1.

Background :
1.1 S. 14A has been inserted in Chapter IV of the Income tax Act by the Finance Act,
2001, with retrospective effect from 1-4-1962. This Section provides for
disallowance of expenditure incurred in relation to income which is not included in
the total income of the assessee (i.e. exempt income). The operative part of this
Section reads as under :
"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."
1.2 Proviso to the Section was added by the Finance Act, 2002 w.e.f. 11-5-2001. It
provides that the A.O. cannot reopen the assessment u/s.147 for any assessment
year prior to A.Y. 2001-02 for this purpose or pass any rectification order u/s.154 for
prior years to disallow any such expenditure.
1.3 In the case of CIT v. Indian Bank Ltd., (56 ITR 77), Supreme Court had decided in
1964 that the condition for deductibility of an expenditure does not depend upon its
quality of directly or indirectly producing taxable income and, therefore, there was
no warrant for disallowing a proportionate part of the interest referable to moneys
borrowed for the purchase of tax free securities. This principle was reiterated in the
case of CIT v. Maharashtra Sugar Mills Ltd.,(82 ITR 452). In this case it was held that
no part of managing agency commission can be disallowed on the ground that it
partly relates to managing sugarcane cultivation, the income from which was
exempt from tax. Again, in the case of Rajasthan State Warehousing Corporation v.
CIT, (242 ITR 450) the above principle was once again reiterated by the Supreme
Court. In this case, it was held that if business is one and indivisible, the
expenditure cannot be apportioned and disallowed to the extent it may relate to
income which is exempt from income tax.
1.4 It may be noted that the explanatory memorandum issued with the Finance Bill,
2001, gives the purpose for which the amendment is made. This reads as under :
"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 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.
It is proposed to insert a new S. 14A so as to clarify the intention of the legislature
since the inception of the Income-tax Act, 1961, that no deduction shall be made in
respect of any expenditure incurred by the assessee in relation to income which
does not form part of the total income under the Income-tax Act."
1.5 From the above, it appears that only direct expenses incurred for earning the
income which is exempt will be covered by S. 14A. Even in the decisions of the
Supreme Court referred to above there is nothing to infer that direct expenses
incurred for earning exempt income is allowable. Therefore, even in the absence of

a provision contained in the new S. 14A law was well settled. There is nothing in this
Section to suggest that indirect expenses will be disallowed.
1.6 In actual implementation of this provision, the Income-tax Department has been
taking the view that all items of income (including dividend on shares and units of
Mutual Funds etc. on which Dividend Distribution Tax is paid) stated in S. 10 of the
Income-tax Act are governed by S. 14A. The intention of this legislation was to
disallow only direct expenses incurred for earning exempt income. In almost all
cases even indirect expenses are also being disallowed on proportionate basis. In
order to ensure uniform approach, S. 14A was amended by the Finance Act, 2006,
w.e.f. 1-4-2007 (A.Y. 2007-08). By this amendment Ss.(2) and Ss.(3) were added in S.
14A to provide that AO shall determine the amount of expenditure incurred in
relation to the exempt income in accordance with such method as may be
prescribed by Rules. The reasons for making this amendment in S. 14A are
explained in Paras 11.1 to 11.3 of CBDT Circular No. 14/2006 of 28-12-2006.
2. New Rule 8D :
2.1 In exercise of the powers given in S. 14A(2) C.B.D.T. has issued a Notification No.
S.O. 547(E) on 24-3-2008 (299 ITR (ST) 88). This notification amends the Income-tax
Rules by insertion of a new Rule 8D providing for a "Method for determining amount
of expenditure in relation to income not includible in total income". Reading this
Rule it is evident that the Rule provides for disallowance of not only direct
expenditure incurred for earning the exempt income but also for disallowance of
proportionate indirect expenditure. This is clearly contrary to the main objective
with which S. 14A was enacted.
2.2 Broadly stated, the new Rule 8D provides as under :
(i) The method prescribed in the Rule is to be applied only if the AO is not satisfied
with :
(a) The correctness of the claim of expenditure incurred for earning the exempt
income made by the assessee or
(b) The claim made by the assessee that no expenditure has been incurred for
earning exempt income.
(ii) The method prescribed in the Rule states that the expenditure in relation to
income which does not form part of the total income shall be theaggregate of the
following amounts :
(a) The amount of expenditure directly relating to income which does not form part
of total income.
(b) In the case of interest on borrowed funds which is not directly attributable to any
particular income or receipt, the amount computed in accordance with this following
formula :
A
x

B
C

A = Amount of interest, other than the amount of interest which is directly

attributable to the exempt income stated in (a) above.

B = The average of value of investment, income from which does not or shall not
form part of the total income, as appearing in the balance sheet of the assessee,
on the first day and the last day of the relevant accounting year.
C = The average of total assets as appearing in the balance sheet of the assessee,
on the first day and the last day of the relevant accounting year. The term Total
Assets means total assets as appearing in the balance sheet excluding the increase
on account of revaluation of assets but including the decrease on account of
revaluation of assets.
(c) An amount equal to % of the average of the value of investment, income from
which does not or shall not form part of the total income, as appearing in the
balance sheet of the assessee, on the first day and the last day of the relevant
accounting year.
2.3 From the above Rule, it will be noticed that CBDT has, instead of prescribing a
simple method, prescribed a complicated formula. By applying this formula, in most
cases, expenditure which has no connection with earning the exempt income will
get disallowed. Some of the issues relating to this New Rule require consideration :
(i) As stated in para 2.2(ii)(b) above, interest which is directly attributed to borrowed
funds used for the purpose of earning taxable income or receipts will not be
considered for disallowance of proportionate interest u/s.14 A. Therefore, interest on
term loan taken for purchase of Plant & Machinery, Motor car loan, amount
borrowed for acquiring factory or office building or any other business asset will not
be considered for such disallowance.
(ii) It is not mentioned that interest which is disallowable u/s.43B or u/s.36(1)(iii) will
also be excluded. But it can be assumed that only such expenditure, which is
otherwise allowable in the computation of total income, will be considered for
disallowance u/s.14A.
(iii) In the above formula in para 2.2(ii)(b) above while explaining the terms B and
C there is a reference to the average value of investments and total assets as per
the Balance Sheet of the assessee. It is not clear as to what figures shall be adopted
in the cases of non-corporate assessees, such as Individuals and HUFs who do no
maintain books of accounts.
(iv) In explanation to the term B it is stated that for considering average value of
Investments, we have to consider "Investment, income from which does
not or shall not form part of the total income". This will mean that even if there is
no income from some or all of the investments, the average value of these
investments will enter the formula for disallowance of proportionate interest. This
will mean that in some cases where there is no income from such investments and
no exemption from tax is claimed on any income, proportionate interest will be
disallowed. In some cases, if income from some investments is say only Rs.1 lac on
which exemption is claimed, but disallowance of proportionate interest under the
formula may work out to Rs.2 lacs.
(v) While explaining the term C it is stated that average of Total Assets as per
Balance sheet should be taken. It can be assumed that items like (a) Preliminary
Expenses not written off, (b) Deferred Revenue expenses, (c) Deferred Tax Assets,
(d) Debit Balance of Profit & Loss A/c. etc., which do not represent any tangible or

intangible asset, appearing in the Balance sheet of the assessee will be excluded
from Total Assets.
(vi) Similarly, current liabilities which are to be deducted from current assets in the
case of the company can be added while working out the amount of Total Assets.
(vii) The formula given in para 2.2.(ii)(c) above, states that amount equal to % of
the average value of investments, income from which is exempt from tax, should
also be disallowed u/s.14A. This provision is not at all equitable. Such disallowance
is to be made with reference to average value of such investments from which
exempt income is received or not. This disallowance has no relation to either the
exempt income or to the expenditure claimed by the assessee. In many cases the
amount worked out may exceed the exempt income or may exceed even the total
expenditure (for taxable as well as exempt income) incurred by the assessee. If we
take the illustration of a closely held Investment company it is common knowledge
that the administrative expenses are nominal as compared to the value of the
investments. In such cases, the amount to be disallowed under the formula will far
exceed the total expenses. It is suggested that a very strong representation should
be made for deletion of this part of the New Rule. In any event, it should be
represented that the total disallowance under the formula should not exceed 5% of
the income for which exemption is claimed.
(viii) The validity of the New Rule 8D can be challenged on the ground that S. 14A
authorises CBDT to prescribe the method for determination of expenditure incurred
in relation earning the exempt income, but the method prescribed by this Rule only
determines the notional cost for holding investments which may or may not yield an
exempt income. Such notional cost for holding the investment has no relationship
with the actual expenditure incurred and claimed by the assessee. Therefore, the
New Rule goes beyond the authority given to CBDT by S. 14A.
2.4 As stated earlier, the above amendment giving power to CBDT to prescribe the
method for determination of expenditure to be disallowed u/s.14A was made by the
Finance Act, 2006 w.e.f. A.Y. 2007-08. Therefore, the above method, as now
prescribed by New Rule 8D, should apply to computation of income for A.Y. 2007-08
and onwards. However, there are certain judicial pronouncements which suggest
that amendment made in S. 14A(2) and (3) made by Finance Act, 2006, is a
procedural provision and, therefore, the method for computation of disallowable
expenditure, whenever prescribed, will be applicable to all pending assessments for
earlier years also. Reference in this connection may be made to the following
decisions :
(i) ACIT v. Citicorp Finance (India) Ltd., 108 ITD 457 (Mum.)
(ii) Kalpataru Construction Overseas (P) Ltd. v. DCIT, 13 SOT 194 (Mum.)
(iii) DCIT v. Seksaria Biswar Sugar Factory Ltd., 14 SOT 66 (Mum.)
(iv) Prakash Heat Treatment & Industries (P) Ltd. v. ITO, 14 SOT 348 (Mum.)
(v) DCIT v. Smita Conductors Ltd., 16 SOT 251 (Mum.)
(vi) Narotamdas Bhau v. ACIT, 15 SOT 629 (Mum.)
(vii) Conwood Agencies (P) Ltd. v. ITO, 15 SOT 308 (Mum.)

Contrary view has been taken in the case of Vidyut Investments Ltd. v. ITO, 10 SOT
284 (Delhi) where it is held that S. 14A(2) and (3) will only apply w.e.f. A.Y. 2007-08
and onwards.
3. What is Exempt Income u/s.14A :
3.1 As stated earlier, the objective behind enactment of S. 14A was to disallow
expenditure incurred in relation to any income which is completely exempt from
tax e.g. Agricultural Income. Interest on Tax Free Bonds etc. However, in view of the
wording of the said Section "expenditure incurred by the assessee in relation to
income which does not form part of the total income under this Act", courts and ITA
Tribunal have given very wide meaning to the scope of disallowance u/s.14A.
Therefore, income listed in S. 10, S. 10A, S. 10AA, S. 10B, S. 10BA, S. 10C as well as
Chapter VIA where 100% exemption is available will get covered u/s. 14A for
disallowance of direct and indirect expenditure relating to such income. S. 14A does
not make any distinction between income which is completely exempt from tax and
income received after payment of tax (e.g. Dividend Distribution tax, Tax payable by
firms, etc.)
3.2 In this respect reference may be made to some of the decisions wherein it is
held that disallowance can be made u/s.14A in respect of income from agricultural
income, dividend on shares or units of Mutual Fund, Share from Partnerships Firms,
income exempt under Chapter VIA, etc.
(i) Agricultural Income : Haryana Land Reclamation & Development Corp. v.
CIT, 159 Taxman 271 (P & H).
(ii) Dividend on shares and units of mutual funds : Wallfort Shares & Stock
Brokers Ltd. v. ITO, 96 ITD 1 (Mum.) (SB), Harish Krishnakant Bhatt v. ITO, 91 ITD
311 (Ahd.), DCIT v. S. G. Investments & Industries Ltd., 89 ITD 44 (Kol.), Muruti
Udyog Ltd. v. DCIT, 92 ITD 119 (Del.), Shree Synthetics Ltd. v. CIT, 205 CTR 386
(MP), Escorts Ltd. v. ACIT, 102 TTJ 522 (Del.).
(iii) Share of Profit from Firm : Sudhir Dattaram Patil v. DCIT, 2 SOT 678
(Mum.), A. H. Baldota v. ACIT, 103 TTJ 517 (Mum.), Marezban Bharucha v. ACIT, 12
SOT 133 (Mum.).
(iv) Tax Free Bonds : Punjab National Bank v. DCIT, 103 TTJ 908 (Del.).
(v) Chapter VIA Income : Punjab State Co-operative Milk Producers Federation
Ltd. v. ITO, 104 ITD 408 (Chand).
3.3 In view of the above trend of judicial pronouncements, it is possible that the
disallowance may be made u/s.14A for expenditure relating to long term capital
gain on sale of shares or redemption of units of Mutual Fund which is exempt
u/s.10(38) as Securities Transaction Tax (STT) is paid. Whether S. 14A can be
invoked for disallowance of expenditure relating to dividend on shares held as stockin-trade or not is a matter on which divergent views have been expressed.
Therefore, this matter has been referred to a Special Bench of ITA Tribunal at
Mumbai in the case of Daga Management Pvt. Ltd. and its judgment is awaited.
4. To sum up :
4.1 From the above discussion it will be noticed that the New Rule 8D prescribed by
CBDT will further complicate the working of the amount disallowable u/s.14A.
Hitherto some adhoc basis was being adopted. Now, if the method prescribed under

the New Rule 8D is applied the expenditure to be disallowed will be substantial and
will have no relation to the actual expenditure incurred. In other words, in most
cases, a notional amount will be disallowed.
4.2 If we trace the history of this legislation it will be noticed that S. 14A was
introduced to cover cases where expenditure in relation to income such as
agricultural income, tax free bonds, etc. which did not suffer any tax under the
Income-tax Act, was being claimed. This was held to be allowable by the Supreme
Court in certain cases. It was only to deny such claim that this provision was
introduced.
4.3 In the explanatory memorandum issued with the Finance Bill, 2001, while
enacting S. 14A, it is stated 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". S. 14A was enacted to curb this tendency.
4.4 In the case of dividend income, the scheme of the Income-tax Act is to collect
tax at 15% plus applicable surcharge at the time of distribution. It is for this reason
that tax is not levied in the hands of the investor. Similarly, the firm is required to
pay tax at 30% plus applicable surcharge. For this reason, the balance of profit
apportioned to partners is exempted in the hands of the partners. Similar exemption
is given u/s.10(38) in respect of long term capital gains on which STT is paid. This
exemption is granted not as an incentive but because the tax is levied at source.
Therefore, there is no logic in disallowing expenditure u/s.14A in such cases where
tax is collected at source. It is, therefore, suggested that the section should be
suitably amended or CBDT should clarify that S. 14A should not be invoked where
income is received by the assessee after payment of tax under the Income-tax Act.