Analysis of the cases u/s 14A
(In favour of Revenue)
(1) Interest on Borrowed Funds for Dividend Income Hit by Section 14A
Mahesh K. Mehta v. DCIT [2024] 166 taxmann.com 176 (SC)
(i) Issue Decided by the Court: Whether the interest expenditure incurred on borrowed capital used for investing in shares of companies (with the primary objective of earning dividend income) is disallowable under Section 14A when such dividend income is not taxable.
(ii) Facts of the Issue: The assessee borrowed funds to invest in the equity shares of two companies. The primary purpose of the investment was to earn dividends, which are exempt from tax under the Income Tax Act. The assessee claimed deduction under Section 36(1)(iii) for the interest paid on the borrowed funds. The Assessing Officer disallowed this interest expense by invoking Section 14A, stating that the expenditure was incurred to earn exempt income.
(iii) Arguments of the Appellant (Assessee)
The assessee contended that the investments in shares were made in operational companies and that the interest paid on borrowed capital was a genuine business expense.
It was argued that the deduction should be allowed under Section 36(1)(iii) as the borrowed capital was used for business or investment purposes.
(iv) Arguments of the Respondent (Revenue)
The Revenue maintained that the only purpose of the investment in shares was to earn dividend income, which is exempt from tax.
Therefore, interest incurred on such borrowed funds falls squarely within the ambit of Section 14A and is not allowable as a deduction.
(v) Decision of the Court: The Supreme Court dismissed the Special Leave Petition filed by the assessee, thereby upholding the High Court’s decision which had disallowed the interest expenditure under Section 14A.
(vi) Reasoning Advanced by the Court for Its Decision
The Court agreed with the High Court’s rationale that if the investment is made with the purpose of earning exempt income (such as dividend), any expenditure incurred, including interest, must be disallowed under Section 14A.
The Supreme Court did not interfere with the High Court's finding, effectively confirming that interest on borrowed capital used for earning exempt income is not deductible.
(vii) Full Citation of the Judgements Relied on by the Court for Its Decision
The judgment affirms the earlier Bombay High Court decision in Mahesh K. Mehta v. DCIT [2024] 160 taxmann.com 468 / 298 Taxman 238 (Bombay).
(viii) Application of the Judgement
This ruling establishes that any interest expenditure on funds borrowed for the purpose of investing in shares with a view to earning tax-free dividend income is hit by Section 14A. It clarifies that the dominant purpose of investment is crucial, and such expenses are not allowable even under Section 36(1)(iii).
(ix) Why assessee lost the case on facts; what were the deficiencies: The assessee had borrowed funds and used them to invest in shares of his two group companies. He claimed deduction under section 36(1)(iii) for the interest paid on these borrowings. However, the Assessing Officer disallowed the interest expenditure on the ground that the purpose of investment was to earn exempt dividend income, which does not form part of the total income. The High Court concurred, noting that the investment was not for business purposes. The factual deficiency lay in the direct nexus between borrowed capital and acquisition of income-exempt assets, triggering disallowance under section 14A.
(x) What was the error in law committed by assessee as per the provision: The legal error committed by the assessee was in claiming interest deduction under section 36(1)(iii) despite using borrowed funds to earn income which is exempt from tax. Section 14A clearly bars deduction of any expenditure incurred in relation to income not forming part of total income. The assessee failed to appreciate that once the funds are borrowed for investments yielding exempt income, the interest is hit by the disallowance under section 14A, regardless of intent or business rationale. The Supreme Court upheld the High Court’s finding that section 14A overrides section 36 when income is exempt.
(xi) What will be the status of decision under current law: Under current law, the decision remains valid and authoritative. Section 14A has been clarified by way of Explanation inserted by Finance Act, 2022, with retrospective effect, which states that the section applies even when exempt income has not accrued, arisen or been received during the year. This strengthens the ratio that expenditure (such as interest) incurred to earn exempt income is not allowable, even if such income has not materialized in a particular year. The Supreme Court’s decision aligns with this settled principle, and the disallowance under section 14A in such circumstances is fully sustainable in law.
(2) Rectification Valid Where Disallowance Under Section 14A Was Admitted by Assessee
Andhra Bank Financial Services Ltd. v. CIT [2024] 169 taxmann.com 237 (Telangana)
(i) Issue Decided by the Court: Whether the rectification order passed by the Commissioner (Appeals) under Section 154, enhancing the disallowance under Section 14A based on the assessee’s own submitted calculations, was valid and not debatable, thus falling within the scope of rectification.
(ii) Facts of the Issue
The assessee, a non-banking financial company (NBFC), earned exempt income from tax-free bonds during AY 1999–2000.
The AO made a disallowance of ₹1.10 lakhs under Section 14A, based on one of the alternative calculations submitted by the assessee.
In appeal, the assessee did not press the disallowance ground. The CIT(A) partly allowed other claims.
Subsequently, CIT(A) issued a notice under Section 154, proposing rectification to increase the Section 14A disallowance based on another calculation submitted by the assessee.
Despite objections, CIT(A) passed a rectification order enhancing the disallowance to ₹2.77 crore.
The Tribunal upheld this rectification. The assessee challenged the order before the High Court.
(iii) Arguments of the Appellant (Assessee)
The issue of disallowance under Section 14A was debatable and had already attained finality.
CIT(A) could not re-open or enhance the disallowance under the guise of rectification under Section 154.
Invoked Supreme Court rulings in T.S. Balaram v. Volkart Brothers and MEPCO Industries Ltd. v. CIT to argue that debatable matters fall outside the scope of Section 154.
(iv) Arguments of the Respondent (Revenue)
Assessee had accepted applicability of Section 14A and submitted various disallowance calculations voluntarily.
Since the ground was not pressed during the first appeal, the rectification merely aligned the order with the correct figure based on assessee’s own submissions.
The issue was not debatable and fell squarely within the permissible scope of Section 154.
(v) Decision of the Court: The High Court dismissed the appeal and upheld the Tribunal's and CIT(A)'s orders. It ruled that the rectification under Section 154 enhancing disallowance under Section 14A was valid and not debatable.
(vi) Reasoning Advanced by the Court
Since the assessee had accepted the disallowance under Section 14A, the issue was not open to debate.
The CIT(A) followed due process by issuing a notice and considering objections before passing the rectification order.
The revised disallowance amount was based on the assessee’s own calculation.
The enhancement did not violate appellate principles or go beyond powers under Section 154, as it corrected an omission apparent from the record.
The Court emphasized that Section 14A intends to deny deductions of expenses incurred in earning exempt income.
(vii) Full Citation of Judgements Relied on by the Court
T.S. Balaram, ITO v. Volkart Brothers [1971] 82 ITR 50 (SC) – distinguished.
MEPCO Industries Ltd. v. CIT [2009] 185 Taxman 409 (SC) – distinguished.
Maxopp Investment Ltd. v. CIT [2018] 91 taxmann.com 154 (SC).
South Indian Bank Ltd. v. CIT [2021] 130 taxmann.com 178 (SC).
(viii) Application of the Judgement: This ruling clarifies that once an assessee accepts applicability of Section 14A and provides its own disallowance computation, any omission to reflect the correct figure in the appellate order can be rectified under Section 154. The judgment limits the assessee’s ability to later challenge such corrections as “debatable,” especially when the issue was conceded or left unchallenged in appeal.
(ix) Why assessee lost the case on facts; what were the deficiencies: The assessee lost the case on facts primarily because it had itself submitted three alternative calculations for disallowance under section 14A and accepted the disallowance in principle during assessment proceedings. However, in appeal, the assessee did not press the ground relating to section 14A, thereby conceding the correctness of disallowance. The appellate authority, during rectification proceedings under section 154, merely applied the assessee’s own calculation to rectify the omitted disallowance. Thus, the factual deficiency lay in the inconsistency of the assessee’s stance and failure to dispute the disallowance at the appropriate stage, weakening its case on facts.
(x) What was the error in law committed by assessee as per the provision: The legal error committed by the assessee was its claim that the rectification under section 154 amounted to an unlawful enhancement of assessment, despite having accepted the disallowance earlier. Section 154 permits rectification of a “mistake apparent from record,” and since the appellate authority merely corrected an omission based on the assessee’s own calculations, it was not a debatable issue. The assessee’s reliance on case law concerning debatable issues under section 154 failed, as the disallowance had already been accepted and quantified. Therefore, its objection was legally untenable under the specific facts and section 14A framework.
(xi) What will be the status of decision under current law: Under the current law, this decision remains valid and is fortified by Explanation inserted in section 14A by the Finance Act, 2022, clarifying that disallowance applies even if exempt income has not arisen in the relevant year. The judgment confirms that when an assessee has accepted applicability of section 14A and provided calculations, a rectification to apply correct figures does not constitute a debatable enhancement. Further, the proviso to section 14A(3) restricting enhancement under section 154 for pre-1 April 2001 assessments did not apply here. Thus, the ruling remains consistent with both pre- and post-amendment law.
(3) Interest Disallowance under Section 14A Justified on Admitted Investment from Borrowed Funds
Shri Rampriya Developers (P.) Ltd. v. DCIT [2024] 166 taxmann.com 628 (Hyderabad - Trib.)
(i) Issue Decided by the Court: Whether disallowance under Section 14A in respect of interest expenditure was justified where the assessee had admittedly used interest-bearing borrowed funds for making investments in shares which yielded exempt income.
(ii) Facts of the Issue
The assessee-company was engaged in real estate development and other investment activities.
During the assessment year 1999–2000, the assessee borrowed funds from banks and financial institutions and incurred interest expenditure.
Simultaneously, the assessee had made substantial investments in shares and securities of various companies, some of which generated tax-free income (i.e., dividend income).
The Assessing Officer disallowed a portion of the interest expenditure under Section 14A, arguing that interest-bearing funds were used for earning exempt income.
The CIT(A) partly upheld the disallowance after considering the nexus between borrowed funds and investments in shares and disallowed proportionate interest related to investments and non-business use.
The remaining portion was allowed as deduction.
The assessee appealed further before the ITAT.
(iii) Arguments of the Appellant (Assessee)
The assessee claimed that the borrowed funds were used for business purposes and not directly for making investments that yielded exempt income.
It argued that there was no direct and proximate connection between the borrowed funds and the investments in shares, hence disallowance under Section 14A was not justified.
It contended that the CIT(A) had wrongly attributed borrowed funds to investment in shares.
(iv) Arguments of the Respondent (Revenue)
The Revenue submitted that the assessee itself had admitted that a part of the borrowed funds was used for making investments in shares and for purposes unrelated to business.
Hence, a proportionate disallowance under Section 14A was justified.
The CIT(A) had reasonably and correctly applied the principles of Section 14A and allocated interest expenditure accordingly.
There was no infirmity in the findings of the CIT(A) and thus, no interference was warranted.
(v) Decision of the Court: The Tribunal dismissed the assessee’s appeal and upheld the order of the CIT(A). It held that disallowance of proportionate interest under Section 14A was justified since the assessee had admitted use of interest-bearing funds for non-business purposes and for making investments in tax-free instruments.
(vi) Reasoning Advanced by the Court for Its Decision
The Tribunal observed that the CIT(A) had carefully examined the source of funds, nature of investments, and nexus between borrowed funds and tax-free investments.
Since the assessee admitted partial use of borrowed funds for investment in shares, the disallowance under Section 14A was legally tenable.
The principle that no deduction shall be allowed in respect of expenditure incurred in relation to income not forming part of total income was applied correctly.
The Tribunal found no error or infirmity in the CIT(A)’s reasoning and computation of disallowance.
The balance portion of interest, where funds were demonstrably used for business purposes, was rightly allowed.
(vii) Full Citation of the Judgements Relied on by the Court for Its Decision
While no specific case citations were discussed in the reported headnotes, the judgment upheld principles laid down in earlier decisions on Section 14A regarding the apportionment of interest expenditure where borrowed funds are partly used for investments generating exempt income.
(viii) Application of the Judgement: The judgment reiterates the principle that where the assessee admits to having used interest-bearing funds for making investments that yield exempt income, disallowance under Section 14A is mandatory to the extent of such usage. It also affirms the CIT(A)’s powers to proportionately allocate expenditure between business and non-business activities in a reasoned and evidence-based manner.
(ix) Why assessee lost the case on facts – Factual deficiencies: The assessee claimed nil disallowance under Section 14A despite substantial investments in shares generating exempt income. However, it failed to produce convincing evidence to establish that no expenditure was incurred in earning such income. The fund flow statements and financials did not demonstrate a clear nexus between own funds and investments. Also, there was no proof to rebut the AO's satisfaction regarding incorrectness of the claim. In the absence of documentation justifying the absence of any indirect expenditure, the AO applied Rule 8D and the Tribunal upheld it, finding that the assessee failed to discharge its initial factual burden.
(x) What was the error in law committed by assessee as per the provision: The assessee erred in relying solely on a self-declaration that no expenditure was incurred in relation to exempt income. Section 14A(1) read with sub-sections (2) and (3), as well as Rule 8D, impose a statutory obligation on the assessee to substantiate such claims with proper accounts. Once the AO is not satisfied with the assessee’s explanation, he is empowered to compute disallowance as per Rule 8D. The legal error was in assuming that the absence of exempt income or voluntary disallowance suffices, whereas the law mandates a computation method. This misapprehension led to unsustainable claims and consequent disallowance.
(xi) What will be the status of decision under current law: Under the current law, especially post the Finance Act, 2022 amendment, Explanation to Section 14A clarifies that disallowance applies even if exempt income has not accrued, arisen, or been received during the year. The legal position is now settled that if expenditure is incurred in relation to anticipated or existing investments likely to yield exempt income, disallowance under Section 14A is justified. The decision in Shri Rampriya Developers aligns with this statutory clarification. Thus, even under current law, the disallowance would remain valid, and any claim of nil expenditure without supporting documentation would continue to be rejected.
(4) Section 14A Applies to Dividend Income Despite DDT; Rule 8D Not Retrospective
Godrej & Boyce Manufacturing Co. Ltd. v. DCIT [2017] 81 taxmann.com 111 (SC)
(i) Issue Decided by the Court: Whether the provisions of Section 14A of the Income-tax Act, 1961, are applicable to dividend income where tax is already paid by the dividend-paying company under Section 115-O, and whether Rule 8D has retrospective application.
(ii) Facts of the Issue
The assessee earned dividend income from investments in shares of group companies.
The dividend income was exempt in the hands of the assessee, as the dividend-paying companies had paid Dividend Distribution Tax (DDT) under Section 115-O.
The Assessing Officer invoked Section 14A to disallow expenditure incurred in relation to such exempt income.
The core dispute arose over whether Section 14A applied to such dividend income and whether Rule 8D (introduced by notification dated 24-3-2008) applied retrospectively to assessment years prior to AY 2008–09.
(iii) Arguments of the Appellant (Assessee)
The dividend received was already subjected to DDT under Section 115-O and hence did not form part of the total income; therefore, Section 14A should not apply.
Rule 8D could not apply retrospectively and hence cannot be invoked for AY 2002–03.
The AO had made the disallowance without establishing a direct nexus between the expenditure and the exempt income.
(iv) Arguments of the Respondent (Revenue)
Exempt income under Section 10(33) (now Section 10(34)) includes dividend income, even if tax is paid by the company under Section 115-O.
Therefore, Section 14A, which applies to all expenditures incurred in relation to exempt income, must apply to such dividend income.
The AO was justified in making a reasonable estimate of expenditure relatable to exempt income.
(v) Decision of the Court
The Supreme Court held that Section 14A applies to dividend income, even when such income is exempt in the hands of the shareholder due to tax paid under Section 115-O by the company.
However, Rule 8D is prospective and applies only from assessment year 2008–09 onwards.
For earlier years, the AO must make a reasonable and satisfactory determination of the disallowance under Section 14A without invoking Rule 8D.
(vi) Reasoning Advanced by the Court for Its Decision
The Court clarified that even though DDT is paid by the company under Section 115-O, the dividend remains exempt in the hands of the recipient, and hence Section 14A squarely applies.
The intent of Section 14A is to prevent taxpayers from claiming deductions for expenses incurred to earn income which is not chargeable to tax.
Rule 8D merely provides a method of quantification, and since it was introduced prospectively, it cannot be applied to AY 2002–03.
The AO, in such cases, is expected to record satisfaction and make a reasonable disallowance without the aid of Rule 8D.
(vii) Full Citation of the Judgements Relied on by the Court for Its Decision
Commissioner of Income-tax v. Walfort Share and Stock Brokers (P.) Ltd. [2010] 326 ITR 1 (SC)
Maxopp Investment Ltd. v. CIT (later affirmed in [2018] 91 taxmann.com 154) was referred to in later jurisprudence aligning with the present ratio.
(viii) Application of the Judgement: This judgment settled the legal position that Section 14A applies even to dividend income subject to DDT under Section 115-O. It also clearly drew a line stating that Rule 8D has only prospective effect and cannot be invoked for years prior to AY 2008–09. It remains a foundational case for litigation involving disallowance of expenditure for exempt income.
(ix) Why assessee lost the case on facts; what were the deficiency: The assessee failed to justify its claim that no expenditure was incurred for earning exempt income. The Assessing Officer was not satisfied with this claim after analyzing the accounts, and thus proceeded to make a disallowance under section 14A. The Bombay High Court held, and the Supreme Court concurred, that the Assessing Officer was empowered to determine disallowance under section 14A(1) based on his dissatisfaction. The factual deficiency was the absence of substantiating records from the assessee showing zero expenditure. Consequently, disallowance under section 14A was held valid, though Rule 8D was not made applicable retrospectively for AY 2002–03.
(x) What was the error in law committed by assessee as per the provision: The legal error committed by the assessee was in contending that unless some exempt income is received, no disallowance under section 14A can be made. The Supreme Court rejected this view, holding that section 14A applies even when no actual exempt income is earned, provided there is an intention to earn such income and related expenditure has been incurred. The assessee also erred in arguing that Rule 8D, though introduced in 2008, should apply retrospectively. The Court clarified that Rule 8D is prospective (from AY 2008–09 onwards), but section 14A itself is applicable in earlier years based on reasonable estimation.
(ix) What will be the status of decision under current law:
Under the current law, especially after the Explanation inserted to section 14A by the Finance Act, 2022 (with retrospective effect), the position laid down in Godrej & Boyce has been fortified. The Explanation clarifies that disallowance under section 14A applies even if no exempt income has arisen during the year. Hence, the disallowance can still be made on notional or anticipated exempt income. Rule 8D remains prospective from AY 2008–09, but prior assessments can be subjected to reasonable disallowance under section 14A(1). Therefore, the core principles of Godrej & Boyce remain binding and consistent with present statutory interpretation.
(5) "Reopening Valid for Ignoring Section 14A Disallowance"
T.K. Salim v. Union of India [2024] 163 taxmann.com 385 (Kerala)
(i) Issue Decided by the Court: Whether reopening of assessments under Section 147 on the ground of incorrect allowance of interest expenditure—disallowed under Section 14A read with Rule 8D—is valid, and whether such reopening constitutes a "change of opinion" or a valid reassessment due to a prior omission to follow law and CBDT Circular No. 5/2014.
(ii) Facts of the Issue: The assessee had borrowed funds from Kotak Mahindra Bank, part of which was used to invest in another business concern. He claimed the interest paid on these borrowings as business expenditure. In the original assessments for AYs 2013–14 and 2014–15, the Assessing Officer did not disallow any part of this expenditure under Section 14A. Later, reassessment proceedings were initiated on the basis that the original assessment had erroneously allowed interest deduction which ought to have been disallowed under Section 14A and Rule 8D.
(iii) Arguments of the Appellant (Assessee)
The Assessing Officer had already considered all facts and legal provisions during the original assessment and had consciously not invoked Section 14A.
All material disclosures were made, and reopening was only a change of opinion, which is impermissible under Section 147.
Reliance was placed on judicial precedents such as CIT v. Usha International Ltd. and ACIT v. Marico Ltd. to argue that reassessment on mere change of opinion is invalid.
(iv) Arguments of the Defendants (Revenue)
The original assessments were completed without applying mandatory provisions of Section 14A or considering CBDT Circular No. 5/2014.
The assessee had claimed deduction for interest that was not allowable under Section 14A, as the funds were invested in an exempt-income-yielding venture.
The reopening was necessitated by an error in the original assessment and not a change of opinion.
The omission of Section 14A compliance constituted income escaping assessment.
(v) Decision of the Court: The Court upheld the validity of the reassessment, holding that the reopening was justified as the original assessment orders ignored mandatory statutory provisions. The reassessment was not based on a mere change of opinion.
(vi) Reasoning Advanced by the Court for its Decision
Section 14A is mandatory in nature, and any omission in applying it, despite applicable facts, renders the assessment defective.
Circular No. 5/2014 clarified that disallowance under Section 14A applies even if no exempt income is earned in that year.
Reassessment is valid if the original assessment was not in accordance with law, and such a situation constitutes "reason to believe" under Section 147.
The phrase "change of opinion" does not apply where there is a statutory error in original assessment.
(vii) Full Citation of the Judgements Relied on by the Court
CIT v. Usha International Ltd. [2012] 25 taxmann.com 200 (Delhi) (FB)
ACIT v. Marico Ltd. [2020] 117 taxmann.com 244 (SC)
Phool Chand Bajrang Lal v. ITO [1993] 203 ITR 456 (SC)
CIT v. Essar Teleholding Ltd. [2018] 90 taxmann.com 2 (SC)
(viii) Application of the Judgement: This judgment affirms that where mandatory provisions like Section 14A and Rule 8D are ignored in original assessments, reopening under Section 147 is valid even beyond four years if proper sanction is obtained. It reinforces the binding nature of CBDT circulars and that such non-application is not protected by the "change of opinion" doctrine.
(ix) Why assessee lost the case on facts, what were the deficiencies?
The assessee claimed interest deduction on loans used for investment in a newly formed company. However, the Assessing Officer found that such investment yielded exempt income and disallowed the related interest under section 14A. The factual deficiency lay in the assessee’s failure to demonstrate that the borrowed funds were used exclusively for business purposes and not for generating exempt income. Furthermore, the assessee did not disclose this fact fully and truly during the original assessment. This non-disclosure, along with the omission to apply section 14A and Rule 8D by the AO earlier, justified the reassessment.
(x) What was the error in law committed by assessee as per the provision?
The legal error by the assessee was in treating interest paid on borrowed funds as deductible under section 36(1)(iii) despite investing those funds in a business generating exempt income. As per section 14A(1), no deduction is allowed for expenditure incurred in relation to income not forming part of total income. Rule 8D mandates a specific method to quantify such disallowance. Ignoring CBDT Circular No. 5/2014 and failing to establish the nexus of funds with taxable income, the assessee violated section 14A’s mandate. Thus, deduction claimed was legally unsustainable under both statutory provisions and judicial interpretation.
(xi) What will be the status of the decision under current law?
Under the current law, as amended by the Finance Act, 2022, section 14A explicitly disallows expenditure even in years when no exempt income is earned, and applies retrospectively as clarified by the Explanation. With the non obstante clause overriding other provisions, the position is further strengthened. Therefore, the Kerala High Court’s decision remains valid and fully aligned with the prevailing legal framework. Reassessment based on failure to apply section 14A or follow CBDT Circulars would still be upheld, provided the procedural preconditions under sections 147 and 151 are satisfied. The assessee’s arguments of “change of opinion” would not succeed.
(6) “Section 14A Applies to Dividend on Stock-in-Trade with Retrospective Procedure”
(i) Issue Decided by the Court: Whether disallowance under Section 14A applies to expenses incurred in relation to exempt income, even if such income is incidental or indirect in nature, and whether such disallowance extends to shares held as stock-in-trade. Also, whether sub-sections (2) and (3) of Section 14A are retrospective and procedural.
(ii) Facts of the Issue: The assessee, a share broker and dealer, held shares as stock-in-trade. During the year, it earned dividend income which was exempt from tax. The assessee claimed that no expenditure was incurred to earn the exempt dividend income and hence disallowance under Section 14A was not warranted. The AO disagreed and made disallowance. The matter was referred to the Special Bench to resolve whether Section 14A applied to dividend income on shares held as stock-in-trade and whether indirect expenditure could be disallowed.
(iii) Arguments of the Appellant (Revenue)
Section 14A being a special provision overrides all other sections.
Expenditure need not be direct; even indirect expenses “in relation to” exempt income attract disallowance.
Rule 8D only provides the method of computation and applies retrospectively.
Shares held as stock-in-trade yielding dividend cannot escape Section 14A.
The phrase “in relation to” is broad and covers even incidental earning of exempt income.
(iv) Arguments of the Defendant (Assessee)
Dividend earned on shares held as stock-in-trade is incidental and not the objective of trading; hence, Section 14A is not applicable.
Only direct expenditure should be disallowed, not notional or indirect.
Rule 8D and sub-sections (2) and (3) of Section 14A were inserted later and should not be applied retrospectively.
The main intention was trading in shares and not earning exempt income.
(v) Decision of the Court
The Special Bench decided in favour of the Revenue. It held that:
Section 14A is applicable even to shares held as stock-in-trade.
Disallowance applies to both direct and indirect expenditure related to exempt income.
Sub-sections (2) and (3) of Section 14A are procedural and hence retrospective in operation.
Rule 8D applies from AY 2008–09 onward.
(vi) Reasoning Advanced by the Court for its Decision
Section 14A overrides general provisions and mandates disallowance of expenditure related to exempt income, irrespective of the head under which the expense falls.
The term “in relation to” covers both direct and indirect expenses, even if the exempt income is not the primary goal of the investment.
Shares held as stock-in-trade, though purchased for trading, if they yield dividend, attract Section 14A.
Judicial and legislative intent behind Section 14A is to prevent allowance of deductions for expenses linked to exempt income.
Sub-sections (2) and (3) are machinery provisions and apply to all assessments pending as on the date of their introduction.
(vii) Full Citation of Judgements Relied on by the Court
CIT v. Walfort Share & Stock Brokers (P.) Ltd. [2009] 310 ITR 421 (SC) (then available as Bombay HC decision)
CIT v. Hero Cycles Ltd. [2010] 323 ITR 518 (P&H)
Consolidated Photo and Finvest Ltd. v. ACIT [2006] 281 ITR 394 (Del)
Azadi Bachao Andolan v. UOI [2003] 263 ITR 706 (SC)
(viii) Application of the Judgement: This landmark Special Bench ruling forms the jurisprudential foundation for applying Section 14A widely—even where shares are held as stock-in-trade. It affirms the retrospective applicability of Section 14A’s procedural clauses and legitimizes disallowance of indirect expenses associated with incidental exempt income. It remains a precedent for disallowance under Section 14A in a broad range of business and investment scenarios.
(ix) Why the Assessee Lost the Case on Facts (Factual Deficiencies) : The assessee failed to demonstrate the actual expenditure incurred in relation to exempt income. Although the assessee claimed that no expenses were attributable to dividend income, it did not maintain segregated records or substantiate that claim with supporting evidence. There was no nexus analysis or documentation establishing that borrowed funds or indirect costs were not deployed for earning tax-free income. The Special Bench of the ITAT observed that the accounts lacked transparency to assess the correctness of the expenditure claim. Therefore, the Assessing Officer was justified in invoking Section 14A and applying Rule 8D to compute disallowance.
(x) What Was the Error in Law Committed by the Assessee: The principal legal error was the incorrect assumption that in the absence of actual exempt income or direct expense linkage, Section 14A would not apply. The assessee failed to appreciate that even indirect or common expenses—if they have a proximate nexus with exempt income—must be disallowed under Section 14A. Further, by not offering any disallowance voluntarily and by failing to prove correctness under Section 14A(2), the assessee violated the statutory burden of proof. The tribunal also clarified that Section 14A applies even if exempt income has not accrued during the year, as confirmed by the Explanation inserted by Finance Act, 2022 retrospectively.
(xi) Status of the Decision Under Current Law: Under the current legal framework post the Finance Act, 2022, the principle laid down in Daga Capital remains largely valid and has been codified more explicitly. The Explanation to Section 14A clarifies that disallowance applies even if no exempt income arises in the year, resolving earlier judicial conflicts. Rule 8D continues to guide the computation where the AO is not satisfied with the assessee’s claim. However, recent Supreme Court rulings (e.g., South Indian Bank, Maxopp Investment) emphasize that dominant purpose and nexus must still be established before disallowance. Thus, the decision is still binding in substance, though applied cautiously post-judicial refinement.
(7) Rule 8D Mandatory for Section 14A Disallowance Despite Strategic Investments
(i) Issue Decided by the Court: Whether the computation of disallowance under Section 14A by the Commissioner (Appeals) and affirmed by the Tribunal, deviating from the method prescribed in Rule 8D, is valid; and whether the Assessing Officer (AO) should recompute disallowance in accordance with Rule 8D and the Supreme Court’s ruling in Maxopp Investment Ltd. v. CIT.
(ii) Facts of the Issue: The assessee, engaged in real estate development, filed its return declaring a loss. The AO made a disallowance under Section 14A amounting to ₹4.05 crore, applying Rule 8D, and assessed the income accordingly. On appeal, the CIT(A) reduced the disallowance to 5% of fixed/semi-variable expenditure, citing the strategic nature of investments (in subsidiaries, associates, and partnership firms). The Tribunal upheld this view. Revenue challenged the validity of such computation not adhering to Rule 8D.
(iii) Arguments of the Appellant (Revenue)
Disallowance under Section 14A must be strictly computed as per Rule 8D once conditions for its invocation are satisfied.
The CIT(A)'s alternative method of calculating disallowance (i.e., 5% of fixed/semi-variable expenditure) was contrary to the binding judgment of the Supreme Court in Maxopp Investment Ltd. and, hence, untenable.
The Tribunal erred in approving this deviation without directing fresh computation as per law.
(iv) Arguments of the Respondent (Assessee): The assessee did not enter an appearance before the High Court despite service, and hence no arguments were recorded or considered.
(v) Decision of the Court: The Bombay High Court set aside the orders of the CIT(A) and the ITAT. It directed the Assessing Officer to recompute the disallowance under Section 14A strictly in accordance with the procedure laid down in Maxopp Investment Ltd. v. CIT and Rule 8D.
(vi) Reasoning Advanced by the Court for Its Decision
The Court held that once Section 14A is applicable, the expenditure attributable to exempt income must be disallowed using the statutory method under Rule 8D.
The deviation by the CIT(A) in adopting a percentage-based approximation (5% of fixed/semi-variable expenses) was not supported by law.
Following the Supreme Court's reasoning in Maxopp Investment Ltd., only that expenditure which has a causal link with earning exempt income should be disallowed, and this must be quantified using Rule 8D unless shown otherwise.
(vii) Full Citation of the Judgments Relied on by the Court for Its Decision
Maxopp Investment Ltd. v. CIT [2018] 91 taxmann.com 154 (SC) / 254 Taxman 325 / 402 ITR 640 – followed and applied by the Bombay High Court in its entirety.
(viii) Application of the Judgment: This judgment reiterates that Rule 8D provides the mandatory methodology for computing disallowance under Section 14A when the AO is not satisfied with the correctness of the assessee's claim. It bars arbitrary or discretionary computations by appellate authorities. Strategic investments are not excluded from the scope of Section 14A disallowance merely because of their business purpose.
(ix) Why the assessee lost the case on facts: The assessee claimed that its investments were "strategic" in nature—mostly in subsidiaries, associates, and partnership firms—and thus sought limited disallowance under Section 14A. However, it failed to demonstrate, with adequate evidence, that no expenditure was incurred in relation to earning exempt income. The Commissioner (Appeals) and the ITAT accepted a flat 5% disallowance without applying Rule 8D rigorously, despite the Assessing Officer’s satisfaction recorded under Section 14A(2) that the assessee’s claim was incorrect. This factual deficiency—failure to justify the nexus or absence of nexus between investments and exempt income—led to Revenue's success in appeal.
(x) What was the error in law committed by assessee: The primary legal error was the failure to comply with Rule 8D once the AO had recorded dissatisfaction under Section 14A(2). The CIT(A) applied an ad hoc percentage (5% of fixed/semi-variable costs) instead of mandatorily applying Rule 8D, as clarified by the Supreme Court in Maxopp Investment Ltd. v. CIT [(2018) 91 taxmann.com 154 (SC)]. The assessee's reliance on the "strategic investment" argument was insufficient to escape the operation of Rule 8D, which is a prescribed method under law once preconditions under Section 14A(2) are satisfied.
(xi) What will be the status of decision under current law: Under the current law, especially post the Supreme Court’s binding decision in Maxopp Investment Ltd. and subsequent High Court rulings, the entire expenditure attributable to earning exempt income must be disallowed once the AO rejects the assessee’s computation. Rule 8D remains applicable unless adequately rebutted. Strategic investments too fall within the ambit of Section 14A if they yield exempt income. Hence, under current law, the Bombay High Court's decision remains good law—disallowance must be made as per Rule 8D and not on an estimated or discretionary basis unless exceptional facts justify deviation.
(8) Failure to Prove Fund Source Attracts Section 14A Disallowance
(i) Issue Decided by the Court: Whether the disallowance of expenditure under Section 14A read with Rule 8D was justified where the assessee failed to furnish details of the source of funds utilized for making investments in shares yielding exempt dividend income.
(ii) Facts of the Issue: The assessee, a private limited company, had earned exempt dividend income of ₹10,22,953 during Assessment Year 2012–13 by investing in shares. In the course of scrutiny assessment, the assessee claimed that no expenditure was incurred to earn such income. However, it failed to provide any evidence or working to establish whether the investments were made out of interest-free own funds or borrowed funds. Consequently, the Assessing Officer applied Rule 8D and made a disallowance of ₹1,82,763 under Section 14A.
(iii) Arguments of the Appellant: The assessee argued before the CIT(A) and Tribunal that the disallowance under Section 14A was unwarranted, asserting that no specific expenditure had been incurred to earn the dividend income. It contended that the order of the AO invoking Rule 8D was incorrect and excessive, and the disallowance should be deleted.
(iv) Arguments of the Respondents (Revenue): The Department contended that the assessee had not submitted any bifurcation or details of the funds used for investment. In the absence of any evidence to show whether the investments were made out of own funds or borrowed funds, the AO was correct in invoking Rule 8D to compute the disallowance under Section 14A. The CIT(A) also sustained this view, citing failure of the assessee to rebut the application of Rule 8D with appropriate documents.
(v) Decision of the Court: The Tribunal upheld the disallowance of ₹1,82,763 made by the Assessing Officer under Section 14A read with Rule 8D and dismissed the assessee’s appeal. It found no infirmity in the orders of the lower authorities.
(vi) Reasoning Advanced by the Court for its Decision: The Tribunal observed that the assessee had failed to furnish any document or detail regarding the utilization of funds for investments in shares yielding exempt income. It held that in the absence of such evidence, both the Assessing Officer and the CIT(A) were justified in invoking Rule 8D to determine the disallowance under Section 14A. The assessee’s failure to establish that the investments were made out of non-interest-bearing own funds necessitated the disallowance.
(vii) Application of the Judgement: This judgment reiterates the principle that where an assessee fails to establish the source of funds used for earning exempt income, disallowance under Section 14A read with Rule 8D is mandatory. It also reinforces the requirement for the assessee to rebut the presumption of expenditure in relation to exempt income with sufficient evidentiary support, failing which Rule 8D shall apply in full force.
(viii) Why the assessee lost the case on facts – Deficiency in factual submissions: The assessee failed to provide documentary evidence demonstrating the source of funds used for investments generating exempt income. It did not substantiate whether the investments were made from own funds or borrowed capital. Despite being asked during assessment and appellate proceedings, the assessee did not furnish a fund-flow statement, bifurcation, or any other material to support its claim of non-incurrence of expenditure. This absence of factual substantiation led to the application of Rule 8D and a resultant disallowance under Section 14A. As no contrary evidence was produced even before the Tribunal, the factual deficiency proved fatal to the assessee’s claim.
(ix) Error in law committed by assessee – Section 14A and Rule 8D non-compliance: The assessee incorrectly presumed that a bare assertion of no expenditure incurred in earning exempt income would suffice. However, under Section 14A(2) read with Rule 8D, if the Assessing Officer is not satisfied with the correctness of such claim—based on the assessee's accounts—the AO is statutorily empowered to apply the prescribed formula for disallowance. The assessee failed to discharge its initial onus of proving the claim with supportive accounts or working. Thus, the disallowance made by applying Rule 8D became legally sustainable. The assessee erred in law by not appreciating the mandatory nature of Section 14A and the authority vested in the AO.
(x) Status of decision under current law – Post-2022 legal position: As per the Finance Act, 2022, a clarificatory explanation was inserted in Section 14A with retrospective effect from 1 April 2001. It provides that disallowance under Section 14A shall apply even where no exempt income has been earned during the year. The present case involved actual exempt income and undisputed investments, thereby making Section 14A clearly applicable. Further, judicial precedents (e.g., Maxopp Investment Ltd. [2018] SC) continue to uphold disallowance if the assessee fails to demonstrate proper fund usage. Thus, even under the current legal regime, the Tribunal’s decision remains good law and would still result in disallowance in similar factual circumstances.
(9) Burden to Prove Source of Funds Lies on Assessee in 14A Disputes
(i) Issue Decided by the Court: Whether disallowance under Section 14A read with Rule 8D is sustainable when the assessee fails to demonstrate that no part of borrowed funds were used to earn exempt income, especially when such investments result in tax-free dividend income.
(ii) Facts of the Issue: The assessee had made substantial investments in shares and earned significant tax-free dividend income. The Assessing Officer invoked Section 14A and applied Rule 8D, disallowing a portion of the interest expenditure. The CIT(A) had restricted the disallowance, but the Tribunal reversed the relief and upheld the full disallowance due to lack of evidence by the assessee showing source of investment as own funds.
(iii) Arguments of the Appellant (Assessee): The assessee argued that it had sufficient own funds and reserves to cover the investments in shares and that there was no nexus between the interest-bearing borrowings and the exempt income. Therefore, disallowance under Section 14A was not warranted.
(iv) Arguments of the Respondent (Revenue): The Revenue contended that the assessee had failed to furnish conclusive evidence, such as fund flow statements or bank records, to show that own funds were actually used for the investments. In the absence of such proof, the AO was justified in invoking Rule 8D and disallowing proportionate interest.
(v) Decision of the Court: The High Court upheld the Tribunal’s findings and ruled in favour of the Revenue. It sustained the disallowance made under Section 14A and held that the burden of proof lay on the assessee to substantiate the source of investment.
(vi) Reasoning Advanced by the Court for Its Decision: The Court emphasized that Section 14A is a substantive provision and Rule 8D is a mandatory computational mechanism. The absence of documentary evidence linking own funds to investment justifies the disallowance. It rejected the assessee’s claim of sufficiency of own funds as a mere theoretical presumption without factual foundation. The High Court also noted that the AO's satisfaction regarding incorrectness of the assessee’s claim was duly recorded.
(vii) Full Citation of the Judgements Relied on by the Court for Its Decision
Maxopp Investment Ltd. v. CIT [2018] 402 ITR 640 (SC)
CIT v. Walfort Share & Stock Brokers (P.) Ltd. [2010] 326 ITR 1 (SC)
South Indian Bank Ltd. v. CIT [2021] 438 ITR 1 (SC)
(viii) Application of the Judgement: This ruling reiterates that to avoid disallowance under Section 14A, especially under Rule 8D(2)(ii), the assessee must provide cogent documentary evidence demonstrating that no borrowed funds were diverted towards tax-free investments. It applies strongly in cases involving composite or mixed funds.
(ix) Why assessee lost the case on facts; what were the deficiencies: The assessee claimed to have made a disallowance of ₹2.25 crores under section 14A against ₹3.70 crores of exempt dividend income. However, the Assessing Officer was not satisfied with the correctness of this claim, especially since the assessee had made significant investments (₹186 crores) without maintaining separate accounts or establishing that investments were made from interest-free funds. The AO accordingly applied Rule 8D. The Tribunal upheld the AO’s findings, and the High Court held there was no perversity in this factual appreciation. The deficiency lay in the absence of justification for quantum and basis of the suo motu disallowance.
(x) What was the error in law committed by assessee as per the provision: The assessee argued that no disallowance could be made under section 14A when no exempt income had accrued or arisen during the year. This was based on earlier judicial precedents that read a limitation into section 14A. However, the Finance Act, 2022 inserted a retrospective Explanation clarifying that section 14A applies even where exempt income has not been earned in the relevant year. The High Court upheld the retrospective applicability of this amendment. Thus, the legal error committed by the assessee was relying on overruled precedents and ignoring the retrospective clarification legislatively inserted to section 14A by the Finance Act, 2022.
(xi) What will be the status of decision under current law: Under current law, following the retrospective Explanation inserted by the Finance Act, 2022, the position is settled that disallowance under section 14A can be made even in the absence of exempt income in a particular year. This has nullified earlier rulings such as those in Cheminvest Ltd. and PCIT v. IL&FS Energy. The Gauhati High Court judgment affirms the constitutional validity of this Explanation and endorses its retrospective effect. Therefore, the decision upholding the disallowance under section 14A read with Rule 8D—even in the absence of received or accrued exempt income—is fully aligned with the prevailing legal position.