Exempt-income disallowance cap protects bona fide explanations from under-reporting penalty where higher assessment disallowance was accepted.

Disallowance of expenditure relating to exempt income under Section 14A read with Rule 8D cannot exceed the exempt income earned in the relevant year. Restricting the disallowance to that income reflects the settled legal position and provides a valid, reasonable explanation; acceptance of a higher disallowance during assessment does not itself establish under-reporting. Penalty for under-reporting is not automatic where the explanation falls within the statutory exception for bona fide explanations. The article notes that the penalty under Section 270A was therefore unsustainable and deleted.

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Issues: Whether penalty for under-reporting of income could be sustained where the assessee restricted disallowance of expenditure relating to exempt income to the amount of exempt income earned.

Analysis: The disallowance under Section 14A read with Rule 8D cannot exceed the exempt income earned in the relevant assessment year. Restricting the disallowance to such exempt income was supported by settled legal position and constituted a valid and reasonable explanation. Acceptance of the higher disallowance in assessment proceedings did not, by itself, establish under-reporting of income. Penalty under Section 270A is not automatic, and the explanation fell within the exception under Section 270A(6)(a).

Conclusion: The penalty under Section 270A was unsustainable and was deleted, in favour of the assessee.

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