The Hindu Business Line : Quantification conundrum

The IT Department had all along taken the stand that some sort of an expenditure has to be incurred to earn tax-free income, and this expenditure needs to be disallowed. The Finance Bill makes it mandatory to quantify the expenditure incurred for earning exempt income

Companies invest in the shares of other companies. These are made either to promote new ventures or earn income. In the current scheme of things, where dividend is tax-free in the hands of the recipient, the number of entries in the investment schedule of various companies is on the rise. When dividends on investments are earned tax-free, there is always an element of expenditure incurred to earn such income. The Department had all along taken the stand that some sort of an expenditure has to be incurred to earn tax-free income and this expenditure needs to be disallowed. But assessees are of the view that no expenditure is incurred particularly in respect of investments held over a long period.

Legal position

Section 14A was introduced in the Income-Tax Act, 1961 by the Finance Act, 2001. This section expressly provides that 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. While the provision states that the expenditure shall not be allowed, there was no formulae or methodology specified in the provision as to how to quantify such expenditure.

Corporate assessees cannot maintain specific records to show that Rs XXX has been incurred to earn a particular tax-free income. At the appellate stage, the matter was settled more on an ad hoc basis rather than by scientific assessment of the amounts involved. The Madras Tribunal sought to settle this issue by arriving at a figure of 2 per cent of the dividend earned, as in the ACIT vs Teeaye Investments Ltd (ITA No. 1816 MDS/99) case. Though ad hoc and somewhat illogical and in order not to precipitate the dispute, corporate assessees settled for this proposition.

Budget proposal

The Finance Bill, 2006 has amended Section 14A of the Act to clearly state that effective assessment order 2007-08, the assessing officer shall determine the amount of expenditure incurred in relation to such exempt income. The provision also suggests that a suitable method will be prescribed to facilitate this process.

Further, even where the assessee claims that no expenditure has been incurred, the assessing officer has a right to quantify the expenditure and make a disallowance on the basis of such quantification. In one way, this has settled the dispute prospectively and has confirmed the standpoint of the Department that such expenditure needs to be disallowed. However, as far as the earlier cases are concerned, it appears that the tribunal decision of 2 per cent will have to be accepted as the only guiding principle or proposition on the matter.

To understand the amendment better, one has to wait for the details of the method that will be prescribed. But there is likely to be a fresh round of litigation over the amended Section 14A of the Act.

(The author is a Chennai-based chartered accountant.)