What Is Section 14A of the Income Tax Act: Applicability, Requirements And Rule 8D
In India, several categories of income are completely tax-free. It includes agricultural income, the income of charitable institutions, etc. Taxpayers cannot claim expenses incurred while earning these exempt incomes as deductions. There was an ambiguity about it, and finally, Supreme Court gave its order, stating that individuals can claim expenses as deductions in specific cases. To negate or bypass that verdict, GOI inserted Section 14A in the Income Tax Act, which disallows expenses incurred for earning exempt income to be claimed as deductions.
This post gives you a detailed overview of what is Section 14A, its applicability and requirements and rule 8D. Keep reading!
What is Section 14A of the Income Tax Act?
There was a recurring battle between taxpayers and tax authorities on whether one can claim expenses incurred on all exempt income as deductions. This would have reduced tax liability for individuals. However, the Income Tax Department was of the view that those specific incomes were already tax-free.
Supreme Court in 2001 delivered its judgement partially in favour of taxpayers. GOI inserted Section 14A in Income Tax Act with retrospective effect from April 1962.
The Section states that taxpayers cannot claim expenses related to exempt income as deductions. This amendment to the tax law provides clarity and removes all ambiguity.
Applicability of Section 14A
Section 14A applies in the following conditions:
- It applies only when the assessee has made an investment that may generate income, and such income does not form a part of gross total income.
- Section 14A comes into effect when an individual has made a deduction claim for the expenses incurred, and the Assessing Officer does not agree with the fairness of such claim taking into account the financial profile of the assessee.
- This rule also comes into effect when an assessee claims that no expenses have been incurred.
Requirements of Section 14A
The following are the subsections of Section 14a:
- Section 14A(1) of the Income Tax Act
- The first subsection of 14A will take effect when an assessee incurs expenses for earning any exempt income.
- The second subsection will be applicable when the assessee claims those expenses as deductions.
- The third subsection is applicable when an assessee claims that no expenses were incurred.
- Section 14A(2) of the Income Tax Act
This subsection comes into force when an assessee claims any expense as a deduction. In such a case, the Assessing Officer will verify the fairness of claims after taking into consideration the books of accounts of the individual. The AO, if satisfied, will disallow the expenses under Section 14A.
On the other hand, if the AO is not satisfied with the claims mentioned by the assessee, then an individual must report disapproval and go ahead and apply Rule 8D for computing the disallowance amount.
- Section 14A(3) of Income Tax Act
Under Section 14A(3), when a taxpayer claims that he/she has not incurred expenses while earning tax-free income, the AO will directly apply Rule 8D to determine disallowable expenses. The AO doesn’t need to express or report his/her disapproval.
Also Read: Deductions Under Section 80C of The Income Tax
How to Determine Expenses Incurred Towards Exempt Income?
Expenditure incurred while earning any exempt income is calculated by Income Tax Department officials through Rule 8D. In other words, IT Department officials read rule 8D with Section 14a of the Income Tax Act to compute disallowed expenses. However, it is only applicable in the following situations:
- Whenever the assessee claims that he/she did not incur any expenses while earning tax-free income.
- Whenever a taxpayer has disallowed the amount towards expenses incurred while earning exempt income, but the AO is not satisfied with the fairness of the assessee’s claims after taking into consideration the taxpayer’s books of accounts.
Rule 8D of Income Tax
This enables one to compute disallowed expenses under deductions. The expenditure is an aggregate of the following:
- All expenses directly connected with exempt incomes.
- Any amount that is equivalent to 1% of an annual average of closing and opening balances of an investment whose income does not constitute a part of total taxable income.
Disallowance under this Section cannot exceed the total expenses claimed by assesses.
CBDT Circular on Section 14A of the Income Tax Act
There was a controversy regarding the implementation of the aforementioned Section. It was not clear whether this disallowance provision would take effect even when no tax-free income was earned during a financial year.
The circular clarified that the intent of the Section was to discourage taxpayers’ motive to reduce tax liability by claiming expenses as deductions incurred while earning tax-free income. It also ended the controversy by mentioning that Rule 8D, when read with section 14a, disallows expenses in a year even when no tax-free income is earned.
Also Read: Tax Relief Under Section 87A Of Income Tax Act: How To Claim Tax Rebate Under Section 87A
Final Word
Section 14A of the Income Tax Act clarifies legislative intent with regard to claiming expenses as deductions. Taxpayers must avoid claiming these deductions, or else authorities will trigger Rule 8D to negate these claims.
FAQs on Section 14A of the Income Tax Act
Ans: Dividend on shares is exempt income, whereas any gains on sale of shares are subject to taxation. Supreme Court, in its judgement, clarified that this Section would be applicable in case of shares as stock in trade only when one is earning exempt dividend income. In the case of profit from the sale of shares, one can claim expenses incurred on them as deductions.
Ans: A high court verdict settled this question. With regard to various provisions, the disallowance under the relevant Section cannot exceed exempt income. Therefore, authorities must restrict the disallowance amount till the limit of tax-exempt income.
Ans: There are several categories of disallowed expenses under the Income Tax Act. These include – expenses in case of TDS default, expenses in case of equalisation levy default and some cash expenditures.
Ans: This Section allows taxpayers to reduce their tax liability by making tax-saving investments or incurring certain expenses. The maximum limit of deductions u/s 80C in each financial year is Rs. 1.5 lakh. Investments eligible for deduction under Section 80C are PPF, SCSS, ELSS, EPF, tax-saving FDs, infrastructure bonds, etc.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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