Transcript Baroda Cpe Study circle 30th August, 2011

ISSUES ON SECTION 14A
B ARODA C PE S TUDY CIRCLE
30 th A UGUST , 2011
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H ISTORY

OF
S ECTION 14A
The Net Income Principle
Any Income earned during any year, must
always be taxed on a net basis i.e. Gross
Income minus the expenditure incurred for
earning such income.

Conversely, another principle emerges
That any expenditure which was incurred to
earn an income which was exempted on a
gross basis would automatically be nondeductible.
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Section
14A
History
Supreme Court held otherwise in:
 Indian Bank Ltd.
 Maharashtra Sugar Mills Ltd.
 Rajasthan Sate Warehousing Corp Ltd.
56 ITR 77
82 ITR 452
242 ITR 450
The Supreme Court held:
1) Where a business consisted of two parts, one which
generated taxable income and the second which
generated exempted income and if the business by
itself was indivisible
2) Then, Entire expenditure which is incurred wholly for
the purpose of business would be deductible, even if
part of such expenditure could reasonably be
apportioned to the exempt income
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Section
14A
History
To o ve r - r i d e t h e s a i d p o s i t i o n , S e c t i o n 1 4 A
i n t ro d u c e d b y F i n a n c e A c t , 2 0 0 1 w i t h re t ro s p e c t i v e
e f fe c t f ro m 1 / 4 / 1 9 6 1 .

Section 14A read as under:
For the purposes of computing the total
income under this Chapter, no deduction
shall be allowed in respect of expenditure
incurred by the tax payer in relation to
income which does not form part of the
total income under this Act.
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Section
14A
History
P ro v i s o t o S e c t i o n 1 4 A i n t ro d u c e d b y F i n a n c e A c t ,
2002

Proviso provided that Assessing Officers shall not
be entitled to reassess under Section 147 or
rectify any order Section 154 in order enhance
the income on account of Section 14A for any
assessment year prior to 1st April, 2001.

Proviso introduced in order to mitigate hardship
caused to Assessees, whose settled cases were
reopened on account of retrospective nature of
Section 14A

Proviso however did not cover assessments which
had not achieved finality on account of appeals or
any other pending proceedings.
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Section
14A
History
S u b - s e c t i o n ( 2 ) a n d ( 3 ) t o S e c t i o n 1 4 A i n t ro d u c e d
b y F i n a n c e A c t , 2 0 0 6 w i t h e f fe c t f ro m AY 2 0 0 7 - 0 8 ,

The sub-sections read as under:
(2) 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 this Act in
accordance with such method as may be prescribed, if
the Assessing Officer, 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 income which does not form part of the
total income under this Act.
(3) The provisions of sub-section (2) shall also apply in
relation to a case where an assessee claims that no
expenditure has been incurred by him relation to
income which does not form part of the total income
under this Act.
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Section
14A
History
B a s i s o f D i s a l l o wa n c e u n d e r S e c t i o n 1 4 A , w h e n n o
m e t h o d p re s c r i b e d

Since, no methods were prescribed upto 24th March, 2008, adhocism in disallowance continued.

In Dhanlaxmi Bank Ltd. 2 SOT 625, Cochin Tribunal held that since
method of working out disallowance of the expenditure is not
prescribed, no disallowance is permissible

A contrary view has been taken by Bombay High Court in Godrej &
Boyce Manufacturing Company Ltd. 234 CTR 1, where it was held
a)
Even in absence of sub section (2) and (3), the AO was not
precluded from making apportionment and eventual disallowance
u/s 14A. In fact, such apportionment would be necessary to give
effect to the substantive provisions of sub-section (1) of Section
14A.
b)
In absence of sub section (2) and (3) or prior to Rule 8D, the AO is
entitled to make a disallowance u/s 14A any reasonable method.
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Section
14A
History
I n t ro d u c t i o n o f R u l e 8 D

Introduced on 24th March, 2008

Rule 8D essentially provided the AO with a 3 part
formula to determine disallowance under Section
14A, where he is satisfied that the required
expenditure has not been disallowed under
Section 14A by the Assessee suo-moto in his
Return of Income
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Section
14A
History
M et h o d p re s c ri b e d u n d e r R u l e 8 D
 The disallowance under Section 14A shall be the
aggregate of following 3 parts:
1) Any Expenditure which is directly related to an exempt
income
2) Interest, which is not directly attributable to any
particular income or receipt, calculated by the following
formula: A * (B/C), where
A = Interest other interest included in (1) above
B = Average of Opening and Closing Investments, which
are source of exempted Income
C = Average of Opening and Closing Total Assets.
3) 0.5% of Average of Opening and Closing Investments
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Rule 8D
Issues
Ap p licabi lity – Ret ro spe c tive o r P ro s p e cti ve ?
 Mumbai Tribunal in Daga Capital Management Pvt. Ltd.
26 SOT 603 held the applicability of Rule 8D to be
retrospective as Rule 8D was purely procedural in nature.
 Bombay High Court over-ruled Mumbai Tribunal in Godrej
& Boyce Manufacturing Company Ltd. 234 CTR 1 and
clarified that Rule 8D would only have prospective effect
from AY 2008-09.
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Rule 8D
Issues
Wh e n can R u l e 8 D by i nvo ke d by AO ?

The AO cannot straight away resort to Rule 8D

Sub-Section 2 of Section 14A and Rule 8D(1), both require
the AO to first consider the books of accounts of the
taxpayer before resorting to Rule 8D.

The AO must arrive at an objective satisfaction that the
Assessee’s claim is incorrect.

Bombay High in Godrej & Boyce Manufacturing Company
Ltd. 234 CTR 1 has held that for objective satisfaction,
following would be required from the AO:
a)
Notice by the AO to the Assessee to present his facts and
justify his claim
b)
Recording of his reasons for arriving at a conclusion that the
Assessee’s claim is not justified
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Rule 8D
Issues
Wh ic h I nte re st i s e l i g i b le fo r d i s al lowanc e ?
 Interest which is directly attributable to borrowed funds
used for the purpose of earning taxable income or receipt
is out of the purview of Rule 8D.
 For the purpose of computing proportionate disallowance
of Interest under Rule 8D, only interest which is not
attributable to any particular income or receipt is to be
included
 Interest which is already disallowed u/s 43B or 36(1)(iii)
cannot be again disallowed u/s 14A.
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Rule 8D
Issues
Co m p u tat ion o f Ave rage I nve st m e nts
 Only investments, which are source of exempted income
to be considered for Part 2 and Part 3 of Rule 8D method.
 Method fails in following two circumstances:
1) Opening and Closing values of Investments are Nil, though
there is holding through the year
2) Where investments are treated as Stock in trade
 A ground can be taken that in view of the judgment of
the Supreme Court in B. C. Sriniwas Shetty 128 ITR 284,
that once the computation mechanism fails, so does the
charging section and hence disallowance u/s 14A is not
possible
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Rule 8D
Issues
Co m p u tat ion o f Ave rage To tal A s s et s
 Total Assets refers to value of all Assets reflected in the
Balance Sheet and hence would not include any of the
following:
a)
Preliminary Expenses or Deferred Revenue Expenses not
written off
b) Deferred Tax Assets
c)
Debit Balance of Profit & Loss Account
 Whether Current Assets to be included in Total Assets are
Net Current Assets or Gross Current Assets ? Logic would
dictate that since words used are Total Assets, Gross
Current Assets would be included.
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Section
14A
issues
I s d is al lowanc e u /s 1 4 A p o s s ib le , wh e re t h e re
is n o exe m pt i n co m e ?
 Mumbai Tribunal in Lafarge India Holding (P) Ltd. Taxcorp
(ITAT) 17086 held that if no dividend income is earned during
the year, there can be no disallowance under Section 14A
 Chennai Tribunal in Siva Industries & Holdings Ltd. (ITA no.
2148 / Mds / 2010) also similarly held that for the applicability
of sec.14A there must be
(1) income which is taxable under the Act for the relevant
assessment year and
(2) there should also be income which does not form part of the
total income under the Act during the relevant assessment year.
If either one is absent, then sec. 14A(1) has no applicability.
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Section
14A
issues
I s d is al lowanc e u /s 1 4 A p o s s ib le , wh e re t h e re
is n o exe m pt i n co m e ?
 Delhi Tribunal in Cheminvest Ltd. 317 ITR 86 and Everplus
Securities and Finance Ltd. 285 ITR 112 has held that as long as
expenditure is incurred on a source of exempt income, whether
income is earned or not earned is not material, such
expenditure ought to be disallowed.
 The Delhi Tribunal has drawn its conclusions from a converse
principle drawn from the Supreme Courts’ landmark judgment
in Rajendra Prasad Moody 115 ITR 522. In Rajendra Prasad
Moody, the Supreme Court held that interest on monies
borrowed for purchase of shares was allowable as deduction
u/s 57(iii) irrespective of whether or not there is any yield of
dividend from such shares.
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Section
14A
issues
O wn e d F u n d s v /s B o rro we d F u n d s?

Can an Assessee claim that investments have been made
entirely from Owned Funds, which are non-interest bearing
and hence no disallowance u/s 14A is justified ?
 Is mere presence of Owned Funds in excess of Investments on
the Balance Sheet enough or does a direct nexus between
investments and interest free funds needs to be proved ? On
whom does the onus of proof lie ?
 Principle laid out by Supreme Court in Munjal Sales
Corporation 298 ITR 298 can be of important consideration:
Where the opening balance of profits of the firm exceeds the
loans given to sister concerns, then it is presumed that the said
loans are given out of its own funds.
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Section
14A
issues
O wn e d F u n d s v /s B o rro we d F u n d s?
 Delhi Tribunal in Maruti Udyog Ltd. 92 ITD 119 had held that
where sufficient own funds of the assessee were available for
making investment, it cannot be assumed that any part of
investment producing the tax free income must have been from
borrowed funds unless there is evidence to show that any
specific investment has been made from borrowed funds.
 The Mumbai Tribunal in Faze Three Exports Ltd. v. Add. CIT
(ITA no. 7701/Mum/2004 (AY 2001-02) and 4677/Mum/2005
(AY 2002-03) relying on the decision of the Hon. Supreme Court
in Munjal Sales Corporation v. CIT 298 ITR 298 (SC) 2008 had
held that no disallowance u/s 14A was justified when sufficient
interest free funds were available to cover the investments in
equity shares.
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Section
14A
issues
O wn e d F u n d s v /s B o rro we d F u n d s?

The Bombay High Court in Reliance Utilities and Power Ltd.
313 ITR 340 held that If there be interest free funds available
to an assessee sufficient to meet its investments and at the
same time the assessee had raised a loan it can be presumed
that the investments were from the interest free funds
available.

The Bombay High Court has drawn the above conclusion
based on the Supreme Court judgment in East India
Pharmaceutical Works 224 ITR 627.
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Section
14A
issues
O wn e d F u n d s v /s B o rro we d F u n d s?

Mumbai Tribunal in Daga Capital Management Pvt. Ltd. 26 SOT
603 held that all disallowances u/s 14A ought to be strictly
computed as per Rule 8D irrespective of the fact that whether
interest free funds are available or not.

The Bombay High Court in Godrej & Boyce Manufacturing
Company Ltd. 234 CTR 1 held that
1)
The judgment in Reliance Utilities shows that there were interest
free owned funds available and not merely reserves.
2)
The real enquiry is whether there are interest free funds available
on the assets side and in the absence of sufficient proof of
available interest free funds, no such presumption can be drawn.
Moreover, it has been urged that after the introduction of Section
14A(1), no such presumption can in any event be drawn, since
Parliament expressly requires apportionment.
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Section
14A
issues
O wn e d F u n d s v /s B o rro we d F u n d s?

Punjab and Haryana High Court in Hero Cycles Ltd. 323 ITR 518,
held that:
a)
If the investment in the shares is out of the non-interest bearing
funds, disallowance u/s. 14A of the Act is not sustainable;
b)
The contention of the revenue that directly or indirectly some
expenditure is always incurred which must be disallowed u/s. 14A
of the Act cannot be accepted;
c)
Disallowance u/s. 14A of the Act requires a finding of incurring of
expenditure. If it is found that for earning exempt income, no
expenditure has been incurred, disallowance u/s. 14A of the Act
cannot stand;
d)
The contention of the revenue that even if the assessee has made
investments in shares out of its own funds, the said own funds are
merged with the borrowed funds in a common kitty and, therefore,
disallowance u/s. 14A of the Act can be made is also not justified.
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Section
14A
issues
O wn e d F u n d s v /s B o rro we d F u n d s?

The Mumbai Tribunal in Godrej Industries Ltd. (ITA no. 1090 /
Mum / 09) held that the Assessee had sufficient own funds in
the form of own capital and reserve to make the investments.
The Tribunal also considered the Fund Flow Statement
presented to observe that the Assessee had generated sufficient
funds from its own operations to make investments and thus
disallowance u/s 14A is not justifiable.

The Mumbai Tribunal in Godrej Agrovet Ltd. (ITA no. 1629
/Mum/09) accepted the assessee’s plea that since it was
maintaining a separate current account with a bank for parking
its surplus funds and had only used the same for the purpose of
making investments, no disallowance ought to be made under
Section 14A.
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Section
14A
issues
O wn e d F u n d s v /s B o rro we d F u n d s?

The Supreme Court in Walfort Share and Stock Pvt. Ltd. 326
ITR 1 has held that for attracting the provisions of Section 14A,
there has to be a proximate cause for disallowance which is its
relationship with the tax exempt income. Hence, even if the tax
payer has interest bearing borrowed funds, for disallowing the
interest expenditure under Section 14A, the AO has to establish
the relationship of the expenditure with the exempt income. In
absence of it, no disallowance can be made under Section 14A.

This judgment, firmly puts the onus of proving the nexus
between interest bearing borrowed funds and investments on
the AO, before he can invoke Section 14A.
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Section
14A
issues
1 4 A ap p l i cab ili ty v i z S h are s h e l d as S to c k i n
Trad e ?

Can disallowance u/s 14A be attracted in cases, where trading
in equity shares is a business activity and dividend income is
merely incidental ?

Mumbai Tribunal in Mukund Global Finance Ltd. v. DCIT held
that Interest on borrowed funds invested in trading of Shares
and kept as Stock in Trade deserves to be allowed as revenue
expenditure and no disallowance under Section 14A would be
justified even though exempt dividend income is earned from
shares held as stock in trade.

Kerala High Court in Smt. Leena Ramchandrani ITA no. 1784 of
2009 has held that interest on borrowed funds utilized for
acquisition of shares held as stock in trade would be eligible for
deduction u/s 36(1)(iii).
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Section
14A
issues
1 4 A ap p l i cab ili ty v i z S h are s h e l d as S to c k i n
Trad e ?

Mumbai Tribunal in Daga Capital Management Pvt. Ltd. 26 SOT
603, where the Special Bench of Mumbai Tribunal while
considering a similar question held that Sub-section (1) of
Section 14A provides in unequivocal terms for not allowing
deduction in respect of expenditure incurred by the assessee in
relation to exempt income….. There is hardly anything to infer,
that the legislature intended to immune the expenditure in
relation to incidental exempt income from the operation of
Section 14A. There is no exception for not considering any
income which is not exempt from tax, bet it main or
incidental.
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Section
14A
issues
1 4 A ap p l i cab ili ty v i z S h are s h e l d as S to c k i n
Trad e ?

Bombay High Court in Godrej & Boyce Manufacturing
Company Ltd. 234 CTR 1, while dealing with a similar question
held that Dividend income being exempt under section 10(33),
the expenditure incurred in relation to earning such income
cannot be allowed under Section 14A, whether the shares are
held as investments or as stock in trade will not have any
impact on applicability of Section 14A so long as dividend
income which does not form part of the total income under
the Act is earned from the shares
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Section
14A
issues
1 4 A ap p l i cab ili ty v i z S h are i n P ro f i t s o f a F i rm

The Mumbai Trbunal in Hitesh D. Gajaria ITA No.
993/Mum/2007 (AY 2003-04) held that
share in profits of the Firm is exempt from tax u/s 10(2A) not in
the absolute sense. It is only to avoid double taxation, once in
the hands of the firm and secondly in the hands of the partner.
Therefore, we find that the provisions of Section 14A would not
apply to the assessee / partner and it is not necessary for the
Assessing Authority to disallow the proportionate expenditure
form the claim of the Assessee. Section 14A is not applicable in
the case.
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Section
14A
issues
1 4 A ap p l i cab ili ty v i z S h are i n P ro f i t s o f a F i rm

The Mumbai Trbunal in Dharamsingh M. Popat, the Tribunal
held that
Firm pays tax on its profits in its own capacity and not on behalf
of the parthers. The tax so paid is not available as credit to the
partners. Further, partner’s share in such profits is exempt from
tax and hence would be regarded as tax free income in the
hands of the partner even though the firm has paid tax thereon.
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Section
14A
issues
Pe n alt y o n d i s al lowanc e u /s 1 4 A

The Supreme Court in Reliance Petroproducts (P) Ltd. 230 CTR
320, while considering the issue of penalty on account of
disallowance u/s 14A held that
The argument of the revenue that submitting an incorrect claim
for expenditure would amount to giving inaccurate particulars
of such income is not correct. By no stretch of imagination can
the making of an incorrect claim in law tantamount to
furnishing inaccurate particulars. ……If the contention of the
Revenue is accepted then in case of every Return where the
claim made is not accepted by the AO for any reason, the tax
payer will invite penalty u/s 271(1)(c).
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Section
14A
issues
Pe n alt y o n d i s al lowanc e u /s 1 4 A

Delhi Tribunal in the case of Nalwa Investments Ltd. ITA no. 3805 /
Del /2010 held that
The section, as it existed at the time of filing the return, does
contain a provision for disallowance of expenditure which is related
to non-taxable income. Therefore, it is expected of any assessee to
attempt at segregating expenditure which is related to such a
claim. No attempt has been made in this behalf. However, it is also
a fact that such segregation is beset with lot of problems as the
issue has finally been laid to rest by introduction of Rule 8D in the
Income-tax Rules in the year 2008. The assessee did not have
benefit of this rule when it filed the return of income. Therefore,
even in absence of any attempt on the part of the assessee, it can
be said that questions of disallowance and its quantification are
quite disputable and can lead to bona fide difference in opinion
between the assessee and the authorities. In such a situation, the
levy of penalty will not be justified.
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Section
14A
issues
S UMMARY
The law on Section14A can still be considered as a young law.
Most of the judicial precedents available pertain to a period
prior to introduction of Rule 8D. Even amongst these, there
are severe contradictions and no clear view is possible. One
needs to carefully evaluate one’s own facts, the quantum of
disallowance involved and the risk one is willing to take and
thereafter decide the ground to be taken.
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T HANK Y OU