By TIOL News Service

AHMEDABAD, SEPT 07, 2017: THE issue before the Bench is - Whether, when an assessee pays interest on borrowings & also earns taxable interest on investments made during a particular year, the interest expenditure has to be considered as one which is the net of interest paid minus interest earned. YES is the verdict.

Facts of the case

The assessee company for the AY 2008-2009, declared a loss of about Rs. 5.63 crores. On scrutiny, the AO noted that the assessee had shown dividend income of Rs.25.26 lacs from the investment made by it in the shares and securities which was claimed as an exempt income. The AO opined that the assessee failed to prove that the investment in shares and securities was made out of interest free funds only, and that that the assessee had made substantial borrowings in the form of unsecured and secured loans and had claimed interest expenses. Thereby, the AO applied the formula provided in Rule 8D r/w Section 14 of the Act. The AO then adopted the full figure of Rs. 7.01 crores on account of interest expenditure, and computed a sum of Rs.99.41 lakhs under Rule 8D(2). The AO then added half a percent of the average value of investments not forming part of the total income in terms of Rule 8D(2)(iii) to come to total figure of Rs.1.06 crores for disallowance u/s 14A.

The CIT(A) upheld the AO's assessment. Later, the Tribunal confirmed the applicability of section 14A and Rule 8D, but clarified that for computation of disallowance under Rule 8D, not the gross interest payment but the net interest payment would be considered.

After hearing the matter, the Tribunal held that,

++ the computation of factor 'A' in the Rule 8D formula is significant. Factor 'A' represents the amount of expenditure by way of interest ignoring the interest expenditure already included in clause (i). The expression used by the legislature is “amount of expenditure by way of interest”. When the legislature has therefore, used this expression “amount of expenditure”, the said term shall have to be interpreted in the manner that will bring about the correct legislative intent and equitable application thereof. In the present case, when the assessee pays interest on borrowings as also earns taxable interest on investments made by him during a particular year, his interest expenditure has to be considered as one which is the net of interest paid minus interest earned. Any other view would give the unintended computation of factor 'A' provided in clause Rule 8D(2)(ii) which will in turn distort the computation of disallowable expenditure under the said clause. It is true that the legislature has not given any further indication as to how such amount of expenditure would be ascertained. Therefore, the provision has to interpreted as is most likely to give effect to legislative intent for disallowance of expenditure by an assessee for earning income which is not accountable to tax. It is true that investment made by the assessee out of such borrowed funds will continue to be factored in denominator in the formula provided in Rule 8D(2)(ii) since factor 'C' which forms the denominator refers to average of total assets of assessee as on the first and the last day of the previous year. However, ignoring taxable interest earned by the assessee for the purpose of ascertaining the amount of expenditure incurred by the assessee by way of interest, would amount to distorting the factor 'A' provided in Rule 8D(2)(ii). It may be possible for variety of reasons that in a given financial year the assessee might have earned interest income which is higher than the interest paid on the borrowed funds. This may be because assessee's investments may have earned interest at rates higher than the interest rate paid by the assessee on the borrowings or may also be because assessee's investment in earning interest may be higher in value than the assessee's borrowings, inviting interest. In such a situation, essentially, the assessee would have earned more interest than the interest paid. Applying the formula by computing factor 'A' by taking into account interest paid ignoring the interest earned, there would be disallowance under this formula even if in the net result, the assessee may have not paid any interest on borrowings;

++ while answering the question in favor of the assessee, the purpose of applying the factors contained in Rule 8D(2)(ii) prior to its amendment, what would be considered as amount of expenditure by way of interest would be the interest paid by the assessee on the borrowings minus the taxable interest earned during the FY.

(See 2017-TIOL-1781-HC-AHM-IT)