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1. Background :

1.1 S. 14A has been inserted in Chapter IV of the Income tax Act by the Finance Act,2001, with retrospectie e!ect from 1"4"1#$2. %his Section proides fordisa&&owance of expendit're inc'rred in re&ation to income which is not inc&'ded inthe tota& income of the assessee (i.e.exempt income). %he operatie part of this

Section reads as 'nder *+For the p'rposes of comp'tin the tota& income 'nder this chapter, no ded'ctionsha&& be a&&owed in respect of expendit're inc'rred by the assessee in re&ation toincome which does not form part of the tota& income 'nder this Act.+

1.2 -roiso to the Section was added by the Finance Act, 2002 w.e.f. 11""2001. Itproides that the A./. cannot reopen the assessment 's.14 for any assessmentyear prior to A.. 2001"02 for this p'rpose or pass any recti3cation order 's.14 forprior years to disa&&ow any s'ch expendit're.

1. In the case of CIT v. Indian Bank Ltd.,($ I%5 ), S'preme Co'rt had decided in1#$4 that the condition for ded'ctibi&ity of an expendit're does not depend 'pon its6'a&ity of direct&y or indirect&y prod'cin taxab&e income and, therefore, there was

no warrant for disa&&owin a proportionate part of the interest referab&e to moneysborrowed for the p'rchase of tax free sec'rities. %his princip&e was reiterated in thecase of CIT v. Maharashtra Sugar Mills Ltd.,(72 I%5 42). In this case it was he&d thatno part of manain aency commission can be disa&&owed on the ro'nd that itpart&y re&ates to manain s'arcane c'&tiation, the income from which wasexempt from tax. Aain, in the case of Rajasthan State Warehousing Corporation v.CIT,(242 I%5 40) the aboe princip&e was once aain reiterated by the S'premeCo'rt. In this case, it was he&d that if b'siness is one and indiisib&e, theexpendit're cannot be apportioned and disa&&owed to the extent it may re&ate toincome which is exempt from income tax.

1.4 It may be noted that the exp&anatory memorand'm iss'ed with the Finance 8i&&,

2001, ies the p'rpose for which the amendment is made. %his reads as 'nder *+Certain incomes are not inc&'dib&e whi&e comp'tin the tota& income as these areexempt 'nder ario's proisions of the Act. %here hae been cases whereded'ctions hae been c&aimed in respect of s'ch exempt income. %his in e!ectmeans that the tax incentie ien by way of exemptions to certain cateories ofincome is bein 'sed to red'ce a&so the tax payab&e on the non"exempt income bydebitin the expenses inc'rred to earn the exempt income aainst taxab&e income.

%his is aainst the basic princip&es of taxation whereby on&y the netincome, i.e.,ross income min's the expendit're, is taxed. /n the ana&oy, theexemption is a&so in respect of the net income. 9xpenses inc'rred can be a&&owedon&y to the extent they are re&atab&e to the earnin of taxab&e income.

It is proposed to insert a new S. 14A so as to c&arify the intention of the &eis&at'resince the inception of the Income"tax Act, 1#$1, that no ded'ction sha&& be made inrespect of any expendit're inc'rred by the assessee in re&ation to income whichdoes not form part of the tota& income 'nder the Income"tax Act.+

1. From the aboe, it appears that on&y direct expenses inc'rred for earnin theincome which is exempt wi&& be coered by S. 14A. 9en in the decisions of theS'preme Co'rt referred to aboe there is nothin to infer that direct expensesinc'rred for earnin exempt income is a&&owab&e. %herefore, een in the absence of

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a proision contained in the new S. 14A &aw was we&& sett&ed. %here is nothin in thisSection to s'est that indirect expenses wi&& be disa&&owed.

1.$ In act'a& imp&ementation of this proision, the Income"tax :epartment has beenta;in the iew that a&& items of income (inc&'din diidend on shares and 'nits ofectiewith which S. 14A was enacted.

2.2 8road&y stated, the new 5'&e 7: proides as 'nder *

(i) %he method prescribed in the 5'&e is to be app&ied on&y if the A/ is not satis3edwith *

(a) %he correctness of the c&aim of expendit're inc'rred for earnin the exempt

income made by the assessee or

(b) %he c&aim made by the assessee that no expendit're has been inc'rred forearnin exempt income.

(ii) %he method prescribed in the 5'&e states that the expendit're in re&ation toincome which does not form part of the tota& income sha&& be the aggregate of thefollowing amounts*

(a) %he amo'nt of expendit're direct&y re&atin to income which does not form partof tota& income.

(b) In the case of interest on borrowed f'nds which is not direct&y attrib'tab&e to anypartic'&ar income or receipt, the amo'nt comp'ted in accordance with this fo&&owin

form'&a *

Ax

8

C

A ? Amo'nt of interest, other than the amo'nt of interest which is direct&yattrib'tab&e to the exempt income stated in (a) aboe.

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8 ? %he aerae of a&'e of inestment, income from which does not or shall notform partof the tota& income, as appearin in the ba&ance sheet of the assessee,on the 3rst day and the &ast day of the re&eant acco'ntin year.

C ? %he aerae of tota& assets as appearin in the ba&ance sheet of the assessee,on the 3rst day and the &ast day of the re&eant acco'ntin year. %he term @%ota&

Assets means tota& assets as appearin in the ba&ance sheet exc&'din the increaseon acco'nt of rea&'ation of assets b't inc&'din the decrease on acco'nt ofrea&'ation of assets.

(c) An amo'nt e6'a& to B of the aerae of the a&'e of inestment, income fromwhich does notor shall notform part of the tota& income, as appearin in theba&ance sheet of the assessee, on the 3rst day and the &ast day of the re&eantacco'ntin year.

2. From the aboe 5'&e, it wi&& be noticed that C8:% has, instead of prescribin asimp&e method, prescribed a comp&icated form'&a. 8y app&yin this form'&a, in mostcases, expendit're which has no connection with earnin the exempt income wi&&et disa&&owed. Some of the iss'es re&atin to this =ew 5'&e re6'ire consideration *

(i) As stated in para 2.2(ii)(b) aboe, interest which is direct&y attrib'ted to borrowedf'nds 'sed for the p'rpose of earnin taxab&e income or receipts wi&& not beconsidered for disa&&owance of proportionate interest 's.14 A. %herefore, interest onterm &oan ta;en for p'rchase of -&ant D

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intanib&e asset, appearin in the 8a&ance sheet of the assessee wi&& be exc&'dedfrom %ota& Assets.

(i) Simi&ar&y, c'rrent &iabi&ities which are to be ded'cted from c'rrent assets in thecase of the company can be added whi&e wor;in o't the amo'nt of %ota& Assets.

(ii) %he form'&a ien in para 2.2.(ii)(c) aboe, states that amo'nt e6'a& to B of

the aerae a&'e of inestments, income from which is exempt from tax, sho'&da&so be disa&&owed 's.14A. %his proision is not at a&& e6'itab&e. S'ch disa&&owanceis to be made with reference to aerae a&'e of s'ch inestments from whichexempt income is receied or not. %his disa&&owance has no re&ation to either theexempt income or to the expendit're c&aimed by the assessee. In many cases theamo'nt wor;ed o't may exceed the exempt income or may exceed een the tota&expendit're (for taxab&e as we&& as exempt income) inc'rred by the assessee. If weta;e the i&&'stration of a c&ose&y he&d Inestment company it is common ;now&edethat the administratie expenses are nomina& as compared to the a&'e of theinestments. In s'ch cases, the amo'nt to be disa&&owed 'nder the form'&a wi&& farexceed the tota& expenses. It is s'ested that a ery stron representation sho'&dbe made for de&etion of this part of the =ew 5'&e. In any eent, it sho'&d be

represented that the tota& disa&&owance 'nder the form'&a sho'&d not exceed ofthe income for which exemption is c&aimed.

(iii) %he a&idity of the =ew 5'&e 7: can be cha&&ened on the ro'nd that S. 14Aa'thorises C8:% to prescribe the method for determination of expendit're inc'rredin re&ation earnin the exempt income, b't the method prescribed by this 5'&e on&ydetermines the notiona& cost for ho&din inestments which may or may not yie&d anexempt income. S'ch notiona& cost for ho&din the inestment has no re&ationshipwith the act'a& expendit're inc'rred and c&aimed by the assessee. %herefore, the=ew 5'&e oes beyond the a'thority ien to C8:% by S. 14A.

2.4 As stated ear&ier, the aboe amendment iin power to C8:% to prescribe themethod for determination of expendit're to be disa&&owed 's.14A was made by the

Finance Act, 200$ w.e.f. A.. 200"07. %herefore, the aboe method, as nowprescribed by =ew 5'&e 7:, sho'&d app&y to comp'tation of income for A.. 200"07and onwards. oweer, there are certain >'dicia& prono'ncements which s'estthat amendment made in S. 14A(2) and () made by Finance Act, 200$, is aproced'ra& proision and, therefore, the method for comp'tation of disa&&owab&eexpendit're, wheneer prescribed, wi&& be app&icab&e to a&& pendin assessments forear&ier years a&so. 5eference in this connection may be made to the fo&&owindecisions *

(i)ACIT v. Citicorp inance !India" Ltd.,107 I%: 4 (

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Contrary iew has been ta;en in the case of -id(ut Invest*ents Ltd. v. IT$,10 S/%274 (:e&hi) where it is he&d that S. 14A(2) and () wi&& on&y app&y w.e.f. A.. 200"07and onwards.

. What is Exempt Income u/s!"# :

.1 As stated ear&ier, the ob>ectie behind enactment of S. 14A was to disa&&ow

expendit're inc'rred in re&ation to any income which is comp&ete&y exempt fromtax e.g.Aric'&t'ra& Income. Interest on %ax Free 8onds etc. oweer, in iew of thewordin of the said Section +expendit're inc'rred by the assessee in re&ation toincome which does not form part of the tota& income 'nder this Act+, co'rts and I%A

%rib'na& hae ien ery wide meanin to the scope of disa&&owance 's.14A.%herefore, income &isted in S. 10, S. 10A, S. 10AA, S. 108, S. 108A, S. 10C as we&& asChapter VIA where 100 exemption is aai&ab&e wi&& et coered 's. 14A fordisa&&owance of direct and indirect expendit're re&atin to s'ch income. S. 14A doesnot ma;e any distinction between income which is comp&ete&y exempt from tax andincome receied after payment of tax (e.g.:iidend :istrib'tion tax, %ax payab&e by3rms, etc.)

.2 In this respect reference may be made to some of the decisions wherein it ishe&d that disa&&owance can be made 's.14A in respect of income from aric'&t'ra&income, diidend on shares or 'nits of

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the =ew 5'&e 7: is app&ied the expendit're to be disa&&owed wi&& be s'bstantia& andwi&& hae no re&ation to the act'a& expendit're inc'rred. In other words, in mostcases, a notiona& amo'nt wi&& be disa&&owed.

4.2 If we trace the history of this &eis&ation it wi&& be noticed that S. 14A wasintrod'ced to coer cases where expendit're in re&ation to income s'ch as

aric'&t'ra& income, tax free bonds, etc. which did not s'!er any tax 'nder theIncome"tax Act, was bein c&aimed. %his was he&d to be a&&owab&e by the S'premeCo'rt in certain cases. It was on&y to deny s'ch c&aim that this proision wasintrod'ced.

4. In the exp&anatory memorand'm iss'ed with the Finance 8i&&, 2001, whi&eenactin S. 14A, it is stated that +the tax incentie ien by way of exemptions tocertain cateories of income is bein 'sed to red'ce a&so the tax payab&e on thenon"exempt income by debitin the expenses inc'rred to earn the exempt incomeaainst taxab&e income+. S. 14A was enacted to c'rb this tendency.

4.4 In the case of diidend income, the scheme of the Income"tax Act is to co&&ecttax at 1 p&'s app&icab&e s'rchare at the time of distrib'tion. It is for this reason

that tax is not &eied in the hands of the inestor. Simi&ar&y, the 3rm is re6'ired topay tax at 0 p&'s app&icab&e s'rchare. For this reason, the ba&ance of pro3tapportioned to partners is exempted in the hands of the partners. Simi&ar exemptionis ien 's.10(7) in respect of &on term capita& ains on which S%% is paid. %hisexemption is ranted not as an incentie b't beca'se the tax is &eied at so'rce.

%herefore, there is no &oic in disa&&owin expendit're 's.14A in s'ch cases wheretax is co&&ected at so'rce. It is, therefore, s'ested that the section sho'&d bes'itab&y amended or C8:% sho'&d c&arify that S. 14A sho'&d not be ino;ed whereincome is receied by the assessee after payment of tax 'nder the Income"tax Act.