Section 14A: Disallowance of Expenses Incurred for Earning Exempt Income

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Section 14A: Disallowance of Expenses Incurred for Earning Exempt Income
 

Section 14A of income tax act has always been a matter of debate among assesses and tax experts. The income tax law has specified certain income whereby income tax shall be exempted. A general principle of income tax is that expenditure incurred to earn any income shall be allowed as a deduction from such income. However, what if the income itself is exempted? What shall be the treatment of expenditure in relation to such income?
 

Expenditure Incurred in Relation to Exempt Income

An assessee might earn both taxable and exempt income. Income tax law states that if the assessee is earning an income that is exempt from tax, then the expenditure incurred to earn such income shall not be allowed as a deduction against taxable income. The prime purpose is to maintain equity in the treatment of income and expenditure. Section 14A of the Income Tax Act, 1961 holds prominence in this regard.

As per Section 14A of income tax act, no deduction shall be allowed in respect of expenditure incurred for earning exempt income. It is upon the assessee to furnish the details of the expenditure incurred in respect of the exempt income. However, if the assessing officer is not satisfied with the correctness of the claims made by the assessee, then the AO shall have the power to determine the amount of such expenditure by following the manner prescribed in Rule 8D. AO can follow the manner prescribed in Rule 8D even if the assessee claims that no expenditure has been incurred in relation to the exempt income.


Rule 8D of Income Tax Act, 1961

Rule 8D of income tax act deals with the following two scenarios where the AO is dissatisfied either by the:

  • Correctness of the claims of the assessee in respect of such expenditure or
  • Claim by the assessee that no expenditure has been incurred for earning the exempt income.

In such a case, the AO shall adopt the following methodology to determine the expenditure incurred to earn the exempt income:

  • The amount of expenditure directly relating to exempt income; and
  • An amount equal to 1% of the annual average of the monthly average of the opening and closing balances of the value of the investment from which exempt income is being earned.

However, the total of the above two shall not exceed the total expenditure as claimed by the assessee. 

Let’s understand the above with a practical example of Section 14A of the income tax act:

Mr. A took a loan of Rs. 1,00,000 @ 10% p.a. from the bank to invest in various avenues the income from which is exempt from tax. He ended up paying Rs. 10,000 as interest on loan. There are various other expenses incurred for earning income from these exempt sources. However, the income tax department sent a notice disallowing expenditures as per Section 14A. Following was the calculation provided by the department:

Expenditure Directly Related to the Exempt Income (Interest on Loan)

Rs. 10,000

Expenditure Disallowed as per Section 14A (Note-1)

Rs. 1933.33

Total Expenditure Disallowed

Rs. 11,933.33

Note-1: Disallowance as per Section 14A

Disallowance as per Section 14A shall be calculated by applying the provisions of Rule 8D:

Period

Opening Balance

Closing Balance

Average Balance

April 2022

1,00,000

1,50,000

1,25,000

May 2022

1,50,000

1,65,000

1,57,500

June 2022

1,65,000

1,65,000

1,65,000

July 2022

1,65,000

1,45,000

1,55,000

August 2022

1,45,000

1,85,000

1,65,000

September 2022

1,85,000

1,95,000

1,90,000

October 2022

1,95,000

2,00,000

1,97,500

November 2022

2,00,000

2,30,000

2,15,000

December 2022

2,30,000

1,90,000

2,10,000

January 2022

1,90,000

2,40,000

2,15,000

February 2022

2,40,000

2,55,000

2,47,500

March 2022

2,55,000

3,00,000

2,77,500

GRAND TOTAL

23,20,000

 

Annual Average = 23,20,000 / 12 months = Rs. 1,93,333.33
Expenditure amount = 1% of Rs. 1,93,333.33 = Rs. 1,933.33

Key Points

Disallowance under section 14A has been a matter of debate in various courts. Following are some of the key points surrounding disallowance under section 14A:

  • Only the investments in relation to the exempt income shall be considered for calculation of the amount of expenditure as per Rule 8D.
  • Disallowance under Section 14A can be made only if the assessee has claimed a deduction of the expenditure. If the deduction is not claimed, no question of disallowance arises.
  • In many cases, the judiciary held that if there is no exempt income, then Section 14A cannot be invoked to disallow any expenditure. This came as a relief for the assesses that if they have not earned the exempt income for the year under consideration, then the income tax department cannot disallow any expenditure. This was held in the case of Ballarpur Industries by the Hon’ble Bombay High Court as well as in the case of Cheminvest Ltd. by the Delhi High Court.

However, CBDT vide release of Circular No. 5/2014 dated 11-02-2014 clarified that if an expenditure was incurred for the purpose of earning an exempt income, then such expenditure shall be disallowed under Section 14A regardless of whether the exempt income was earned or not.
It has been held by various courts and tribunals that while calculating book profits under Section 115JB, no adjustments in the book profit shall be made on account of disallowance under section 14A.
 


Author : Dipen

Date     : 28-Jul-2022


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