Section 14A and Rule 8D of the Income Tax Act: Understanding Exempt Income and Expenditure

When it comes to taxation in India, certain income is considered exempt from tax. This includes agricultural income, dividend received from an Indian company, income of eligible charitable institutions, and tax-free interest. However, taxpayers often incur expenses to earn this exempt income, such as interest on loans for investments in tax-free bonds and company shares. The question arises: should these expenses be allowed as deductions when calculating taxable income?

The debate between taxpayers and income tax authorities on the treatment of expenditure earned on exempt income has been ongoing. Taxpayers argue that such expenses should be allowed for deduction, while the income tax department holds the view that since the income is already exempted, the related expenses should not be deductible. The Supreme Court of India has previously ruled partially in favor of taxpayers, stating that the principle of apportionment does not apply to composite and indivisible businesses.

To clarify the intention of the legislature regarding expenses related to earning exempt income, Section 14A was introduced in the year 2001 with retrospective effect from April 1962.

Section 14A: Expenditure Incurred in Relation to Exempt Income

No deduction is supposed to be made on the amount spent by a taxpayer on earning non-taxable income as provided in section 14A of the Income Tax Act.

The method prescribed by the income tax officer under Rule 8D of the Income Tax Rules is used to determine the expenditure incurred for earning exempt income. Nonetheless, this method only applies in certain cases:

1. When a taxpayer claims that no expenses were incurred for the purpose of earning exempt income.
2. When such an amount has already been disallowed by the taxpayer regarding it as an expenditure towards earning exempt income but according to taxpayer’s accounts, or an assessing officer disagrees with it.

Rule 8D: Method to Determine Expenditure Incurred towards Exempt Income

As per the current income tax laws (post amendment in June 2016), the expenditure incurred in relation to earning exempt income is determined using the following formula:

Expenditure Incurred = Directly Related Expenditure + 1% of Average Monthly Opening and Closing Balances of Exempt Income Investments

However, the disallowance computed under Rule 8D cannot exceed the total expenditure claimed by the taxpayer.

Let's illustrate the computation of Rule 8D with an example:

Example: Mr. A has taken a loan of Rs.15 lakh on 5 January 2018 at an interest rate of 10% during the FY 2017-18. The interest expenditure for the year on this loan is Rs.1,50,000. The loan was utilized for making an investment of Rs.15 lakh in various avenues, and the income from these investments is exempt from tax. The monthly closing balances of this investment are as follows: Rs 10,00,000 (January 2018), Rs 12,50,000 (February 2018), Rs 15,00,000 (March 2018).

Rule 8D Disallowance:

Key Points to Note

1. Disallowance under Section 14A is applicable only to expenditure that has already been claimed as a deduction. If the taxpayer has not claimed any deduction, there can be no disallowance.
2. The basic condition for the applicability of Rule 8D must be satisfied, and the assessing officer must show why they are not satisfied with the taxpayer's computation, based on the principle of natural justice and relevant case laws.
3. Only investments relating to exempt income should be considered for the average, not the entire investment.
4. Section 14A and Rule 8D have been controversial provisions of the Income Tax Act, leading to litigation due to the lack of clarity on various aspects.

Frequently Asked Questions

Can disallowance be made in the absence of exempt income in any FY?

Though this issue has been the subject of numerous litigations, it has been settled by various high court judgments that disallowance cannot be attracted under Section 14A in the absence of exempt income.

Does exempt income for the purpose of this section include profit-linked deductions under Chapter VI-A?

Yes, exempt income includes deductions in respect of profits and gains of specific industries, such as hotel business, small-scale industrial undertakings, housing projects, export businesses, infrastructure development, and units in Special Economic Zones (SEZ).

Is this section applicable to shares held as stock in trade?

In the case of shares held as stock in trade, only dividend income would be exempted, and the gain on sale would be taxable business income. This issue has been settled by the Supreme Court in its judgment pronounced in February 2018, where it stated that even when shares are held as stock in trade, disallowance is attracted on expenditure apportioned towards exempt dividend income, while expenditure apportioned towards business profit is allowed as a deduction.

Is disallowance attracted on dividend income from Indian companies, considering that the dividend income is not actually exempted due to the Dividend Distribution Tax (DDT) paid by the companies?

This issue has been a matter of debate before various courts and tribunals, but it has now been settled by the Supreme Court. In May 2017, the Supreme Court held that disallowance is attracted even when DDT is paid by companies.

In conclusion, Section 14A and Rule 8D of the Income Tax Act play a crucial role in determining the treatment of expenditure incurred towards earning exempt income. Taxpayers must carefully consider these provisions and ensure compliance with the prescribed method of calculation to avoid any disputes with the income tax authorities. It is essential to seek professional advice to navigate the complexities of this area of taxation and ensure accurate and lawful tax assessments.