Introduction

When the going gets tough, taxman get going. During the time when economic recovery is sluggish, the tax collection is also dismal. Whereas, welfare schemes require considerable spending. Hence, we got section 14 A in the Income Tax Act, 1961. Ever since its entry into the statute book, it has been a rockstar, rocking the boats of taxpayers. Finally it seems Supreme Court has been able to anchor the controversies around this section.

The basic principle of taxation is to tax the net income, i.e., gross income minus the expenditure. Applying the same analogy, the exemption from tax is also allowable in respect of net income.

Section 14 specifies five heads of income which are chargeable to tax. In order to be chargeable, an income has to be brought under one of the five heads. Sections 15 to 59 of the Income Tax Act, 1961 ("Act") lay down the provisions for computing income for the purpose of chargeability to tax under those heads. Sections 15 to 59 quantify the total income chargeable to tax. The permissible deductions enumerated in sections 15 to 59 are to be allowed only with, reference to income which is brought under one of the above heads and is chargeable to tax.

The basic reason for insertion of section 14A of the Act was that certain incomes are not includible while computing total income as these are exempt under certain provisions of the Act and hence the relatable expense should not be allowed as deduction. In other words, section 14A clarifies that expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income. Therefore, the purpose behind Section 14A of the Act, by not permitting deduction of the expenditure incurred in relation to income, which does not form part of total income, is to ensure that the assessee does not get double benefit in case of composite transactions. In this article we are touching upon various issues arising under section 14A of the Act:

1. What was the position prior to introduction of Section 14A ?

Section 14A was first inserted by Finance Act, 2001 with retrospective effect w.e.f. 01.04.1962. It is to be noted that Section 14A was inserted by Finance Act, 2001 and the provisions were fully workable without their being any mechanism provided for computing the expenditure. Although Section 14A was made effective from 01.04.1962 but proviso was inserted by Finance Act, 2002, providing that Section 14A shall not empower assessing officer either to reassess under Section 147 or pass an order enhancing the assessment or reducing a refund already made or otherwise increasing the liability of the assessee under Section 154, for any assessment year beginning on or before 01.04.2001. Thus, all concluded assessments prior to 01.04.2001 were made final and not allowed to be re-opened.

Prior to introduction of section 14A, the law was that when an assessee had a composite and indivisible business which had elements of both taxable and non-taxable income, the entire expenditure in respect of said business was deductible and, in such a case, the principle of apportionment of the expenditure relating to the non-taxable income did not apply. (Rajasthan State Warehousing Corpn. v. CIT [2000] 242 ITR 450).

However, where the business was divisible, the principle of apportionment of the expenditure was applicable and the expenditure apportioned to the 'exempt' income or income not exigible to tax, was not allowable as a deduction. The theory of apportionment of expenditure between taxable and non-taxable has been in principle widened under section 14A. CIT v. Walfort Share & Stock Brokers P Ltd. [2010] 326 ITR 1 (SC).

2. After the introduction of Section 14A but prior to introduction of Rule 8D?

The provisions of section 14A of the Act, as introduced by Finance Act, 2001 provided no method of computing the expenditure incurred in relation to income which did not form part of the total income. It is to be noted that Section 14A was inserted by Finance Act, 2001 and the provisions were fully workable without their being any mechanism provided for computing the expenditure. CIT v. Essar Teleholdings Ltd. [2018] 401 ITR 445 (SC). The Hon'ble Bombay High Court in the case of Godrej & Boyce Mfg. Co. Ltd. vs. Dy. CIT - {(2010) 328 ITR 81 (Bom)} held that even prior to introduction of rule 8D of the Rules, Assessing Officer had to enforce provisions of sub-section (1) of section 14A and for that purpose, Assessing Officer was duty bound to determine expenditure which had been incurred in relation to income which did not form part of total income under the Act by adopting a reasonable basis or method consistent with all relevant facts and circumstances.

3. Whether Rule 8D is prospective in operation?

Rule 8D is prospective in operation and cannot be applied to any assessment year prior to assessment year 2008-09 this issue has now been settled. CIT v. Essar Teleholdings Ltd. [2018] 401 ITR 445 (SC)

4. Can Disallowance of Expenditure under section 14 A of the Act be made with respect to dividend earned on shares held as stock–in –trade or where the shares/stocks were purchased of a company for the purpose of gaining control over the said company?

In this regard, there were diverse judgments of the Delhi High Court in Maxopp Investment Ltd. v. CIT [2012] 347 ITR 272 and that of Punjab and Haryana High Court in Pr. CIT .v State Bank of Patiala [2017] 391 ITR 218 (Punj. & Har.). Recently, the same fell for consideration before the Hon'ble Supreme Court in the case of Maxopp Investment Ltd. v. CIT [2018] 402 ITR 640 (SC).

It was argued that where the shares/stocks were purchased of a company for the purpose of gaining control over the said company or as 'stock-in-trade', then the dominant purpose for the same was for business and therefore any income in the form of dividends generated incidentally cannot lead to applicability of section 14A of the Act.

The Hon'ble Apex court finally held that the fact remains that dividend income is non-taxable and if expenditure is incurred on earning the dividend income that much of the expenditure which is attributable to the dividend income has to be disallowed and cannot be treated as business expenditure. The court was of the view that the dominant purpose for which the investment into shares is made by an assessee may not be relevant and keeping the objective behind Section14A of the Act in mind, the said provision has to be interpreted, particularly, the word 'in relation to the income' that does not form part of total income in a manner that the principle of apportionment of expenses comes into play as that is the principle which is engrained in Section 14A of the Act.

5. Does the expenditure must also have taken place in relation to income which does not form part of total income?

If no expenditure is incurred in relation to the exempt income, no disallowance can be made under section 14A of the said Act. Maxopp Investment Ltd. v. CIT [2018] 402 ITR 640 (SC)

6. Can the Disallowance under section 14A be more than expenditure claimed by the assessee?

Disallowance under section 14A cannot exceed expenditure actually claimed by assessee. Gillette Group India (P.) Ltd. vs. Asstt. CIT (2012) 16 ITR (Trib) 57 (Del.).

7. Can the Disallowance under section 14 A be made even if there is no exempt income earned?

The Hon'ble Delhi Tribunal in the case of Relaxo Footwears Ltd vs. Addl. CIT (2012) 50 SOT 102 (Del.) held that earning of an income in a particular year is not a sine qua non for allowing an expenditure.

8. Where the Assessee has surplus funds out of which tax free investments are made, will the provisions of section 14A applicable?

Where assessee had its surplus fund against which minor investment was made, no question of making any disallowance of expenditure in respect of interest and administrative expenses under section 14A would arise and therefore, the question of any estimation of expenditure in respect of interest and administrative expenses under rule 8D would also not arise (Principal Commissioner of Income-tax-IV, Ahmedabad v. Sintex Industries Ltd. [2018] 93 taxmann.com 24 (SC)).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.