Budget 2022 has removed this tax deduction for current financial year also

Section 14A of the Income-tax Act, 1961 which provides for disallowance of expenses incurred for earning exempt income, has been a matter of widespread litigation. The most common issue is in case of investment in shares of Indian companies since dividends distributed by Indian companies were exempt from tax for the shareholders (for both individuals and non-individuals) uptil March 31, 2020 (subject to a limit of Rs.10 lakh in case of non-corporate shareholders).

What the current law says

Section 14A provides for disallowance of deduction in respect of expenditure incurred by an assessee to earn tax-exempt income. If the Assessing Officer, having regard to the books of accounts of the assessee is not satisfied, either with the correctness of the claim of expenditure made by the assessee or if the assessee claims that no expenditure has been incurred for earning exempt income, shall then determine the amount of expenditure to be disallowed in accordance with the provisions of Rule 8D(2).

According to Rule 8D(2), the expenditure in relation to exempt income shall be the aggregate of following amounts, namely:

(i) the amount of expenditure directly relating to tax-exempt income which does not form part of total income; and

(ii) an amount equal to 1% of the annual average of the monthly average of the opening and closing balances of the value of investment , income from which does not or shall not form part of total income. This means for each month an assessee takes average of the opening and closing balance and then take annual average of all the months.

However, the total amount disallowed shall not exceed the total expenditure actually claimed as deduction by the assessee.

The determination of expenses incurred for earning tax-exempt income is inherently subjective as generally the investments would be out of a common pool of funds which would include general borrowings. The expenses which may require identification would include interest, demat charges, portfolio management fees, salaries, office overheads, corporate costs and so on. Rule 8D was intended to bring an objective method of working out the disallowance on this account but has not been able to achieve the intended purpose to the desired extent.

Point of Controversy

The controversy is whether such disallowance will be made even if the assessee does not earn any exempt income.

The Central Board of Direct Taxes (CBDT) vide Circular No. 5 of 2014 dated February 11, 2014 clarified that, the legislative intent is to allow only that expenditure which is relatable to earning of income which is taxable and it therefore follows that the expenses which are relatable to earning of tax-exempt income have to be considered for disallowance, irrespective of the fact whether such income has been earned during the financial year or not. However, various courts gave verdict in favor of the taxpayers that in case no tax-exempt income is earned, no disallowance should be made under section 14A.

In the case of Joint Investments Pvt. Ltd. v. CIT [372 ITR 694], the Hon’ble Delhi High Court held that the disallowance under Section 14A of the Act should not exceed the tax-exempt income. The tax department filed a Special Leave Petition (SLP) against this decision and the Hon’ble Supreme Court dismissed the SLP filed by the tax-department. A similar view has been taken by the Hon’ble Delhi High Court in the case of Cheminvest Limited versus. Commissioner of Income Tax [378 ITR 33]

In the case of ACIT v. Ballarpur Industries Limited in ITA No. 346 to 379/NAG/2014, the Nagpur Bench of Tribunal following the decision of the Hon’ble Delhi High Court in the case of Cheminvest v. CIT (supra) held as under:

“In the context of the facts enumerated hereinbefore, the Court answers the question framed by holding that the expression “does not form part of the total income” in Section 14A of the Act envisages that there should be an actual receipt of income, which is not includible in the total income, during the relevant previous year for the purpose of disallowing any expenditure incurred in relation to the said income. In other words, Section 14A will not apply if no exempt income is received or receivable during the relevant previous year.”

The Finance Bill 2022 proposes to insert the following explanation in section 14A of the Income-tax Act:

“Explanation.–For the removal of doubts, it is hereby clarified that notwithstanding anything to the contrary contained in this Act, the provisions of this section shall apply and shall be deemed to have always applied in a case where the income, not forming part of the total income under this Act, has not accrued or arisen or has not been received during the previous year relevant to an assessment year and the expenditure has been incurred during the said previous year in relation to such income not forming part of the total income.”

Impact of Budget 2022 proposal on individuals

Firstly, the amendment proposed is clarificatory and although the provision is effective from financial year 2021-22 (assessment year 2022-23) which is currently ongoing, it would apply to even earlier years where assessment proceedings or appeal or other proceedings are open. It is likely that there will be no impact on those assessee where the proceedings have been closed.

Secondly, the disallowance of expenditure will be made even in case no tax-exempt income is earned during the relevant financial year.

The proposed amendment would impact investment in agricultural land or partnership firms and other avenues resulting in tax exempt income Thankfully, for majority of tax payers, dividend received on shares of Indian companies which were exempt earlier, are taxable with effect from financial year 2020-21. Hence, the clarificatory amendment under Section 14A shall not be applicable to such investments and the impact of the amendment would be limited.

(The writer is the founder of RSM India – a tax consultancy firm)

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