Disallowance under exempt income rules invalidated where AO failed to record dissatisfaction and miscomputed the adjustment

An assessing officer must record specific dissatisfaction with an assessee's claim before invoking the statutory disallowance mechanism for expenses relating to exempt income; absence of such recorded dissatisfaction invalidates the invocation of the disallowance rule. The officer rejected a taxpayer's suo moto 14A adjustment without referencing expenses or accounts and failed to deduct the taxpayer's offered suo moto disallowance from the rule based computation, resulting in a double addition. Because the officer acted on incorrect factual assumptions and without proper application of mind, the appellate authority disallowed the assessment additions and allowed the appeal for statistical purposes.

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Issues: Whether the Assessing Officer validly invoked Section 14A read with Rule 8D to compute disallowance when the assessee had made a suo-moto disallowance in the return, i.e., whether the AO recorded the required satisfaction/dissatisfaction with the assessee's suo-moto computation before applying Rule 8D.

Analysis: Applicable legal framework includes Section 14A of the Income-tax Act, 1961 and Rule 8D of the Income Tax Rules, 1962 which permit computation of expenditure attributable to exempt income only after the Assessing Officer records dissatisfaction with the assessee's claim; authorities have held that such dissatisfaction must be formed with reference to the assessee's accounts and relevant facts. The AO's assessment order and computation were examined to determine whether the AO referred to the assessee's accounts, explained why the assessee's suo-moto disallowance was incorrect, or reduced the Rule 8D computation by the amount already disallowed by the assessee. The AO's observations merely stated statutory provisions, cited circulars and decisions, asserted that substantial exempt income existed, and proceeded to compute disallowance under Rule 8D without engaging with the assessee's submitted computation and without recording a specific satisfaction based on the accounts or expenses claimed. The AO also proceeded on an incorrect factual premise that the assessee had claimed no expenditure for exempt income despite the assessee having made a specific suo-moto disallowance consisting of salary and telephone expenses.

Conclusion: The AO did not record the requisite dissatisfaction with the assessee's suo-moto disallowance based on the assessee's accounts or give cogent reasons for rejecting the assessee's computation; consequently, invocation of Rule 8D and the resulting addition were not legally sustainable and the addition is deleted in favour of the assessee.

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