Rule 8D inapplicable before 24.03.2008; bad debt needs write-off, and keyman policy gains remain taxable.

Rule 8D cannot be applied for assessment year 2006-07 because it came into force only on 24.03.2008; disallowance under section 14A for that year must be made on a reasonable estimate, and the expenditure was restricted to 2% of exempt income. A provision for claims and compensation shown as a security deposit, without actual write-off in the accounts, does not qualify as a deductible bad debt and also was not accepted as a trading loss. Difference arising on assignment and later encashment of a keyman insurance policy remains taxable where the transaction is used as a colourable device to avoid tax.

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Issues: (i) Whether disallowance under section 14A could be made by applying Rule 8D for assessment year 2006-07 and, if not, what estimate of expenditure was ; (ii) Whether the amount of security deposit shown as provision for claims and compensation could be treated as a deductible bad debt or trading loss; (iii) Whether the difference arising on assignment and subsequent encashment of a keyman insurance policy was taxable in the assessee's hands.

Issue (i): Whether disallowance under section 14A could be made by applying Rule 8D for assessment year 2006-07 and, if not, what estimate of expenditure was .

Analysis: Rule 8D came into force only with effect from 24.03.2008 and was therefore not applicable to assessment year 2006-07. For that year, the expenditure relatable to exempt income had to be determined on a reasonable basis. The assessment was thus required to be made by estimation instead of mechanical application of Rule 8D.

Conclusion: The disallowance was restricted by directing adoption of 2% of the exempt income. This issue was partly in favour of the assessee.

Issue (ii): Whether the amount of security deposit shown as provision for claims and compensation could be treated as a deductible bad debt or trading loss.

Analysis: The amount remained reflected in the balance sheet as a provision for claims and compensation and had not been written off in the accounts. A deduction for bad debt required a write-off in the books, and the amount, on the facts, did not qualify as a trading loss either. The claim was therefore unsupported on the record.

Conclusion: The deduction claim was rejected and the disallowance was sustained against the assessee.

Issue (iii): Whether the difference arising on assignment and subsequent encashment of a keyman insurance policy was taxable in the assessee's hands.

Analysis: Sum received under a keyman insurance policy is includible in income, and the assessee had already offered the surrender value as income when the policy was assigned. The policy was encashed shortly thereafter for a higher amount without continuation of premiums by the assessee. On these facts, the arrangement was treated as a colourable device to avoid tax, and the excess received on encashment was held taxable.

Conclusion: The addition was upheld and the issue was decided against the assessee.

Final Conclusion: One issue relating to section 14A was granted partial relief, but the remaining additions were sustained, and both appeals ultimately failed.

Ratio Decidendi: Rule 8D cannot be applied to assessment years prior to its commencement, section 36(1)(vii) requires an actual write-off in the accounts for bad debt deduction, and sums arising from a keyman insurance policy remain taxable when the transaction is used as a colourable device to avoid tax.

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