Beware of AIR Reports of Taxmen
The Government of India is in a very aggressive mode as far as collecting information about large financial transactions is concerned and also about tracking tax evaders. There is a also a very strong movement to make many processes relating to tax administration electronic and automated. This would ensure that the Income-tax department has a central database of all tax payers in the country alongwith details of large financial transactions entered into by each such person in a year.
One important tool used by the Government to collect such information is the AIR.
What is AIR?AIR is an abbreviation for the term "Annual Information Return". AIR was made effective from the financial year 2003-04. An AIR has to be filed by the prescribed person who is responsible for registering or maintaining books of accounts or other documents containing record on any specified financial transaction under any law for the time being in force.
Use of AIR?The purpose of collecting such information is to ensure that a person who enters into such transactions duly accounts for all such transactions for which information is independently collected from the specified persons through the AIR.
Section 14A of the Income-Tax Act
Introduction:
Section 14A was brought onto the statute by the Finance Act, 2001 with retrospective effect from 1st April, 1962. While introducing this section, the Finance Minister has explained the rationale for this section as follows:
"No deduction for expenditure incurred in respect of exempt income against taxable income
Certain incomes are not includible while computing the total income as these are exempt under various provisions of the Act. There have been cases where deductions have been claimed in respect of such exempt income. This in effect means that the tax incentive given by way of exemptions to certain categories of income is being used to reduce also the tax payable on the non-exempt income by debiting the expenses incurred to earn the exempt income against taxable income. This is against the basic principles of taxation whereby only the net income, i.e., gross income minus the expenditure, is taxed. On the same analogy, the exemption is also in respect of the net income. Expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income.
It is proposed to insert a new section 14A so as to clarify the intention of the legislature since the inception of the Income-tax Act, 1961,that no deduction shall be made in respect of any expenditure incurred by the assessee in relation to income which does not form part of the total income under the Income-tax Act."
Objective of the section:
Based on the above rationale, it would seem that the objective of the section is to prevent tax payers from setting off expenses incurred to earn tax free income against other income which is taxable. What this means therefore is that a tax payer must, in the first place, have tax free income and must have actually incurred expenses to earn such tax free income. The next step then would be to quantify such expenses and ensure that the same are not claimed by the tax payer as a deduction against any other income.
Computation of the disallowance:
As per the section, in the following circumstances, the tax officer has to compute the disallowance as per Rule 8D:
1) When he is not satisfied with the correctness of the claim of expenditure made by the tax payer or
2) When the tax payer claims that he has not incurred any expenditure to earn tax free income.
Rule 8D lays down the computation mechanism for this purpose. The formula laid down in the said Rule is highly unfair and does not take into cognisance the facts of any case. It merely lays down an arithmetical method of arriving at a disallowance. This disallowance often comes to much more than the entire expenses debited to the Profit and Loss Account by the tax payer.
Recent developments:
Once the Rule 8D was notified sometime in early 2008, the tax officers have been mechanically applying the said Rule to all pending assessments. In most cases, they have been rejecting the working prepared by the tax payer and huge disallowances have been made under section 14A based on the irrational computational mechanism laid down in the Rule.
However, the latest development has made matters even worse now. Recently, the Income-tax Appellate Tribunal had occasion to decide on the issue of applicability of the section in those cases where a tax payer had invested money in investments, the income from which, as and when received, would be tax free in the hands of the tax payer. In view of conflicting decisions of various Tribunals in the matter, it was decided to constitute a Special Bench. This Special Bench at Delhi has given its decision vide its consolidated order dated 5th August, 2009 in the case of ITA Nos. 87/Del/2008, 4788/Del/2007 and 233/Ahd/2006.
The gist of the Special Bench decision is that section 14A would be applicable even in those cases where the tax payer has not earned any income which is tax free but has invested funds in investments which, when they start yielding income, such income would be tax free. The rationale of the Special Bench in coming to this conclusion was its interpretation of the language of section 14A. According to the Special Bench, what was relevant was to work out the expenditure in relation to the exempt income and not to examine whether the expenditure incurred by the assessee has resulted into exempt income or taxable income. It held that when the expenditure is incurred in relation to income which does not form part of the total income , it has to suffer the disallowance irrespective of the fact whether the income is earned by the assesssee or not. Section 14A does not envisage any such exception The Tribunal also held that the earlier decisions of the Supreme Court in the case of Maharashtra Sugar Mills and Rajashthan State Warehousing holding that if there is one indivisible business , the entire expenditure is allowable, would have no application after the introduction of section 14A. Thus, as per this decision, even if the tax payer has not earned any tax free income in a year, yet, a part of his expenses would necessarily have to be disallowed under section 14A read with Rule 8D if funds have been borrowed at a cost and if the tax payer has investments in shares or mutual funds, the income from which, when received, would be tax free.
Implications of the decision:
The implications of this decision would be very harsh on those tax payers who have borrowings and who have invested in shares and mutual funds. In such cases, even if the investments are long term and/or strategic ones and even if there is no income actually accruing or received during a year, there would still be a disallowance of part of the interest paid based on the formula laid down in Rule 8D. It is pertinent to note that the decision is that of the Special Bench and hence carries more persuasive value than an ordinary Tribunal decision. This is also binding on the other benches of the Tribunal. Hence, now to adopt a different view, one will have to wait till some High Court decides the matter in favour of the assessee.
It would be very risky to take a stand that no expenses have been incurred to earn tax free income or that since there is no tax free income, the question of disallowance of any expense does not arise.
