The Hindu Business Line : Apportionment of expenses

The method of estimating the expenditure to be disallowed will be prescribed by the Central Board of Direct Taxes Fine-tuning the computation of taxable income

A longstanding litigation relating to direct taxes concerned the computation of taxable income in the context of allocating expenditure between taxable and tax-free incomes. Section 37 of the Income-Tax Act, 1961 allows expenditure wholly and exclusively incurred for earning the taxable income. The law was silent on the question of bifurcating expenditure as relatable to taxable and non-taxable income.

Attempt at bifurcation

The Finance Act, 2001, for the first time, attempted such bifurcation of expenditure by inserting Section 14A in the I-T Act. It was laid down that for computing total income, no deduction shall be allowed in respect of expenditure incurred in relation to income, which does not form part of the total income under the Act.

Section 14A was given retrospective operation with effect from April 1, 1962. This gave rise to fears about abuse of powers by reopening concluded proceedings. The Central Board of Direct Taxes issued a circular on July 23, 2001, directing the officers not to reopen completed assessments which had become final before April 1, 2001.

Finance Act, 2002 gave statutory recognition to the circular and the newly inserted proviso clarified that the assessing officer shall not reassess cases under Section 147 or pass orders under Section 154 for any assessment year beginning on or before April 1, 2001.

The latest amendment

While the law provided for disallowance of deduction of expenditure incurred in relation to income, which does not form part of the total income, there was no provision for calculating or computing such disallowable expenditure. Disputes have arisen under Section 14A with regard to the disallowance of expenditure incurred for earning interest and dividend incomes.

No method is provided under the existing provisions for working out the disallowance, which can be made pro-rata in respect of common expenditure incurred for earning taxable and tax-free incomes. This was also found to be unsatisfactory. Judicial authorities were divided with regard to the question of estimated disallowance of common expenditure.

Estimating disallowance

Finance Act, 2006 inserts a new sub-section (2) in Section 14A making it mandatory for the assessing officer to determine the expenditure incurred in relation to earning of tax-free income. The method of estimating the expenditure to be disallowed will be prescribed by the CBDT. It is also provided that Section 14A(2) will also apply in relation to a case where an assessee claims that no expenditure has been incurred in relation to income which does not farm part of the total income. This amendment will take effect from April 1, 2007, and will apply in relation to the assessment year 2007-08 and subsequent years.

A long list of case law exists on the question of disallowing expenditure with regard to exempt incomes. Where the company claims that no expenditure was incurred, the burden is on the Revenue to prove that some expenditure was incurred.

The Bombay High Court held that expenses incurred on staff salary were not directly relatable to earning dividend income for computing special deduction under Section 80M (254 ITR 203). A similar view was taken in CIT vs Central Bank of India 264 ITR 522 (Bombay).

A Bench of the Income-Tax Appellate Tribunal held that no interest can be allocated to a tax-free income since actual expenditure has to be incurred (Maruti Udyog Ltd vs Deputy CIT — 1992 ITD 119 Delhi). All this is set to change. But why arrogate to the Board powers to prescribe rules for allocation of expenditure even when no expenditure is incurred for earning taxable income?

The law in this regard was elaborately laid down by the Supreme Court in Rajasthan State Warehousing Corporation vs CTI (242 ITR 450). The court ruled that the principle of apportionment of expenditure would apply if there is no nexus between the expenditure attributable to a particular venture not forming integral part of the business and the expenditure sought to be deducted as the business expenditure of the company.

This is a salutary principle and should have been accepted. Instead, the law is getting more complicated and we will shortly have Rules framed by the CBDT compulsory allocating expenditure to tax-free incomes even when the company claims that no expenditure was incurred for earning such tax-free income.

(The author is a former Chief Commissioner of Income-Tax.)