S. 14A & Rule 8D cannot be applied in a mechanical manner. Disallowance cannot exceed expenditure claimed as a deduction

In AY 2009-10, the assessee was assessed to income of Rs. 12.62 crore. The assessee had investments of Rs. 32.71 crore. The investment transactions were managed by investment advisers and the assessee paid portfolio management services (PMS) fees which were debited to his capital account. The demat expenses and security transaction tax (STT) was also debited to the capital account. The assessee claimed that the expenses relating to salary, telephone and other administrative expenses were incurred by him for his professional income and not for earning tax-free income. However, the AO rejected the claim and made a disallowance of Rs. 16.35 lakhs, being 0.5% of the average investments under Rule 8D(2)(iii). The CIT(A) deleted the disallowance on the ground that it was without establishing any nexus. On appeal by the department to the Tribunal HELD dismissing the appeal:

The assessee had debited direct expenses on account of dematerialization and STT in the capital account and not in the Profit and loss account. The AO had presumed that the assessee had must have incurred some expenditure under the heads salary, telephone and other administrative charges for earning the exempt income. It is further found that the total expenditure claimed by the assessee for the year is about 13 lakhs and the AO had made a disallowance of about Rs.16 lakhs. He has just adopted the formula of estimating expenditure on the basis of investments. But, the justification for calculating the disallowance is missing. The assessee had not claimed any expenditure in its P&L account and so the onus was on the AO to prove that out of the expenditure incurred under various heads were related to earning of exempt income. Not only this he had to give the basis of such calculation. In any manner disallowance of Rs.16.35 lakhs as against the total expenditure of Rs.13 lakhs claimed by the assessee in P&L account is not justified. Rule 8D cannot and should not be applied in a mechanical way. Facts of the case have to be analyzed before invoking them. Consequently the disallowance is deleted (Justice Sam P. Bharucha 53 SOT 192 (Mum) referred).