Disallowances of Expenses on Exempt Income

Disallowances of Expenses on Exempt Income

(Intricacies of Section 14 A of the Income Tax Act)

In this blog, we shall learn about Disallowances of Expenses on Exempt Income. In most of the cases, a taxpayer has some exempt income or other and it is a common practice that the assessing officers will attribute normal business expenditure to such exempt income. Let us study about this section in detail.

Section 14A of the Income Tax Act, 1961

• Section 14A was brought by Finance Act, 2001 with retrospective effect from 1^st, April 1962. This section provides that when an assessee earns income which is exempt from the payment of tax as specified under section 10 of the Income Tax Act, 1961, the corresponding expenses related to earn such exempt income, if claimed, will be disallowed under this section.
• Section 10 lists out income which do not form part of total income like agricultural income, dividend income, partner’s share in firm’s income, long term capital gain from transfer of equity shares (STT paid) or units of an equity oriented fund etc. Expenditure incurred for earning these incomes shall not be allowed a deduction as they have been incurred in respect of income which is not taxable & which does not form part of total income.
• For example, an individual takes a loan of Rs.10 lakhs @ 12% p.a. and the funds are invested in buying the shares. During the year, the individual may or may not have earned any dividend income. In case while filing tax return, the individual charges off the interest paid as expenses against the other incomes earned by him, the interest of Rs.1.2 lakhs paid by the assessee shall be disallowed as it has been incurred for earning dividend income which is exempt u/s 10.

Objective of the section

• The objective of the section is to prevent tax payers from setting off expenses incurred to earn exempt income against taxable income.
• This means that in the first place, the taxpayer must have exempt income & must have actually incurred expenses to earn such income. The next step then would be to identify such expenses & ensure that the same are not claimed by the taxpayer as a deduction against any other income.
• The intention of this legislation was to disallow only direct expenses incurred for earning exempt income. In almost all cases, even indirect expenses are also being disallowed on proportionate basis. In order to ensure uniform approach, Section 14A was amended by the Finance Act, 2006, w.e.f. 1-4-2007 (A.Y. 2007-08). By this amendment Sub-section (2) and Sub-section (3) were added in Section 14A to provide that Income Tax Officer shall determine the amount of expenditure incurred in relation to the exempt income in accordance with such method as may be prescribed by Rules. In view of the same, Rule 8 D was introduced.

Method of calculation of dis-allowance

• The Assessing officer shall determine the amount of expenditure which has been incurred in relation to exempt income which shall be the sum of the following:
  • The expenditure directly relating to exempt income
  • Where the assessee has incurred expenditure which is not directly attributable to any particular income, proportionate amount shall be taken as per the formula devised under Rule 8 D and file the tax return accordingly

Conclusion

• Only that expenditure which relates to taxable income should be deducted in computing the total income.
• Expenditure relating to exempt income should not be considered in computation of total income as otherwise this would result in double advantage to the assessee.
• For example, when agricultural income itself is exempt from taxation, there is no justification to consider expenditure on agricultural activities in the computation of total income.
• The section applies only in those cases where the tax payer is filing tax return and claiming certain expenses whether directly or indirectly related to earning of exempt income against the exempt income. In case expenses are not claimed like in the case of Salaried employee, there is no incidence of section 14 A of the Income Tax Act.

In view of the above, any tax payer while filing the tax return needs to ensure that he is not claiming any expense against any exempt income so as to avoid inconvenience in the hands of the tax department.