Disallowance of expenses relating to exempt income challenged as arbitrary; mechanical allocation formula found inconsistent with funding presumption, relief granted

Challenge to disallowance of expenses attributable to exempt income focuses on whether the assessing officer validly recorded dissatisfaction to invoke a formulaic computation. The assessing officers purported dissatisfaction related only to interest expense allocation but lacked factual basis, rendering it arbitrary. Reliance on the judicially recognised presumption that own funds are applied to investments negates a finding of attributable interest in the present facts. Consequently, the mechanical application of the prescribed computation for allocating expenses to exempt income was held not in accordance with law, resulting in relief to the taxpayer.

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Issues: Whether the invocation of Rule 8D of the Income-tax Rules, 1962 for computing disallowance under section 14A of the Income-tax Act, 1961 was validly made by the Assessing Officer when the Assessing Officer recorded dissatisfaction with the assessee's claim that investments were made out of internal accruals.

Analysis: Section 14A and section 14A(2) require that disallowance for expenditure in relation to exempt income be determined; Rule 8D provides a method of computation but its invocation is conditioned on the Assessing Officer being dissatisfied with the assessee's claim regarding absence or extent of expenditure, such dissatisfaction to be arrived at after examining the assessee's accounts. The assessee had offered a specific disallowance during assessment and produced details showing investments funded from internal accruals and limited borrowings. The Assessing Officer recorded a generalized disagreement with the assessee's claim and applied Rule 8D without articulating factual basis in the accounts to justify genuine dissatisfaction. In the circumstances, and having regard to the principle that where own funds are available the presumption is that own funds are used for investments, the recorded satisfaction was not a reasoned dissatisfaction based on accounts and therefore the statutory precondition for invoking Rule 8D was not met.

Conclusion: Invocation of Rule 8D was not in accordance with law and the disallowance of Rs. 40,79,796 under section 14A computed under Rule 8D is deleted; decision in favour of the assessee.

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