Whether even if investments made by assessee earn no income, expenditure incurred on such investments is liable to disallowed under Rule 8D(2) - NO: ITAT

THE issue before the Bench is - Whether even if investments made by assessee earn no income, expenditure incurred on such investments is liable to disallowed under Rule 8D(2). And the tribunal's answer is NO.

Facts of the case

The assessee is a non-banking financing company engaged in the business of investing in micro-

finance companies in India. Assessee entered into a fund management agreement with CAPL as per which, the said company would render consultation services to the assessee in the matter of investment etc. as a fund manager. Assessee filed its return declaring 'Nil' income. Initially the return was processed u/s 143(1) and refund on account of TDS was also issued to the assessee. Subsequently, assessee's case was selected for scrutiny. During the scrutiny assessment proceeding, after examining the books of account and other details submitted by the assessee, it was noted by the AO that the fund manager i.e. CAPL was holding 18.7% shareholding in the assessee company. One of the Director in the assessee company was also a director in CAPL with 99% shareholding. He further noticed that in lieu of the services rendered, the fund manager was to be paid remuneration to the fund based services. It was furthernoticed that while computing its income, assessee has disallowed expenditure u/s 14A read with Rule 8D, out of the fund management fees claimed. After examining the details, AO was of the view that the disallowance of fund management fees worked out by the assessee was not correct. On the basis of the agreement with fund manager, AO worked out the fees paid to the fund manager. AO also quantified the expenditure pertaining to exempt/taxable income for the purpose of disallowance u/s 14A and called for an explanation from assessee for proposed disallowance. Assessee objecting to the disallowance proposed by the AO u/s 14A submitted that dividend income and income from mutual fund could not be regarded as exempt income since tax had been imposed and paid by the payer u/s 115-O and 115J. It was submitted that tax on dividend distributed cannot be anything other than tax on dividend income of the recipient/shareholder, which for the sake of administrative convenience and cost effectiveness wascollected from the paying company. It was further submitted that the situation is analogous to FBT paid on ESOP issued to non-resident. Vide CBDT Circular No. 9 of 2007 the non resident employee is allowed to take credit, in a foreign country, for the FBT paid by the employer on ESOPs. It was submitted that in terms with Ruled 8D assessee has computed disallowance u/s 14A by arriving at the direct expenditure by considering fees attributable to those investments which have yielded income. AO rejecting arguments of the assessee and made addition.

In appeal, CIT(A), upheld the addition made by the AO. CIT(A) held that based on the assessee's agreement with CAPL, the AO correctly computed the disallowance under rule 8D(2)(i). It was held that the AO can apply the provisions of rule 14A even if no expenditure is incurred to earn exempt income. The AO was fair enough in computing the disallowance u/s 14A separately for exempt income and for taxable income. It was further held that AO disallowed only that part of expenditure which pertained to exempt income. It was observed that the Rule 8D(2)(iii) applies even in cases where there is no exempt income as the formula relates to investment and not to income earned. Meaning thereby certain disallowance has to be made even in cases where there is no income at all and also in cases where no expenditure was actually incurred.

Assessee contended that there being no expenditure incurred by the assessee towards earning of exempt income, provisions of section 14A were not attracted. It was submitted that since dividend income earned by the assessee was subject to dividend distribution act u/s 115-O of the Act, it could not be considered as exempt income so as to bring it within the ambit of section 14A of the Act. It was submitted that AO had committed fundamental error by disallowing expenditure relating to investments which have not yielded any income during the year. It was contended that while computing disallowance under rule 8D(2)(i), AO should not have considered the investments which have not yielded any income.

Revenue submitted that AO is empowered to disallow expenditure relating to exempt income u/s 14A of the Act. It was submitted that the balance sheet of the assessee since did not provide correct picture, AO had undertaken the exercise himself for quantifying disallowance to be made u/s 14A read with Rule 8D(2)(i). It was submitted that neither during the assessment proceeding nor before the CIT(A), assessee had furnishing details as to what amount related to earning of exempt income and what amount was towards earning of taxable income. Therefore, in absence of any details by the assessee, it cannot be said that the computation made by the AO is incorrect.

Having heard the parties, the tribunal held that,

++ the assessee itself recognizing the fact that it has incurred expenditure towards earning of exempt income has disallowed expenditure to the tune of Rs. 35,65,860/- u/s 14A read with Rule 8D(2) of the Act. Therefore, assessee's challenge with regard to applicability of section 14A read with Rule 8D (2) cannot be sustained;

++ the first part contained in sub-rule D(2)(i), speaks of disallowance of the amount of expenditure directly relating to income which does not form part of the total income. Second part under sub-rule 8D(2)((ii) deals with disallowance to be computed on the basis of formula given therein in a case where the assessee incurs expenditure by way of interest which is not directly attributable to any particular income or receipt. The third part as provided under Sub-Rule 8D(2)(iii) is an artificial figure i.e. one-half per cent of the average 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. Aggregate of these three components would constitute expenditure in relation to exempt income and would be disallowed u/s 14A of the Act. Therefore, if we examine the facts of the present case in the context of the aforesaid statutory provision, it is quite clear that AO while working out disallowance under rule 8D(2)(i) has taken the total investment irrespective of the fact whether they have yielded income or not during the assessment year under consideration. The reasoning of the AO in this regard is actual earning or receipt of income will not be a condition for disallowance of such expenditure under the provisions of section 14A as it speaks about expenditure in relation to income which does not form part of the total income. He was of the view that even if no income was received, expenditure incurred can be disallowed u/s 14A. However, Rule 8D(2)(i) speaks of expenditure directly relating to income which does not form part of "total income". The term total income has not been defined either u/s 14A or under Rule 8D;

++ definition of 'total income u/s 2(45) refers to section 5 which envisages 'scope of total income'. On a reading of section 5 of the IT Act, it would be evident that as per this section 'total income' is of any previous year and which includes income from whatever source derived which is received or deemed to be received in India in such year by or on behalf of such person or accrues or arises or is deemed to accrue or arises to him in India during such year or accrues or arise to him outside India during such year. Considered in aforesaid context, expression 'total income' referred to in rule 8D(2)(i) cannot be in abstract. It must relate to a previous year income of which is sought to be assessed. Therefore, as a natural corollary it follows that only expenditure directly relating to income which is earned either on receipt basis or on accrual basis and which does not form part of total income of a particular assessment year can be disallowed under clause (i) of Rule 8D(2). Rule 8D(2)(i) does not refer to the investment made by the assessee. On a conjoint reading of clause (i) and clause (iii) of Rule 8D(2), the difference between them is clearly discernible. While clause (i) speaks of disallowance of expenditure directly relating to income which does not form part of total income, clause (iii) provides for disallowance of expenditure of the average 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 first day and last day of the previous year. Therefore, while disallowance of expenditure under clause (i) is related to income earned which does not form part of total income, clause (iii) relates to the average of the value of investment appearing in the balance sheet. On a plain reading of Rule 8D(2) as a whole the legislative intent becomes clear that the disallowance of expenditure contemplated under sub-rule(i) must relate to the income which does not form part of the total income of that year. Therefore, investment, which has not resulted in any income cannot be considered for the purpose of disallowance under Rule 8D(2)(i). However, while computing disallowance under rule 8D(2)(iii), the average of the total investment of the assessee as appearing in the balance sheet on the first day and last day of the year irrespective of the fact whether it has yielded income or not can be considered for the purpose of disallowance. The use of the words does not or shall not in Rule 8D(2)(iii) connotes that income not only does not form part of total income during the year but it also shall not form part of total income at any time. Had it been the intention of the Rule framing authorities to disallow under rule 8D(2)(i) expenditure relating to total value of investment or income which is not earned during the relevant previous year, then, they would have used the expression 'does not or shall not form part of total income' as appearing in rule 8D(2)(iii) instead of words 'does not form part of total income'. That being the case, AO cannot disallow expenditure relating to investment which has not yielded any exempt income during the previous year relevant to the assessment year under dispute. Therefore, we direct the AO to disallow the expenditure relating to investments resulting in income earned/accrued which does not form part of total income of the impugned assessment year. However, so far as AO's computation of expenditure to be disallowed under rule 8D(2)(iii), the same in our view, is in conformity with Rule 8D(2)(iii), hence, do not call for any interference.