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Friday, 20 July 2012

Understanding Section 14A Impact with Case Laws Part- I

Now a days, every assessee who is doing investment in shares are getting hitted hard  by the impact of section 14A. The AO are adding back a huge sum on account of this, whereas the assessee had not earned so much from it.  The article will provide you brief analysis of this section which will help to substantiate your
views at the time of the the assessment or before the appellate authority.
It must be noted that when an assessee earned exempted income under section 10 of the Income tax Act, 1961, the corresponding expenses related to earn such exempted income is required to be disallowed under section 14A of the Income tax Act, 1961.
For the sake of reference, the relevant portion of section 14A of the Income Tax Act, 1961 is reproduced below:
14A. [(1)] 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.]
[(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 :]
[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.]
Every assessee while computing its total income must consider the above mentioned provisions of section 14A for disallowing expenses incurred for earning exempted income. if the same is not considered by the assessee himself and AO noticed the same, he will disallow the expenditure in the assessment order whose further consequences will be impact of levy of interest and penalty on the assessee.
So, it is very important to correctly compute the amount of disallowance under section 14A while computing total income of the assessee. It is interesting to note that sometimes no exempted income is earned during the financial year, however expenses related to the same still to be disallowed under section 14A . For example, the assessee had taken a loan of Rs. 10 Million @ 12% and the same is invested in shares. During the year, the assessee has not earned any dividend income( exempted u/s 10(34) or Long term capital gain (exempted u/s 10(38) from the same shares, however he has to disallow Rs. 1.2 Million of interest paid for loan taken as expenses disallowed under section 14A as the purpose of the expenses incurred is to earn exempted income.
Methods of calculation of disallowance under section 14A
It must be noted that Chapter III of the IT Act. Sub-section (2) of section 14A further provides that 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 he, 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.
In the absence of the rules prescribing the method for disallowance of expenses, there was no consistency in the approach taken by the revenue authorities in disallowing the expenditure and this had let to undue litigation.
The Central Board of Direct Taxes (CBDT) in exercise of the powers conferred by section 295 of the Income-tax read sub-section (2) of section 14A of the Income-tax Act, 1961 has vide Notification No. 45/2008, dated March 24th 2008 prescribed the method for determining the expenditure to be disallowed under section 14A in relation to income not forming part of the total income by inserting Rule-8D in the Income-tax Rules. The method for determining of expenses to be disallowed as per Rule-8D read with section 14A is as under:
“Method for determining amount of expenditure in relation to income not includible in total income.
8D(1) Where the Assessing Officer, having regard to the accounts of the assessee of a 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 which is to be disallowed shall be the aggregate of (i) to (iii) below:
(i) the amount of expenditure directly relating to income which does not form part of total income;
(ii) where interest is not directly attributable to any particular income or receipt, an amount computed in accordance with the following formula, namely:-
A x B
C
A = Total interest paid less interest included in (i) above
B = Average of value of investment (income from which is exempt), as per balance sheet, on the first day and the last day of the previous year;
C = the average of total assets as per balance sheet of the assessee, on the first day and the last day of the previous year;
(iii) 0.50 per cent of the average of the value of investment, as per balance sheet, on the first day and the last day of the previous year.”
As per rules, “total assets” would mean, total assets as per balance sheet excluding the increase on account of revaluation of assets but including the decrease on account of revaluation of assets.
As can be seen from the above that the method prescribed vide insertion of Rule-8D, would be applied to determine the amount of disallowance under section 14A, where the Assessing Officer, having regard to the accounts of the assessee, is not satisfied with- (a) the correctness of the claim of disallowance 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).
Further, as can be noted that disallowance of expenses as per Rule-8D almost in all cases would be much higher on account of utilisation of borrowed funds for earning taxable as well as exempted income in the form of dividend, long-term capital gains on listed securities, etc. and the way formula is prescribed. In view of the same it is suggested to make two calculations determining the disallowance of expenses under section 14A, namely:
  • Determining the amount of interest on borrowed funds with respect to the funds utilised in investment which yield exempted income. This needs to be done by determining the direct nexus with dates and utilisation of funds for investments which yield exempted income
  • By using the method as given in Rule-8D of the Income-tax Rules, 1962 (as explained above)


Methods of calculation of disallowance under section 14A – When there is a direct nexus of expenses incurred .
01. Find the rate of interest for borrowed capital utilized for investment to earn exempted income.
02. Find the number of days for which such investment was made
03. Find the amount invested out of borrowed capital
04. Get Interest amount attributable to be disallowed under section 14A of the I.T. Act.
05. These should be done individually for separate asset.
06. A chart showing the illustration of the above is given below:


S. No.Details of Investment made out of Borrowed CapitalInvestment dateMaturity/ sale dateInvestment value (Rs.)No of DaysRate of InterestInterestAmount
(i)(ii)(iii)(iv)(v)(vi)(vii)(viii)
(iv-iii)(viXviiXviii)
1A Shares01.04.200830.04.2008100000308%658
2B SharesOldNot Sold500003658%4000
3AB Mutual Fund01.06.200815.06.087000000158%23014
Total


Methods of calculation of disallowance under section 14A – When there is no direct nexus of expenses incurred .
It is very common in the assessee business that the borrowed capital has been utilized for multipurpose activities of the business ie day to day requirement of working capital , acquisition of capital asset, business advances or for investment for earning exempted income.  Since the investment for earning exempted income is partly from owned capital of the assessee , it is very difficult to find any direct nexus of the same from borrowed capital.
A illustration has been provided below to compute the amount of disallowance u/s 14A in the aforesaid situation.
Rate of Interest :  8%

ParticularsDateAmount(Rs.)DaysInterest(Rs.)
Investment as on April 01, 2008-10000000
AddShare application money paid as on April 01, 208-2500000
Total-12500000
LessOwn Fund as on April 01, 2008-6000000
6500000
Less½ of Profit earned during the year (taken on average basis)-500000
6000000
Add/ LessInvestment Purchased / Sold during the year
+A Shares13-9-081000000
7000000166254685
-B Shares2-11-08500000
65000005071233
+AB Mutual Fund31-3-091500000
8000000149261260
Total3655,87,178

Note : Sum of Days should be 365 days
It must be further noted that if there is substantial nos. of transactions related to earn exempted income, assessee himself further disallow part of administrative expenses , as the same relates to expenses attributable to earn exempted income and hence to be disallowed.
Analysis:
Now, let us see the detailed analysis of section 14A & rule 8D
01. As per well settled law and also according to canons of taxation only that expenditure which is relatable to taxable income should be deducted in computing the total income. Expenditure which has a bearing on exempt income should not be considered in the computation of total income as otherwise this would result in double advantage to the assessee. For example when agricultural income itself is exempt from taxation, there is no justification to consider expenditure on agricultural activities in the computation of total income. Likewise there is no legitimacy for claiming deduction of interest on moneys borrowed for capital contribution in a partnership in the assessment of the partner, since the share of profit from the firm is exempt from tax. To assert this position categorically section 14A was brought on the statue book to the effect that for the purpose of computing the total income, no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income which does not form part of total income under the provisions of the Income tax Act, 1961.
02. A note worthy feature of this new provision is that it has been patched up in a piecemeal manner by way of insertion, substitution, addition of sub sections, proviso and Board’s circular with the result that there is sufficient room for different interpretations as regards the effective year of applicability of the provisions and the determination of the amount expenditure to be disallowed.
03. The need and the rationale for specific provision :- Situations might arise where expenditure by way of interest may be incurred indivisibly both for earning taxable and exempt income, as it happens in the case of a business enterprise where a part of working capital loans may be deployed in tax free bonds or shares of companies, the interest/dividend from which is exemptible under the provisions of section 10. The decisions in the earlier case laws on the subject were in favor of the assessee.
04. In the case of Rajasthan State Warehousing Corporation v CIT [242 ITR 450 (2000), the Supreme Court reversing the decision of the High Court held .that in view of the fact that income from various ventures was earned in the course of one indivisible business, apportionment of the expenditure and allowing deduction of only that proportion of it which was referable to taxable income was unsustainable.
05. Supreme Court decision in CIT V Indian Bank [56 ITR 77] did not accord with disallowance of proportionate expenditure. This view was followed in CIT vs Maharashtra Sugar Mills limited (82 ITR 452). It was held that no part of managing agency commission can be disallowed on the ground that it partly relates to managing sugarcane cultivation, the income of which was exempt from tax.
06. The Memorandum explaining the rationale behind the insertion of new section states that the claim of expenditure in respect of exempt income will reduce tax payable on non-exempt income and expenditure can be allowed only to the extent they are relatable to taxable income.
07. Exempt income and deductions from total income: Section 10 lists out income which do not form part of total income, like agricultural income, share of income of a partner from the firm, interest on notified bonds arising to a non-resident, interest on tax –free bonds, income by way of dividend, long-term capital gains from transfer of equity shares in a company or units of an equity oriented fund, through a Recognized Stock Exchange (RSE). The expenditure for earning those items of income should not find a place in the computation of total income.
08. Sections 10A, 10AA, 10B, 10 BA, allows for a deduction of the profits as specified in the respective sections in the computation of the total income. Similar is the case with respect to sections 80IA, 80IAB, 80IB, 80IC, 80ID, 80IE, 80JJA & 80JJAA. The provisions of section 14A will have no application to income referred to in these sections for the reason that income is ascertained after setting off against gross receipts, the expenses incurred for earning the income. The profits as ascertained will be considered and deduction allowed from the total income on so much of the profits as provided for in the respective sections.
09. Some payments or contributions referred to in Chapter VIA will have the effect of reducing the taxable income, as they are deductible from the gross total income. This deduction may be contrasted with exclusion of certain income, in that, the deduction reduces the taxable income whereas exclusion eliminates the exempt income from tax purview.
10. The sequence of insertion of section 14A & issuance of allied circulars/notifications
(i)                 Section 14A was introduced by the Finance Act 2001 effective from 01.04.1962
(ii)               Circular No 11/2001 was issued dated 23-7-2001
(iii)             A proviso to section 14A was inserted by the Finance Act, 2002 with effect from 11-5- 2001)
(iv)              The Finance Act, 2006 revamped the Section 14A adding sub sections (2) & (3) with effect from 1st April, 2007.
(v)                Rule 8D was added by Notification 45/2008 dated 24th March, 2008
11. GLIMPSES OF THE NEW PROVISION
Expenditure incurred in relation to income not includible under total income, to be ignored
12.   Section 14 A inserted in Chapter IV of the Income Tax Act, by the Finance Act, 2001, with retrospective from 1-4-1962 is intended to safeguard the interest of Revenue on account of wrong claim of expenditure relating to exempt income against taxable income.
13. The Finance Act, 2006 revamped the Section 14 A adding sub sections (2) & (3) with effect from 1st April, 2007.The provisions can be summed up as under
(1) For computation of total income under Chapter IV no deduction shall be allowed in respect of expenditure incurred in relation to income which does not form part of total income of the assessee
(2) If the AO is not satisfied with the correctness of claim of the assessee in respect expenditure relating to exempt income, the AO shall determine such expenditure in accordance with such method as may be prescribed
(3) The provision of sub section (2) shall apply where the assessee claims that no expenditure has been incurred with respect to exempt income.
14. As per Circular No 11/2001dated 23-7-2001, assessments where the proceedings have become final before 1-4-2001 should not be re-opened under section 147 to disallow expenditure incurred to earn exempt income by applying the provisions of newly inserted section
15. The proviso inserted by the Finance Act, 2002 with effect from 11-5- 2001, provides that the A.O cannot reassess under section 147 or pass an order enhancing assessment or reducing a refund already made or otherwise increase the liability of the assessee under section 154, for any assessment year beginning on or before the 1-4-2001.

Certain critical issues
1. The method prescribed for disregarding expenditure related to exempt income
For disallowing expenditure related to exempt income, the method of determining such expenditure especially the one under (iii) above seems arbitrary and not equitable. For, in a case where there is no income at all but only loss is incurred, this ad hoc addition to income by way of disallowance under the notification would cause unwarranted hardship. At times the disallowance may be more than the exempt income itself, going by the method prescribed. Investment held in group companies for control purposes should be viewed from a different angle rather than mere dividend income. For, the benefits accruing from the shares so held is far more than the dividend, which make the holding company to have more economic power and increase synergy in the group. Also there is nothing in the section to suggest that indirect expenses will have been disallowed. Section 14A is on the expenditure relatable to exempt income and not on indirect expenditure which has no nexus to the earning of income.
Average of total assets in the formula given above would, it looks, would include debit balance in P& L account and miscellaneous expenses/ Deferred Revenue Expenses to be written off. Also Current assets may be taken at gross value without netting off against current liabilities. This would inflate the denominator in the formula given in (ii) above.
Averages used for value of assets and investment are not always infallible. Peak level investment or asset can sharply tilt the average. To iron out distortions, time-weighted averages could be used.
2. AO not to have suo motto right to resort to Rule 8D: It looks imperative on the part of the AO to resort to application of Rule 8D only if he is not satisfied with the correctness of the quantum of disallowance admitted by the assessee and where the assessee claims that no expenditure has been incurred with respect to exempt income.
3. Whether the “prescribed method” is retrospective or Prospective: The “Prescribed method” was announced by notification dated 24-3-2008, though sub sections (2) & (3) empowering AO to compute the disallowance of expenditure by the prescribed method were inserted by the Finance Act 2006 with effect from 1-4-2007, AY 2007-08. The notification comes into effect from the date of its publication. The AY for which the prescribed method is applicable would be 2008-09. However the considered view is that the prescription of method being a procedural formality the applicability would be from AY 2007-08.
4.   Whether the Rule apply to other indirect expenditure: The Rule extends (besides interest) to disallowing other expenses or indirect expenses as was held in the case of ITO vs. Daga Capital Management Private limited (2008) 26 SOT 603 (Mum).
5.         Dividend earned by an assessee who holds shares as stock in trade: It may also be observed that earning of dividend on shares held as stock in trade cannot be treated as a separate venture other than the business of trading in shares and therefore no disallowance will be called for under this Rule in view of Supreme Court decision in CIT vs. Indian Bank [56 ITR 77] and Rajasthan State Warehousing Corporation v CIT [242 ITR 450 (2000). However under the changed circumstances, the importance of this decision gets diluted.
6          Where there is no specific borrowing for investment: A manufacturing company having suppliers’ credit facility only, has the practice of investing or parking surplus money on a regular basis in mutual funds (dividend plan) and gets dividend income credited to its bank account. Such dividend income does not form part of total income under section 10 (34). Since there was no specific loan used for investment, except the cash flows generated from operations by way of profits, no identifiable cost could be attributed for the investment. Even opportunity cost could not be imputed, assuming that the source of investment being borrowed funds. The disallowance of indirect expenditure at 0.5% of the average investment would cause unwarranted hardship.
At times, it is possible that the assessee could have taken various types of loans for different purposes. It is not open to the AO to presume that a portion of some of these loans could be used for investment in shares of companies including group companies. The ITAT in Faze Three Exports Limited v Addl. CIT(Mum) (2008), noted that the presumption of lower authorities that the assessee could have used a portion of the loan taken for business purposes, for investments as well was unwarranted. The ITAT also further observed that the assessee could demonstrate that funds owned by it was much more than the loans taken and investment made and allowed the appeal by the assessee. Under these circumstances disallowance of a part of interest cost as per section 14A is not possible.
7          Where there is no income received as dividend: In Shree Shyamkamal Finance &   Leasing Company private limited, v ITO, the ITAT (Mum) (2006) observed that as the assessee did not receive any income as dividend in the relevant assessment year 2002-03, there could be no income which could be termed as income which did not form part of total income under the Act, and therefore the provisions of section 14A were not applicable. However the validity of this decision for future reference may not be acceptable to the Department for the reason that interest cost is always there whether income is received or not on the money borrowed for investment, supposed to yield tax free income like dividend.
8    Loss in a transaction covered by section 10 (38): A trader in shares and securities transfers/sells shares through RSE and incurs a loss. Since section 10(38) exempts income from transfer of capital assets being shares in a company and units of equity-oriented funds, transacted through RSE, a question may arise whether the trader in shares could claim the expenditure relatable to the such transactions in the computation of his income from business or profession and whether the loss could be adjusted against any other income in the same year or carried forward. Shares and securities constitute stock in trade for a trader in shares. Stock in trade is excluded from the definition of capital asset under section 2(14) and therefore 10(38) may not apply. Consequently section 14A is uncalled for. Adjustment of loss/Carry forward of loss is sustainable.
But in the case of ITO vs Daga Capital Management Private limited (2008) 26 SOT 603 (Mum) the Special bench took the view that the provisions of section 14A were applicable with respect to dividend income earned by the assessee engaged in the business of dealing in shares and securities, on the shares held as stock in trade when earning of such dividend income was incidental to trading in shares.
9    Whether loss on sale of capital asset being shares to which section 10(38) applies can be adjusted against any other long term capital gain: Views may be split as to whether the loss sustained in a transfer of capital asset to which exemption under section 10(38) applies, could be adjusted against any other long term capital gain in the same assessment year or carried over for set off in future. Section 10 starts with the words “In computing the total income of any person, any income falling within any of the following clauses shall not be included”. “Any income” referred to here means that neither income nor loss should be taken into account in the computation of total income. Logically the loss on sale of shares referred to in section 10(38) shall not be eligible for adjustment or carry over since it is outside the scope of computation of total income.
10 Investment and the loan taken for investment are not recorded in the books of account: If the loans taken for investment as well as the income from investment are not recorded in the books of accounts, it appears that the method prescribed for computation of the expenditure to be disallowed may not be relevant. Hopefully the prescribed method may be reviewed and the hardship caused averted.
11 Whether addition on account of applying section 14A attracts penalty under section 271 (1)(c) : Only when there is concealment of income or the particulars of income furnished are inaccurate, the provisions of this section is attracted. By applying the prescribed method under rule 8D, addition by way of disallowance of expenditure under section 14A is made, we have to ascertain whether or not the assessee has furnished inaccurate particulars in the course of assessment proceedings. If the assessee offers an explanation which is not found by the Assessing Officer to be false there is no need to invoke this penal provision. By offering correct explanation, the assessee enables the AO to quantify the amount of disallowance. Having cooperated with the AO in the assessment proceedings in this manner, the assessee cannot be faulted for furnishing inaccurate information or explanation. Under these circumstances section 271(1)(c ) will have no role to play. However the assessee should not give room for any misgivings. He should place before the AO all the records and documents besides furnishing correct information.
12 14A in the context of MAT: Section 115 JB provides for increasing the book profit by the amount of expenditure relatable to any income to which section 10 [other than 10(38)] applies and reducing the book profit by the amount of income to which section 10 [other 10(38) applies. Now that the “method” is in place, the rigmarole of determining the amount of expenditure to be added and year of applicability of the “prescribed method” has to be undergone.
Now let us analyze few latest judicial judgments related to section 14A of the Income tax Act, 1961.
  • In the case of CIT v Winsome Textile Industries Limited 204 ITR 319, the court decided that when shares were acquired by way of own fund and no interest incurred as there was no borrowed fund, then there cannot be any disallowance under section 14A of the Income Tax Act, 1961.
  • In the case of CIT v Hero Cycles Limited 323 ITR 518 the hon’ble court decided that disallowance under section 14A is not permissible where no nexus between expenditure incurred and income generated.
  • The section 14A of the Income tax Act, 1961 is not applicable to any insurance business as they are governed under specific provisions of section 44 of the Income Tax Act, 1961.  This had been decided by Pune ITAT in the case of Bajaj Alliance General insurance Co. Ltd. vs. Addl. CIT 38 DTR 282.
  • In the case of Bombay Dyeing Mfg. 30 SOT 461 It has been held that the AO, in view of the statutory embargo placed on his jurisdiction by virtue of the proviso to S.14A of the Act, to make reassessment, in respect of specified assessment years has acted without jurisdiction in re-opening the assessments for the A.Y. 1998-1999 to bring to tax income described under substantive provisions of s.14A
  • The fact that the profits are charged to tax in the hands of the firm does not mean that the share of such profits is non exempt in the hands of the partner. The profits being exempt in the hands of the partner, Section 14A does apply in computing his total income. A firm and the partner are consequently separate entities under the act. This had been decided in the Tribunal decision of Dharmasingh Popat  ‘H’ ITA No. 7534/M/04, A.Y. 2001-02. Mumbai.
  • Further in the case of Hitesh D. Gajaria  ITA No. 993/Mum/2007, Bench – H, AY 2003–04, dt. 14-11-2008 BCAJ p. 519, Vol. 40-B, Part 4, January 2009, Tribunal decided that, it is not possible to hold the view that share income in the hands of partner of a partnership firm is altogether tax free. It is held that share of profit in the hands of a partner is income which has suffered tax in the hands of the firm and found that the share of profit from the firm is exempt from tax u/s. 10(2A) not in absolute sense but with a view to avoid double taxation. Accordingly, s. 14A is not applicable to the facts of the case.
  • In one of the case, where the AO had not invoked the provision of s. 14A of the Act to disallow the expenditure incurred by the assessee in relation to the earning of exempt income, the High Court held that tribunal was not justified in remanding the matter back to the file of  the AO with a direction to consider the applicability of s. 14A.
  • The Calcutta High court decided in the case  of Eih Associated Hotels Limited that  It could not be assumed that assessee did not incur any expenditure in earning dividend and therefore disallowance u/s. 14A restricted to I percent of tax free dividend received by the assessee. 126 TTJ 246
  • The Delhi High Court in the case of Mrs Susma Kapoor decided that Interest could be disallowed only to the extent of loan invested in shares.  32 DTR 212
  • In the historical judgment of Cochin High Court in the case of State bank of Travancore 318 ITR 171 it had been decided that any expenditure incurred by the assessee bank for investing in the bonds, even tax free was expenditure incurred for carrying on its business, so as to maintain the required statutory liquidity ratio and tax free interest is just an incidence to it. Thus, s. 14A had no application in the case of the assessee.
  • In the case of Cheminvest Ltd  317 ITR 86, the Delhi High court decided that disallowance under section 14A, can be made in a year in which no exempt income has been earned or received by the assessee.
  • ITO v Daga capital Management P. Ltd. (2009) 312 ITR 1 (AT)(Mumbai)(SB) where it held that  Section 14A applies to all heads of income and gains at disallowing expenditure incurred in relation to income not forming part of total income even though such expenditure may be allowable under any other provision e.g. 36(1)(iii). Provisions of s.14A are applicable with respect of dividend income earned by the assessee engaged in the business of dealing in shares and securities, on the shares held as stock in trade. Provisions of sub-s. (2) and (3) of s. 14A are procedural in nature, hence, applicable retrospectively.
  • In another important judgement of  S. Balan Alias Shanumugam Balkrishnan Chettiar  120 TTJ 397  it had been decided that  Interest on funds borrowed for acquisition of shares is to be taken into account towards the cost of acquisition for the purpose of computation of capital gains as prescribed u/s. 48(1). Capital  gain on sale of shares being part of the total income of the assessee and not an  exempted income and accordingly section  14A has no application.
  • Regarding the constitutional validity of section 14A , the Mumbai High Court decided in the case of Godrej & Boyce Mfg Co. Ltd v DCIT 328 ITR 81 that  Provisions of sub section 2& 3 of section 14A are constitutionally valid and accordingly In view of Godrej Boyce Mfg. Co. 328 ITR 81 (Bom.) Rule 8D is applicable only prospectively i.e. from A.Y. 2008-09 and not for earlier years. The facts showed that the assessee had made the investment in shares out of its own funds and the borrowed funds were entirely utilized for the purpose of its business. The investment in shares in the current year was made from a separate bank account where the surplus funds generated in that year were deposited. The argument that the assessee could have utilized its surplus funds in repaying the borrowings instead of investing in shares and by not doing so, there was diversion of borrowed funds towards investment in shares to earn dividend income is not acceptable in view of CIT vs. Hero Cycles Ltd 323 ITR 518 where it was held, distinguishing Abhishek Industries 286 ITR 1 (P&H), that if investment in shares is made by an assessee out of own funds and not out of borrowed funds, disallowance under section 14A is not sustainable. Accordingly, the disallowance of interest on borrowed funds was deleted.
  • In the light of Godrej & Boyce Mfg. Co. Ltd. As above (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. This had been decided by ITAT Delhi in the case of Continental Carriers Pvt. Ltd. vs. ACIT
  • In the case of Pawan Kumar Parmeshwarlal vs. ACIT, it had been decided that  The assessee being a  stock broker & Member of BSE earned tax–free income by way of dividend interest on RBI bonds and PPF interest. The assessee claimed that no disallowance under section 14A could be made as no expenditure was incurred by him to earn tax free income as shares were in the Demat account for long time and dividend was automatically credited to bank account. The Assessing Officer disallowed Rs. 20,000/- under section 14A. In appeal CIT(A) instead of examining the issue on factual basis directed the Assessing Officer to apply Rule 8D. On appeal to the Tribunal, allowing the appeal held that disallowance under section 14A cannot be made on being for personal purposes.
  • The ITAT Delhi in the case of Dy. CIT vs. Jindal Photo Ltd decided that  it was held that Rule 8D r.w.s. 14A(2) can be invoked only 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 expenditure incurred” in relation to tax-free income. The burden is on the Assessing Officer to establish  nexus of expenses incurred with the earning of exempt income, before making any disallowance under section 14A. There cannot be any presumption that the assessee must have incurred expenditure to earn tax free income.
  • ITAT Delhi again the case of Dy. CIT vs. Maharashtra Seamless Ltd. Decided that   no disallowance can be made under section 14A of interest on borrowed funds where in case of mixed funds, it is not possible to ascertain whether the investment in tax free bonds is out of the assessee’s own funds, the source of investment in the tax free bonds is identified, and the Assessing Officer failed to establish any nexus between the borrowed funds and the investments in the tax free bonds. As also the cash flow of the assessee was not seen. Therefore, the apportionment on a pro rata basis was improper in the absence of anything brought by the Assessing Officer to rebut the assessee’s stand that the investment in the tax free bonds had been made out of the funds of own funds (Minda Investments, Hero Cycles 323 ITR 518 (P&H) and Winsome Textile Industries 319 ITR 204 (P&H) followed)
  • In ACIT v Citicorp Finance (India) Limited [300 ITR 398(AT Mum)] it was held that the provisions of sub sections (2) & (3) are procedural in nature and therefore section 14A will apply to all pending matters.
  • However in the case of Wimco Seedlings limited v Dy CIT (Del) (TM) it was observed that the Assessing Officer is given the authority to determine the expenditure to be disallowed by the prescribed method only from the Assessment Year 2007-08, the year from which year the sub sections came in to force.
Conclusion: As could be seen from the above discussions a few issues need to be addressed by the law makers to avoid litigation. The disallowance of assumed indirect expenses on a percentage basis would nullify the exemption itself. It is preferable to keep expenses of exempt income under separate cost code and demonstrate that no such expenditure has been taken into account in the computation of total income, so as to avoid recourse to Rule 8D. It is advisable to compute the total income taking into cognizance the expenditure to be disregarded with respect to exempt income as provided for under this rule.
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