ITAT Lucknow caps Section 14A disallowance at amount of exempt income

Background of the dispute

The Lucknow Bench of the Income Tax Appellate Tribunal recently dealt with an appeal in the case of Rohit Real Estates Pvt. Ltd. Vs ACIT concerning disallowance under Section 14A of the Income Tax Act 1961 read with Rule 8D of the Income Tax Rules 1962. The core controversy was whether the disallowance determined by the Assessing Officer for expenditure “relating to” exempt income could exceed the amount of dividend income that was actually exempt during the relevant year.

The appeal arose from an order of the Commissioner of Income Tax (Appeals)/National Faceless Appeal Centre, Delhi dated 16.08.2022 for Assessment Year 2017-18. The assessee challenged the confirmation of disallowance of Rs.2,54,373 made under Section 14A read with Rule 8D in respect of exempt dividend income of only Rs.31,070`.

The assessee also questioned the interpretation and application of the Explanation inserted below Section 14A by the **Finance Act, 2022`, contending that:

  • The Explanation was wrongly applied to Assessment Year 2017-18; and
  • Even if treated as clarificatory, it could not be invoked retrospectively to justify the higher disallowance.

In addition, the assessee alleged breach of principles of natural justice and asserted that the lower authorities’ conclusions were contrary to the statutory requirements under Section 14A(2).

Facts of the case

Return of income and selection for scrutiny

  • The assessee, a company registered under the Companies Act, filed its return of income for Assessment Year 2017-18 on 29.10.2017, declaring a total income of Rs.8,22,96,116.
  • The case was picked up for limited scrutiny under the Computer Assisted Scrutiny System (CASS) with a specific focus on examining expenses claimed in relation to exempt income.

Exempt income and assessee’s stand

During the scrutiny assessment proceedings:

  • The Assessing Officer noticed that the assessee had earned dividend income of Rs.31,070, which was claimed as exempt.
  • A notice under Section 143(2) of the Income Tax Act 1961 was issued and a pointed query was raised on expenditure incurred for earning this exempt income.
  • The assessee’s explanation was that no specific expenditure had been incurred to earn the said exempt dividend income.
  • The assessee, however, had made a suo motu disallowance of Rs.3,085, treating the same as administrative expenses relatable to the exempt income.

Assessment order and disallowance under Section 14A

The Assessing Officer rejected the assessee’s contention that no expenditure was incurred and proceeded as under:

  • Invoked Section 14A(2) read with Rule 8D(2)(ii) of the Income Tax Rules 1962.
  • Computed a disallowance of Rs.2,54,373 (later referred in the Tribunal’s order with working at Rs.2,57,458), much higher than the exempt income of Rs.31,070.
  • Completed the assessment by determining total income at Rs.8,25,50,493.

The Assessing Officer also recorded his “satisfaction” that the assessee’s own disallowance was not adequate having regard to the magnitude of investments and the likely administrative costs associated with them.

First appeal before CIT(A)/NFAC

Aggrieved, the assessee carried the matter before the CIT(A)/NFAC, Delhi. The primary arguments before the first appellate authority broadly were:

  • The computation under Rule 8D was wrongly triggered in the absence of a proper, legally tenable satisfaction as required under Section 14A(2).
  • The disallowance cannot in law exceed the exempt income actually earned.
  • The Explanation inserted to Section 14A by the Finance Act 2022 could not be imported into AY 2017-18 assessment, especially for the purpose of justifying an inflated disallowance.

The CIT(A) did not accept the assessee’s contentions and sustained the disallowance made by the Assessing Officer, thereby upholding the addition of Rs.2,54,373 (over and above the suo motu amount). This led to the present appeal before the ITAT, Lucknow Bench.

Grounds raised before the Tribunal

The assessee’s appeal before the Tribunal challenged the order of the CIT(A) on multiple fronts, notably:

  1. Improper application of Section 14A read with Rule 8D:
    It was contended that the disallowance was made mechanically without following the statutory pre-conditions for invoking Rule 8D.