The Tax laws in India treat certain income for a taxpayer as non-taxable income such as agricultural income, dividend received from an Indian company, income of eligible charitable institution, tax-free interest etc. It is possible for taxpayers to have incurred certain expenditures to earn any such income amongst others for eg: interest on a loan to fund investment in tax-free bonds, company shares.
As per Section 14A of the IT Act, expenditure incurred by the taxpayer in relation to income which does not form part of total income at all as per the provisions of the IT Act should not be allowed as deduction while computing total income of the taxpayer.
Method to determine expenditure incurred towards exempt income:
Section 14A has prescribed the method for determining the expenditure incurred towards earning exempt income under Rule 8D of the IT Act by income tax officer. The method prescribed under Rule 8D can be applicable only in the following scenarios:
- Where the taxpayer claims that no expenditure has been incurred towards earning exempt income; or
- Where the taxpayer has already disallowed amount towards expenditure incurred in relation to earning exempt income, however, assessing officer is not satisfied that the claim of the taxpayer is correct considering the accounts of the taxpayer.
Rule 8D – Methods to determine expenditure incurred towards exempt income:
As per the IT Act expenditure incurred in relation to earning exempt income is the aggregate of the following:
- Any amount of expenditure which is directly related to the exempt income; and
- The amount equal to 1% of the annual average of monthly average of opening and closing balances of a value of investment whose income is or shall be exempt
However, any disallowance computed under this Rule cannot exceed the total expenditure claimed by the taxpayer.
An illustration on Rule 8D computation
Mr. X has taken a loan on 5 January 2018 of Rs 15 lakhs @ 10% for the FY 2017-18. Therefore, his interest expenditure for the year on this loan is Rs 1,50,000. The loan was utilized for making an investment of Rs 15 lakhs in various avenues, income from which is tax exempt.
Monthly closing balances of this investment was Rs 10,00,000 (January 2018), Rs 12,50,000 (February 2018), Rs 15,00,000 (March 2018).
|Particulars||Amount (in Rs)|
|Any amount of expenditure which directly relates to exempt income||1,50,000|
|Amount equal to 1% of annual average of monthly average of opening and closing balances of value of investment whose income is or shall be exempt – 1% of Rs 10,00,000
Monthly average of Investment
January 2018 – Rs 0 + Rs 10,00,000/2 = Rs 5,00,000
Annual Average of the above monthly averages= Rs 5,00,000 + Rs 11,25,000 + Rs 13,75,000 / 3 (Loan was borrowed only in January 2018) = Rs 10,00,000
|Total disallowance under Section 14A read with Rule 8D||1,60,000|
Key points while calculating Tax Exemptions
- Disallowance under Section 14A is only with respect to the expenditures that are already claimed as a deduction. If the taxpayer has not claimed any deduction at all, there cannot be any question of disallowance.
- The Basic condition for applicability of Rule 8D has to be satisfied and AO needs to mandatorily show why he is not satisfied with taxpayer’s computation and show taxpayer’s computation to be incorrect based on the principal of natural justice and various other case laws including the decision of SC.
- For the purpose of Rule 8D, only those investments relating to the exempt income should be considered for calculating the average and not the entire investment.
Following are few controversies that have arisen over a period of time due to different views adopted by various deciding forum:
- Where disallowance can be made in the absence of exempt income in any FY?
- Though there had been countless litigation on this issue, it seems to have been settled by various judgments of high courts which have held that disallowance cannot be attracted under Section 14A in absence of exempt income.
- Whether exempted income for the purpose of this section includes profit-linked deduction under Chapter VI-A?
- This includes a deduction in respect of profits and gains of specific industries such as hotel business, small-scale industrial undertaking, housing projects, export business, infrastructure development, units in Special Economic Zone etc
- Whether the Section is applicable to shares held as stock in trade?
- As only dividend income in such case would be exempt and gain on sale would be taxable business income based on a dominant intention of the taxpayer to hold shares as stock in trade and not to earn dividend? This issue was also settled by SC in its judgment pronounced in February 2018 (published in March 2018) in the case of Maxopp Investment Ltd. SC held that “even when shares are held as stock in trade, disallowance is attracted on expenditure apportioned towards exempt dividend income and expenditure apportioned towards business profit is allowed as a deduction”.
- Whether disallowance can be attracted to dividend income from Indian Companies?
- As dividend income is actually not exempt but tax is collected from the companies itself in the form of Dividend Distribution Tax (DDT).This issue has been a matter of debate before various courts and Tribunals which is now settled with the decision of SC in May 2017 in the case of Godrej & Boyce Manufacturing Company Limited where SC held that disallowance is attracted even when Dividend Distribution Tax (DDT) is paid by companies.
Section 14A and Rule 8D of the Income Tax Act have been one of the most controversial provisions of Income Tax Act wherein there is no clarity on various things and has utmost litigation even for something that may seem simple and straight.