Under the provisions of the Income-tax Act, 1961, certain incomes such as dividend from domestic companies, interest from specified bonds, etc., are not includible while computing the total income, as they are exempt.

As per Section 14A, any expenditure incurred by the taxpayer in relation to earning tax-free income is not allowed as a deduction.

As only net income is exempt from tax, identification of expenses incurred in relation to earning such tax-free income has always posed a challenge. Present-day business is quite complex and it often becomes difficult to maintain a separate identity between the various sources of income and the expenses incurred thereto.

In the absence of any direct nexus and any prescribed method to identify the expenses incurred by the taxpayer in relation to earning tax-free income, the tax authorities generally tend to disallow certain amount of expenditure on notional or ad hoc basis based on some percentage of the tax-free income.

In some cases, the tax authorities adopt a proportionate method to quantify such expenses. Further, in some cases, the tax authorities even go further and attribute certain indirect expenses as well.

Raising disputes

This section has raised considerable disputes between the taxpayer and the tax authorities and there have been several judicial pronouncements on this issue.

To overcome such disputes, the Finance Act, 2006 w.e.f. assessment year 2007-08 inserted sub-sections (2) and (3) in Section 14A, whereby the assessing officers (AOs) are now required to determine the expenditure relating to tax-free income only as per the prescribed method.

However, such prescribed method can be used by the AO only if he is not satisfied with the correctness of claim of expenditure made by the taxpayer or the taxpayer claims that no expenditure has been incurred in relation to tax-free income.

The Central Board of Direct Taxes (CBDT), vide its Circular of 14/2006 dated December 28, 2006, also emphasised the importance of new sub-sections (2) and (3) and stated that as no method of computing the expenditure incurred in relation to earning tax-free income was provided for, there was considerable dispute between the taxpayers and the tax authorities on the method of determining such expenditure and, consequently, the above new sub-sections have been inserted in Section 14A.

The method now to be adopted by the AO for determining the expenditure relating to tax-free income has been recently notified and a new rule 8D has been inserted.

As per the rule, the expenditure relating to tax-free income has to be determined as aggregate of:

(i) expenditure directly relating to tax-free income;

(ii) interest expenditure (which is not directly attributable to any particular income), to be computed as follows:

Interest expenditure x Average value of investment (income from which does not or shall not form part of the total income) / Average value of total assets

(iii) 0.5 per cent of the average value of investments (income from which does not or shall not form part of the total income)

The question that needs to be asked is whether the formula prescribed will help in reducing the litigation as was the intention behind introducing it, or does it still leave room for disputes.

Even before going into the nuances of the formula, the very first issue that needs to be dealt with is the year to which the above formula prescribed would apply. As discussed, the new sub-sections (2) and (3) of Section 14A empowering the AOs to compute the expenditure as per the prescribed formula were inserted from April 1, 2007, that is, assessment year 2007-08.

However, rule 8D prescribing the formula was notified only on March 24, 2008, and the notification states that it comes into force from the date of its publication in the Official Gazette which is March 24, 2008.

Therefore, can one say that the prescribed formula in rule 8D is applicable only from assessment year 2008-09 since there was no formula prescribed by the legislature for assessment year 2007-08?

Perhaps, a better view would be that since the formula that has been prescribed is only procedural in nature, the said formula should apply to assessment year (AY) 2007-08 as well.

Can this logic further be stretched to say that the above formula should be applied even for AYs prior to 2007-08?

There have been a few decisions of the Mumbai Tribunal on this issue which have held that the amendment is retrospective in nature and would, therefore, apply to all pending assessments even prior to AY 2007-08.

The Mumbai Tribunal in the ACIT vs Citicorp Finance (India) Ltd [(300 ITR 398 (AT)] case held that the provisions for quantification of disallowance as contained in sub-sections (2) and (3) of Section 14A are procedural and, therefore, apply to all pending matters. The above decision has been followed in other decisions as well.

However, the Delhi Tribunal in the Vidyut Investment Ltd vs ITO (10 SOT 284) case has taken an opposite view and has held that sub-sections (2) and (3) are to take effect from AY 2007-08 onwards and they did not find any implication to hold the same to be retrospective in nature.

Thus there is a difference of opinion on this issue.

Thus even before the amended provisions make any headway, litigations may have to be faced.

Concerns over formula

As regards the formula is concerned, again there are a few concerns.

First, the very first limb of the formula, that is, determination of expenditure directly relating to tax-free income could result in difference of opinion between the taxpayer and the AO. As mentioned earlier, prior to the method being notified, the determination of expenditure directly relating to tax-free income always used to be a bone of contention between the taxpayer and the tax authorities. By retaining the same in the formula, the dispute has been carried forward rather than resolved.

Second, by virtue of the second limb of the formula, interest expenditure has to be pro-rated on the basis of average value of investment. Similarly, by virtue of third limb of the formula, 0.5 per cent of the average value of investments is to be considered.

Whether the value of entire investments is to be considered, irrespective of whether the tax-free income has been received during the year or only those investments which have generated tax-free income is to be considered?

This may lead to a chaotic situation where, regardless of the tax-free income earned during a particular year, the expenditure will be determined artificially by applying the above formula, which may be higher than the tax-free income earned during a particular year.

This may also lead to a piquant situation where though the actual expenditure incurred may be minimal, the expenditure determined artificially by applying the above formula may be significantly higher.

Again reference in the formula is made only to investments and not stock-in-trade and, therefore, one needs to consider whether the investments held as stock-in-trade would need to be excluded or not.

To sum up, though amending Section 14A may be well-intentioned, that is, of reducing the litigation amongst the taxpayers and tax authorities, perhaps only time will tell whether it has indeed achieved its purpose.