Income Tax Taxation

Read About the Provisions and Exemptions Under Section 14A

Tax is the primary source of revenue for Government in India, and thus, various forms of income are taxable under the purview of the Income Tax Act^[1]. However, individual incomes are exempted from taxability and don’t fall within the scope of the tax laws of India. Incomes such as agricultural income, tax-free interest, eligible incomes of charitable institutions, etc. are exempted from tax, and thus assessee needs not to pay any tax on such income.

However, in a few cases, assessee incurred certain expenditures to earn income, which is tax-free income, i.e., exempted income. For Instance, to finance the investment in tax-free bonds, the taxpayer has taken the loan and is paying the interest on such a loan.

So, the question arises whether the taxpayer can claim the expenses incurred to earn the exempted income. There is a contradictory view on this debate. The taxpayer contended that such expenses incurred to earn the exempted income should be allowed as a deduction to arrive at taxable income. On the contrary, Income Tax Department holds an entirely different view stating that whole income is already exempted from tax liability, and those expenses shall not be allowed as they will reduce the total tax liability on non-exempted incomes.

Therefore, section 14A was introduced with effect from 2001, bringing clarity on the intentions of the legislature concerning the expenses made to earn exempt income, which is discussed in brief henceforth.

Section 14A- An Overview

As per the Section 14A of the Income Tax Act, 1961 expenditure incurred by the taxpayer for earning the income which is not included in the taxable income or such incomes are exempted from the tax implications should not be considered or taken into account while computing the total income of the taxpayer to levy tax thereon.

The main motive behind the insertion of this section is to ensure that the taxpayer doesn’t get the double benefits in case of composition transactions.

Applicability of Section 14A

Section 14A applies in the following cases:

• The taxpayer claims that there is no expenditure incurred for earning such exempted income.
• The taxpayer has incurred the expenses to earn the exempted income, and such expenses are disallowed by the taxpayer
• The assessing officer is not satisfied with the correctness of the amount claimed for expenditure incurred.
• The assessee has invested to earn exempted income.

Process of Applying Section 14A

Section 14A contains the following sub-section:

1. Section 14A (1) prevails if the taxpayer has incurred the expenditure to incur the exempted income.

• Section 14A (2) if the taxpayer claims the amount of expenditure incurred concerning earning the exempted income and the Assessing officer has to verify the accounts of such taxpayer for verifying the correctness of the claim. Assessing Officer verifies the expenses mentioned in the books of account and after assessment, if the officer is:
• Satisfied with the claim after such verification, he shall disallow the expenses u/s 14A.

OR

•  In case he is not satisfied with the claim, he will start the application of Rule 8D for calculating the amount of disallowance.

• Section 14A (3) is applied in case the taxpayer has not incurred any expenditure for earning the exempted income. In this case, assessing officers directly apply Rule 8D for determination of the expenditure that can be disallowed under section 14A.

Rule 8D of Income Tax Rules

As per rule 8D(1), in case the assessing officer after verifying the books is not satisfied by:

1. The correctness of the claim made by the assessee concerning expenditure made by the taxpayer to incur tax-free income

OR

• Regarding the claim of the taxpayer that no expenditure has been incurred on exempted income during the previous year.

The assessing officer shall determine the value of the above-stated expenditure as per Rule 8D(2). As per this rule expenditure incurred for earning the exempted income shall be the aggregate of the following two:

1. Amount of expenditure that directly relates to the exempted income that doesn’t form part of total income.

AND

• The amount equals to 1% of the average monthly value of the investment that yields exempted income. Such amount shall not exceed the actual expenses claimed by the taxpayer.

Key-Points

Following are the key points for understanding section 14A:

• Disallowances under section 14A are only for the expenses that have been claimed as a deduction.  No question of disallowance arises in case the assessee has not claimed the deduction at all.
• Assessing officer shall prove that the claims of the assessee are incorrect based on the principle of natural justice and fairness with the supporting documents of case laws and order passed by the Supreme Court for proving the computation of taxpayer is incorrect.
• Only those investments shall be considered for calculating the average that yields exempted income and not the entire investments for computation under Rule 8D.

Case Study

• Can the disallowance be claimed if the exempted income doesn’t exist?

There have been countless litigation on this issue, but it has been decided that the disallowance of expenditure is towards exempted income. As in the case of Assistant CIT vs. M. Baskaran, it was held that disallowance is for exempted income and not exempted investment.

Baskaran_14A_Rule_8D

• Can the disallowance be more than the actual expenditure claimed by the assessee?

Disallowance under section 14A can never exceed the amount of expenditure claimed by the assessee as discussed in the popular case of Gillette Group Pvt Ltd vs. Assistant CIT.

Gillette_14A_Rule_8D_dividend

• Will the provisions of section 14A be applicable in cases if the assessee has utilized his surplus fund to make the tax-free investment?

As the order passed in the case of Principal Commissioner of Income Tax vs. Sintex Industries stating that in case the assessee has utilized its surplus fund for making a minor investment, there will be no disallowance of interest expenses and administrative expenditure under section 14A.