A will help you in getting some relief from the hardship from the ITD. In case you have any further clarification please mail me at mr_manish_ca@yahoo.com.

Thank you.