Income Tax Taxation

Analysis of Tax on Exempt Income


Analysis of Tax on Exempt Income u/s 14A Read with Rule 8D under Income Tax Act, 1961

It is well established governing principle of income tax act where it is very clear not to tax-exempt income, however, it is always a part of the dispute in between taxpayer and department regarding allow or not to allow expenses incurred for exempt income.

Over time, based on various issue and its decision as of now, the government has already notified the section 14A but due to initiation of provision with the word “No” is always been problematic for both assess an officer. Therefore Rule 8D come into the picture to analyses the allowance and disallowance of expenditure incurred for exempt income by assessed.

Provision u/s 14A

It starts with “No”, means in a first instance whatever may be the expenses incurred for exempt income deduction is not allowed. Therefore in most of the cases Assessing Officer is always of concern to disallow the expenditure in totality irrespective the fact of involvement of exempt income on totality in the computation of income and tax thereon. In the 2nd instance of the provision of Income-tax stated in Section 14A, Assessing Officer should follow Rule 8D to determine the amount of expenditure incurred in relation to such exempt income.

Rule 8D

It prescribes the method for computing the amount of expenditure in relation to income not includible in total income. It can be opted by Assessing officer (AO) having regard to the account of assessed of the previous year is not satisfied with the correctness of the claim of expenditure or the claim made by the assessee that no expenditure has been incurred in relation to income which does not form part of total Income Tax Notice.

Method gave u/r 8D

In sub-rule 2 of Rule 8D, the method is explained which read as expenditure in relation to income which does not form part of total income shall be aggregate of following amounts:-

  1. Amount of expenditure directly relating to income which does not form part of income;
  2. In a case where taxpayer has incurred expenditure by way of interest during previous year which is not directly attributable to any particular income or receipt, an amount = amount of expenditure by way of interest other than of point (a) * average value of investment as appearing in balance sheet of assets 1st day and last day of Previous Year/ average of total assets appearing in balance sheet on 1st and last day of previous year
  3. Amount equal to .5% of annual average of monthly average of opening and closing balance of value of Foreign investment, income from which does not or shall not form part of total income
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Concluding the amount of expenditure disallowed will be the sum of (a), (b) & (c) however the same shall not exceed the total expenditure claimed by the assessee.

While summarizing the method of determination of allowance and disallowance of expenditure, the Tax Audit department has given formula under which it has given total amount to be disallowed in respect of having income which is not part of total income. The method is negatively derived i.e. non-allowing expenditure for exempt income.

Expenditure directly related to exempt income is always not allowed. The query is always what if income is mixed i.e. inclusion of both exempt and non-exempt income, the first is exempt income which is not taxable and the query is what about expenditure claimed by assessee in books at all.

Now the method is used to disallow the expenditure. Income comprising both exempt and non-exempt with expenditure claimed at all has issued for the department. Hence it is always tried to find out the best-suited way out to eradicate the false practice to minimize the tax amount based on this rule.

At a conclusion, the department has given rule stating the expenditure directly related to exempt income, interest expenditure incurred on investment and amount equal to .5% of the annual average of the monthly average of opening and closing balance of the value of the investment is disallowed.

The rule is very specific on computation of disallowance of expenditure but what if having exempt income in books and  no expenses are incurred/booked on books of account by assessing, department can do assessment based on this rule and can add back the expenditure to increase the income of assessee just because of holding such investment in its books.

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Expenses directly incurred in relation to exempt income then disallow the expenses, rightly assessed.

Have exempt income and no expenditure then it is always very difficult to assess to substantiate the fact by producing eligible evidence of not having expenditure on such income. Most of the case, Assessing officer follow Rule 8D and add back expenditure to increase the profit of assessed. In consequence, assess is forced to pay extra tax or to go on appeal subject to the materiality of add back on books.


Assessing officer objected the expenditure incurred on “Finance Cost” and issue the notice to explain why provision of section 14A read with Rule 8D is not invoked.

Here, AO must have focused on Investment, Dividend Income, and Borrowing & Finance Cost and invoke section 14A and disallow the expenditure as below:-

  1. Expenditure directly related to exempt income = Nil [Rule 8D (2) (a)]
  2. 1, 66,154/- [Finance Cost*Average of investment/Average of Total Assets i.e. 3, 00,000*9, 00,000/16, 25,000] based on Rule 8D (2) (b)
  3. 4,500/- [.5% of Average of investment] based on Rule 8D (2) (C)

As per calculation, AO needs to add back the expenditure of Rs. 1, 70,654/- [Sum of (a), (b) & (c) however as per the proviso the disallowed expenditure can’t exceed the total exempt income.

Hence AO required doing adjustment accordingly.

However, this is practice going on as of today also.

Therefore a lot of litigation is also pending in Department either in AO, CIT, CIT (A), or ITAT too. The matter seems easy and dispute eliminating but the way of computation applied by AO is objected able for assessed in each corner.

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Similar to this example, a number of the dispute is there in department and subject to a number of merit on case and documents/evidence produced before the authority to substantiate the fact of case accordingly decision is provided.

Based on Section 14A read with Rule 8D of Income Tax, most of AO move with this calculation and provide the add back for assessing hence number of judgment is there to address the issue where it has been established that the disallowance of expenditure can’t exceed the exempt income. Therefore law should not be interpreted to mean disallowance of entire tax-exempt income.

PCIT-I Vs M/s Empire Package Pvt. Ltd (Punjab & Haryana High Court) in ITA No. 415 of 2015 dated 12.01.2016 and Pest Control India Pvt. Ltd V DCIT in ITA No. 5048 of 2016 dated 31.10. 2017 (ITAT Mumbai) both case has given benchmark judgment to establish the fact that the disallowance of expenditure on exempt income can’t exceed the amount of exempt income earned that year.

After reviewing the provision of Section 14A read with Rule 8D, the authority has the power to Change the Effects on taxpayer just because of holding investment and having exempt income in his/her books of account. Therefore it is very required to have good practice from both assessing officer and taxpayer.

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