Section 14A : Disallowance of Expenditure incurred in relation to income exempt from tax

Background

Section 14A is a disallowance provision. This section provides that while computing the total income of any assessee, no deduction will be permitted in respect of any expense incurred in relation to any income which is exempt from income tax.

Chronology of amendments

Analysis of section 14A

Expenditure incurred in relation to income which does not form part of the total income [Section 14A(1)]

Sub-section (1) of section 14A stipulates that for the purposes of computing total income under Chapter IV (Computation of Total Income), no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income which is exempt from the levy of Income tax.

Relevance of the word ‘expenditure incurred’

The need for incurring of actual expenditure for earning exempt income has also been a subject matter of dispute. The debate is whether the expression ‘expenditure incurred’ refers to actual expenditure and not to some imagined expenditure. The judicial position in this regard is that, the ‘actual’ expenditure that is in contemplation under section 14A(1) is the ‘actual’ expenditure in relation to or in connection with or pertaining to exempt income. The corollary to this is that if no expenditure is incurred in relation to the exempt income, no disallowance can be made under section 14A.

Relevance of the words ‘in relation to’

The need for a direct and proximate connection with the subject matter has been the central point of debate on the applicability of 
section 14A to certain specific instances. The judicial position in this regard is that, the expression ‘in relation to’ appearing in section 14A is not to be given a narrow or constricted meaning. The expression does not have any embedded object, it simply means ‘in connection with’ or ‘pertaining to’.

Given the above, if the expenditure in question has a relation or connection with or pertains to exempt income, it is likely to be disallowed as a deduction even if it otherwise qualifies under the other provisions of the said Act.

CBDT’s clarification regarding disallowance of expenses under section 14A in cases where corresponding exempt income has not been earned during the financial year

The CBDT vide its circular [No. 5/2014 dated 11-2-2014] has clarified that Rule 8D and section 14A of the Act provides for disallowance of the expenditure even where taxpayer in a particular year has not earned any exempt income. Also, section 14A of the Act does not use the word ‘income of the year’ but the ‘income under the Act’.

Determination of expenditure incurred in relation to exempt income by the Assessing Officer as per the method prescribed i.e. in accordance with Rule 8D [Section 14A(2) & Section 14A(3)]

Section 14A(2)

Sub section (2) provides that if the Assessing Officer, having regard to the accounts of the assessee, is not satisfied with the correctness of assessee’s claim for the expenditure incurred in relation to exempt income.

Section 14A(3)

Sub-section (3) applies to cases where the assessee claims that no expenditure has been incurred in relation to exempt income earned

In both cases, the Assessing Officer has to record his satisfaction about the correctness of the assessee’s claim regarding the expenditure incurred or not incurred, as the case may be, to earn exempt income, before proceeding with his determination of the amount of expenditure in accordance with Rule 8D.

Thus, before rejecting the claim of the assessee, the Assessing Officer has to indicate cogent reasons for his rejection.

Prescribed method of determining the quantum of expenditure incurred for earning exempt income [Rule 8D]

Sub-rule (2) provides that the expenditure in relation to exempt income shall be the aggregate of following amounts, namely:—

1. The amount of expenditure directly relating to exempt income;
2. An amount equal to one per cent of the annual average monthly averages of the opening and closing balances of the value of investment, income from which does not or shall not form part of the total income,

It is the aggregate of these components which would constitute the expenditure in relation to exempt income and would be disallowed under section 14A. The substituted sub-rule provides that the disallowance shall not exceed the total expenditure claimed by the assessee.

It is pertinent to note that amount of disallowance under section 14A of the Act is restricted to the exempt income based on the decision of the Hon’ble Supreme Court in the case of Principal Commissioner of Income-tax vs. State Bank of Patiala [2018] (99 taxmann.com 286).