Section 14A was inserted by Finance Act, 2001 having a retrospective effect from 01.04.1962. To understand the reason behind the insertion of section 14A, the relevant part of memorandum of Finance Act, 2001 is reproduced herewith:
“Certain incomes are not includible while computing the total income as these are exempt under various provisions of the Act. There have been cases where deductions have been claimed in respect of such exempt income. This in effect means that the tax incentive given by way of exemptions to certain categories of income is being used to reduce also the tax payable on the non-exempt income by debiting the expenses incurred to earn the exempt income against taxable income. This is against the basic principles of taxation whereby only the net income, i.e., gross income minus the expenditure, is taxed. On the same analogy, the exemption is also in respect of the net income. Expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income.”
Section 14A reads as under:
(1) For the purposes of computing the total income under this Chapter, 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 under this Act.
(2) The Assessing Officer shall determine the amount of expenditure incurred in relation to such income which does not form part of the total income under this Act in accordance with such method as may be prescribed, if the Assessing Officer, having regard to the accounts of the assessee, is not satisfied with the correctness of the claim of the assessee in respect of such expenditure in relation to income which does not form part of the total income under this Act.
(3) The provisions of sub-section (2) shall also apply in relation to a case where an assessee claims that no expenditure has been incurred by him in relation to income which does not form part of the total income under this Act
Provided that nothing contained in this section shall empower the Assessing Officer either to reassess under section 147 or pass an order enhancing the assessment or reducing a refund already made or otherwise increasing the liability of the assessee under section 154, for any assessment year beginning on or before the 1st day of April, 2001.
Scope of section 14A
- Agricultural income
One of the common source of exempt income is income earned from agricultural activities which is exempted from taxation u/s. 10(1). According to the section 14A the assessee shall not be allowed to deduct any expenditure incurred to earn agricultural income as it is free from tax in the hands of assessee.
- Income from partnership firm.
An individual earns income from partnership firm in the form of interest, remuneration and profits. All the components, except the profit earned from partnership firm, is taxable in the hands of the assessee. Therefore, section 14A shall apply only to expenditure incurred in order to earn profit.
There might be a circumstance where the assessee, a partner in a firm, may borrow funds and advance it to the firm. Therefore, the interest expense incurred on the said borrowed fund shall fall within the scope of Section 14A and will not be allowed as expense since the profit earned from the partnership firm, to which funds are advanced, is exempt u/s. 10(2A) in the hands of assessee.
However, according to the judgment of High Court of Bombay in the case of CIT vs. Delite Enterprises [I.T.A. No.: 110 of 2009], it is to be noted that if during the assessment year if partnership firm incurs loss then no disallowance of interest expense can be made u/s. 14A as there is no (tax free) profit for the relevant year.
- Income from investments
A taxable person may earn dividend income, income from mutual funds, long term capital gain, which are exempt under relevant sections of Income Tax Act, 1961 and which shall attract section 14A disallowance.
In relation to the dividend income earned by the assessee, it is held that section 14A shall apply only to those dividends on which tax in the form of DDT is payable by the dividend paying company u/s. 115-O. As the dividend in the hands of the recipient is exempt, it will attract section 14A.
There are various other sources from which an assessee earns exempt income and expenditure on which will be disallowed u/s. 14A. However following are the various circumstances which doesn’t attract section 14A:
- Expenditure incurred for earning of export income which is exempt u/s 80HHC, cannot be held to be income which does not form part of total income. Such expenses cannot be disallowed u/s14A – CIT v. Kings exports 318 ITR 100 (2009) (Punj. & Har.)
- Section 14A could not be applied to provisions of Chapter VI-A where deductions are to be made in computing the total income and in no way that can be compared with the exempted income which does not form part of the total income- ACIT v. Tamil Nadu Silk Producers Federation Ltd.  103 TTJ (Chennai) 716]; ACIT vs. Bank of Madura  007 ITR (Trib) 139 ITAT [Chennai]
- Deduction of income derived by a co-operative society u/s 80P is not a case of “exempt income” but of “deduction from income”. Therefore provisions of sec.14A are not applicable in this case ‐ACIT Vs. Kribhco 6 ITR 686 (2010) (ITAT‐Del)
- Section 14A cannot be applied if the interest free funds available are more than the investments made from which the assessee earns exempt income. As held by Honourable ITAT in case of ACIT vs. Torrent Power Ltd.[I.T.A. No.1668/Ahd/2012,
“The appellant has shown that it has aggregate interest free funds by way of share capital and reserves amounting to Rs.195.10 crores which is more than the investment in shares and mutual funds amounting to Rs.129.8 crores. Thus, the appellant is having enough interest free funds and, therefore, also the disallowance out of interest expenditure could not be made ..”.
This is also covered in the judgement of High Court of Gujarat in case of CIT vs. Raghuvir Synthetics Ltd [(2013) 354 ITR 222 (Gujarat)] wherein the AO made disallowance of interest expense claimed u/s. 36(1)(iii) on account of interest free advances made to sister concern. It was held that
“Factually, it found huge funds were available without any interest liability with the assessee and that there was no evidence to hold that the borrowed money was utilized for the purpose of advance to the sister concerns. All these aspects cumulatively led the Tribunal to hold that the disallowance made only on the ground that advances were given out of the borrowed funds, holding the assessee ineligible for allowance of interest by the Assessing Officer of the sum of Rs. 18.66 lakhs was not sustainable”.
Once the provisions of Section 14A are triggered, w.e.f A.Y 2008-09, the working of disallowance is to be made as per the provisions of Rule 8D. The same is covered in a separate article which can be found at itatorders.in/blog.