Disallowance u/s 14A set-5

(favour assessee)

Disallowance u/s 14A (FA) set-5

41

(1) Rule 8D is Not Automatic — AO Must Record Proper Satisfaction

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

1. Issue Decided by the Court: Whether disallowance under Section 14A is justified when the assessee has sufficient interest-free funds and no nexus is established between borrowed funds and investments yielding exempt income.

2. Facts of the Issue Decided by the Court: The assessee, Reliance Utilities and Power Ltd., had made investments which yielded exempt income. The Assessing Officer disallowed a portion of the interest expenditure under Section 14A, arguing that interest-bearing funds were used for investments. The assessee had significant own funds (reserves and surplus), far in excess of the investments made. The AO did not establish any nexus between the borrowed funds and the investments, nor did he record any dissatisfaction with the assessee’s explanation.

3. Arguments of the Appellant (Revenue): The Revenue argued that since exempt income was earned and the assessee had availed loans, it should be presumed that borrowed funds were used for investments. Therefore, proportionate interest should be disallowed under Section 14A.

4. Arguments of the Defendant (Assessee): The assessee submitted that it had sufficient own interest-free funds to make investments and there was no basis for presuming that borrowed funds were diverted for tax-free income. It also pointed out that no specific finding was recorded by the AO to contradict its claim.

5. Decision of the Court: The Bombay High Court decided in favour of the assessee and held that no disallowance under Section 14A is permissible when the assessee has interest-free funds available and there is no evidence that borrowed funds were used for investments.

6. Reasoning Advanced by the Court: The Court laid down a crucial presumption that if an assessee possesses mixed funds (interest-bearing and interest-free), and the own funds are sufficient to cover investments, then it should be presumed that investments were made from interest-free funds. This presumption can only be rebutted if the AO brings evidence showing direct nexus of borrowed funds. The Court also emphasized the procedural necessity of recording dissatisfaction under Section 14A(2) before applying any computational rule like Rule 8D.

7. Case Laws Full Citation Relied by the Court:

a) East India Pharmaceutical Works Ltd. v. CIT [(1997) 224 ITR 627 (SC)]

b) Woolcombers of India Ltd. v. CIT [(1982) 134 ITR 219 (Cal.)] – principle of presumption in favour of assessee

c) CIT v. Radico Khaitan Ltd. [(2005) 274 ITR 354 (All.)]

8. Application of the Judgement: This judgment is a vital authority used by assessees to rebut arbitrary interest disallowance under Section 14A. It provides relief where own funds exceed investments and no direct linkage to borrowed funds is established. The presumption favouring the taxpayer has been widely followed in later decisions, offering strong protection against mechanical or presumptive disallowance.

9. Why Revenue lost the case on facts; what were the deficiencies?: The Revenue's case was primarily based on the assertion that the assessee had utilized borrowed funds for making investments in sister concerns and thus disallowance of interest under section 36(1)(iii) was justified. However, the CIT(A) and ITAT had both recorded a finding of fact that the assessee possessed interest-free funds aggregating to Rs. 398.19 crores, which was more than sufficient to cover the investments made. The Revenue relied on the balance sheet as of 31-3-1999, which was irrelevant, since the investments were made between January and March 2000 and the relevant balance sheet was as of 31-3-2000. Furthermore, the Revenue failed to demonstrate any nexus between borrowed funds and the investments made. Thus, factual deficiencies—such as relying on outdated financials and failing to counter the factual findings—led to dismissal of the appeal.

10. What was the error in law committed by Revenue as per the provision?: The fundamental legal error committed by the Revenue was the failure to apply the established principle of “presumption in favour of utilisation of own funds” where interest-free and borrowed funds are both available. As per judicial precedent (notably East India Pharmaceutical Works Ltd. and Woolcombers of India Ltd.), if the assessee has sufficient own funds to meet its investments, a presumption arises that such investments were made from own funds. The Revenue wrongly assumed without rebuttal that borrowed funds were utilised and disallowed interest, thereby shifting the burden improperly. The Tribunal and High Court reiterated that unless contrary evidence is led by the Revenue to establish direct nexus between borrowed funds and investment, such disallowance cannot be sustained under Section 36(1)(iii).

11. What will be the status of the decision under current law?: Under the current law, particularly post-amendments to Section 14A and the settled position under Section 36(1)(iii), this decision continues to hold good law. The principle laid down in this case—i.e., if interest-free funds are available in excess of investments, a presumption arises that the investment is out of own funds—is affirmed by the Supreme Court in CIT v. Reliance Industries Ltd. (2019) 410 ITR 466 (SC). Even after Rule 8D (prescribed under Section 14A) came into force, this presumption is relevant in determining whether disallowance is warranted. Therefore, unless the Assessing Officer can disprove this presumption with concrete evidence of nexus, disallowance of interest remains untenable under the current law.

42

(2) Disallowance Unsustainable Without Expenditure Being Incurred

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

1. Issue Decided by the Court: Whether any disallowance under Section 14A can be made when the assessee has not incurred any expenditure to earn exempt income.

2. Facts of the Issue Decided by the Court: The assessee, Winsome Textile Industries Ltd., earned dividend income during the assessment year, which was exempt under Section 10(34). The AO applied Section 14A and made a disallowance despite the assessee’s clear stand that it had not incurred any expenditure—direct or indirect—towards earning the exempt income. The AO did not conduct any enquiry or provide a basis to rebut this assertion.

3. Arguments of the Appellant (Revenue): The Revenue argued that once exempt income is earned, some expenditure must be presumed to have been incurred to earn such income. Hence, disallowance under Section 14A was justified even if the assessee claimed otherwise.

4. Arguments of the Defendant (Assessee): The assessee argued that it had not incurred any expenditure whatsoever to earn the exempt income, and no evidence was placed by the AO to the contrary. It contended that disallowance cannot be made based merely on assumptions or presumptions.

5. Decision of the Court: The Punjab and Haryana High Court ruled in favour of the assessee, holding that no disallowance under Section 14A is permissible when the assessee has not incurred any expenditure to earn exempt income, and the AO has not brought any material to suggest otherwise.

6. Reasoning Advanced by the Court: The Court held that Section 14A contemplates actual expenditure incurred in relation to exempt income. It cannot be applied in the absence of any such expenditure. The AO must demonstrate that expenditure was in fact incurred or that the assessee’s claim is unsustainable. In this case, the AO neither made any enquiry nor rebutted the assessee’s stand. Therefore, the disallowance was based merely on assumption, which is legally impermissible.

7. Case Laws Full Citation Relied by the Court:

a) CIT v. Hero Cycles Ltd. [(2010) 323 ITR 518 (P&H)] – relied on for absence of nexus

b) CIT v. Reliance Utilities and Power Ltd. [(2009) 313 ITR 340 (Bom.)] – for presumption of use of own funds

c) CIT v. Chettinad Logistics (P) Ltd. [(2017) 80 taxmann.com 221 (Mad.)] – for “no disallowance without exempt income” (referred later in related jurisprudence)

8. Application of the Judgement: This case is regularly cited where no expenditure was incurred and the AO fails to establish any contrary evidence. It emphasizes that Section 14A does not operate in a vacuum; it must be rooted in facts, not presumptions. Assessees can rely on this ruling to contest disallowances made without satisfaction or enquiry by the AO.

9. Why Revenue lost the case on facts; what were the deficiencies? The Revenue failed to demonstrate that the assessee had incurred any expenditure, particularly interest, in earning exempt income. The investment in shares was made in AY 1994–95 from the assessee’s own funds. During the relevant year (AY 2004–05), there was no exempt income received or claimed. The Assessing Officer presumed disallowance under Section 14A without establishing any factual nexus between borrowed funds and the investment or any actual expense incurred. This lack of evidence and reliance on incorrect presumptions led to the Revenue’s failure on facts.

10. What was the error in law committed by Revenue as per the provision? The Revenue incorrectly invoked Section 14A without satisfying its legal preconditions. Section 14A mandates that disallowance is permissible only when (i) exempt income is earned and (ii) expenditure is incurred to earn such income. The Revenue erred in applying Section 14A in a year where no exempt income was received. It also misapplied Abhishek Industries Ltd., which dealt with Section 36(1)(iii) and diversion of interest-bearing loans, not Section 14A. Thus, disallowance was legally untenable due to lack of exempt income and absence of actual expenditure.

11. What will be the status of decision under current law: Under the current law, the principle in Winsome Textile has been significantly modified by the Finance Act, 2022, which inserted an Explanation to Section 14A with retrospective effect from 1 April 2002. The Explanation clarifies that disallowance under Section 14A applies even in cases where no exempt income has accrued, arisen, or been received during the relevant previous year. This directly overrides judicial precedents such as Chettinad Logistics and PCIT v. Oil Industry Development Board, which had held otherwise. Therefore, under current law, even in the absence of exempt income, disallowance under Section 14A is now statutorily permissible, and the ratio in Winsome Textile—to the extent it relied on the absence of exempt income—no longer holds good. However, Rule 8D can still be invoked only if the Assessing Officer records dissatisfaction with the assessee's claim regarding expenditure incurred in relation to exempt income.

43

Rule 8D Not Mandatory Without AO's Proper Satisfaction

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

1. Issue Decided by the Court: Whether disallowance under Section 14A can be made by directly applying Rule 8D without first recording satisfaction that the assessee's claim of no expenditure incurred for earning exempt income is incorrect.

2. Facts of the Issue Decided by the Court: The assessee had made investments in shares but claimed that no exempt income was earned during the assessment year. The AO, without examining the validity of this claim or recording dissatisfaction, invoked Section 14A and applied Rule 8D to disallow a proportionate amount of expenditure. The CIT(A) and the Tribunal ruled in favour of the assessee, noting that the AO had failed to follow the mandatory steps prescribed under the statute.

3. Arguments of the Appellant (Revenue): The Revenue contended that Rule 8D is a mandatory mechanism for computing disallowance and that the AO was justified in applying it once the assessee had made investments capable of yielding exempt income, regardless of whether exempt income was actually earned.

4. Arguments of the Defendant (Assessee): The assessee submitted that since no exempt income had been earned, Section 14A was not applicable. Further, it was argued that Rule 8D could not be applied unless the AO recorded specific dissatisfaction with the assessee’s claim, which was not done in this case.

5. Decision of the Court: The Gujarat High Court dismissed the Revenue’s appeal, holding that no disallowance under Section 14A can be made without first recording the AO’s dissatisfaction, and Rule 8D is not to be applied mechanically or automatically.

6. Reasoning Advanced by the Court: The Court reiterated that Section 14A(2) and (3) mandate a specific procedure: before invoking Rule 8D, the AO must first examine the assessee’s claim regarding expenditure and then record dissatisfaction with its correctness. Since the AO failed to comply with this mandatory condition and did not demonstrate that any expenditure was incurred in relation to exempt income, the disallowance was unsustainable. The Court also emphasized that Rule 8D is not a standalone provision, but only a computational tool to be used after compliance with the substantive conditions of Section 14A.

7. Case Laws Full Citation Relied by the Court:

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

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

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

8. Application of the Judgement: This judgment is frequently invoked in litigation where the AO makes a mechanical disallowance under Rule 8D without recording satisfaction. It strengthens the procedural shield available to the assessee by ensuring that the AO must justify the disallowance with reasoning and evidence. It is particularly useful when no exempt income is earned or when the AO has not applied his mind to the assessee’s computation.

45

Summary of the cases u/s 14A

(In favour of assessee)

Presumption in Favour of Use of Own Funds for Tax-Free Investments

CIT v. HDFC Bank Ltd. [2014] 49 taxmann.com 335 (Bombay)

(i) Issue Decided by the Court: Whether disallowance under section 14A was justified when the assessee's own funds and other non-interest-bearing funds exceeded the amount invested in tax-free securities, thus allegedly negating the need for apportioning interest expenditure.

(ii) Facts of the Issue: The assessee, HDFC Bank Ltd., had invested in tax-free securities. The Assessing Officer (AO) made a disallowance of part of the interest expenditure under section 14A, asserting that the investments were made from a common pool of funds consisting of both interest-bearing and interest-free resources. However, the assessee's own funds and non-interest-bearing funds were more than the investments made in tax-free instruments. Both CIT(A) and ITAT ruled in favour of the assessee, holding that no disallowance was warranted.

(iii) Arguments of the Appellant (Revenue)

1. The assessee could not prove that investments were specifically made from its own funds.

2. Since funds were fungible, the presumption should be that investments were made from a common pool, warranting proportionate disallowance.

3. Apportionment of expenditure under section 14A is automatic in such cases, even without direct nexus.

(iv) Arguments of the Defendant (Assessee)

1. The assessee had sufficient own funds and non-interest-bearing funds to cover investments in tax-free securities.

2. As per the judgment in Reliance Utilities & Power Ltd., if interest-free funds are sufficient, a presumption arises that such funds were used for the investments.

3. The AO had made disallowance without proper factual analysis or satisfaction as required under section 14A.

(v) Decision of the Court: The Bombay High Court dismissed the Revenue's appeal, upholding the decisions of the CIT(A) and ITAT. It held that no disallowance under section 14A was warranted in light of the sufficiency of interest-free funds and the presumption laid down in earlier binding precedents.

(vi) Reasoning Advanced by the Court for its Decision

1. The Court affirmed the presumption doctrine laid down in CIT v. Reliance Utilities & Power Ltd.: if interest-free funds are sufficient to cover investments, it must be presumed that such funds were utilized.

2. It emphasized that the factual finding of the ITAT that interest-free funds exceeded investments was not disputed.

3. The Court rejected the Revenue’s argument that absence of a direct nexus mandates disallowance under section 14A.

4. It held that the mere presence of mixed funds does not automatically invoke Rule 8D unless the AO records satisfaction that the claim of the assessee is incorrect.

(vii) Full Citation of the Judgments Relied on by the Court

1. CIT v. Reliance Utilities & Power Ltd. [2009] 313 ITR 340 / 178 Taxman 135 (Bom.)

2. CIT v. Lord Krishna Bank Ltd. [2014] 366 ITR 416 (Bom.)

3. East India Pharmaceutical Works Ltd. v. CIT [1997] 224 ITR 627 (SC)

4. American Express International Banking Corp. v. CIT [2002] 258 ITR 601 / 125 Taxman 488 (Bom.)

(viii) Application of the Judgement

1. The judgment reinforces that no disallowance under section 14A read with Rule 8D can be made where interest-free funds are sufficient to cover the investment in tax-free securities.

2. It applies in all cases involving mixed funds where the assessee’s own capital, reserves, and non-interest-bearing funds are more than the investments generating exempt income.

3. The decision sets a precedent against automatic application of Rule 8D in the absence of recorded satisfaction by the AO.

(ix) Why Revenue lost the case on facts; what were the deficiencies: The Revenue failed to disprove the factual finding that the assessee’s own funds and non-interest-bearing funds were more than the investments made in tax-free securities. The Tribunal rightly applied the presumption from Reliance Utilities & Power Ltd. that where interest-free funds are sufficient, the investments are deemed to have been made out of such funds. The AO neither established a direct nexus between borrowed funds and exempt investments, nor rebutted the sufficiency of interest-free funds. Thus, the disallowance under Section 14A lacked factual basis, and the Tribunal’s order was upheld in favour of the assessee.

(x) What was the error in law committed by Revenue as per the provision: The Revenue erroneously applied Section 14A disallowance without first disproving the assessee’s claim of using own interest-free funds for exempt investments. The AO ignored the legal principle established in Reliance Utilities & Power Ltd., which permits a presumption in favour of the assessee if interest-free funds are adequate. There was no evidence of direct expenditure incurred in earning exempt income or of dissatisfaction with the assessee’s claim as required under Section 14A(2). The AO treated mixed funds as necessarily involving borrowed funds without justification, thereby misapplying the apportionment principle under Rule 8D without proper statutory satisfaction.

(xi) What will be the status of decision under current law?: Under current law, including the retrospective Explanation inserted in Section 14A by the Finance Act, 2022, the position has evolved. The Explanation clarifies that Section 14A applies even where exempt income has not accrued, arisen, or been received during the year, overturning several earlier judicial precedents that required actual exempt income. However, the Bombay High Court’s presumption regarding use of interest-free funds remains intact, especially post South Indian Bank Ltd. v. CIT [2021] 438 ITR 1 (SC), which upheld such a presumption. Thus, though Section 14A can apply without exempt income, disallowance still requires satisfaction under sub-section (2).

(xii) Similar view in HDFC Bank Ltd. v. DCIT [2016] 67 taxmann.com 42 (Bombay)

46

Rule 8D Disallowance Invalid Without AO’s Satisfaction

PCIT v. Godrej & Boyce Mfg. Co. Ltd. [2023] 149 taxmann.com 222 (Bombay)

(i) Issue Decided by the Court: Whether the Assessing Officer (AO) is empowered to invoke Rule 8D to disallow interest expenditure under Section 14A without recording satisfaction about the incorrectness of the assessee's computation of expenditure incurred in relation to exempt income.

(ii) Facts of the Issue

1. The assessee, Godrej & Boyce Mfg. Co. Ltd., earned exempt income of ₹84.30 crores from shares and mutual funds during AY 2011–12.

2. It voluntarily disallowed ₹13.66 lakhs under Section 14A as per its computation based on the books of account.

3. The AO disallowed an additional ₹5.11 crores under Section 14A read with Rule 8D(2)(ii) for interest expenditure, without recording dissatisfaction about the assessee's computation.

4. CIT(A) deleted the disallowance, and ITAT upheld the CIT(A)’s decision. The Revenue filed an appeal before the Bombay High Court.

(iii) Arguments of the Appellant (Revenue)

1. The AO had implicitly recorded dissatisfaction in para 5 of the assessment order by referring to the assessee’s improper set-off of interest cost against taxable income, violating the matching concept.

2. Rule 8D prescribes a mechanical formula and overrides presumptions of interest-free fund availability.

3. Since the assessee did not maintain separate accounts for exempt income-related investments, proportionate disallowance of interest was justified.

(iv) Arguments of the Defendant (Assessee)

1. The AO neither discussed nor evaluated the assessee's computation nor recorded dissatisfaction with the correctness of the expenditure claimed in the return.

2. The AO directly invoked Rule 8D without following the statutory mandate under Section 14A(2).

3. The assessee had sufficient own interest-free funds, and no evidence was produced by the AO to show diversion of borrowed funds towards exempt investments.

(v) Decision of the Court: The Bombay High Court dismissed the Revenue's appeal and upheld the decisions of the CIT(A) and ITAT. It ruled that the AO was not empowered to invoke Rule 8D without recording dissatisfaction based on examination of the assessee’s books.

(vi) Reasoning Advanced by the Court

1. The AO failed to record satisfaction regarding the incorrectness of the assessee's claim in accordance with Section 14A(2).

2. The invocation of Rule 8D without such satisfaction violates the statutory condition and is contrary to judicial principles.

3. Citing Apex Court rulings, the Court reaffirmed that where sufficient interest-free funds are available, investments can be presumed to be made from those funds.

4. The AO had not demonstrated any nexus between borrowed funds and investments generating exempt income.

(vii) Full Citation of the Judgments Relied on by the Court

1. Godrej & Boyce Mfg. Co. Ltd. v. Dy. CIT [2017] 81 taxmann.com 111 (SC)/247 Taxman 361/394 ITR 449

2. South Indian Bank Ltd. v. CIT [2021] 130 taxmann.com 178 (SC)/283 Taxman 178

3. Pr. CIT v. Bombay Dyeing & Mfg. Co. Ltd. ITA No. 1225 of 2015 (Bom HC), decision dated 28-11-2017 (SLP dismissed)

(viii) Application of the Judgement

This judgment can be invoked:

1. When the AO applies Rule 8D without recording satisfaction under Section 14A(2).

2. In cases involving mixed funds, where the assessee has sufficient interest-free funds.

3. For assessment years post AY 2008-09, where Rule 8D is applicable, but only after procedural compliance with Section 14A(2).

4. To contest mechanical or formula-based disallowances made by Revenue without due application of mind.

Loss Not Expenditure under Section 14A

CIT v. Walfort Share & Stock Brokers (P.) Ltd. [2010] 192 Taxman 211 (SC)

(i) Issue Decided by the Court: Whether the difference between the purchase and sale price of units (resulting in a loss) in a dividend stripping transaction could be treated as expenditure incurred in relation to exempt income (i.e., dividend), and thereby disallowed under Section 14A of the Income-tax Act, 1961.

(ii) Facts of the Issue

1. The assessee purchased mutual fund units before the record date (24-03-2000) to earn a tax-free dividend of ₹1.82 crores.

2. Due to the dividend payout, the Net Asset Value (NAV) fell by ₹4 per unit.

3. The units were sold immediately after the record date, resulting in a capital loss of ₹2.09 crores, which the assessee sought to set off against taxable income.

4. The AO disallowed the loss, contending that the dividend was a return of investment, not an income, and hence the expenditure incurred (i.e., the loss) was in relation to exempt income and should be disallowed under Section 14A.

(iii) Arguments of the Appellant (Revenue)

1. The dividend received was embedded in the unit price, hence its cost was recoverable and should be treated as expenditure incurred to earn exempt income under Section 14A.

2. The loss on sale of units was artificial, designed to avoid tax.

3. Return of investment was wrongly being claimed as business loss.

4. Even before the insertion of Section 94(7), such losses ought to be disallowed to the extent of the dividend received.

5. Section 14A is wide and covers all expenditure, including the differential amount in such transactions.

(iv) Arguments of the Defendant (Assessee)

1. The dividend was a revenue receipt under Section 10(33), not a capital receipt or return of investment.

2. The loss was genuine, resulting from sale at reduced NAV.

3. No expenditure was claimed against dividend income, and hence Section 14A was not applicable.

4. If Section 14A applied as Revenue argued, it would render Section 94(7) redundant, which was prospectively enacted from AY 2002–03.

5. The transaction involved acquisition and sale of an asset, and Section 14A applies only to expenditure, not business losses.

(v) Decision of the Court

The Supreme Court held in favour of the assessee, ruling that:

1. Section 14A does not apply to losses on sale of units, as such losses are not expenditure in the nature of Sections 30–37.

2. There was no proximate cause linking the loss to earning of exempt income, hence no disallowance under Section 14A was warranted.

(vi) Reasoning Advanced by the Court for Its Decision

1. "Expenditure incurred" under Section 14A refers to actual outgoings like rent, salaries, interest—i.e., real debits to profit and loss account, not notional losses or return of investment.

2. Return of investment (as in dividend stripping transactions) affects the balance sheet, not profit and loss, and hence cannot be disallowed under Section 14A.

3. Section 14A requires a proximate connection between expenditure and earning of exempt income—which was absent in this case.

4. The loss occurred upon sale of an asset (units), not due to any expenditure to earn exempt dividend.

5. Section 94(7) (which was inserted from AY 2002–03) deals with disallowance of losses in dividend stripping—its prospective application confirms that Section 14A was never intended to address such transactions.

6. Sections 14A and 94(7) operate in distinct fields—the former disallows expenditure, the latter curbs fictitious losses on asset sales linked to dividend.

(vii) Full Citation of the Judgements Relied on by the Court

1. CIT v. Walfort Share & Stock Brokers (P.) Ltd. [2010] 192 Taxman 211 (SC)

2. Rajasthan State Warehousing Corpn. v. CIT [2000] 242 ITR 450 (SC)

3. CIT v. Indian Bank Ltd. [1965] 56 ITR 77 (SC)

4. Vijaya Bank v. Addl. CIT [1991] 187 ITR 541 (SC)

5. McDowell & Co. Ltd. v. CTO [1985] 154 ITR 148 (SC)

6. Union of India v. Azadi Bachao Andolan [2003] 263 ITR 706 (SC)

(viii) Application of the Judgement

1. The judgment is a landmark precedent clarifying that:

a) Business losses on asset sales are not “expenditure” under Section 14A.

b) Dividend stripping transactions prior to 1-4-2002 cannot be disallowed under Section 14A.

c) Section 14A requires actual expenditure and proximate nexus with exempt income.

d) Section 94(7), not Section 14A, governs disallowance of losses in dividend stripping from AY 2002–03 onwards.

2. Applicable where no expenditure is claimed against exempt income, yet Revenue seeks disallowance.

(ix) Why Revenue lost the case on facts; what were the deficiencies?

The Revenue lost the case on facts because the Assessing Officer (AO) did not examine or discuss the assessee's computation of inadmissible expenditure under Section 14A, despite it being part of the return. There was no satisfaction recorded by the AO regarding the correctness or incorrectness of the assessee’s computation based on its books of account. Furthermore, the AO applied Rule 8D without fulfilling the statutory precondition of dissatisfaction under Section 14A(2). This procedural lapse—failure to scrutinize the assessee’s claim and record specific reasons—led the Tribunal and High Court to rule in favour of the assessee.

(x) What was the error in law committed by Revenue as per the provision?

The Revenue committed an error in law by invoking Rule 8D of the Income Tax Rules without first recording satisfaction as required under Section 14A(2) of the Income Tax Act. The statutory mandate clearly requires the AO to assess the correctness of the assessee’s claim based on examination of the books of account. Without such recorded dissatisfaction, mechanical application of Rule 8D is impermissible. The AO also failed to consider that the assessee had sufficient interest-free funds for investments, thereby ignoring settled legal principles laid down in earlier decisions like Godrej & Boyce (SC) and South Indian Bank Ltd..

(xii) What will be the status of the decision under current law?

Under current law, the principle requiring the AO’s satisfaction under Section 14A(2) continues to hold force. Despite the 2022 Explanation to Section 14A inserted retrospectively by the Finance Act, which clarifies that disallowance can apply even if no exempt income is earned during the year, the precondition of recorded dissatisfaction remains mandatory for invoking Rule 8D. The Supreme Court’s judgment in South Indian Bank Ltd. v. CIT (2021) reaffirms the presumption in favour of assessee’s use of interest-free funds. Hence, unless the AO explicitly examines and records reasons to doubt the assessee’s computation, disallowance under Rule 8D is not tenable.

47

" Section 14A Disallowance Cannot Exceed Exempt Income"

PCIT v. State Bank of Patiala [2018] 99 taxmann.com 286 (SC)

(i) Issue Decided by the Court: Whether the disallowance under Section 14A of the Income-tax Act, 1961, can exceed the quantum of exempt income earned by the assessee during the relevant assessment year, or must be restricted to the actual amount of such exempt income.

(ii) Facts of the Issue

1. The assessee, State Bank of Patiala, was assessed under Section 143(3) for AY 2010–11, and the Assessing Officer (AO) made a disallowance of ₹7.03 crore under Section 14A read with Rule 8D.

2. Subsequently, the Principal Commissioner of Income-tax (PCIT) passed a revision order under Section 263, directing the AO to enhance the disallowance by ₹12.67 crore, resulting in a total disallowance of ₹19.70 crore under Section 14A.

3. The assessee challenged both the original disallowance and the revisionary enhancement before the Income Tax Appellate Tribunal (ITAT).

4. The Tribunal set aside both the AO’s revised order and the revisionary order passed under Section 263, holding that Section 14A disallowance cannot exceed exempt income.

5. The High Court of Punjab and Haryana affirmed the Tribunal’s order, holding that disallowance under Section 14A must be limited to the amount of exempt income earned.

6. The Revenue filed a Special Leave Petition (SLP) before the Supreme Court challenging the High Court's decision.

(iii) Arguments of the Appellant (Revenue)

1. The Revenue contended that:

a) The disallowance under Section 14A should be computed as per Rule 8D, irrespective of the quantum of exempt income.

b) The disallowance made under Section 143(3) was correctly enhanced by the CIT under Section 263 as it was allegedly prejudicial to the interest of revenue.

c) The Tribunal erred in restricting disallowance to the amount of exempt income only.

(iv) Arguments of the Respondent (Assessee)

1. The assessee argued that:

a) No disallowance under Section 14A can exceed the amount of exempt income actually earned during the year.

b) The Tribunal had rightly held that both the original and enhanced disallowance were unsustainable.

c) The revision under Section 263 was bad in law as it sought to enhance disallowance without legal basis.

d) The High Court had rightly affirmed the Tribunal’s view based on settled legal principles.

(v) Decision of the Court

The Supreme Court dismissed the Special Leave Petition, both on the ground of delay and on merits, thereby affirming the High Court’s view that disallowance under Section 14A cannot exceed the amount of exempt income.

(vi) Reasoning Advanced by the Court for its Decision

While the Supreme Court did not provide a detailed judgment, it dismissed the SLP on merits, thereby implicitly endorsing the reasoning of the High Court and the Tribunal, which was as follows:

1. Section 14A is intended to disallow only such expenditure which is incurred in relation to exempt income.

2. When no or limited exempt income is earned, the disallowance cannot exceed such exempt income.

3. Applying Rule 8D mechanically, without reference to the actual exempt income, leads to arbitrary and excessive disallowance, which is not permitted under the law.

(vii) Full Citation of the Judgments Relied on by the Court for its Decision

1. PCIT v. State Bank of Patiala [2018] 99 taxmann.com 285 (Punjab & Haryana High Court) – High Court held that disallowance under Section 14A cannot exceed exempt income.

2. State Bank of Patiala v. PCIT [2017] 393 ITR 476 / 88 taxmann.com 667 (Punj. & Har.) – Similar view adopted in an earlier year for the same assessee.

3. ITAT Order in ITA No. 1203/CHD/2016 – Deletion of disallowance exceeding exempt income and quashing of Section 263 revision.

Although not explicitly cited in the Supreme Court order, these were relied upon in the High Court and Tribunal decisions upheld by the Supreme Court.

(viii) Application of the Judgment

This decision applies in all cases where:

1. The disallowance under Section 14A read with Rule 8D exceeds the amount of exempt income earned during the assessment year.

2. Revenue attempts to justify a higher disallowance based on notional or formulaic computation under Rule 8D.

3. It affirms that Section 14A disallowance must be proportionate and reasonable, and not mechanical.

This judgment strengthens the legal position that in absence of or limited exempt income, no or proportionate disallowance under Section 14A is permissible, a principle now well-settled in multiple High Court and Tribunal rulings.

(ix) Why Revenue lost the case on facts; what were the deficiencies?

The Revenue lost the case primarily because both the Tribunal and the High Court found that the disallowance under Section 14A could not exceed the quantum of exempt income actually earned by the assessee. The Assessing Officer and the Commissioner made disproportionate disallowances without establishing any direct nexus or factual basis justifying such higher disallowance. The factual deficiency lay in enhancing disallowance under Section 263 proceedings purely on estimation, even though the exempt income for the year was lower. There was no examination of the actual expenditure incurred. This led to rejection of the Revenue’s position at every appellate stage.

(x) What was the error in law committed by Revenue as per the provision?

The key legal error by the Revenue was misapplying Section 14A read with Rule 8D without adhering to its threshold requirement—that disallowance should relate to actual exempt income earned. The Revenue authorities enhanced the disallowance far beyond the exempt income, ignoring settled legal position that such disallowance cannot exceed the exempt income. This contravened the principle affirmed in earlier High Court decisions that Rule 8D cannot be mechanically invoked without a proper factual foundation. The revision under Section 263 was also found to be without jurisdiction since the original assessment was not erroneous or prejudicial to the interests of Revenue.

(xi) What will be the status of decision under current law?

Following the Explanation to Section 14A inserted by the Finance Act, 2022 with retrospective effect from AY 2002–03, the law now provides that disallowance under Section 14A can apply even if no exempt income is earned. This legislatively nullifies a key basis of the decision in the State Bank of Patiala case, where disallowance was restricted to the extent of actual exempt income. However, the principle that disallowance should be proportionate and based on AO’s recorded satisfaction under Section 14A(2) still holds. Hence, while the quantum limitation no longer applies under law, procedural safeguards remain mandatory

48

" No Section 14A Disallowance When Sufficient Interest-Free Funds Exist"

PCIT v. Nirma Chemical Works (P.) Ltd. [2024] 164 taxmann.com 380 (Gujarat)

(i) Issue Decided by the Court: Whether disallowance of interest expenditure under Section 14A read with Rule 8D is permissible where the assessee had sufficient interest-free funds to cover the investments that yielded exempt dividend income, and in absence of any evidence that borrowed funds were used for such investment.

(ii) Facts of the Issue

1. The assessee earned exempt dividend income of ₹5,298 in AY 2018–19 and also incurred interest expenditure of ₹5.04 crore.

2. The Assessing Officer (AO) presumed that the exempt income-yielding investments were made out of borrowed funds and disallowed the full amount of interest expenditure under Section 14A read with Rule 8D.

3. The CIT (Appeals) deleted the disallowance, noting that the assessee had sufficient interest-free funds (₹897.39 crore in share capital and reserves) as compared to investments (₹760.87 crore), and hence no nexus with borrowed funds could be presumed.

4. The ITAT upheld the CIT(A)’s findings, holding that the AO’s presumption was unsupported by any evidence and that the assessee had ample interest-free resources for the investments.

5. The Revenue appealed before the High Court under Section 260A.

(iii) Arguments of the Appellant (Revenue)

1. The ITAT erred in deleting the disallowance of ₹5.04 crore under Section 14A.

2. The assessee allegedly failed to establish that only interest-free funds were utilized for investments yielding exempt income.

3. Cited Rule 8D(2)(iii) (as amended w.e.f. 02/06/2016) to justify the disallowance, regardless of actual fund utilization.

4. Claimed that the appeal was maintainable due to the tax effect exceeding ₹1.74 crore, per CBDT Circular No. 17/2019.

(iv) Arguments of the Respondent (Assessee)

1. The assessee had sufficient own funds, exceeding the amount invested, negating any presumption of use of borrowed funds.

2. No direct nexus between borrowed funds and exempt investments was established by the AO.

3. Only ₹5,298 was earned as exempt income, and no actual expenditure was incurred to earn it.

4. The AO’s disallowance was purely presumptive and contradicted established judicial principles.

5. Tribunal’s decision was consistent with earlier years, which the Revenue had accepted.

(v) Decision of the Court: The High Court dismissed the Revenue’s appeal, holding that no substantial question of law arose. The Tribunal’s order deleting the disallowance was based on concurrent findings of fact, and the Revenue’s case was based on unsupported presumptions.

(vi) Reasoning Advanced by the Court for its Decision

1. The CIT(A) and Tribunal found as a matter of fact that interest-free funds exceeded the amount of investment.

2. There was no material evidence to show that borrowed funds were used for investments yielding exempt income.

3. The PCIT’s sanction for filing the appeal was mechanical, ignoring both the AO’s and Range Head’s opinion that the Tribunal’s decision was acceptable.

4. The High Court criticized the PCIT for acting contrary to the record and on incorrect factual assumptions.

5. Relied on the principle that when own funds are available, a presumption arises that they were used for investments.

6. The court concluded that the entire disallowance was without factual foundation, and thus the appeal was not maintainable.

(vii) Full Citation of Judgments Relied on by the Court for its Decision

1. CIT v. Gujarat Narmada Valley Fertilizers Co. Ltd. [2014] 42 taxmann.com 270 / 221 Taxman 479 (Gujarat)

2. Pr. CIT v. Shapoorji Pallonji & Co. Ltd. [2020] 117 taxmann.com 625 / 273 Taxman 167 / 423 ITR 220 (Bombay)

3. South Indian Bank Ltd. v. CIT [2021] 130 taxmann.com 178 / 283 Taxman 178 / 438 ITR 1 (SC)

4. Dy. CIT v. Nirma Chemical Works (P.) Ltd. ITA No. 60/Ahd/2023 (Tribunal Order dated 15-09-2023) – affirmed

(viii) Application of the Judgment

This judgment applies in cases where:

1. Assessee has sufficient own funds, and AO makes interest disallowance under Section 14A read with Rule 8D without proving actual use of borrowed funds.

2. The presumption of use of interest-bearing funds is not supported by tangible evidence.

3. The case reinforces that disallowance of interest under Section 14A cannot be made mechanically, and principles of nexus and fund flow must be applied logically and judicially.

4. It strengthens judicial view that when own funds exceed investments, presumption favours the assessee.

(ix) Why Revenue lost the case on facts; what were the deficiencies?

The Revenue failed to establish a factual basis for the enhanced disallowance under Section 14A. The AO initially made a disallowance of ₹7.03 crore, which the Commissioner later revised to ₹19.70 crore without fresh enquiry or justification. The Tribunal found no evidence linking the additional expenditure to exempt income. The Revenue did not disprove the assessee’s claim that the disallowance should be limited to actual exempt income earned. Both the Tribunal and the High Court held that disallowance must be based on evidence, not assumptions. As the Revenue’s enhancement lacked evidentiary backing, the Supreme Court dismissed its challenge

(x) What was the error in law committed by Revenue as per the provision?

The legal error by the Revenue lay in mechanically applying Rule 8D to enhance disallowance under Section 14A without first recording dissatisfaction with the assessee’s original claim, as required by Section 14A(2). Additionally, the Commissioner invoked Section 263 to revise the assessment despite no error or prejudice to Revenue being demonstrated in the original order. The courts held that the disallowance under Section 14A cannot exceed the amount of exempt income, a settled principle at the time. Hence, enhancing disallowance arbitrarily and without jurisdiction under Section 263 was a misapplication of the law.

(xi) What will be the status of decision under current law?

Under current law, particularly after the insertion of the Explanation to Section 14A by the Finance Act, 2022 (retrospective from AY 2002–03), disallowance can be made even in the absence of actual exempt income. This legislative amendment overrides the basis of the Supreme Court’s decision in State Bank of Patiala, which limited disallowance to the extent of exempt income earned. However, the requirement of recording dissatisfaction under Section 14A(2) remains mandatory. Therefore, while the quantum restriction is no longer valid, procedural compliance remains essential for invoking Rule 8D disallowance in assessments.

49

"Section 14A Disallowance Capped at Exempt Income"

DCIT v. Jite Shipyard Ltd. [2023] 157 taxmann.com 733 (Delhi)

(i) Issue Decided by the Court: Whether disallowance under Section 14A of the Income-tax Act, 1961, can exceed the amount of exempt income earned by the assessee in a given assessment year.

(ii) Facts of the Issue

1. The case pertains to Assessment Year 2015–16.

2. The only issue raised by the Revenue in its appeal before the Delhi High Court was whether the disallowance under Section 14A could exceed the actual exempt income earned by the assessee.

3. The Income Tax Appellate Tribunal (ITAT) had ruled in favour of the assessee by applying judicial precedents that limited the disallowance under Section 14A to the quantum of exempt income.

4. The Revenue challenged this order by filing an appeal before the High Court.

(iii) Arguments of the Appellant (Revenue)

1. The Revenue contended that even if the exempt income was lower, the disallowance under Section 14A read with Rule 8D could still be computed using the prescribed formula, potentially exceeding the exempt income.

2. Sought reversal of the Tribunal’s order which had capped disallowance at the actual exempt income earned.

(iv) Arguments of the Respondent (Assessee)

1. The assessee relied on well-established precedents to argue that Section 14A disallowance cannot exceed the exempt income actually earned.

2. Asserted that any disallowance beyond the exempt income would be unjust, excessive, and contrary to the legislative intent.

3. Supported its case with binding precedents from both the Delhi High Court and the Madras High Court, affirmed by the Supreme Court.

(v) Decision of the Court

The Delhi High Court dismissed the Revenue’s appeal, affirming that no disallowance under Section 14A can exceed the exempt income earned by the assessee. The court found no substantial question of law arising for consideration.

(vi) Reasoning Advanced by the Court for its Decision

1. The issue was already covered by prior judgments of the Delhi High Court and the Madras High Court, both holding that Section 14A disallowance must be limited to the amount of exempt income.

2. The Court cited the decisions in:

a) Cheminvest Ltd. v. CIT – Delhi High Court

b) CIT v. Chettinad Logistics (P.) Ltd. – Madras High Court

3. The Supreme Court had dismissed the SLP against the Chettinad Logistics decision on both grounds of delay and merits, thus confirming the legal position.

4. In light of these precedents, the Court concluded that the issue was settled, and no further adjudication was warranted.

(vii) Full Citation of the Judgments Relied on by the Court for its Decision

1. Cheminvest Ltd. v. CIT [2015] 61 taxmann.com 118 / 234 Taxman 761 / 378 ITR 33 (Delhi)

2. CIT v. Chettinad Logistics (P.) Ltd. [2017] 80 taxmann.com 221 / 248 Taxman 55 (Madras)

3. CIT v. Chettinad Logistics (P.) Ltd. [2018] 95 taxmann.com 250 / 257 Taxman 2 (SC)
   – SLP dismissed by Supreme Court on 2 July 2018 on both delay and merits

(viii) Application of the Judgment

This judgment reinforces the principle that:

1. Disallowance under Section 14A cannot exceed exempt income, regardless of the formula prescribed under Rule 8D.

2. It is applicable in all cases where the disallowance made exceeds actual exempt income, and especially relevant when interest or administrative expenses are disallowed mechanically under Rule 8D.

3. This judgment further consolidates the jurisprudence against excessive or formulaic disallowances in absence of proportionate exempt income.

(ix) Why Revenue lost the case on facts; what were the deficiencies?

The Revenue lost on facts because it failed to show that disallowance under Section 14A could legally exceed the exempt income earned by the assessee during the relevant year. The assessee had declared a specific amount of exempt income, and the disallowance was sought beyond this without factual justification or evidence of proportionate expenditure. The Tribunal followed settled judicial precedents and found no material irregularity in the assessee's claim. Thus, the factual foundation for excess disallowance was lacking.

(x) What was the error in law committed by Revenue as per the provision?

The legal error committed by the Revenue was its incorrect interpretation of Section 14A, especially in light of binding precedents. The Revenue contended that disallowance could be made even if it exceeded the exempt income, which contradicted rulings like Cheminvest Ltd. and Chettinad Logistics (P.) Ltd. The Delhi High Court reaffirmed that such an interpretation was contrary to settled law at that time. The AO also failed to record dissatisfaction with the assessee’s computation as mandated under Section 14A(2), further invalidating the disallowance.

(xi) What will be the status of decision under current law?

Under current law, following the insertion of the Explanation to Section 14A by the Finance Act, 2022 (with retrospective effect from AY 2002–03), disallowance can now be made even if no exempt income has been earned during the year. This fundamentally overrides the basis of earlier decisions like Chettinad Logistics and Cheminvest. As a result, the ratio of the Jite Shipyard case — that disallowance cannot exceed actual exempt income — is no longer valid in law. However, procedural safeguards like recording dissatisfaction under Section 14A(2) still remain a legal necessity.

50

"No Section 14A Disallowance without AO’s Recorded Satisfaction"

Asian Paints Ltd. v. ACIT [2024] 160 taxmann.com 402 (Mumbai - Trib.)

(i) Issue Decided by the Court: Whether the disallowance made by the Assessing Officer under section 14A read with Rule 8D is valid in the absence of recording any satisfaction regarding the correctness of the assessee’s claim of expenditure incurred in relation to exempt income.

(ii) Facts of the Issue

1. The assessee, Asian Paints Ltd., engaged in manufacturing paints and enamels, earned exempt dividend income and interest from tax-free bonds during AY 2013–14.

2. It suo motu disallowed ₹23.86 lakhs under section 14A as expenses related to such exempt income, based on a report from its accountant.

3. The Assessing Officer (AO) disregarded this and applied Rule 8D, enhancing the disallowance to ₹1.82 crores.

4. The CIT(A) granted partial relief, reducing the disallowance to ₹93.30 lakhs.

5. Both the assessee and revenue appealed.

(iii) Arguments of the Appellant (Assessee)

1. The assessee contended that the AO did not record any satisfaction as required under section 14A(2) before invoking Rule 8D.

2. It argued that such satisfaction is a prerequisite, as confirmed by judicial precedents.

3. The assessee also emphasized that sufficient own funds were available, and the investment in tax-free securities was made from internal accruals, not borrowed funds.

(iv) Arguments of the Defendant (Revenue/Department)

1. The Departmental Representative supported the AO’s order.

2. It was argued that the disallowance made under Rule 8D was proper considering the magnitude of exempt income and general expenses of the assessee.

(v) Decision of the Court

1. The ITAT deleted the disallowance of ₹1.82 crores made under section 14A read with Rule 8D.

2. It held that in the absence of valid satisfaction recorded by the AO, such disallowance is unsustainable.

(vi) Reasoning Advanced by the Court for its Decision

1. Recording of satisfaction under section 14A(2) is mandatory. The AO must evaluate the correctness of the assessee’s claim by referring to its accounts before invoking Rule 8D.

2. The Tribunal found no such satisfaction recorded by the AO in this case.

3. The Tribunal relied on its own previous judgment in the assessee’s own case for AY 2012–13, and on jurisdictional High Court and Supreme Court rulings, affirming that Rule 8D cannot be applied without the mandatory procedural safeguard.

4. Also, the assessee had substantial own funds exceeding the investments, rebutting any presumption of interest expense linkage.

(vii) Full Citation of the Judgments Relied on by the Court

1. Asian Paints Ltd. v. Asstt. CIT [2024] 160 taxmann.com 214 (Mumbai - Trib.)

2. Maxopp Investment Ltd. v. CIT [2018] 91 taxmann.com 154 / 402 ITR 640 (SC)

3. Godrej & Boyce Manufacturing Co. Ltd. v. DCIT [2017] 81 taxmann.com 111 / 394 ITR 449 (SC)

4. CIT v. Asian Paints Ltd. ITA No. 1564 of 2016 (Bombay HC) dated 06.04.2019

(viii) Application of the Judgment

This judgment applies in cases where:

1. The AO has not recorded reasons for dissatisfaction with the assessee’s computation of expenses related to exempt income under section 14A(2).

2. The assessee has sufficient own funds and has made suo motu disallowance supported by working or documentation.

3. It serves as a precedent restricting automatic invocation of Rule 8D in absence of a reasoned finding and satisfaction by the AO.

(ix) Why Revenue lost the case on facts; what were the deficiencies?

The Revenue lost on facts because the Assessing Officer invoked Rule 8D without recording dissatisfaction under Section 14A(2). The assessee had sufficient own interest-free funds to cover the investments that yielded exempt income, and this fact was accepted by the Tribunal. Moreover, there was no clear nexus shown between borrowed funds and exempt income. The Revenue failed to rebut the assessee's claim with evidentiary support, leading to the conclusion that disallowance lacked proper factual foundation.

(x) What was the error in law committed by Revenue as per the provision?

The primary legal error was invoking Rule 8D mechanically without recording the mandatory dissatisfaction as required under Section 14A(2). The AO did not analyze the assessee’s accounts or computation to justify rejection of its claim. Courts have consistently held that unless such dissatisfaction is recorded based on examination of accounts, Rule 8D cannot be applied. Thus, the AO bypassed a critical procedural safeguard, rendering the disallowance legally unsustainable under the prevailing statutory framework.

(xi) What will be the status of decision under current law as per second document?

As per the Explanation inserted by the Finance Act, 2022 (retrospectively applicable from AY 2002–03), disallowance under Section 14A is permitted even in cases where no exempt income has accrued, arisen, or been received. This overrides judicial precedents limiting disallowance to the amount of exempt income earned. However, the requirement to record dissatisfaction under Section 14A(2) remains unaffected. Therefore, while quantum restrictions no longer protect the assessee, procedural non-compliance—like lack of recorded dissatisfaction—can still vitiate the disallowance, making the Tribunal’s reasoning in Asian Paints partially valid even now.