A Guide on Section 14A And Rule 8D Of Income Tax Act
According to Indian tax laws, some income is exempt from taxes, including income from cultivation, partnership firm shares, income from competent nonprofit groups, and tax-free interest. To generate such income, taxpayers may have to pay for particular expenses. An example is the interest paid on a loan used to finance the acquisition of tax-free bonds. Taxpayers and income tax authorities have been contemplating whether or not expenditure incurred on excluded income should be allowed. For noticeable reasons, taxpayers have consistently argued that these expenses should be deductible when evaluating taxable income. The income tax department genuinely believed the income was exempt from taxes. Section 14A was enacted in 2001 with retroactive effect from April 1962 in order to make clear the legislature's intent regarding the costs related to generating exempt income. In this guide, we will give an overview of this section.
Table of Content
What is Section 14A of the Income Tax Act?
According to Section 14A, a taxpayer's costs related to income not included in their total income as outlined by the Act's provisions should not be accepted as a deduction when analysing their total income. Section 14A aims to stop taxpayers from deducting taxes from purchases to obtain tax-exempt income. For example, Section 14A restricts the deduction of management fees from taxable income if a taxpayer invests in tax-free bonds and incurs such costs. This declaration ensures that taxpayers don't receive a tax break on income that isn't subject to taxes. The implications of Section 14A are extensive for taxpayers, especially those who obtain exempt income. Tax officials can inflict penalties and interest charges on a taxpayer who breaches Section 14A. The disallowance of expenses under Section 14A may increase taxpayers' liabilities. Therefore, to avoid fines and further tax obligations, taxpayers must recognise and comply with the provisions of this section.
Applicability of Section 14A
When a person fulfils the conditions listed below, this section is applicable:
Section 14A is relevant if the assessee has invested money in generating revenue not incorporated into their overall earnings.
If the assessee asserts that expenses were incurred and the assessing officer disputes the allegation due to the taxpayer's financial statements, Section 14A is applicable.
An assessee who asserts that no expenses were generated is subject to Section 14A.
Requirements of Section 14A
The following subsections appear in section 14A:
Section 14A(1) of the Income Tax
Subsection 1 of section 14A applies if the assessee has spent money to get tax-free income.
Subsection 2 comes into play when the assessee claims the amount incurred for exempt income.
In subsection 3, the assessee states that no costs occurred.
Section 14A(2) of the Tax Code
Income Tax Section 14A(2) Subsection 2 states that if an assessee asserts that expenses spent on exempt income, the Assessing Officer must confirm the accuracy of the claim concerning the assessee's books of accounts. Following verification, the Assessing Officer requires details of the spending in the books of accounts; if satisfied, the Assessing Officer declines the expenses by section 14A. If the Assessing Officer struggles with the assessee's claim, the taxpayer should report disapproval and use rule 8D to determine the disallowance amount.
Section 14A(3) Income Tax Act
Income Tax Section 14A(3) Subsection 3 declares if a creditor asserts that the taxpayer has not spent any money on tax-free income, the Assessing Officer may implement Rule 8D to identify the expenses prohibited by Section 14A. The Assessing Officer is exempt from reporting any discontent in this situation.
Rule 8D: Determining Expenditure Incurred Towards Exempt Income
According to the recent income tax regulations (as amended in June 2016), the total of the following expenses spent in connection with generating exempt income:
Any expenditure that has a direct relation to exempt income and
A sum equivalent to 1% of the monthly average of the first and last balances of the investment value, whose income does not or won't get included in all earnings.
However, no disallowance calculated under this rule may be more than the taxpayer's total claimed cost. Let's look at a Rule 8D computation example. On January 5, 2023, Mr. A took out a Rs. 15 lakh loan at a 10% interest rate for FY 2023–2024. Consequently, he will pay Rs. 1,50,000 in interest on this debt this year. This loan had invested Rs. 15 lakh in several different ventures; the revenue from this investment is tax-exempt. This investment's monthly closing balances are Rs 10,00,000 in January 2023, Rs 12,50,000 in February 2023, and Rs 15,00,000 in March 2023.
Disallowance of Rule 8D
The only expenses that can be disallowed are those that can be demonstrated to have been related to the exempt income. The tax officer cannot deny expenses that are presumed to have been incurred in order to acquire such exempt income under the provisions of this section. Additionally, it is not possible to arbitrarily allocate expenses that were incurred jointly for both exempt and taxable revenue on the grounds that some of these expenses would have been incurred for the objective of earning exempt income. Additionally, the tax officer must explicitly point out the error in the taxpayer's calculation before applying Rule 8D. Rule 8D cannot be used arbitrarily by the tax officer without pointing out the error in the allocation or apportionment of expenses. It is the tax officer's duty to demonstrate that the assessee has spent money in order to obtain tax-free income.
Notable Points
The disallowance under Section 14A applies solely to expenses previously claimed as deductions. There can be no issue of any disallowance if the taxpayer has not claimed any deductions at all.
The condition for Rule 8D's applicability should be fulfilled, and the AO must address why he is dissatisfied with the taxpayer's computation and demonstrate that it is inaccurate in light of the natural justice principle, numerous case laws, and the SC's ruling.
Only exempt income-related investments, not the full investment, shall be considered for the average purposes of Rule 8D.
Conclusion
Taxpayers are required to abide by Section 14A of the Income Tax Act of 1961. Penalties and additional tax obligations may follow noncompliance with this section's requirements. Maintaining correct books of accounts, calculating the amount of exempt income received, calculating the disallowance of expenses made in order to obtain exempt income, and disclosing the disallowance in tax returns are all requirements for taxpayers. To avoid penalties or increased tax obligations, taxpayers can make sure they are adhering to the terms of Section 14A.
FAQ
Q1. What is Section 14A of the Income Tax Act?
Section 14A deals with the refusal of expenditures that taxpayers incur to earn tax-exempt income.
Q2. What is the objective of Section 14A?
Section 14A's goal is to stop taxpayers from deducting business expenses from their tax-exempt income.
Q3. Which expenses are disallowed under Section 14A?
Section 14A prohibits costs that arise from the pursuit of exempt income.
Q4. What is exempt income?
A tax-free income is known as exempt income. Profits from Indian firms, long-term capital gains on equity shares, and interest from tax-free bonds are some examples of exempt income.
Q5. How is the disallowance of expenses under Section 14A computed?
The ratio of exempt income to total income determines the disallowance of expenses. The disallowance is calculated using the following formula: Expense incurred to generate exempt income multiplied by exempt income divided by total income.
Q6. Do taxpayers need to keep separate books of accounts for exempt income?
A separate book of accounts for exempt income is not necessary for taxpayers. They are bound to maintain thorough and accurate books of account that accurately reflect the costs incurred in generating taxable and exempt income.
Q7. Is there a penalty for non-compliance with Section 14A?
Non-compliance with Section 14A does carry a penalty. The tax authorities may impose fines and interest charges on a taxpayer who offends the terms of this section.
Q8. How do taxpayers disclose the disallowance of expenses as per Section 14A in their tax returns?
In their tax returns, taxpayers must assert that expenses incurred in the exempt income are disallowable. You can include this information in the relevant section of the tax return form.
Q9. Can disallowance be claimed in the absence of exempt income in any FY?
Many high court decisions have settled the countless legal disputes surrounding this matter, asserting that disallowance under Section 14A cannot be imposed in the absence of exempt income.
Q10. Is there a way to ascertain expenses associated with exempt income?
Indeed, Section 14A lays out a procedure for the income tax officer to calculate the expenses incurred to obtain exempt income under Rule 8D. Nevertheless, the approach outlined in Rule 8D is only appropriate in one of the following situations:
The assessing officer is suspicious that the taxpayer's claim is accurate in light of the taxpayer's accounts.
When the taxpayer asserts that no expenses were incurred to earn exempt income, and the assessing officer disallows the amount for costs related to earning exempt income, the assessing officer is not satisfied that the taxpayer's claim is accurate in light of the taxpayer's accounts.
Q11. Is disallowance attracted on dividend income from Indian companies as the dividend income is actually not exempt but tax is collected from companies themselves in the form of Dividend Distribution Tax (DDT)?
This issue has been discussed in many courts and tribunals, but it has now been resolved by the Supreme Court's ruling in the May 2017 case of Godrej & Boyce Manufacturing Company Limited, which held that disallowance is imposed even when businesses pay DDT.
Since dividend income is taxable, this is irrelevant for the current fiscal year.
Q12. What is the Supreme Court’s decision on 14A disallowance?
The Supreme Court has thus supported the idea that disallowance must be limited to the amount of exempt income.
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