Disallowance under Section 14A (of Income Tax Act, 1961) quashed: AO must record reasons before applying Rule 8D (of Income Tax Rules, 1962)

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Case Name

M/S. Kodagu District Co-operative Central Bank Ltd. vs. Assistant Commissioner of Income Tax (High Court of Karnataka)

ITA No. 318 of 2016

Date: 19th January 2021

Key Takeaways

• Section 14A (of Income Tax Act, 1961) and Rule 8D (of Income Tax Rules, 1962): The AO must record dissatisfaction with the taxpayer’s claim about expenses related to exempt income before applying Rule 8D (of Income Tax Rules, 1962) to disallow expenses.
• Mandatory Requirement: The AO cannot mechanically apply Rule 8D (of Income Tax Rules, 1962); they must first provide cogent reasons for rejecting the taxpayer’s claim.
• Outcome: The court quashed the disallowance under Section 14A (of Income Tax Act, 1961) because the AO did not fulfill this mandatory requirement.
• Precedent Cited: The court relied on the Supreme Court’s decision in “MAXOPP INVESTMENT LTD. Vs. CIT”, (2018) 402 ITR 640, which clarified the procedure for disallowance under Section 14A (of Income Tax Act, 1961).

Issue

Was the Assessing Officer justified in disallowing expenses under Section 14A (of Income Tax Act, 1961) read with Rule 8D (of Income Tax Rules, 1962) without recording reasons for dissatisfaction with the assessee’s claim?

Facts

• Parties: The appellant is M/S. Kodagu District Co-operative Central Bank Ltd., a co-operative bank engaged in banking business. The respondent is the Assistant Commissioner of Income Tax.
• Assessment Year: 2009-10.
• Dispute: The AO disallowed Rs. 24,95,846/- under Section 14A (of Income Tax Act, 1961), claiming it was expenditure related to earning exempt income (from mutual funds).
• Process: The bank appealed the disallowance to the Commissioner of Income Tax (Appeals) and then to the Income Tax Appellate Tribunal (ITAT), both of which upheld the AO’s decision. The bank then appealed to the High Court.

Arguments

Assessee (Bank)

• Main Point: Section 14A (of Income Tax Act, 1961) requires the AO to first reject the assessee’s claim about expenses with cogent reasons before making any disallowance.
• Claim: The AO did not record any such reasons or dissatisfaction before applying Rule 8D (of Income Tax Rules, 1962).
• Support: Cited the Supreme Court’s decision in “MAXOPP INVESTMENT LTD. Vs. CIT”, (2018) 402 ITR 640, which mandates this procedure.

Revenue (Tax Department)

• Main Point: The authorities correctly disallowed the claim under Section 14A (of Income Tax Act, 1961) and applied Rule 8D (of Income Tax Rules, 1962).
• Support: Referred to the Tribunal’s order, arguing that the disallowance was justified.

Key Legal Precedents

• MAXOPP INVESTMENT LTD. vs. Commissioner of Income-Tax, (2012) 347 ITR 272 (Delhi): This case clarified that the AO must record dissatisfaction with the assessee’s claim before invoking Rule 8D (of Income Tax Rules, 1962).
• MAXOPP INVESTMENT LTD. Vs. CIT, (2018) 402 ITR 640 (Supreme Court): Upheld the above principle, making it binding law.
• Section 14A (of Income Tax Act, 1961): Deals with disallowance of expenditure incurred in relation to income not includible in total income.
• Rule 8D (of Income Tax Rules, 1962): Prescribes the method for determining the amount of expenditure to be disallowed under Section 14A (of Income Tax Act, 1961).

Judgement

• Decision: The High Court ruled in favor of the assessee (the bank).
• Reasoning: The AO did not record any reasons for being dissatisfied with the bank’s claim regarding expenses related to exempt income before applying Rule 8D (of Income Tax Rules, 1962). This is a mandatory requirement under Section 14A(2) (of Income Tax Act, 1961).
• Order: The disallowance of Rs. 24,95,846/- under Section 14A (of Income Tax Act, 1961) was quashed. The orders of the AO, CIT (Appeals), and ITAT on this issue were set aside, and the appeal was allowed.

FAQs

Q1: What is Section 14A (of Income Tax Act, 1961)?

A: Section 14A (of Income Tax Act, 1961) disallows expenses incurred in relation to income that does not form part of the total taxable income (like exempt income from mutual funds).

Q2: What is Rule 8D (of Income Tax Rules, 1962)?

A: Rule 8D (of Income Tax Rules, 1962) provides a formula for calculating the amount of expenditure to be disallowed under Section 14A (of Income Tax Act, 1961).

Q3: Why was the disallowance quashed in this case?

A: Because the AO did not record any reasons for being dissatisfied with the bank’s claim about expenses before applying Rule 8D (of Income Tax Rules, 1962), which is a mandatory legal requirement.

Q4: What precedent did the court rely on?

A: The court relied on “MAXOPP INVESTMENT LTD. Vs. CIT”, (2018) 402 ITR 640, which requires the AO to record dissatisfaction before making a disallowance under Section 14A (of Income Tax Act, 1961).

Q5: What does this mean for other taxpayers?

A: Tax authorities must follow the correct procedure and record reasons before disallowing expenses under Section 14A (of Income Tax Act, 1961). If they don’t, such disallowances can be challenged and set aside.

This appeal under Section 260-A (of Income Tax Act, 1961), 1961 (hereinafter referred to as ‘the Act’, for short) has been filed by the assessee. The subject matter of the appeal pertains to the Assessment Year 2009-2010. The appeal was admitted by a Bench of this Court vide order dated 09.11.2016 on the following substantial questions of law:

"1. Whether the Tribunal is justified in law in confirming the addition of Rs.24,95,846/- made under section 14A (of Income Tax Act, 1961) read with Rule 8D (of Income Tax Rules, 1962) by holding that the Appellant has not made any claim that it has not incurred any expenditure for earning the exempt income which is contrary to material on record and

consequently perverse on the facts and circumstance of the case?

2. Whether the Tribunal erred in law in not holding that the assessing officer has not arrived at the mandatory satisfaction as required under section 14A (of Income Tax Act, 1961) and hence no disallowance is possible on the facts and circumstances of the case?"

2. Facts leading to filing of this appeal briefly stated are

that the assessee is a District Central Co-operative Bank and

is engaged in the banking business. The assessee filed

return of income for the Assessment Year 2009-10 on

29.09.2009 declaring an income of Rs.3,80,29,000/-. The

case of the assessee was selected for scrutiny and the

Assessing Officer completed the assessment by an order

dated 30.12.2011 and made addition of a sum of

Rs.2,38,30,775/- which included a sum of Rs.24,95,846/-

disallowed under Section 14A (of Income Tax Act, 1961). The assessee

thereupon filed an appeal before the Commissioner of

Income Tax (Appeals), who by an order dated 27.02.2013

affirmed the order passed by the Assessing Officer.

Thereafter, the assessee filed an appeal before the Income

Tax Appellate Tribunal (hereinafter referred to as 'the

Tribunal' for short). The Tribunal sustained disallowance of

Rs.24,95,846/- made under Section 14A (of Income Tax Act, 1961).

However, the appeal preferred by the assessee was partly

allowed. In the aforesaid factual background, the assessee

has filed this appeal.

3. Learned counsel for the assessee submits that

Section 14A (of Income Tax Act, 1961) mandates the Assessing Officer to first

reject the claim of the assessee regarding the extent of such

expenditure and rejection must be disclosed by assigning

cogent reasons. It is only after rejection of cogent reasons,

the question of determination of expenditure by the

Assessing Officer would arise. It is further submitted that in

the instant case, the aforesaid mandatory requirement has

not been fulfilled by the Assessing Officer. However, the

aforesaid aspect of the matter is neither been appreciated by

the Commissioner of Income Tax (Appeals) nor the Tribunal.

In support of aforesaid submission, reliance has been placed

on the decision of the Supreme Court in 'MAXOPP

INVESTMENT LTD. Vs. COMMISSIONER OF INCOME-

TAX', [2012] 347 ITR 272 (DELHI), which has been

upheld by the Supreme Court in the decision reported in

'MAXOPP INVESTMENT LTD. Vs. CIT', (2018) 402 ITR

640. On the other hand, learned counsel for the revenue

has invited our attention to Paragraphs 10 and 11 of the

order passed by the Tribunal and has submitted that all the

authorities under the Act have rightly disallowed the claim for

deduction under Section 14A (of Income Tax Act, 1961) and no interference

in this appeal is called for.

4. We have considered the submissions made by the

learned counsel for the parties and have perused the record.

Before proceeding further, it is apposite to take note of the

relevant extract of Section 14A (of Income Tax Act, 1961), which reads as

under:

(2) The Assessing Officer shall

determine the amount of expenditure

incurred in relation to such income which

does not form part of the total income

under this Act in accordance with such

method as may be prescribed. If the

Assessing Officer, having regard to the

accounts of the assessee, is not satisfied

with the correctness of the claim of the

assessee in respect of such expenditure in

relation to income which does not form part

of the total income under this Act.

(3) The provisions of sub-section (2)

shall also apply in relation to a case where

an assessee claims that no expenditure has

been incurred by him in relation to income

which does not form part of the total

income under this Act.”

Thus, from perusal of the aforesaid provision, it is

axiomatic that if the Assessing Officer, having regard to the

accounts of the assessee, is not satisfied with regard to the

correctness of the claim of the assessee in respect of such

expenditure in relation to income which does not form part of

the total income of the assessee, then the Assessing Officer

may either re-assess the income under Section 147 (of Income Tax Act, 1961) of the

Act or pass an order enhancing the assessment or reducing

the refund already made or otherwise increasing the liability

of the assessee under Section 154 (of Income Tax Act, 1961) for any

Assessment Year.

5. In the instant case, the Assessing Officer in

Paragraph 5 of the order has dealt with the claim of the

assessee with regard to disallowance under Section 14A (of Income Tax Act, 1961) of

the Act. Paragraph 5 of the Income Tax Act, 1961 is reproduced below for

reference:

“5. Disallowance U/s 14A (of Income Tax Act, 1961): The assessee

claimed that Income received from Mutual Fund is

totally exempt from Income Tax U/s 10(23D)(i) (of Income Tax Act, 1961) & (ii)

of the Income Tax Act, 1961. These mutual funds are

registered under the Securities and Exchange Board

of India Act, 1992 or regulations made thereunder.

Further any income from such other Mutual fund set

up by the Public Sector Bank or a Public Financial

Institution or authorized by the Reserve Bank of India

and subject to such conditions as the Central

Government may, by Notification in the Official

Gazette, specify in this behalf are exempted from

Income tax. Rule 8D (of Income Tax Rules, 1962) is not applicable in this case and

the entire income from mutual fund be allowed under

Sec.10(23D)(i) (of Income Tax Act, 1961) & (ii) of the Income Tax Act, 1961.

I have considered the claim of the assessee.

Under Rule 8D (of Income Tax Rules, 1962), with effect

from asst. year 2008-09 there is a provision for

disallowance to the extent of one-half per cent of the

average of the value of Investment, income which

does not or shall not form part of the total income, as

appearing in the balance sheet of the assessee, on

the first day and the last day of the previous year.

The assets represent Bond Fund/Income Fund, State

Govt. Undertaking Bonds and Shares in Co-operative

Institutions and the average is worked out as under:

Opening Balance Rs.47,40,36,800

Closing Balance Rs.52,43,01,677

Rs.99,83,38,477

Rs.99,83,38,477 divided by 2 = 49,91,69,239 x

0.5% = Rs.24,95,846/-.

Accordingly, a sum of Rs.24,95,846/- is

disallowed and added to the total income admitted by

the assessee and brought to tax.”

Thus, from perusal of the order passed by the

Assessing Officer, it is evident that the Assessing Officer has

not determined the amounts of the expenditure and has not

recorded any reasons with regard to correctness of the claim

made by the assessee in respect of such expenditure, in

relation to the income which does not form part of the total

income of the assessee. The Assessing Officer before

embarking upon determination of the amount of expenditure

incurred in the light of the exempted income, has to record a

finding that he is not satisfied with the correctness of the

claim of the assessee in respect of such expenditure. The

aforesaid mandatory requirement has not been fulfilled by

the Assessing Officer before disallowing the assessee under

Section 14A (of Income Tax Act, 1961).

6. In view of the preceding analysis, the substantial

questions of law framed by this Court is answered in favour

of the assessee and against the revenue.

7. In the result, the order passed by the Assessing

Officer dated 30.12.2011, order passed by the Commissioner

of Income Tax (Appeals) dated 27.02.2013 and the order

passed by the Tribunal dated 30.12.2015, insofar as it

pertains to disallowance of the claim of the assessee under

Section 14A (of Income Tax Act, 1961), are hereby quashed.

In the result, the appeal is allowed.

Sd/-

JUDGE

Sd/-

JUDGE