Deduction against exempt income: indiscriminatory application of Sec. 14A

Sec. 14A disallows expenditure which relates to exempt income but claimed against taxable income. But in actual practice, the legitimate expenses against taxable income are being shifted to exempt income so as to enhance the taxable income. Where one of my clients had income from dividends out of investments made out of his own funds, so that no expenditure was incurred by him, Rule 8D was applied treating half per cent of the investment relating to dividend as an addition to the taxable income.

As pointed out by the reader, Sec. 14A is meant to set right any attempt on the part of an assessee to claim expenditure relating to an exempt income against taxable income. It cannot give rise to a new class of disallowance. It is meant only to prevent shifting of expenditure from exempt to taxable income. Rule 8D only provides for a measure of such expenditure, where such shifted income cannot otherwise be identified. Half per cent disallowance of investment against exempt income is being incorrectly applied on reader's facts, if no expense at all was incurred on exempt income.

Some assessing officers do make a mistake in overlooking the fact that Rule 8D is in pursuance of sub-sections (2) and (3), which were inserted in Sec. 14A by the Finance Act, 2006, with effect from assessment year 2007-08. Sub-section (2) would have application only where the assessing officer is not satisfied with the correctness of the claim made by the assessee, while sub-section (3) would apply where no expenditure is claimed in relation to exempt income. Rule 8D starts with these conditions for invoking the disallowance of expenditure relating to exempt income, while giving a formula for disallowance of interest in proportion to the extent of investment, besides one half per cent of average value of the investments as per balance sheet. Hence where the conditions are not satisfied, the Rule would have no application. It can be invoked, where the common expenses are not properly allocated. The question of application where no expense is claimed can arise only where some expense had to be incurred, but such expenditure is charged under other heads.

The Rule should also have no application, where it is possible to arrive at a consensus between the assessing officer and the assessee as to what is reasonable, even where the assessing officer feels that the assessee has claimed more against the exempt income.

Is Rule 8D providing for allocating interest on a proportionate basis with reference to investments applicable for an investor?

In the case of an investor, it should be possible to arrive at the precise amount of interest attributable to investments, the income from which is exempt. It is only in the case of a dealer, both with income from business as well as investments, the income from which is non-taxable, the Rule should ordinarily have application. If the Rule is applied, even where the related expenditure is identified, it can distort the real income. The Rule is meant only for common expenditure, since direct expenditure relating to exempt income can always be disallowed. The applicability of the Rule itself may be open to question, where the correctness of the expenditure claimed by the assessee cannot be questioned, since the threshold condition for application of the Rule under Sec. 14A(2) is that the assessee's basis of allocation of common expenses should be incorrect.

Is it right to presume that dividend income is exempt income so as to attribute expenditure to it and thereby reducing what is deductible against taxable income?

It would not be correct to assume that dividend income has not been taxed merely because it is not taxed in the hands of the assessee under Sec. 10(38) which exempts such income in the hands of the shareholder. This exemption is consequential to the tax levied on such dividend income in the hands of the company under Sec. 115-O. Since tax is directly relatable to dividend income, which has been distributed and it is not a tax on the income of the company, the inference that it is a tax paid by the shareholder requires consideration for the purpose of application of Sec. 14A or Rule 8D.

In fact, the Central Board of Direct Taxes itself, in the case of Fringe Benefits Tax paid by the employer on stock option benefits availed by the employee, has stated in Paragraph 8 of Circular No.9 of 2007 dated December 20, 2007 (2008) 297 ITR (St.) 1, that the non-resident employee can claim the benefit of double taxation in his own country by treating the tax paid by the employer as tax paid by the employee. The same reasoning should have application for the inference that the tax paid by the company should be treated as tax paid by the shareholder so that all the deductions relating to income from dividend should be available for computation of taxable income of the assessee.

It is understood that the validity of Rule 8D has been challenged in the courts. Is it safe for the taxpayer to rely on the successful outcome of such challenge?

The validity of the Rule is not one which can be adjudged by the assessing officer, Commissioner (Appeals) or the Tribunal, since as creatures of the very law, they cannot question the constitutionality of such law. Validity could be considered only before the High Court and the Supreme Court. But it may not be necessary in most cases to question the validity because of the protection given under Sec. 14A(2) and (3) themselves as well as the preamble to Rule 8D making the Rule applicable only if the assessee's allocation is not satisfactory or where no claim at all for expenditure is made, where they had necessarily to be incurred.

It stands to reason that where the assessee's working is not acceptable, the assessing officer should put his working to arrive at an acceptable solution before invoking Rule 8D. Rule 8D is an ad hoc rule to be applied only where the normal mechanism of allocation of common expenses cannot supply a solution.

For example, where allocation of interest is sought to be made on the basis of proportionate investments under Rule 8D, it may be possible to show that it could have application only in the case where exempt income from investments forms part of business income. For others, the actual nexus of relatable interest to investments could be established and where it is so established, there is no need for application of Rule 8D. Even where no deduction is claimed against exempt income, the Rule can have application only where there are expenses against exempt income, but are claimed against other income.

In view of the above reasoning, the need for challenging the validity of the Rule may not arise, if the applicability of the Rule could be successfully questioned. Any other inference would mean that Rule 8D goes beyond Sec. 14A, the purpose of which is only to ensure the proper computation of deductions as between exempt and taxable income.

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Printable version | Apr 5, 2020 7:40:29 AM |

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