The Hindu Business Line : Expenditure on exempt income

If some part of the income does not suffer tax, difficulties arise in allocating common expenditure towards taxable and non-taxable parts of the total income.

T. C. A. Ramanujam

All expenditure related to the earning income will have to be deducted in arriving at the taxable income. If some part of the income does not suffer tax because it is either dividend income or agricultural income, difficulties arise in allocating common expenditure towards taxable and non-taxable part of the total income.

In the Rajasthan State Warehousing Corporation (242 ITR 450) case, the Supreme Court ruled that where a person carries on an individual business with a part of the income being taxable, leaving the other part as exempt, the entire expenditure incurred for earning both the exempt and the taxable income will be deductible while computing the taxable income.

This unsatisfactory situation was redressed by the Finance Act 2001 with the introduction of Section 14A in the Income-Tax Act. The Section provided for disallowance of expenditure in relation to income which does not form part of the total taxable income.

The Section was given retrospective effect from April 1, 1962. The Central Board of Direct Taxes (CBDT) clarified that no assessment will be reopened to take advantage of Section 14A. This assurance was given statutory recognition with the insertion of a proviso w.e.f. May 11, 2001.

Section 14A(2) was inserted by the Finance Act, 2006 w.e.f. April 1, 2007. This enabled the assessing officer (AO) to determine the allowable expenditure in accordance with prescribed method if he is not satisfied about the correctness of the taxpayer’s claim with regard to the deductibility of expenditure. The proviso to Section 14A(2) bars an AO from having recourse to reassessment proceedings under Section 147 or rectification proceedings under Section 154 for applying the new law.

The Haryana Land Reclamation and Development Corporation claimed depreciation of Rs 10.38 lakh on assets in the firm. It was found that the assets were used for agricultural operation and not for business purposes. Nor was there any evidence to show that the staff was engaged in the business operation and not in agriculture. Substantial income was being generated out of agriculture. Depreciation and allied expenditure on staff was disallowed in the computation of the business income invoking Section 14A in the 1997-98 assessment. The High Court upheld the action of the department (302 ITR 218).

Inter-corporate investments

What happens if the company has income from inter-corporate investments? Interest will be taxable but dividend income will have to be exempted under Section 10(33).

A tricky situation arose in the Aquarius Travels (P) Ltd (301 ITR 111 AT Delhi SB) case. The company claimed that income from inter-corporate deposits should be taken as business income. But the department felt that it should be assessed under ‘other sources’.

Expenditure relatable to earning of interest was deductible but not expense for earning of dividends. The case related to the assessment years 1997-98 and 1998-99.

A Special Bench of the Income-Tax Appellate Tribunal (ITAT) went into the matter elaborately. On the one hand, the main Section 14A(1) is given retrospective operation from April 1, 1962. On the other hand, the proviso forbids the AO from having recourse to the main section in order to disallow expenditure relatable to exempt income. Giving a harmonious interpretation of the law, the Special Bench read the proviso along with the main section and ruled:

The bar is only on the AO and he cannot have recourse to Section 147 or Section 154.

The Appellate Authorities can apply Section 14A in the course of hearing the appeal with regard to assessments relating to assessment years prior to 2001-02.

Even the AO can apply the main Section 14A if the relevant assessments are pending before him.

The higher authorities, such as the CIT (Appeals), the CIT under Section 263 and the ITAT, can direct the AO to invoke Section 14A in suitable cases.

Rule 8D

To avoid subjectivity in the matter of apportionment, the CBDT has chosen to provide quantitative guidelines in Notification No.45/2008 dated March 24, 2008. A new rule 8D has been incorporated in the Income-Tax Rules, 1962 by the Income-Tax (Fifth Amendment) Rules, 2008.

The Rule prescribes the method for determining the amount of expenditure in relation to income not includable in total income. It can be invoked in cases where the AO is not satisfied with the correctness of the claim of expenditure or in cases where the taxpayer claims that no expenditure was incurred with regard to the exempt income.

The methodology is no doubt complicated. The new Rule also takes into account the total assets of the company as appearing in the balance-sheet on the first and last days of the previous year. All this only means that the tax law is a maze, which means careful planning of business affairs whenever there is exempt income from investments.

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