By TIOL News Service

NEW DELHI, AUG 21, 2017: THE issue before the HC is - Whether even if assessee returns no exempt income in a particular assessment year, disallowance of certain expenditure incurred to earn such exempt income is warranted u/s 14 rw Rule 8D. NO is the HC's answer.

Facts of the case

The assessee-company is in provision of consultancy services. It filed its return at a loss of Rs. 2,42,63,176/-. The Assessee was asked to explain why disallowance should not be made under Section l4A of the Act read with Rule 8D for the purpose of normal computation of book profit for the purpose of Minimum Alternative Tax (‘MAT’) under Section 115JB of the Act. The response of the Assessee was that it had made investment in mutual funds and that no interest bearing funds were invested to earn tax free income. It accordingly pleaded that no disallowance under Section 14A of the Act was called for.

But the AO rejected the plea relying on the decision of the Special Bench of the ITAT Delhi in Cheminvest Ltd. v. ITO wherein it was held that Section 14A would apply even if during the AY in question, the investment has not actually yielded any exempt income. The AO made an addition of Rs.15,44,43,369/-. The AO held that the Assessee had made investments in shares to the tune of Rs.5,29,38,26,780/- for the purposes of earning dividend income not chargeable to the tax. The AO noted that, even in the tax audit report, the auditors had calculated disallowance under Section 14A read with Rule 8D in the sum of Rs. 5,89,22,873/-, which included direct expenses of Rs. 1,12,025/-.

On apapeal, the CIT(A) reduced the disallowance and also reduced the interest disallowed by the AO. On further appeal, the ITAT allowed the assessee's appeal.

After hearing the parties, the HC held that,

++ we are concerned with the AY 2011-12 and, therefore, the question of the applicability of Rule 8D, which was inserted with effect from 24th March 2008, is not in doubt;

++ the question in the present case is whether the disallowance of the expenditure will be made even where the investment has not resulted in any exempt income during the AY in question but where potential exists for exempt income being earned in later AYs. In the Explanatory Memorandum to the Finance Act 2001, by which Section 14A was inserted with effect from 1st April 1962, it was clarified that “expenses incurred can be allowed only to the extent they are relatable to the earned income of taxable income”. The object behind Section 14A was to provide that “no deduction shall be made in respect of any expenditure incurred by the Assessee in relation to income which does not form part of the total income under the Income Tax Act”;

++ what is taxable under Section 5 of the Act is the “total income" which is neither notional nor speculative. It has to be ‘real income’. The subsequent amendment to Section 14A does not particularly clarify whether the disallowance of the expenditure would apply even where no exempt income is earned in the AY in question from investments made, not in that AY, but earlier AYs. Rule 8D (1) is helpful, to some extent, in understanding this issue;

++ the words “in relation to income which does not form part of the total income under the Act for such previous year” in the above Rule 8 D (1) indicates a correlation between the exempt income earned in the AY and the expenditure incurred to earn it. In other words, the expenditure as claimed by the Assessee has to be in relation to the income earned in ‘such previous year’. This implies that if there is no exempt income earned in the AY in question, the question of disallowance of the expenditure incurred to earn exempt income in terms of Section 14A read with Rule 8D would not arise;

++ the CBDT Circular upon which extensive reliance is placed by the Revenue does not refer to Rule 8D (1) of the Rules at all but only refers to the word “includible” occurring in the title to Rule 8D as well as the title to Section 14A. The Circular concludes that it is not necessary that exempt income should necessarily be included in a particular year’s income for the disallowance to be triggered;

++ in the considered view of the Court, this will be a truncated reading of Section 14A and Rule 8D particularly when Rule 8D (1) uses the expression ‘such previous year’. Further, it does not account for the concept of ‘real income’. It does not note that under Section 5 of the Act, the question of taxation of ‘notional income’ does not arise. The Court is not persuaded that in view of the Circular of the CBDT dated 11th May 2014, the decision of this Court in Cheminvest Ltd. requires reconsideration;

++ the mere fact that in the audit report for the AY in question, the auditors may have suggested that there should be a disallowance cannot be determinative of the legal position. That would not preclude the Assessee from taking a stand that no disallowance under Section 14A of the Act was called for in the AY in question because no exempt income was earned;

++ this Court is of the view that the CBDT Circular dated 11th May 2014 cannot override the expressed provisions of Section 14A read with Rule 8D.

(See 2017-TIOL-1615-HC-DEL-IT)