combining income from exempt sources

Combining income from exempt sources
V. K. SUBRAMANI
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A taxpayer having income from exempt source, and also from chargeable source, resorts to combine both of them, either consciously or otherwise. Expenses which are attributable to an exempt source minimise the income which is otherwise taxable. This has been the scenario for long and lawmakers brought in a specific provision to remedy the situation — section 14A. The fallout of this amendment, in addition to addressing the intended purpose, bestows some advantages to the taxpayers as well. Where the taxpayer has income from exempted source in addition to sources of income chargeable to tax, he is expected to exclude the expenses incurred in relation to exempted source.
I-T RULES
However, where the tax officer isn't satisfied with the correctness of the claim of the taxpayer with regard to expenditures allocated to exempt incomes, he is entitled to invoke rule 8D of the Income-Tax Rules, 1962. Where the tax officer is satisfied with the correctness of claim towards chargeable income, or exclusion of expenses related to exempt income, he needn't take recourse to rule 8D. Rule 8D has three limbs. The first one seeks identification of any expenses directly attributable to earning exempt incomes. The second one is intended to allocate only interest expenditure with regard to exempt income, and the third one is ad hoc 0.5 per cent of the average value of investments meant towards indirect expenses. The aggregate of all the three is liable for disallowance under section 14A.
LEGAL DECISIONS
The apex court in CIT v. Walfort Share & Stock Brokers (P) Ltd 326 ITR 1 (SC) has held that for attracting section 14A, that is, disallowance of expenses attributable to exempt income while computing chargeable income, there has to be a proximate cause for disallowance. Earlier, in CIT v. Winsome Textile Industries Ltd (319 ITR 204), an extended interpretation of section 14A was made by the court, which held that only where the taxpayer makes a claim for some tax exemption, section 14A could apply. Where there is no exempt income, section 14A couldn't be invoked.
Recently, in Siva Industries & Holdings Ltd v. Asst. CIT (ITA No.2148/Mds/2010), it was held that for applying section 14A there must be (i) income taxable under the Act for the relevant assessment year; and (ii) there should be income which doesn't form part of total income (i.e.) exempt income. If either of them is absent, section 14A couldn't be applied.
In Sankar Chemical Works v. Dy. CIT 47 SOT 121, the taxpayer deployed funds in various investments fetching tax-free incomes. It paid interest on capital contribution made by the partners. It was held that section 40(b) regulates payment of interest to the partners and is subservient to section 36(1)(iii). To the extent the capital of the firm or partners is deployed towards earning exempted income, provisions of section 14A would apply.
Also, such disallowance wouldn't reduce the taxable interest income of the partners, since the disallowance made under section 14A is different from the disallowance eligible for exclusion envisaged in the proviso to section 28(v). Also, it is possible that such disallowance made before computation of book profit of the firm may partly be exposed to tax burden, in case the working partner salary absorbs the other part of disallowance made under section 14A in an indirect manner.
In Hoshang D. Nanavati v. Asst. CIT (ITA No.3567/Mum/07), it was held that depreciation is neither a loss nor an expenditure, nor a trading liability, and hence provisions of section 14A couldn't be applied for disallowing a portion of depreciation, as attributable to earning exempt income. The tribunal applied Nectar Beverages P Ltd v. Dy. CIT (314 ITR 314) to hold that section 14A contemplates only disallowance of expenditure incurred by the taxpayer, and as depreciation is an allowance, it wouldn't fall within its ambit. It was discussed if the claim of deduction under Chapter VI-A, could be disallowed by applying section 14A. The taxpayer paid health insurance premium which was sought to be disallowed by applying section 14A. It was held that such expenditure wasn't incurred for earning any income, and after the income had accrued in favour of the taxpayer, such payment was made, which was inherently a personal expenditure. Thus, it was held that the claim cannot be disallowed.



Expenses that are attributable to an exempt source minimise the income which is taxable.



(This article was published in the Business Line print edition dated December 19, 2011)