LEGAL NITTY GRITTIES OF SECTION 14A r.w.

r 8D OF THE
INCOME TAX RULES1962

Section 14A was enacted vide Finance Act, 2001 w.r.e.f. 1-41962, so that net taxable income is actually taxed and no
deduction is allowed against taxable income for expenditure
incurred in earning exempt income. It was enacted to overcome
the Supreme Court decision in the case of Rajasthan State
Warehousing Corporation v. CIT [2000] 242 ITR 450
(SC) wherein it was held that in case of an indivisible business,
some income wherefrom is taxable while some exempt, entire
expenditure would be permissible as deduction. As per the
Memorandum

of

Finance

Bill,

2001,

it

was

explained

that expenses incurred can be allowed only to the extent

they are relatable to the earning of taxable income.

Section 14A was amended by the Finance Act, 2006, w.e.f. 1-42007 (A.Y. 2007-08). By this amendment Sub-section (2) and (3)
were added in Section 14A to provide that AO shall determine the
amount of expenditure incurred in relation to the exempt income
in accordance with such method as may be prescribed by Rules.
In exercise of the powers given in Section 14A (2) CBDT has
issued Notification No. S.O. 547(E) on 24-3-2008 (299 ITR
(ST) 88). This notification amends the Income-tax Rules by
insertion of a new Rule 8D providing for a Method for
determining amount of expenditure in relation to income
not includible in total

income. The Rule provides for

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disallowance of not only direct expenditure incurred for earning

the exempt income but also for disallowance of proportionate
indirect expenditure.
The constitutional validity of the provisions and that of Rule 8D
has been upheld by the Bombay High Court in the case of Godrej
& Boyce Mfg. Co. Limited v. CIT [2010] 328 ITR 81
(Bombay

HC) observing that Rule 8D is applicable w.e.f.

Assessment Year (AY) 2008-09 and subsequent years. A special

leave petition against this judgment of the Bombay High Court is
admitted and pending for final hearing before the Supreme Court
in Appeal Civil No. 7019/2011.
Right from the inception of section 14A, it has been a subject
matter of litigation between the taxpayers and tax collectors.
Divergent views has been expressed by various benches of the
Tribunals and High Courts. Some observations has also been
made by the Supreme Court. The law on section 14A has evolved
over the last 14 years and complex issues have arisen out of its
application. We can summarize some of the recent issues dealt in
the tribunals and courts as follows:

1. Establishment of nexus between the exempt income and

related expenditure:
There can be different situations while making investment in taxfree/taxable securities
a. While making investment in the tax-free securities no
expenditure has got incurred and investment has been made out
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of only capital raised over the years, reserves and surplus, no

interest bearing loans and non-cash provisions.
b. There is a common pool of funds where overall investment in
tax free securities has not exceeded the aggregate amount of
shareholders funds, no interest bearing loans and non-cash
provisions.
c. There is direct nexus between interest bearing funds and the
taxable securities and it can be established that interest bearing
funds has been used for earing taxable income.

Situation (a)

(i) In the case of CIT v. Hero Cycles Ltd. (ITA No. 331 of
2009) P&H High Court held that where it is found that for
earning exempted income no expenditure has been incurred,
disallowance under section 14A cannot stand.

(ii) The Delhi Tribunal in the case of Interglobe Enterprises

Ltd. v. DCIT (ITA No. 1362 & 1032/DEL/2013) held that
assessee had utilized interest free funds for making fresh
investments and that too into its subsidiaries which were not for
the purpose of earning exempt income but for strategic purposes
only. No disallowance of interest is required to be made under
rule 8D (i) & 8D (ii) as no direct or indirect interest expenditure
has incurred for making investments. Strategic investment has to
be excluded for the purpose of arriving at disallowance under
Rule 8D (iii).
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Situation (b)

(i) In the case of CIT v. HDFC Bank Limited (ITA No. 330 of
2012), Bombay High Court has held that no disallowance u/s
14A can be made in respect of interest paid on borrowing
if assessees own funds and non-interest bearing funds
exceeds investment in tax-free securities.

In principle, if there are funds available, both interest-free and

over draft and/or loans taken, then a presumption would arise
that investments would be out of the interest-free funds
generated or available with the company if the interest-free funds
were sufficient to meet the investment.

(ii) In the case of Reliance Utilities and Power Ltd (313 ITR
340(Bom), Bombay High Court has also held that Where an
assessee has his own funds as well as borrowed funds, a
presumption can be made that the advances for non-business
purposes have been made out of the own funds and that the
borrowed funds have not been used for this purpose. Accordingly,
the disallowance of the interest on the borrowed funds is not
justified.

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(iii) In the case of CIT v. Suzlon Energy Ltd (Tax Appeal No.
223 of 2013), Gujarat High Courthas held that where
assessee had own interest free funds many times over the
investment made in Indian subsidiaries and further, there was no
direct nexus between interest bearing borrowed funds and such
investment, no disallowance of interest expenditure could be
made under section 14A.

Situation (c )

(i) In the case of ITO v. Narain Prasad Dalmia, ITAT Kolkata

(ITA No. 1180/Kol/2011) has held that Rule 8D(2)(ii) is very
clear that the expenditure on account of payment of interest
would be covered in the said Rule only if it is not directly
attributable to any particular income or receipt. If the assessee is
able to demonstrate that the payment of interest is directly
attributable to the assessees taxable business activity, it cannot
be considered under Rule 8D(2)(i) of the I.T. Rules and has to be
excluded while computing the disallowance u/s 14A.

2. Investment in subsidiaries is for acquiring control

interest / strategic investment.

(i) The Chennai Tribunal in the case of EIH Associated

Hotels Ltd. v. DCIT has held that investments made by the
assessee in the subsidiary company were not on account of
investment for earning capital gains or dividend income. Such
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investments had been made by the assessee to promote

subsidiary company into the hotel industry and were on account
of

business

expediency

and

dividend

therefrom

is

purely

incidental. Therefore, the investment made by the assessee in its

subsidiary is not to be reckoned for disallowance u/s 14A r.w. rule
8D.

(ii) CIT vs RPG Transmissions Ltd [2014] 48 taxmann.com

57, the Madras High Court has held that Interest on borrowed
funds utilized for investment in group companies for strategic
business purpose was allowable under section 36(1)(iii).

(iii) Recently in the case of ITO v. Pioneer Radio Training

Services Pvt. Ltd. (ITA No. 4448/Del/2013) (Order Dated
19-1-2015), Delhi ITAT has held that (i) Expenditure (like
audit fees) required to be incurred irrespective of income
cannot be disallowed, (ii) investments in subsidiaries are
not to earn dividend income and cannot be considered for
disallowance.

3. Where no exempt income is earned during the relevant

assessment year.

(i) CIT vs Shivam Motors Pvt Ltd ITA No.88/2014, (Order

dt.05.05.2014) the Allahabad High Court has held that As
regards the second question, Section 14A of the Act provides that
for the purposes of computing the total income under the
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Chapter, no deduction shall be allowed in respect of expenditure

incurred by the assessee in relation to income which does not
form part of the total income under the Act. Hence, what Section
14A provides is that if there is any income which does not form
part of the income under the Act, the expenditure which is
incurred for earning the income is not an allowable deduction. For
the year in question, the finding of fact is that the assessee had
not earned any tax free income. Hence, in the absence of any tax
free income, the corresponding expenditure could not be worked
out for disallowance. The view of the CIT (A), which has been
affirmed by the Tribunal, hence does not give rise to any
substantial question of law.

(ii) CIT vs Corrtech Energy Pvt Ltd [2014] 45 taxmann.com

116: The Gujarat High Court has held that where assessee
has not sought any exempt income, there cannot be any expense
to be disallowed.

(iii) CIT v Lakhani Marketing, ITA No.970/2008 (Order

dt.02.04.2014), the Punjab and Haryana High Court has
held that when there was no dividend income and in such a
situation, provisions of Section 14A of the Act has no applicability.

(iv) CIT v Delite Enterprises ITA No.110/2009, the Bombay

High Court on an issue Whether on the facts and in the
circumstance of the case and in law the Honble Tribunal was
right in deleting the disallowance made by the Assessing Officer
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of interest paid by the Assessee Company on borrowed funds

amounting to Rs.241.10 lakhs overlooking the fact that the
borrowed funds were used by the Assessee Company to invest in
the Capital of another Partnership Firm and since profits derived
by the Assessee Company from a Partnership firm were exempt
from tax u/s.10(2A) of the Income-tax Act, the interest expense
related to such tax free profits is to be disallowed u/s.14A of the
Income Tax Act? It has been held that we find that there is no
profit for the relevant assessment year. Hence the question as
framed would not arise.

(v) Alliance Infrastructure Project Pvt Ltd vs DCIT ITA

Nos.220 & 1043 (Bang)/2013, (Order dated 12.09.2014)
the ITAT Bangalore, relying on the decisions of above High
Courts has held that unless and until, there is receipt of
exempted income for the concerned assessment years, we are of
the view, Section 14A of the Act cannot be invoked.

(vi) ACIT vs M Baskaran [2014] 50 taxmann.com 138, the

ITAT Chennai has held the disallowance cannot be made
u/s.14A where assessee has not earned / received any exempt
income during relevant year.

(vii) In the case of Bellwether Microfinance Fund Pvt. Ltd vs.

ITO ITA No. 1743/Hyd/2013 the ITAT Hyderabad, had to
consider whether in computing the figure of disallowance under
Rule

8D(2)(i)

and

8D(2)(iii),

it

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was

necessary

that

the

investments

had

to

have

yielded

income

which

was

not

chargeable to tax. HELD by the Tribunal:

Rule 8D (2)(i) Speaks of expenditure directly relating to income
which does not form part of total income. In the context of s.
2(45) & s. 5, the expression total income in Rule 8D (2)(i) Must
relate to an income which is sought to be assessed. Therefore,
only expenditure directly relating to income which is earned
either on receipt basis or on accrual basis and which does not
form part of total income of a particular assessment year can be
disallowed under clause (i) of Rule 8D(2). However, while
computing disallowance under Rule 8D(2)(iii), the average of the
total investment of the assessee as appearing in the balance
sheet on the first day and last day of the year irrespective of the
fact whether it has yielded income or not can be considered for
the purpose of disallowance.

Further, in Cheminvest Ltd. v. ITO [2009] 121 ITD 318

(Delhi ITAT) (SB), ITAT took a view that when the expenditure
is incurred in relation to exempt income, it has to suffer
disallowance irrespective of the fact whether any exempt income
is earned by the assessee or not. This also prompted the CBDT to
issue a Circular no. 5/2014 dated 11/02/2014 reiterating the
view of the Special Bench. However, Chennai bench of the
Tribunal in ACIT vs M Baskaran (Chennai ITAT)as mentioned
above held that the Delhi Special Bench decision of Cheminvest
Ltd. (supra) and Circular no. 5/2014 dated 11/02/2014 (supra)
are no more good law.
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4. Whether when Capital gains on sale of investments are

liable for tax, it can be considered that investment in
shares is not a tax free investment.

(i) In the case of CIT v. Holcim India P. Ltd ITA No.

486/2014 & 299/2014, Delhi High Courtheld that S. 14A &
Rule 8D disallowance cannot be made if there is no exempt
income or if there is a possibility of the gains on transfer of
the shares being taxable. HC has held that Income exempt
under Section 10 in a particular assessment year, may not have
been exempt earlier and can become taxable in future years.
Further, whether income earned in a subsequent year would or
would not be taxable, may depend upon the nature of transaction
entered into in the subsequent assessment year. For example,
long term capital gain on sale of shares is presently not taxable
where security transaction tax has been paid, but a private sale
of shares in an off market transaction attracts capital gains tax. It
is an undisputed position that assessee is an investment company
and had invested by purchasing a substantial number of shares
and thereby securing right to management. Possibility of sale of
shares by private placement etc. cannot be ruled out and is not
an improbability. Dividend may or may not be declared. Dividend
is declared by the company and strictly in legal sense, a
shareholder has no control and cannot insist on payment of
dividend. When declared, it is subjected to dividend distribution
tax.
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5. 14A & Rule 8D cannot be applied in a mechanical

manner
(i) In the case of ACIT 11(2) vs. Iqbal M Chagala, Palloni
Mansion ITA No. 877/Mum/2013, ITAT Mumbai, it has been
held that 14A & Rule 8D cannot be applied in a mechanical
manner. Disallowance cannot exceed expenditure claimed
as a deduction

6. Disallowance while calculating MAT if there is no exempt

income.

(i) In the case of Minda Sai Limited v. ITO (ITA No.

2974/Del/13),

ITAT

Delhi has

been

held

that In

the

absence of exempt income, s. 14A disallowance cannot be

added to s. 115JB book profits even if assessee has
accepted s. 14A disallowance in the normal computation.

Further in the case of Wallfort Shares & Stock Brokers

Ltd.

vs

I.T.O. the Honble Supreme Court vide judgment

ated 6th July, 2010 has held that For attracting Section 14A,
there has to be a proximate cause for disallowance, which is
its relationship with the tax exempt income. Pay-back or return of
investment is not such proximate cause, hence, Section 14A is
not applicable in the present case. Thus, in the absence of such
proximate

cause

for

disallowance,

invoked.
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Section

14A

cannot

be

From the above discussion, it will be noticed that introduction of

Section 14A (2) & (3) and further Rule 8D as prescribed by CBDT
has complicated the calculation of the amount related to exempt
income. It has given birth to a lot of anomalies as mentioned
below which is required to be given attention immediately.If the
method prescribed under the Rule 8D is applied the expenditure
to be disallowed will be substantial and will have no relation to
the actual expenditure incurred. In other words, in most cases, a
notional amount will be disallowed which can be many times
more than the actual expenditure. Further, In the case of
dividend income, profit apportions to partner, long term capital
gains (where STT has been paid etc. exemption has been granted
not as an incentive but because the tax is levied at source.
Therefore, there is no logic in disallowing expenditure u/s.14A in
such cases where tax is collected at source. It is, therefore,
suggested that the section should be suitably amended. Section
14A was introduced to cover cases where expenditure in relation
to income such as agricultural income, tax free bonds, etc. which
did not suffer any tax under the Income-tax Act, was being
claimed. So the introduced section should be followed in its spirit
for which it was enacted, should not be used just as a tax
collection tool.

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