The Hindu Business Line : Apportionment of expenses to exempt income

There has been considerable litigation between taxpayers and the tax administration ever since Section 14A was inserted in the Income-Tax Act, 1961 vide the Finance Act, 2001.

The section provides that expenditure that has been incurred in relation to tax-free income should not be allowed as a deduction while computing taxable income. To elucidate the provision: any expenditure incurred in earning tax-free dividend income ( like interest on borrowings made to invest in shares) cannot be deducted while computing the taxable income of a taxpayer.

The Supreme Court had been holding that in the case of an indivisible business, the entire expenditure would be eligible for a deduction, although a part of the expenditure may have been incurred for earning exempt income.

It is in this background that Section 14A was inserted in the Act by Finance Act 2001, with retrospective effect from April 1, 1962, to clarify the intention of the legislature.

Position clarified

However, various concerns were raised on the retrospective application of Section 14A, leading to reopening of closed assessments. To address these concerns, a proviso was inserted; the said proviso clarified that the section would not empower the first level tax officers to reopen assessments or pass an order enhancing the taxable income or rectify concluded orders for any tax year prior to 2000-01.

To set the legislature’s intentions right, the CBDT also clarified the above position by way of Circular, stating that where proceedings had become final before April 1, 2001, assessments could not be reopened in view of this newly inserted section.

Thereafter, Section 14A(2) was inserted by Finance Act 2006, with effect from April 1, 2007, which gave the tax officer powers to mandatorily determine the expenditure in relation to tax-free income in accordance with the prescribed method, where he is not satisfied with the taxpayer’s determination of expenditure.

Recently, the method of computation of the disallowance under Section 14A, to be adopted by the tax officer, was prescribed vide Notification No. 45/ 2008 dated March 24, 2008, whereby a new rule 8D has been inserted in the Income-tax Rules. The expenditure in relation to tax-free income is prescribed to be the aggregate of the following amounts:

The amount of expenditure directly relating to tax free income;

In the case of interest expense not directly attributable to any particular income or receipt, an amount computed in accordance with the following formula: (Interest which cannot be directly attributed) x (Average value of investment related to tax free income, appearing in the balance-sheet on the first and last day of the FY / Average total assets in the balance-sheet on the first and last day of the FY)

0.5 per cent of the average value of the investment related to the tax-free income, as appearing in the balance-sheet on the first and last day of the financial year.

Currently, there is no clarity on whether the newly inserted rule 8D would have retrospective application. This is more so in cases where the tax officer believes the apportionment has not been done correctly, and he uses this rule of computation.

Given that this rule has been inserted on March 24, 2008, one could take a strong defence that the legislature cannot expect the taxpayers to do impossible things, and accordingly, it should be prospective in application.

While the taxpayers are already struggling with the applicability of the above rule, a recent decision of the Special Bench of the Delhi ITAT (Income Tax Appellate Tribunal) has made this issue all the more complex.

The Special Bench, in the Aquarius Travels (P) Ltd case, has observed that the proviso to Section 14A cannot be interpreted so widely as to nullify the whole provision and frustrate the legislature’s object of the retrospective amendment. Amongst others, the main observations of the ITAT were as follows:

Section 14A has to be applied to by the appellate authorities and courts retrospectively, if the matter relating to deduction of expenses relating to exempt income is pending before them;

If the assessment for AY 2001-02 and earlier years have not been concluded, the tax officer is empowered to invoke Section 14A.

The proviso to Section 14A does not restrain the tax officer from carrying out the directions of the CIT(A) or the ITAT or for a fresh adjudication in case of an assessment set aside under Section 263 relating to AY 2001-02 or earlier years.

If the appeal for assessment for AY 2001-02 and earlier years is pending before the CIT(A), then the CIT(A) is empowered to invoke Section 14A, if the subject matter of appeal so requires.

The CIT(A) can invoke Section 14A even if the tax officer had not invoked Section 14A, if the subject matter of appeal so requires.

If the appeal for assessment for AY 2001-02 and earlier years are pending before the ITAT, it is empowered to invoke Section 14A, if the subject matter of appeal so requires.

The ITAT can consider the applicability of Section 14A suo motu, even if Section 14A was not invoked by any of the lower authorities, if the subject matter of appeal so requires.

Powers of the ITAT

The above decision gives a greater insight into the powers of the ITAT. It has been held by various courts that the ITAT does not have the power to raise any grievance by itself. However, in this case the ITAT held that if the law is amended retrospectively from a tax year, the issue at hand in respect of the that year will have to be decided in light of the amended law, even if the matter is at the appellate, revision or reference stage.

Support was also taken from a Supreme Court decision, wherein the court spelled out in clear terms that the amended law has to be given effect to by the appellate authorities and courts, if the matter is pending before them. Further, the ITAT, relying on judicial precedent has also observed that proceedings pending before the ITAT should be regarded as continuation of assessment proceedings.

Wide ramifications

In light of the above decision of the ITAT Delhi, it would not be surprising, if the tax authorities seek to invoke Section 14A and/or Rule 8D in respect of AYs prior to 2001-02, more so when matters are pending before courts. Further, the decision being a Special Bench decision, the same would have application all over India.

This decision would certainly have wider ramifications where matters relating to disallowance of expenditure relating to tax free income(s) have been pending before the courts, in which case the taxpayers might be exposed to significant tax liability (including interest).

As is the situation in India, one would need to wait and watch for a High Court or Supreme Court decision, for clarity on the intent of the legislature on the applicability of Section 14A and computation mechanism in Rule 8D. This is so because we have seen in the past that the tax administration does not hold out any position and generally leaves it to the judiciary to come to a conclusion!

(The authors are Partner and Manager in the Tax & Regulatory practice of BSR & Co.)

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