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The Act exempts certain income from tax, such as agricultural income, income received by charitable institutions, gratuity, pension, insurance claim amount etc. To earn such income, the taxpayers might have incurred certain expenditures—for example, the interest on a loan to undertake agricultural activities, etc.
The deduction of expenditure in relation to exempt income is a highly litigated subject matter, with both favorable and adverse judicial rulings in this regard. The taxpayers have always contended that such expenses should be allowed as a deduction. In contrast, the tax authorities have refuted such a claim, as the income is already exempt from taxation and allowance of such expenses would reduce the non-exempt income. This is against the basic principle of taxation, where only expenses that are relatable to the income are allowed as deductions.
To deal with such cases, Section 14A was introduced in the Act, which provides that the expenditure incurred in relation to income that does not form part of the taxable total income under this Act should not be allowed as a deduction against the total income of the taxpayer.
The section further provides an apparatus for the tax officer to undertake/determine the expenditure incurred by the taxpayer concerning the exempt income. This method is prescribed under Rule 8D of the Income-tax Rules, 1962 (“the Rules”). However, it is to be noted that Rule 8D can be invoked only in the following cases –
Only those expenses that are proved to be incurred in relation to the exempt income can be disallowed. Under the garb of this section, the tax officer cannot disallow such expenses which are assumed to have been incurred for earning such exempt income. Also, expenses incurred in common, towards both exempt and taxable income, cannot be artificially apportioned on the basis of such assumption that a part of these expenses would have been incurred towards earning exempt income.
Further, before invoking Rule 8D, the tax officer must clearly indicate the inaccuracy in the taxpayer’s calculation. The tax officer cannot arbitrarily apply Rule 8D without pointing out the inaccuracy in apportionment or allocation of expenses. The responsibility is on the tax officer to show that the assesses has incurred the expenditure for earning tax?free income.
As per Rule 8D, expenditure in relation to the exempt income would be the aggregate of the following:
In any case, the amount of disallowance computed as per this Rule cannot exceed the total expenditure claimed by the taxpayer.
Let understand this by an example;
Mr A has taken a loan of INR 20 lakh on 23 January 2020 @ 10% during the FY 2020-21. Therefore, his interest expenditure for the year on this loan is INR 2,00,000. He utilized this loan for making an investment of INR 20 lakh in various avenues, income from which is exempted from tax.
Monthly closing balances of this investment is INR 20,00,000 (January 2020), INR 15,00,000 (February 2020), INR 5,00,000 (March 2020).
Rule 8D disallowance is computed as below:
Particulars |
Amount (in INR) |
---|---|
Any amount of expenditure that is directly relating to exempt income |
2,00,000 |
1% x [average of(monthly averages of opening and closing balances of investment/income)] Average of the above monthly averages |
12,500 |
Total disallowance under Section 14A read with Rule 8D |
2,12,500 |
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