Articles

Executive Summary

This Article, authored by our Founder Director Sh. Mayank Mohanka, captures the entire journey and life-cycle of Section 14A and Rule 8D, the Legislative Intent of its introduction, and how that is being disregarded, the practical hardships being faced by the assessees, all significant legal precedents on section 14A and Rule 8D, the recent amendment brought in Section 14A by the Finance Act, 2022, its applicability i.e., prospective or retrospective, in the light of real-life assessment scenarios.

The equituous and meritorious objective, purpose and the legislative intent of bringing in the expenditure disallowance section 14A, in respect of exempt income, has somehow, been turned down into an unfettered, unlawful, and arbitrary, demand raising instrument, in the hands of the assessing authorities. This section was inserted to prevent any unjust enrichment in the hands of the assessees, however, ironically, now this provision is being used as an instrument of ensuring unjust enrichment of the Exchequer, in the form of huge and exorbitant demands.

Blind application of Rule 8D, is the biggest threat to the legislative intent, sanctity, and existence of the Statutory Exemptions and Exclusions being categorically provided and mandated under Section 10 of the Income Tax Act. The taxpayers now fear more about the probable tax implications of their tax-free income rather than their taxable income.

Epilogue

“The Board hereby resolves that the Company will not make any investments in any investment instruments, yielding any tax-free income, including those of tax-free infrastructure bonds of the Government of India, NHAI, PFC etc.”

Well Friends, passing of the above Board Resolution, has become the recurring and common phenomenon in the Board Meetings of almost all big, reputed and established corporate entities including the public sector companies.

And, mind you, the real reason for such deterrence towards investments in tax-free investment instruments, including those being issued by the Govt. of India and big public sector financial institutions and entities, is not the rate of return or YTM or the risk factor, but is something else and which is totally unthinkable and unwarranted, at the macro-investment eco-system of our Country.   

Picture this real-life Regular Assessment scenario u/s 143(3A)/144B.

The assessing authority through the National Faceless Assessment Centre, has issued a show cause notice (SCN) cum draft assessment order u/s 143(3) read with section 144B of the Income Tax Act, for the AY 2020-21, proposing to make a disallowance of an amount of Rs. 12 crores u/s 14A of the Income Tax Act read with Rule 8D of the Income Tax Rules, in respect of tax-free interest income of Rs 13.93 lakhs earned by the assessee company on an investment of Rs. 2 crores in tax-free bonds of the Government of India and NHAI and REC/PFC.

Thus, leave aside the paradox of the said exorbitant disallowance of Rs 12 crores u/s 14A/Rule 8D in proportion to the nominal tax-free interest income of Rs 13.93 lakhs, even the total amount of investment by the assessee company, in such tax-free bonds of the Govt. of India and NHAI and REC/PFC of Rs. 2 crores, is much-much lesser than the proposed disallowance of Rs. 12 crores, being made by the assessing authority. 

The assessing authority has proposed this absurd and arbitrary disallowance, by blindly and incorrectly applying the second limb of Rule 8D i.e., clause (ii) of subsection (2) of Rule 8D, which provides for a disallowance of an amount of one percent of the annual average of monthly averages of opening and closing balances of investments, income from which does not or shall not form part of total income.

Before issuing such high-pitched draft assessment order u/s 143(3)/144B of the Income Tax Act, neither the assessing authority, nor the monitoring and approving authority- the National Faceless Assessment Centre, has appreciated and understood that only those investments of the assessee are to be considered for computation of disallowance under Rule 8D(2)(ii), which yield such tax-free/exempt income, and not the total value of investments as appearing in the Balance Sheet of the assessee.

Thus, even presuming the applicability of Rule 8D in this case, the maximum amount of disallowance that can be worked out as per Rule 8D(2)(ii), is Rs. 2 lakhs, only, i.e., 1% of investment value of Rs 2 crores, in tax free bonds of the Govt. of India and NHAI and REC/PFC, earning a tax-free income of Rs. 13.93 lakhs, and not Rs. 12 crores, which has been proposed in the draft assessment order passed u/s 143(3)/144B of the Income Tax Act.

Surprisingly, the monitoring authority i.e., the National Faceless Assessment Centre, has also approved this blunder and mis-adventure of the assessing authority, inspite of the much hyped transparent, efficient, accountable, team based, dynamic jurisdiction based and taxpayer friendly assessment regime in the Faceless Regime.

Though the final assessment order is yet to come, courtesy the last minute extension in time barring completion deadline of assessments for AY 2020-21 up to 30.9.2022, but still concerned and wary of this patent and probable income-tax demand, the Company, in its Board Meeting, has been compelled to pass the above Board Resolution in order to avert this unwarranted and undue hardship, at least for future income tax assessments.      

So, the real culprit, resulting in such deterrent approach of the company, towards investing in the otherwise very good, attractive and safe investment instruments i.e., tax free bonds of Govt. of India, NHAI, PFC etc., is the hanging sword of imposition of this huge addition of Rs. 12 crores, u/s 14A read with Rule 8D, in the assessment order, by the assessing authority, and as approved by the National Faceless Assessment Centre (NaFAC).

Such kind of faceless assessment orders really make one wonder, as to whether the NaFAC is really discharging its expected role of an effective monitoring authority ensuring prevention of high-pitched and unlawful assessments or is it merely acting as a ‘Post-Man’ between the assessee and the anonymous regional assessing authority.

The real-life experience gained by the assessees/authorised representatives, during the personal hearings, conducted exclusively through video conferencing in the first year of faceless assessments, clearly demonstrates and evidences that as opposed to the much proclaimed team based, unbiased and taxpayer friendly conduct of assessments, these faceless assessment proceedings, are being conducted by only one individual assessing officer sitting under some different and unknown jurisdiction, and not by any group or team of competent officers. Further, it has also been experienced that the written submissions being uploaded by the assessees/authorised representatives in response to earlier notices u/s 142(1) and the show cause notice cum draft assessment order, have not even been read by such assessing authorities even uptill the time period of such video conference hearings.

Thus, practically, now, in faceless assessment proceedings, one unknown assessing officer, who could be sitting anywhere in India, is doing the assessment, simply on the basis of written submissions being filed by the assessee (which he may choose to read or not) and one solitary video conference hearing, which also is granted only, when in fact such assessing officer has already made up his/her mind of making additions by passing the draft assessment order/income or loss determination proposal, in place of the jurisdictional assessing officer of the assessee, who in fact used to have much more knowledge, experience, understanding and insights of the assessment issues of his /her jurisdictional assessees.

The Hon’ble Delhi High Court’s undermentioned Observation, in the case of ‘Divya Capital One Private Limited vs. ACIT Delhi’, in W.P.(C) 7406/2022 dated 12th May 2022, though made in the context of implementation concerns of the new re-assessment regime, equally holds good even for the ground level implementation of faceless assessment proceedings.

“A progressive as well as futuristic scheme of re-assessment [can be read as faceless assessments in the present context] whose intent is laudatory has in its implementation not only been rendered nugatory but has also had an unintended opposite result.”

Prologue

Section 14A of the Income Tax Act, 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. Rule 8D of the Income Tax Rules, 1962 provides computation mechanism for said disallowance.

Legislative Intent behind Insertion of Section 14A

Section 14A was inserted in the Income Tax Act, 1961, by the Finance Act 2001, with retrospective effect from 1.4.1962, primarily to overcome the judgement of the Hon’ble Supreme Court in the case of ‘Rajasthan State Warehousing Corporation vs. CIT’ (2000) 109 Taxmann 149 (SC):(2000) 242 ITR 450 (SC). In the said judgement the Hon’ble Supreme Court has held that in the case of an indivisible business, the entire expenditure shall be allowed to the assessee, including that in relation to the exempt income and the principle of apportionment can apply only in respect of divisible business.

Thus, the primary objective of bringing in this section 14A in the Income Tax Act, was to ensure that there is no unjust enrichment in the hands of the assessee, in the form of allowance of an expenditure incurred by such assessee in earning any tax-free income, from the taxable income. Being equituous and justice-oriented, the said insertion of section 14A in the Income Tax Act, found mutual consensus and favour with all the concerned stakeholders.

Further, in order to remove uncertainty and ambiguity in determination of the amount of disallowable expenditure u/s 14A, Rule 8D was inserted in the Income Tax Rules, 1962, in 2008. Rule 8D prescribes the method of computing the amount of disallowable expenditure u/s 14A, to be adopted by an assessing authority, in case of dissatisfaction with the correctness of claim of expenditure/no expenditure, suo-motto made by the assessee for disallowance u/s 14A, in his/her return of income.

The Hon’ble Supreme Court in the case of ‘CIT vs. Essar Teleholdings Ltd’ (2018) 401 ITR 445 (SC) has given its stamp of approval on the prospective applicability of Rule 8D w.e.f. AY 2008-09 and not before.

Disallowance of Expenditure u/s 14A as prescribed in Rule 8D

The amount of disallowance of expenditure u/s 14A, as prescribed in Rule 8D is the aggregate of the following:

(i) For Period up to 1.6.2016

(a) amount of expenditure directly relating to income which does not form part of total income;

(b) interest expenditure not directly attributable to any particular income, in the proportion, which the average value of investments yielding tax-free income bears to the average value of total assets in the Balance Sheet of the assessee;

(c) half percent of the average of opening and closing balances of investments, yielding tax-free income.   

(ii) For Period on or after 2.6.2016

(a) amount of expenditure directly relating to income which does not form part of total income;

(b) one percent of the annual average of monthly averages of opening and closing balances of investments, yielding tax-free income.

Proviso to Rule 8D further provides that the amount of disallowance as computed in accordance with Rule 8D shall not exceed the total expenditure claimed by the assessee.

The Fall Out of Blind & Unlawful Application of Rule 8D

Dividend income from investment in equity shares continued to remain exempt in the hands of recipients uptill 31.3.2020 (AY 2020-21), u/s 10(34) of the Income Tax Act.

Thus, in all such cases, where the assessees were in receipt of the exempt dividend income, even in very nominal proportions, the ugly ghost of disallowance of expenditure u/s 14A read with Rule 8D, on deeming fiction basis, started haunting the assessees, across board, on PAN India basis, as the assessing authorities, somehow used this otherwise equitable provision, as a by-default addition making provision, for Exchequer’s enrichment, at least in the form of raising of huge demands, and ensuring deposition of at least 20% of such demands.

Uptill 1.6.2016, huge disallowances u/s 14A were being made by the assessing authorities primarily, on account of applying the deeming fiction of incurring of a notional interest expenditure by the assessee, as stipulated in then existing clause (ii) of Rule 8D(2), resulting in some absurd amounts of disallowances being computed and made, which even exceeded in manifold, the amount of such exempt income actually earned by the assessees, and even in cases, where the assessees have made such dividend earning investments out of their own surplus funds and not out of any interest bearing funds.

This high-handed approach of the assessing authorities has forced the assessees to approach the hon’ble High Courts. In several judgements, like PCIT vs Shapoorji Paloonji & Co. Ltd [2020] 117 taxmann.com 625 (Bombay), ‘HT Media Ltd vs PCIT’ 399 ITR 576 (Del), the hon’ble High Courts have categorically held that where both interest-free and interest bearing funds were available with the assessee, it is to be presumed that investments were made out of interest-free funds, and as such, a blanket disallowance u/s 14A can’t be made by just blindly applying clause (ii) of Rule 8D(2), in all cases.

Some respite came for the assessees when Rule 8D got substituted with a new Rule 8D w.e.f. 2.6.2016, wherein, this controversial clause (ii) of Rule 8D(2) stipulating the disallowance of interest expenditure on deeming fiction/ notional basis, got omitted and now only two limbs of disallowances are there in Rule 8D viz. (i) amount of expenditure directly relating to income which does not form part of total income, and (ii) one percent of the annual average of monthly averages of opening and closing balances of investments, yielding tax-free income.

Thus, w.e.f. 2.6.20216 onwards, at least no disallowance u/s 14A, can be made on deeming fiction basis, in respect of any notional interest expenditure, in the hands of the assessees.

However, this unfortunate phenomenon of raising of adhoc, arbitrary and exorbitant income tax demand, under the garb of section 14A, is still continuing at present, (as manifested in the Epilogue of this Article), now under the substituted second limb of Rule 8D(2) i.e. one percent of the annual average of monthly averages of opening and closing balances of investments, yielding tax-free income.

Judiciary coming to the Rescue

This habitual practice of raising of adhoc, arbitrary, unlawful and exorbitant income tax demand, under the garb of section 14A, on account of blind application of Rule 8D, by the assessing authorities, has been put to check, to some an extent, by the Judiciary, in the form of a catena of very good, comprehensive, objective and well-reasoned judgements, laying down the undermentioned well-settled legal propositions/ ratios in respect of the disallowance u/s 14A of the Income Tax Act.

1. In order to make any disallowance u/s 14A read with Rule 8D, the nexus has to be established between the exempt income and the expenditure proposed to be disallowed and in the absence of such nexus, no disallowance u/s 14A is warranted. [CIT vs. Walfort Share & Stock Brokers (P) Ltd, [2010] 192 Taxman 211 (SC)].

2. If the assessee claims that he/she has not incurred any expenditure in earning the exempt income or suo-motto disallows a certain amount u/s 14A in the ITR, then in order to invoke Rule 8D, the assessing authority has to record his/her satisfaction in writing, in the assessment order, that as to why he/she is not satisfied with such claim of the assessee and in the absence of recording of such satisfaction, no disallowance u/s 14A read with Rule 8D can be made. [HT Media Ltd vs PCIT 399 ITR 576 (Del) & Maxopp Investments Limited vs. CIT [2018] 254 Taxman 325 (SC):(2018) 402 ITR 640 (SC).

3. Investments not earning/yielding any exempt income, are to be excluded for the purpose of computing disallowance u/s 14A read with Rule 8D. [ACB India Ltd v. ACIT ITA 615/2014 (Delhi High Court) [2015] 62 taxmann.com 71 (Delhi); CIT v. Oriental Structural Engineers Pvt. Ltd. ITA No. 605/2012 (Delhi High Court) [2013] 35 taxmann.com 210 (Delhi).

4. Where both interest-free and interest-bearing funds were available with the assessee, it is to be presumed that investments were made out of interest-free funds, and as such, a blanket disallowance u/s 14A can’t be made. [HT Media Ltd vs PCIT 399 ITR 576 (Del); PCIT vs. Shapoorji Paloonji & Co. Ltd [2020] 117 taxmann.com 625 (Bombay).

5. The disallowance u/s 14A read with Rule 8D can’t exceed the amount of exempt income [Joint Investments Pvt Ltd vs CIT [2015] 59 taxmann.com 295 (Delhi).

6. If no exempt income has been actually earned by the assessee during the financial year, then no disallowance u/s 14A read with Rule 8D can be made for that financial year. [PCIT v. IL&FS Energy Development Company Ltd ITA No. 520/2017 [2017] 84 taxmann.com 186 (Delhi); CIT v. Holcim India (P.) Ltd. [2015] 57 taxmann.com 28 (Delhi)/[2014]; Cheminvest Ltd. v. Commissioner of Income Tax [2015] 61 taxmann.com 118 (Delhi).

Amendment in Section 14A brought about by Finance Act 2022

The Finance Act 2022 has inserted an Explanation to section 14A of the Act, to the effect that notwithstanding anything to the contrary contained in this Act, the provisions of this section shall apply and shall be deemed to have always been applied in a case where exempt income has not accrued or arisen or has not been received during the previous year relevant to an assessment year and the expenditure has been incurred during the said previous year in relation to such exempt income. This amendment shall take effect from 1st April, 2022.

Thus, several judgements of the hon’ble High Courts including the judgements of the hon’ble Delhi High Court in the cases of ‘Cheminvest Ltd vs. CIT reported in CIT (2015) 378 ITR  33 (DEL) and ‘PCIT vs IL&FS Energy Development Company Ltd reported in 250 Taxman 0174, holding that no disallowance u/s 14A of the Act could be made in respect of any expenditure incurred in earning any exempt income, in the absence of any exempt income, as discussed in point no (vi) above, can no longer be relied upon by the assessees, on or after 1.4.2022.

Amendment in Section 14A by the Finance Act 2022 Prospective or Retrospective?

In the humble understanding of the author, the said amendment in section 14A, by the Finance Act 2022, is to be read and construed as a prospective amendment only and not retrospective, as both the Explanatory Memorandum and the Finance Act 2022, stipulate that this amendment shall take effect from 1st April, 2022.

It is imperative to mention here that exactly the same ambiguous language i.e.,“deemed to have always been applied”, as has been used in the newly inserted Explanation to section 14A, by the Finance Act 2022, has also been used in the amendments in sections 36(1)(va) and 43B of the Income Tax Act, by the Finance Act 2021, in respect of the disallowance of belated deposition of employees contribution towards PF and ESI.

However, the said amendments in sections 36(1)(va) and 43B of the Income Tax Act, have been categorically held as prospective in nature only and not retrospective, in various appellate forums, relying upon the principal ratio as pronounced by the hon’ble Supreme Court in its landmark judgement in the case of ‘CIT vs. Vatika Township Pvt Ltd’ reported in 367 ITR 466.

In the said judgement of ‘CIT vs. Vatika Township Pvt Ltd’, the hon’ble Supreme Court has held and observed that the principle of Law “Lex prospicit non respicit”, which means “Law looks forward and not backwards”, governs the aspect of applicability of any legislative provision from any particular date. The hon’ble Supreme Court observed that the idea behind the rule is that a current law should govern current activities. The law passed today cannot be applied to the events of the past. The Hon’ble Supreme Court held that if somebody does something today, he does it keeping in view the law of today and in force and not tomorrow’s backward adjustment of it. According to Hon’ble Apex court every human being is entitled to arrange his affairs by relying on the existing law and should not find that his plans have been retrospectively upset. Any amendment made to a taxing statue can be said to be intended to be clarificatory to remove hardships only of the assessee and not of the department. On the contrary, imposing a retrospective levy on the assessee would cause undue hardship to the assessee.  

It is also imperative to mention here that in the recent decisions of ‘ACIT vs. Bajaj Capital Ventures P Ltd’ [2022] 140 taxmann.com 1 (Mumbai -Trib.) and ‘ACIT vs. K Raheja Corporate Services Pvt Ltd’ in ITA No. 2521/Mum dated 17.6.2022, the hon’ble Mumbai Tribunal has categorically held the said amendment in section 14A to be prospective in nature only, and applicable w.e.f. AYs 2023-24 onwards and not for prior assessment years.

The hon’ble Guwahati ITAT in the case of ‘ACIT vs. Williamson Financial Services Ltd’ in ITA Nos. 154 to 156 /Gau/2019, has taken a differing view of considering the said amendment in section 14A as retrospective in nature. However, the above discussed landmark judgement of the Hon’ble Supreme Court in the case of ‘CIT vs. Vatika Township Pvt Ltd’ reported in 367 ITR 466, was not pleaded and relied upon by the respondent assessee, during the course of hearing proceedings, before the hon’ble Guwahati Tribunal, and as such the hon’ble Guwahati Tribunal had no accession to consider the said SC judgement while adjudicating upon the revenue’s appeal.  

Concluding Remarks:

The Section Heading of Section 14A of the Income Tax Act, reads,

“Expenditure incurred in relation to income not includible in total income”

The unfortunate irony of the above amendment in section 14A as brought about by the Legislature in the Finance Act 2022 is that now the very basis, the mandatory pre-requisite and the statutory trigger point of invoking disallowance u/s 14A, i.e., the earning of any income not forming part of total income of the assessee or in simple words any exempt income, has been tried to be made redundant and infructuous.

Rule 8D has been inserted in the Income Tax Rules, merely as a machinery rule, to facilitate the determination of the quantum of disallowable expenditure u/s 14A, incurred by the assessee in earning any income, not forming part of the total income. The mandatory requirement u/s 14A still remains as that of the earning or accrual of any exempt income by the assessee in the first place, to attract disallowance of any actual or deemed expenditure incurred in respect of earning such exempt income. However, the above discussed insertion of the Explanation in Section 14A, making the very basic requirement of earning of an exempt income, a redundant and infructuous parameter, is nothing but an ardent tussle of overcoming the judgements of the hon’ble High Courts and the hon’ble Supreme Court, on this issue.

By insertion of this Explanation, the machinery Rule 8D, has now been tried to be made a self-contained charging provision in itself, wherein the assessing authority has been empowered to make exorbitant notional disallowances, in respect of even that exempt income, which in fact has not been earned by or accrued to the assessee, in the first place.

If any such exempt income has not been earned by or accrued to the assessee, then how can it be presumed that the assessee has incurred any expenditure in respect of such non-existing exempt income, as has been stated in the newly inserted Explanation to section 14A by the Finance Act, 2022?   

In the above-stated real life assessment case, where even the tax-free interest income earned on tax-free bonds issued by the Govt. of India and big financial institutions and authorities like NHAI, PFC, has not been spared from the clutches of blind application of Rule 8D by the assessing authorities, then how can one even think of investing in any other tax-free investment instruments or even having any tax-free income in the ITR.

The equituous and meritorious objective, purpose and the legislative intent of bringing in this expenditure disallowance section 14A, in respect of exempt income, has somehow, been turned down into an unfettered, unlawful, and arbitrary, demand raising instrument, in the hands of the assessing authorities. This section was inserted to prevent any unjust enrichment of the assessees, however, ironically, now this provision is being used as an instrument of ensuring unjust enrichment of the Exchequer, in the form of huge and exorbitant demands.

Needless to say, that this blind application of Rule 8D, is the biggest threat to the legislative intent, sanctity, and existence of the Exemptions and Exclusions being categorically provided and mandated under section 10 of the Income Tax Act. The taxpayers now fear more about the probable tax implications of their tax-free income rather than their taxable income.

However, in this never-ending tussle of achieving the short-sighted objective of raising big income-tax demands in assessments, under the guise of section 14A/Rule 8D, and thereby compelling deposition of at least 20% of such demands, for completion of revenue collection targets, the far bigger, more relevant and much more significant and crucial long-term vision and objective of raising of adequate capital funds by the Govt. of India, and big Financial Institutions and entities like NHAI, PFC etc. for the development of infrastructure facilities in the Country and for revival of demand etc., and incentivizing key growth sectors through section 10 exemptions, is knowingly or unknowingly being jeopardized and hampered by such misdemeanors.

Note: This Article has also been published in Taxmann with the Citation [2022] 140 taxmann.com 215 (Article).