Section 14A of the Income Tax Act, 1961 - an Overview

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Section 14A of the Income Tax Act, 1961 - an Overview 

There has always been a debate between the taxpayers and the income tax authorities regarding the expenditure incurred on the exempt income. One party would demand a deduction for the expenditure, while the other party would refuse the deduction. 

The Income Tax Act, 1961 provides for certain incomes that are not taxable or are exempt under the law. So, the taxpayers asserted that the expense incurred with regard to such exempt income should also be allowed as a deduction. However, the income tax authority believed that since the income is already fully exempt, the expenditure should not be allowed as a deduction. The authority objected that allowing the deduction here would reduce the tax on other taxable income as well. 

The matter then reached the Court and Section 14A came into force in 2001 with retrospective effect from 1962. This was to provide clarity on the allowance or disallowance of expense incurred on exempt income. 
 

What is Section 14A? 

Section 14A of the Income Tax Act, 1961 provides that any expenditure incurred in relation to income which does not form part of the total income shall not be allowed as a deduction while computing the total income of the assessee. The income which does not form part of the total income means exempt income. 

Sub section (2) and (3) 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 the Act 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 the exempt income or
  • the assessee’s claim that no expenditure has been incurred by him in relation to such exempt income.

Determination of Amount of Expenditure in Relation to the Exempt Income - Rule 8D

The Assessing Officer shall determine the amount of expenditure, in relation to the income which does not form part of the total income, in accordance with the provisions of Rule 8D(2). 
Rule 8D(2) provides for a method to determine the amount of expenditure in relation to the exempt income. According to this rule, the amount of such expenditure shall be the aggregate of the following: 

  • The amount of expenditure directly relating to the income which does not form part of the total income and 
  • An amount equal to one percent of the annual average of the monthly average of the opening and closing balances of the value of the investment, income from which does not or shall not form part of the total income. 

However, the amount referred above shall not exceed the total expenditure claimed by the assessee. 

To understand the determination of the amount of expenditure under Rule 8D(2) more clearly, here is an illustration for the same: 
Assume that Mr. Y took a loan of Rs 25 lakh at the rate of 10% interest on 1st January 2020. The loan was utilized for the purpose of various investments on which Mr. Y received a dividend. Dividend income is exempt from tax under the income tax act. The amount of interest expenditure incurred on the loan was Rs. 250000. 

 

 

Month

Balance

January 

2000000

February

2750000

March

3000000

 

 


Determination of amount of total expenditure to be disallowed: 

 

Particulars

Amount

Amount of expense directly related to the income which does not form part of the total income

250000

Amount equal to one percent of the annual average of the monthly average of opening and closing balances of value of investment whose income is exempt (1% of Rs 2083333)

208333

Total amount of expense disallowed u/s 14A read with Rule 8D(2)

458333


Computation of one percent of average of investment balances: 

Monthly average: 

January: Rs 0 + Rs 2000000/2 = Rs 1000000

February: Rs 2000000 + Rs 2750000/2 = Rs 2375000

March: Rs 2750000 + Rs 3000000/2 = Rs 2875000


Annual average: 

Rs 1000000 + Rs 2375000+ Rs 2875000/3 = 2083333


Section 14A Disallowance in the Absence of Exempt Income

There had been controversies regarding the disallowance of expenditure even in the absence on the exempt income during the financial year. Various litigations were held where courts gave their judgment in favor of the taxpayers that in the absence of exempt income, no disallowance of expenditure shall be made. 

However recently in Budget 2022, an explanation was proposed to be added to Section 14A which put an end to all the debates and controversies. As per the explanation to Section 14A, notwithstanding anything contained in the Act, the provisions of this section shall apply and shall be deemed to have always applied in case where the income not forming the part of total income has not accrued or arisen or has not been received during the previous year relevant to an assessment year and the expenditure has been incurred during the said previous year in relation to such income not forming part of the total income.

To put it in simple words, if during a financial year an assessee has incurred an expense of Rs 50000 in relation to an exempt income which has not been accrued or arisen or received during that year. Now, since the exempt income is not received during the year, section 14A would not be applicable. However, the explanation to section 14A comes into force in this case, Even though there is an absence of exempt income on which the expense of Rs 50000 was incurred, the expense will not be allowed as a deduction.

This explanation has its impact on the investment in agricultural land or partnership firms and various other revenues that are exempt under the law. However, it is not applicable to investments from which dividend income is earned by the assessee. 
 

 


Author : Simran

Date     : 28-Jul-2022


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