Disallowance u/s 14A set-4

(Favour Assessee Set-4)

Disallowance u/s 14A (FA) set-4

31

Book Profit Adjustment under Section 14A Not Permissible for MAT under Section 115JB

ACIT v. Vireet Investment (P) Ltd. [(2017) 165 ITD 27 (Delhi) (SB)]

1. Issue Decided by the Court: Whether disallowance made under Section 14A of the Income-tax Act can be added back while computing book profits under Section 115JB of the Act for the purposes of Minimum Alternate Tax (MAT).

2. Facts of the Issue Decided by the Court: The assessee earned exempt income and offered its books of account prepared under the Companies Act. The AO, invoking Section 14A read with Rule 8D, disallowed certain expenses and proceeded to add back the disallowance while computing book profit under Section 115JB. The CIT(A) reversed the AO’s adjustment. Given divergence of opinion in prior decisions, the issue was referred to the Special Bench.

3. Arguments of the Appellant (Revenue): The Revenue argued that disallowance under Section 14A represents expenditure relatable to exempt income and therefore it must be added back to the book profit under clause (f) of the Explanation 1 to Section 115JB, which disallows expenditure relatable to exempt income.

4. Arguments of the Respondent (Assessee): The assessee contended that book profits are governed by the audited accounts prepared in accordance with the Companies Act, and only those adjustments specifically permitted by the Explanation to Section 115JB can be made. Since Section 14A disallowance is a notional and statutory disallowance under normal computation, it cannot be imported into the MAT computation, unless reflected in the books themselves.

5. Decision of the Court: The Special Bench of the Delhi ITAT ruled in favour of the assessee, holding that disallowance under Section 14A cannot be added back to the book profit under Section 115JB unless it is debited in the Profit & Loss Account.

6. Reasoning Advanced by the Court: The Bench held that the mechanism of computing book profit is self-contained and distinct from normal income computation. The adjustments permitted under Explanation 1 to Section 115JB are exhaustive. Since Section 14A disallowance is determined under the Income-tax Act and not necessarily debited in the books, it does not form part of the computation under Section 115JB. The Court emphasized the principle of strict construction of deeming provisions and rejected the Revenue’s attempt to expand the scope of book profit adjustments.

7. Case Laws Full Citation Relied by the Court:

   • Apollo Tyres Ltd. v. CIT [(2002) 255 ITR 273 (SC)]

   • CIT v. HCL Comnet Systems & Services Ltd. [(2008) 305 ITR 409 (SC)]

   • CIT v. Adbhut Trading Co. (P) Ltd. [(2011) 338 ITR 94 (Del.)]

8. Application of the Judgement: This landmark decision by the Special Bench has become settled law on the non-applicability of Section 14A disallowance to MAT book profit under Section 115JB, unless such expenditure is explicitly debited in the books. It has been cited extensively in Tribunal and High Court cases and acts as a critical safeguard for assessees from dual disallowance—once under normal provisions and again under MAT.

9. Why Revenue Lost the Case on Facts – Factual Deficiencies in AO’s Approach: The Revenue lost the case on facts primarily due to the Assessing Officer’s failure to establish any actual expenditure incurred for earning exempt income. The AO mechanically invoked Section 14A read with Rule 8D without recording satisfaction as required under Section 14A(2). Moreover, the assessee had no interest-bearing loans and had not claimed any interest expenditure, which nullified disallowance under Rule 8D(2)(i) and (ii). Further, while applying Rule 8D(2)(iii), the AO erroneously included all investments rather than restricting the computation to investments that actually yielded exempt income during the year, violating both factual accuracy and judicial principles.

10. What was the Error in Law: – Improper Import of Section 14A into MAT Computation under Section 115JB: The legal error committed by the Revenue lay in equating Section 14A with clause (f) of Explanation 1 to Section 115JB(2). The Tribunal held that Section 14A operates under Chapter IV and cannot be imported into Chapter XII-B, which is a self-contained code for MAT. Since clause (f) does not explicitly refer to Section 14A or Rule 8D, applying its computation method to book profits under Section 115JB was legally untenable. The Tribunal emphasized that MAT adjustments must be based strictly on statutory language, and the matching principle requires only direct expenditure relatable to exempt income to be added

32

Section 14A Disallowance Not Attracted in Absence of Actual Exempt Income

CIT v. Holcim India Pvt. Ltd. [(2014) 90 CCH 081 (Del. HC)]

1. Issue Decided by the Court: Whether disallowance under Section 14A of the Income-tax Act can be made when the assessee has not earned any exempt income during the relevant assessment year.

2. Facts of the Issue Decided by the Court: The assessee had made substantial investments in shares of group companies. However, during the assessment year in question, it did not receive any dividend or other exempt income. The Assessing Officer made a disallowance under Section 14A read with Rule 8D on the ground that the investment had the potential to yield exempt income and some portion of expenses must therefore relate to such income. Both CIT(A) and ITAT deleted the disallowance.

3. Arguments of the Appellant (Revenue): The Revenue submitted that even if no exempt income was earned during the year, the existence of investments capable of generating such income suffices to trigger Section 14A. The AO is empowered to determine the disallowance irrespective of actual exempt income.

4. Arguments of the Respondent (Assessee): The assessee argued that Section 14A is not applicable when there is no exempt income during the year. The section requires a direct connection between the exempt income and the expenditure. In absence of such income, there can be no question of apportioning expenses or making a disallowance.

5. Decision of the Court: The Delhi High Court upheld the order of the Tribunal and ruled in favour of the assessee. It held that no disallowance under Section 14A is permissible in a year in which no exempt income was earned.

6. Reasoning Advanced by the Court: The Court emphasized that the phrase “income which does not form part of total income” is central to the application of Section 14A. It ruled that if no such income is actually received, the provision has no applicability. The Court stressed on a practical and purposive interpretation, holding that Section 14A is not intended to create hypothetical disallowances based on mere potentiality of income.

7. Case Laws Full Citation Relied by the Court:

   • Cheminvest Ltd. v. CIT [(2015) 378 ITR 33 (Del.)]

   • CIT v. Shivam Motors (P) Ltd. [(2014) 272 CTR 277 (All.)]

   • PCIT v. IL & FS Energy Development Co. Ltd. [(2017) 84 taxmann.com 186 (Del.)] (later followed)

8. Application of the Judgement: This ruling is significant for defending against arbitrary disallowances where no exempt income is earned. It has become part of settled law, followed across jurisdictions to reiterate that mere investment is not enough; actual earning of exempt income is a precondition for invoking Section 14A. This judgment is frequently cited by assessees to nullify mechanical disallowances.

33

No Section 14A Disallowance in Absence of Exempt Income During the Year

PCIT v. IL & FS Energy Development Co. Ltd. [(2017) 84 taxmann.com 186 (Del.)]

1. Issue Decided by the Court: Whether disallowance under Section 14A of the Income-tax Act is warranted when the assessee has not earned any income exempt from tax in the relevant assessment year.

2. Facts of the Issue Decided by the Court: The assessee made investments in shares, capable of generating exempt dividend income. However, in the relevant year, it did not actually receive any exempt income. The Assessing Officer nonetheless applied Section 14A read with Rule 8D and made a disallowance on the presumption that some part of the expenditure must have been incurred in relation to such investments.

3. Arguments of the Appellant (Revenue): The Revenue contended that even if no exempt income was earned, Section 14A applies where the investment had the potential to earn such income. Hence, some proportion of administrative or interest expenditure is attributable and must be disallowed.

4. Arguments of the Respondent (Assessee): The assessee argued that no disallowance can be made under Section 14A unless exempt income is actually earned during the assessment year. The legislative intent is to disallow only that expenditure which is incurred in relation to actual exempt income, not notional or anticipated income.

5. Decision of the Court: The Delhi High Court ruled in favour of the assessee and dismissed the Revenue’s appeal. It held that Section 14A cannot be invoked in a year in which the assessee has not earned any exempt income.

6. Reasoning Advanced by the Court: The Court observed that the existence of exempt income is a sine qua non for application of Section 14A. The objective of the provision is to prevent allowance of expenditure against taxable income when it is incurred to earn exempt income. In the absence of such exempt income, the machinery provision fails, and the section has no application. The Court relied on its own earlier judgments reinforcing this interpretation.

7. Case Laws Full Citation Relied by the Court:

   • Cheminvest Ltd. v. CIT [(2015) 378 ITR 33 (Del.)]

   • CIT v. Shivam Motors (P) Ltd. [(2014) 272 CTR 277 (All.)]

   • CIT v. Holcim India Pvt. Ltd. [(2014) 90 CCH 081 (Del.)]

8. Application of the Judgement: This case continues the judicial trend of invalidating Section 14A disallowances in absence of exempt income. It has practical application in multiple assessment years where dividend or other tax-free receipts are zero or nil. The judgment serves as a clear authority to contest and nullify notional disallowances in such circumstances, even where investments exist.

9. Why Revenue Lost the Case on Facts – Factual Deficiencies: The Revenue's case failed on facts as the assessee had not earned any exempt income during the relevant assessment year (AY 2011–12). Despite this, the Assessing Officer applied Section 14A read with Rule 8D, which the Court found unjustified. The AO ignored the actual financials and relied on the tax auditor's suggestion, without establishing a proximate nexus between any expenditure incurred and exempt income. Investments were made in instruments like fully convertible debentures that did not yield tax-free income. The Tribunal rightly found that in absence of exempt income, disallowance under Section 14A was factually unwarranted.

10. Error in Law Committed by Revenue as per the Provision: The Revenue erred in law by invoking Section 14A read with Rule 8D despite the absence of exempt income. The High Court clarified that both the provision and Rule 8D(1) apply only when exempt income is earned “in such previous year.” The CBDT Circular No. 5/2014 relied upon by the AO could not override the statutory language or judicial interpretation. The Court emphasized that Section 14A cannot be applied to notional income and does not permit disallowance when there is no exempt income. Thus, the Revenue's legal basis for disallowance was contrary to the settled interpretative principles.

11. Status of the Decision Under Current Law: The legal position as laid down in this decision continues to hold good under the present law, especially after the Supreme Court affirmed in CIT v. Chettinad Logistics (P) Ltd. and similar rulings that no disallowance under Section 14A is permissible when no exempt income is earned during the year. However, the Finance Act, 2022 inserted an Explanation to Section 14A with retrospective effect from 1 April 2002, stating disallowance is allowable even if exempt income is not earned. This amendment seeks to nullify judicial precedents. Yet, courts are still examining the constitutional validity of such retrospective amendment.

35

Disallowance under Section 14A Not Warranted When Investments Made from Own Funds

CIT v. India Advantage Securities Ltd. [(2016) 380 ITR 471 (Bom.)]

1. Issue Decided by the Court: Whether disallowance under Section 14A is justified when the assessee has sufficient interest-free own funds to cover its investments that yield exempt income.

2. Facts of the Issue Decided by the Court: The assessee had made investments in shares and mutual funds, which yielded tax-exempt dividend income. The Assessing Officer disallowed a portion of interest and administrative expenses under Section 14A read with Rule 8D, assuming that borrowed funds might have been utilized. The CIT(A) and ITAT found that the assessee had enough own funds and reserves to cover its investments and deleted the disallowance.

3. Arguments of the Appellant (Revenue): The Revenue argued that when both borrowed and own funds are used in a mixed pool, some interest expense must be presumed to relate to the exempt investments. Thus, a proportionate disallowance under Section 14A was justified.

4. Arguments of the Respondent (Assessee): The assessee contended that its interest-free own funds, including share capital and reserves, were substantially higher than the investments made. There was no evidence of borrowed funds being used for making investments. Therefore, no disallowance was warranted under Section 14A.

5. Decision of the Court: The Bombay High Court upheld the findings of the Tribunal and ruled in favour of the assessee. It held that when sufficient interest-free funds are available, it must be presumed that the investments are made from such funds, and disallowance under Section 14A is unwarranted.

6. Reasoning Advanced by the Court: The Court reaffirmed that in the absence of any direct nexus between borrowed funds and investments made, the presumption is in favour of the assessee. Relying on earlier decisions, it held that no disallowance of interest can be made under Section 14A if the assessee possesses adequate own funds. The logic is rooted in commercial expediency and proper fund management.

7. Case Laws Full Citation Relied by the Court:

   • CIT v. Reliance Utilities and Power Ltd. [(2009) 313 ITR 340 (Bom.)]

   • CIT v. HDFC Bank Ltd. [(2014) 366 ITR 505 (Bom.)]

   • CIT v. Hero Cycles Ltd. [(2010) 323 ITR 518 (P&H)]

8. Application of the Judgement: This decision further strengthens the legal shield against disallowance of interest expenditure where assessees possess sufficient own funds. It is widely cited in cases where Revenue seeks disallowance purely on the basis of investment volume, without establishing the source. The ruling promotes rational fund-tracing and protects legitimate expenditure claims from unjustified pruning under Section 14A.

9. Why Revenue Lost the Case on Facts: What Were the Deficiencies: The Revenue lost the case on facts primarily because both the Commissioner of Income Tax (Appeals) and the Income Tax Appellate Tribunal (ITAT) found that the disallowance made by the Assessing Officer under Section 14A read with Rule 8D was excessive and unjustified. The CIT(A) noted that based on the actual figures under the head “Investment,” only 10% of the dividend income could reasonably be attributed as expenditure for earning such income. The AO, however, made a mechanical and formula-based application of Rule 8D without appreciating the factual matrix and failing to demonstrate any nexus between expenditure incurred and exempt income. The Tribunal accepted the CIT(A)’s factual assessment, which was reasoned and based on available financials. The High Court declined to interfere since the factual findings were neither perverse nor unsupported.

10. What Was the Error in Law Committed by Revenue as per the Provision: The primary legal error committed by the Revenue was its rigid and mechanical application of Rule 8D of the Income Tax Rules, 1962 without recording any finding as required under Section 14A(2). The Assessing Officer failed to record satisfaction as to why the assessee’s claim of expenditure related to exempt income was not correct. As per the Supreme Court ruling in Godrej & Boyce Mfg. Co. Ltd. v. DCIT (328 ITR 81), the application of Rule 8D is permissible only when the AO is not satisfied with the correctness of the assessee’s claim. This condition precedent was ignored by the AO. Consequently, both the CIT(A) and Tribunal rightly held that the AO’s approach was contrary to law, and the High Court endorsed this view. The Revenue’s failure to appreciate this condition amounted to a legal misapplication of Section 14A and Rule 8D.

11. What Will Be the Status of Decision under Current Law: Under the current legal framework—especially after the Finance Act, 2022 amendment to Section 14A—Explanation 1 now clarifies that disallowance under Section 14A can be made even in cases where no exempt income is earned during the year. However, this judgment will still hold good in post-2022 scenarios in cases where exempt income is earned, and the AO fails to record satisfaction as mandated under Section 14A(2) before invoking Rule 8D. The principle that Rule 8D is not to be applied mechanically without examining the assessee’s claim and without recording dissatisfaction continues to be valid law. Therefore, the ratio of this case remains relevant where procedural safeguards under Section 14A(2) are violated. But the “quantum” approach—such as disallowance being capped at a percentage of exempt income—may face limitation under the amended law if exempt income is absent.

36

(1) Section 14A Applies Irrespective of Whether Exempt Income is Earned in the Year

ACIT v. Champion Commercial Co. Ltd. [(2012) 139 ITD 108 (Kol.) (SB)]

1. Issue Decided by the Court: Whether disallowance under Section 14A can be made even if the assessee has not earned any exempt income during the relevant previous year.

2. Facts of the Issue Decided by the Court: The assessee had made significant investments in shares and mutual funds. However, in the relevant year, no dividend income or other exempt income was earned. Despite this, the Assessing Officer invoked Section 14A and made a disallowance, applying Rule 8D. The assessee argued against the disallowance on the ground that no exempt income had accrued or arisen. The conflicting views across benches led to the matter being referred to the Special Bench of the ITAT Kolkata.

3. Arguments of the Appellant (Revenue): The Revenue submitted that the existence of investments that are capable of generating exempt income is sufficient to attract Section 14A disallowance. Actual earning of exempt income is not a condition precedent for disallowance. The potential to earn such income justifies proportionate expenditure disallowance.

4. Arguments of the Respondent (Assessee): The assessee argued that in absence of exempt income, there is no question of apportioning or disallowing expenditure under Section 14A. The provision is triggered only when exempt income is actually earned. Otherwise, it would result in notional disallowance, which is not supported by the statutory scheme.

5. Decision of the Court: The Special Bench ruled in favour of the Revenue and held that disallowance under Section 14A can be made even if no exempt income is earned in the assessment year, provided there is a proximate nexus between the expenditure incurred and the investments made.

6. Reasoning Advanced by the Court: The Bench reasoned that Section 14A does not explicitly require the earning of exempt income in the year of assessment. What matters is whether expenditure was incurred in relation to investments which could potentially yield exempt income. Even if income is not received, expenses attributable to earning such income must be disallowed to prevent distortion of taxable profits. The decision emphasized the purposive interpretation of the provision.

7. Case Laws Full Citation Relied by the Court:

I. Godrej & Boyce Mfg. Co. Ltd. v. Dy. CIT [2010] 328 ITR 81 (Bom.)

II. Dhanuka & Sons v. CIT [2011] 339 ITR 319 (Cal.)

III. CIT v. Hero Cycles Ltd. [2010] 323 ITR 518 (P&H)

IV. ITO v. Daga Capital Management (P.) Ltd. [2009] 117 ITD 169 (Mum.) (SB)

8. Application of the Judgement: This judgment supports the view that potentiality of exempt income, not its actual realization, is sufficient for invoking Section 14A. While later High Court decisions (e.g., Cheminvest, Holcim) have taken a contrary stance, this Special Bench decision remains relevant, especially for assessments where exempt income is uncertain or contingent. It is frequently cited by the Revenue in appeals where mechanical application of Rule 8D is challenged by the assessee.

9. Why Revenue Lost the Case on Facts, What Were the Deficiencies: The Revenue lost on facts due to its incorrect assumption that the entire interest cost was common interest without verifying the actual application of borrowed funds. The assessee had demonstrated that ₹36.42 lakh out of ₹41.82 lakh was utilized for trading operations and not for earning exempt income. The AO failed to investigate this factual position and mechanically applied the entire interest in the Rule 8D formula. CIT(A)’s factual determination, though incomplete, indicated that major interest was unrelated to exempt income. The Tribunal thus remanded the matter for proper factual verification before applying Rule 8D(2)(ii).

10. What Was the Error in Law Committed by Revenue:The Revenue erred in law by misapplying Rule 8D(2)(ii). While the rule requires exclusion of interest directly attributable to exempt income, the AO included all interest, even that attributable to taxable income, contrary to judicial precedent and departmental stance in Godrej & Boyce. This misapplication led to excessive disallowance. Furthermore, AO failed to appreciate the mandate of Section 14A(3), misinterpreting the need for recording satisfaction. The Tribunal clarified that such satisfaction is not needed when no disallowance is offered by assessee, but rule application must be logically and legally correct with proper identification of common interest.

11. Status of Decision under Current Law: Under the current law (as per the amended Section 14A and judicial interpretation), the ratio of this decision largely holds. Section 14A(3) permits disallowance even if the assessee claims nil expenditure, without requiring AO to record dissatisfaction. Rule 8D remains applicable for computing disallowance, but judicial guidance mandates exclusion of both exempt and taxable directly attributable interest. Courts have consistently held that no disallowance can be made if no exempt income is earned. However, the recent insertion of Explanation to Section 14A overrides this, making the section applicable even where exempt income has not been received, marking a subtle shift.

37

No disallowance u/s 14A in absence of actual exempt income

PCIT v. State Bank of Patiala (2017) 393 ITR 476 (P&H)

1. Issue Decided by the Court: Whether disallowance under Section 14A of the Income Tax Act is permissible where no exempt income is earned during the relevant assessment year.

2. Facts of the Issue Decided by the Court: The assessee, State Bank of Patiala, had invested in tax-free bonds but did not earn any exempt income during the assessment year. The Assessing Officer invoked Section 14A and applied Rule 8D to disallow expenditure, even though the assessee claimed no exempt income had arisen.

3. Arguments of the Appellant (Revenue): The Revenue argued that disallowance under Section 14A read with Rule 8D is mandatory once investments capable of earning exempt income exist, irrespective of whether such income has actually arisen during the year.

4. Arguments of the Defendant (Assessee): The assessee contended that no exempt income was earned during the year and therefore no disallowance under Section 14A could be made. It relied on legal precedents to argue that the condition precedent for invoking Section 14A is the receipt of exempt income.

5. Decision of the Court: The Punjab and Haryana High Court ruled in favour of the assessee and held that no disallowance under Section 14A could be made in absence of actual exempt income during the relevant year.

6. Reasoning Advanced by the Court: The Court emphasized that the legislative intent of Section 14A is to disallow expenditure incurred in relation to income that does not form part of total income. Therefore, if no such income exists during the year, there is no basis for invoking disallowance. Rule 8D cannot operate in isolation from the core principle embodied in Section 14A.

7. Case Laws Full Citation Relied by the Court:

1) CIT v. Chettinad Logistics (P) Ltd. [(2017) 80 taxmann.com 221 (Mad.)]

2) CIT v. Corrtech Energy Pvt. Ltd. [(2015) 372 ITR 97 (Guj.)]

3) Joint Investments Pvt. Ltd. v. CIT [(2015) 372 ITR 694 (Del.)] (implied principles considered

8. Application of the Judgement: This judgment affirms that Section 14A disallowance is not automatic and must be contingent upon the actual earning of exempt income. The decision limits the mechanical application of Rule 8D and protects taxpayers from disallowance in cases where no tax-exempt income was realized, even if investments capable of generating such income exist.

9. Why Revenue Lost the Case on Facts – Deficiencies: The Revenue lost the case on facts because the Assessing Officer failed to establish that borrowed funds were used for investments yielding exempt income. The assessee had substantial own funds far exceeding investments, yet the AO applied Rule 8D(2)(ii) to the entire interest expenditure without factual analysis. There was no evidence that the interest-bearing funds were deployed for earning exempt income. Further, the AO did not distinguish between specific and common interest nor verify the nexus of borrowed funds with investments, which was a fundamental factual requirement before invoking disallowance under Rule 8D.

10. What Was the Error in Law Committed by Revenue: The Revenue committed an error in law by not correctly applying the methodology prescribed under Rule 8D(2)(ii). The AO treated all interest as attributable to exempt income without excluding interest directly related to taxable business activities. This approach contravened the principle laid down in Godrej & Boyce and other precedents. Additionally, AO failed to satisfy the precondition under Section 14A(2) of being dissatisfied, after examining the accounts, with the correctness of the assessee’s claim of no expenditure. The application of Rule 8D was thus mechanical and ultra vires, lacking proper recording of satisfaction and misinterpreting the legal provisions.

11. Status of the Decision as per Supreme Court and Current Law

As per the Supreme Court in Maxopp Investment Ltd. v. CIT [2018] 91 taxmann.com 154 (SC) , it was held that Section 14A applies even when investments are strategic, and Rule 8D can be applied once AO records dissatisfaction. The SC clarified that AO must not apply Rule 8D automatically; satisfaction with the assessee's claim is a sine qua non. Thus, the decision in Champion Commercial remains aligned with the SC's principles on factual inquiry and reasoned satisfaction.

Under Current Law (post amendment), as per the Explanation to Section 14A inserted by the Finance Act, 2022, disallowance can now be made even if no exempt income is earned. This overrides prior jurisprudence where absence of exempt income barred disallowance. Therefore, while Champion Commercial remains valid in reasoning regarding satisfaction and interest attribution, its bar on disallowance in absence of exempt income is overridden by statutory clarification.

38

(2) Disallowance Requires Nexus to Exempt Income

CIT v. Shivam Motors (P) Ltd. (2014) 272 CTR 277 (All.)

1. Issue Decided by the Court: Whether the Assessing Officer is justified in making a disallowance under Section 14A without establishing a proximate connection between the expenditure disallowed and the exempt income.

2. Facts of the Issue Decided by the Court: The assessee, Shivam Motors (P) Ltd., had received dividend income exempt from tax. However, it had not incurred any direct expenditure to earn such income. The AO invoked Section 14A and made an ad hoc disallowance of interest expenditure on the presumption that borrowed funds were used to invest in shares. The CIT(A) and Tribunal had deleted the disallowance on the grounds that there was sufficient own capital and no nexus shown between the borrowed funds and the investment yielding exempt income.

3. Arguments of the Appellant (Revenue): The Revenue argued that once there is exempt income, a proportionate disallowance under Section 14A is mandatory. It relied on the presumption that part of the interest-bearing funds were used for investments in shares, which necessitated a disallowance even without direct nexus.

4. Arguments of the Defendant (Assessee): The assessee contended that it had sufficient interest-free own funds to make investments and that no borrowed funds were utilized. It further argued that no actual expenditure was incurred to earn the exempt income, and the AO failed to establish a direct link between the disallowed interest and the exempt income.

5. Decision of the Court: The Allahabad High Court upheld the decision of the Tribunal and dismissed the Revenue’s appeal, holding that no disallowance under Section 14A is permissible in the absence of a nexus between expenditure and exempt income.

6. Reasoning Advanced by the Court: The Court held that the Assessing Officer cannot make a mechanical or presumptive disallowance under Section 14A. There must be a clear finding or basis showing a proximate relationship between the expenditure incurred and the income which does not form part of total income. If the assessee has sufficient own funds and no interest-bearing funds were used for investments, no disallowance can be made. Rule 8D cannot be applied automatically; it is a method of quantification only after the AO establishes the basic requirement under Section 14A.

7. Case Laws Full Citation Relied by the Court:

   • CIT v. Hero Cycles Ltd. [(2010) 323 ITR 518 (P&H)]

   • CIT v. Reliance Utilities and Power Ltd. [(2009) 313 ITR 340 (Bom.)]

   • CIT v. Winsome Textile Industries Ltd. [(2009) 319 ITR 204 (P&H)]

8. Application of the Judgement: This ruling is widely relied upon in situations where the Assessing Officer makes disallowances without demonstrating any actual expenditure incurred for earning exempt income. It reinforces the principle that a live and proximate nexus must exist between the exempt income and the disallowed expenditure. The judgment safeguards taxpayers against arbitrary or estimated disallowances under Section 14A, especially when investments are made from surplus funds.

9. Why Revenue Lost the Case on Facts – Deficiency: The Revenue lost on facts because the Tribunal found that the assessee had not earned any tax-free income during the relevant assessment year. Since Section 14A disallows expenditure only “in relation to” income that does not form part of total income, the absence of such exempt income rendered disallowance unsustainable. The AO failed to demonstrate any nexus between expenditure incurred and non-existent exempt income. Thus, the disallowance of ₹2,03,752 under Section 14A was found to be factually baseless, and both the CIT(A) and Tribunal rightly deleted the disallowance, which was upheld by the High Court.

10. What Was the Error in Law Committed by Revenue as per the Provision: The legal error committed by the Revenue was its misapplication of Section 14A without the presence of exempt income. Section 14A contemplates disallowance of only that expenditure which is incurred “in relation to” income that does not form part of the total income. In the instant case, as no exempt income had been earned, the precondition for invoking Section 14A was not satisfied. The AO mechanically invoked the provision without considering judicial interpretations requiring a proximate connection between exempt income and expenditure. Therefore, the disallowance was contrary to the statutory framework and judicially settled principles prevailing at the time.

11. What Is the Status of Decision under Current Law: Under the current law, as amended by the Finance Act, 2022, and reflected in the Explanation to Section 14A, the position has changed substantially. Now, disallowance under Section 14A is permissible even in the absence of actual receipt of exempt income. The Explanation clarifies that Section 14A shall apply and be deemed always to have applied, even when income not forming part of total income has not actually accrued, arisen, or been received. Therefore, the decision in Shivam Motors on non-applicability of Section 14A due to absence of exempt income would no longer hold good under the amended statutory regime.

39

(3) Rule 8D Not Retrospective; Disallowance Must Be Reasonable

Godrej & Boyce Manufacturing Co. Ltd. v. DCIT (2010) 328 ITR 81 (Bom.)

1. Issue Decided by the Court: Whether Rule 8D of the Income Tax Rules, 1962 is retrospective in operation and whether the Assessing Officer can apply it for assessment years prior to its insertion in 2008.

2. Facts of the Issue Decided by the Court: The assessee, Godrej & Boyce Manufacturing Co. Ltd., had earned dividend income which was exempt under Section 10(34). The AO applied Rule 8D for disallowing expenses under Section 14A even though the relevant year was AY 2002–03, i.e., prior to the notification of Rule 8D on 24 March 2008. The assessee challenged the retrospective application and the reasonableness of the disallowance.

3. Arguments of the Appellant (Assessee): The assessee argued that Rule 8D is prospective and cannot be applied to assessments prior to AY 2008–09. It further contended that any disallowance must be based on a reasoned analysis and not on a mechanical formula. The AO had neither established expenditure incurred nor recorded dissatisfaction with the assessee’s claim.

4. Arguments of the Defendant (Revenue): The Revenue argued that Rule 8D is clarificatory in nature and can be applied retrospectively. It justified the application of the rule as a method for computing the expenditure disallowable under Section 14A, regardless of the year of assessment.

5. Decision of the Court: The Bombay High Court held that Rule 8D is not retrospective and can only be applied prospectively from AY 2008–09. However, disallowance under Section 14A is permissible even for earlier years, provided it is computed on a reasonable basis.

6. Reasoning Advanced by the Court: The Court clarified that Section 14A, though inserted in 2001, requires that the AO first record a finding that he is not satisfied with the assessee’s claim regarding expenditure incurred. Only then can a disallowance be made. For pre-Rule 8D years, the disallowance must be based on a reasonable estimate, not a mechanical formula. Rule 8D being a procedural tool for computation, cannot be applied retrospectively unless expressly provided.

7. Case Laws Full Citation Relied by the Court:

   • CIT v. Walfort Share & Stock Brokers (P) Ltd. [(2010) 326 ITR 1 (SC)]

   • Maxopp Investment Ltd. v. CIT [(2011) 203 Taxman 364 (Del.)] (referred later in jurisprudence building)

   • Ishikawajma-Harima Heavy Industries Ltd. v. DIT [(2007) 288 ITR 408 (SC)] – for general interpretative principles

8. Application of the Judgement: This case is a landmark ruling clarifying that Rule 8D cannot be applied retrospectively and should be used only from AY 2008–09 onwards. It provides legal support to taxpayers challenging disallowances for earlier years where the AO mechanically applies Rule 8D. The decision also reinforces the requirement that the AO must record dissatisfaction with the assessee’s claim before invoking Section 14A, ensuring procedural fairness and reasoned application of the law.

9. Why Revenue Lost the Case on Facts – What Were the Deficiencies: The Revenue failed to establish the factual connection between borrowed funds and exempt income. The Assessing Officer made a blanket application of Rule 8D without examining the nature of borrowings or verifying the claim that own funds were sufficient for investment. There was no specific finding to show that the interest-bearing funds were diverted toward tax-free investments. Moreover, the AO did not demonstrate dissatisfaction with the assessee’s claim after perusing the accounts, a condition precedent under Section 14A(2). This factual lapse—absence of inquiry and mechanical invocation—led to the Tribunal and High Court invalidating the disallowance.

10. What Was the Error in Law Committed by Revenue as per the Provision: The Revenue erred in law by applying Section 14A read with Rule 8D without first recording dissatisfaction regarding the correctness of the assessee’s claim, as mandated by Section 14A(2) and (3). The AO mechanically assumed that expenditure must have been incurred simply because the assessee had earned exempt income. Furthermore, no effort was made to distinguish between direct and indirect expenses. The Supreme Court in Godrej & Boyce and Maxopp Investment clarified that the application of Rule 8D is permissible only after recording reasons for dissatisfaction based on an examination of accounts—an essential step that the AO ignored.

Status of the Decision as per Supreme Court and under Current Law: In Maxopp Investment Ltd. v. CIT [2018] 91 taxmann.com 154 (SC), the Supreme Court held that Section 14A applies irrespective of whether investments are strategic or not. The AO must record satisfaction about the correctness of the assessee's claim before invoking Rule 8D. Disallowance is not automatic and must be based on objective analysis.

Under current law—post Finance Act, 2022 amendment—an Explanation has been inserted to Section 14A clarifying that the section applies even when no exempt income has accrued or been received. Thus, the assessee can be disallowed expenditure even in years with zero exempt income—a significant shift from earlier jurisprudence.

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(4) Recording of AO’s Dissatisfaction is a Mandatory Precondition

Maxopp Investment Ltd. v. Commissioner of Income Tax (2018) 402 ITR 640 (SC)

1. Issue Decided by the Court: Whether recording of dissatisfaction by the Assessing Officer (AO) regarding the assessee’s claim of expenditure is a mandatory condition for invoking Section 14A and applying Rule 8D, and whether Rule 8D can be invoked without such recording.

2. Facts of the Issue Decided by the Court: The assessee, Maxopp Investment Ltd., had made strategic investments in subsidiaries and other companies and claimed that no expenditure was incurred to earn the exempt dividend income. The AO, without recording any dissatisfaction with the claim made by the assessee, proceeded to invoke Rule 8D and disallowed expenses. The Tribunal and High Court held the disallowance valid, following which the matter reached the Supreme Court.

3. Arguments of the Appellant (Assessee): The assessee argued that Section 14A(2) requires the AO to first record his dissatisfaction with the correctness of the claim made by the assessee regarding expenditure incurred. In the absence of such dissatisfaction, Rule 8D could not be mechanically invoked. It also contended that investments were made for strategic business reasons, not for earning exempt income.

4. Arguments of the Defendant (Revenue): The Revenue argued that Rule 8D is mandatory when investments yielding exempt income exist. It claimed that once such investments are found, the AO is empowered to apply Rule 8D and quantify disallowance, even if exempt income was incidental or unintentional.

5. Decision of the Court: The Supreme Court upheld the principle that recording dissatisfaction is a sine qua non before invoking Rule 8D under Section 14A. It also clarified that strategic investments can still lead to disallowance if they yield exempt income.

6. Reasoning Advanced by the Court: The Court held that Section 14A(2) mandates the AO to record his dissatisfaction with the correctness of the assessee’s claim. Without this, invoking Rule 8D is procedurally defective. The Court also stated that motive behind investment is immaterial; what matters is whether such investments yield exempt income. Even strategic investments, if resulting in exempt income, attract the operation of Section 14A. However, the AO must act after proper inquiry and satisfaction recording.

7. Case Laws Full Citation Relied by the Court:

   • Godrej & Boyce Mfg. Co. Ltd. v. DCIT [(2010) 328 ITR 81 (Bom.)]

   • CIT v. Walfort Share & Stock Brokers (P) Ltd. [(2010) 326 ITR 1 (SC)]

   • CIT v. Chettinad Logistics (P) Ltd. [(2017) 80 taxmann.com 221 (Mad.)] – considered in broader ratio

8. Application of the Judgement: This case is a landmark precedent on procedural safeguards under Section 14A. It ensures that disallowance cannot be made mechanically or without applying mind. The judgment mandates that the AO must record dissatisfaction with the assessee’s claim, thereby preserving the integrity of the process. It also widens the scope of Section 14A by stating that even strategic investments attracting exempt income are not immune to disallowance.

9. Why Revenue Lost the Case on Facts – What Were the Deficiencies: The Revenue failed to establish any factual nexus between the borrowed funds and the exempt income earned by the assessee. The AO applied Rule 8D without identifying whether interest-bearing funds were actually used for investments generating tax-free income. There was no recording of satisfaction based on account scrutiny, a statutory requirement under Section 14A(2). The AO's action was mechanical and lacked factual foundation. The Tribunal and the High Court rightly found that the Revenue’s failure to distinguish between direct, indirect, and unrelated expenses undermined the disallowance, resulting in the Revenue losing the case on evidentiary shortcomings.

10. What Was the Error in Law Committed by Revenue as per the Provision: The primary legal error by the Revenue was in invoking Rule 8D without complying with the mandatory condition in Section 14A(2) — that the AO must first be dissatisfied with the assessee’s claim based on examination of accounts. The AO presumed disallowance was automatic upon earning exempt income. The Supreme Court in Godrej & Boyce clarified that Rule 8D cannot be invoked arbitrarily; procedural satisfaction must precede computation. The Revenue also ignored the principle that the extent of disallowable expenditure must be proportionate and traceable, thus violating both procedural and substantive safeguards laid down in the statutory provision.

11. What Will Be the Status of the Decision Under Current Law: Under current law, as per the Explanation inserted to Section 14A by the Finance Act, 2022 (effective retrospectively), disallowance is now permissible even if no exempt income is received, accrued, or arisen during the relevant year. This significantly alters the legal basis of earlier rulings like Godrej & Boyce, where courts held that no disallowance can be made in the absence of exempt income. While the procedural safeguard of recording dissatisfaction under Section 14A(2) still stands, the core judicial protection against disallowance in “zero exempt income” years is now statutorily overridden, expanding the Revenue’s scope.