2025 (6) TMI 299 - AT - Income Tax

Revenue's appeal fails as disallowance under Section 14A properly deleted for partnership investment exempt profits

ITAT Ahmedabad dismissed Revenue's appeal regarding disallowance under Section 14A. The assessee invested in partnership firm and earned exempt share ... Disallowance u/s 14A - assessee has invested in new capital in partnership firm and has earned exempted share profit - argument of the assessee that it has sufficient interest-free funds available with the assessee was not accepted in view of Rule 8D by CIT(A) and, therefore, the contention of the Ld. DR that no nexus has been established in fact has taken into account by the CIT(A) HELD THAT:- How much dividend the assessee has earned and whether the funds were utilised from the borrowed capital or its own capital has been considered by the CIT(A) in its order and has categorically observed that the AO has made disallowance of proportionate interest expenditure considering interest debited in Profit & Loss account for Rs. 69,60,614/- and the assessee earned interest income of Rs. 1,22,46,901/-. The disallowance of interest expenditure under Rule 8D(2)(ii) of the Act made by the Assessing Officer was rightly deleted by the CIT(A) and administrative expenses to that extent under Rule 8D(2)(iii) of the Act was rightly disallowed by the CIT(A). Thus, the appeal of the Revenue is dismissed. 1. ISSUES PRESENTED and CONSIDEREDThe core legal questions considered in this appeal are:(a) Whether the Assessing Officer was justified in making a disallowance of Rs. 44,35,176/- under Section 14A of the Income Tax Act, 1961, for expenditure incurred in relation to exempt income earned by the assessee during the Assessment Year 2010-11;(b) Whether the CIT(A) erred in restricting the disallowance under Section 14A to Rs. 4,61,744/- instead of upholding the full disallowance made by the Assessing Officer;(c) Whether the reopening of the assessment under Section 147 was valid and whether the audit objection relied upon by the Revenue was properly considered;(d) The applicability and correct interpretation of Rule 8D of the Income Tax Rules, 1962 in determining the quantum of disallowance under Section 14A;(e) Whether the assessee's contention that sufficient interest-free funds were available negates the applicability of Section 14A disallowance;(f) The correctness of the Tribunal's earlier order dismissing the Revenue's appeal and the implications of the remand by the High Court directing reconsideration of audit objections.2. ISSUE-WISE DETAILED ANALYSISIssue (a) and (b): Validity and quantum of disallowance under Section 14A of the ActRelevant Legal Framework and Precedents: Section 14A of the Income Tax Act disallows expenditure incurred to earn income which does not form part of total income, i.e., exempt income. The quantum of disallowance is to be determined as per Rule 8D, which provides a formulaic approach including consideration of interest expenditure and administrative expenses related to exempt income.Precedents such as the decision in ITO vs Adani Infrastructure Pvt Ltd and others have established that the disallowance under Section 14A must be computed strictly in accordance with Rule 8D and that the burden lies on the Revenue to demonstrate nexus between expenditure and exempt income.Court's Interpretation and Reasoning: The Assessing Officer observed that the assessee had exempt income of Rs. 9,40,77,973/- from share of profits in partnership firms and dividends from shares. The assessee had made investments funded partly by borrowed capital and partly by own funds. The Assessing Officer disallowed Rs. 44,35,176/- as expenditure relating to exempt income under Section 14A using Rule 8D.The CIT(A) examined the facts and held that while the Assessing Officer's disallowance of interest expenditure of Rs. 39,73,432/- was not justified, the administrative expenses disallowance of Rs. 4,61,744/- was rightly made. The CIT(A) applied Rule 8D(2)(ii) and (iii) and concluded that only the administrative expenses portion was properly attributable to exempt income.Key Evidence and Findings: The assessee's investments in partnership firms and shares, the exempt income earned, the interest expenditure debited to Profit & Loss account (Rs. 69,60,614/-), and interest income earned (Rs. 1,22,46,901/-) were all considered. The CIT(A) found that the nexus between borrowed funds and exempt income was not sufficiently established to justify full disallowance of interest expenditure.Application of Law to Facts: Rule 8D(2)(ii) disallows interest expenditure in proportion to borrowed funds used for earning exempt income, while Rule 8D(2)(iii) disallows administrative expenses incurred in relation to exempt income. The CIT(A) correctly applied these provisions, deleting interest disallowance and confirming administrative expenses disallowance.Treatment of Competing Arguments: The Revenue argued for full disallowance as per Assessing Officer's order, relying on audit objections and the statutory mandate of Section 14A. The assessee contended that sufficient interest-free funds were available, negating disallowance. The CIT(A) and the Tribunal found the assessee's argument credible and rejected the Revenue's claim for full disallowance.Conclusions: The CIT(A)'s partial disallowance was upheld, restricting the addition to Rs. 4,61,744/-, and the Revenue's appeal against this was dismissed.Issue (c): Validity of reopening under Section 147 and consideration of audit objectionsRelevant Legal Framework: Section 147 allows reopening of assessment if the Assessing Officer has reason to believe income has escaped assessment. Audit objections can provide grounds for reopening.Court's Interpretation and Reasoning: The reopening was based on audit objection dated 31.03.2017, which highlighted the issue of expenditure relating to exempt income. The High Court remanded the matter to the Tribunal to consider the audit objection, which was accepted by the Revenue. The Tribunal took cognizance of the audit objection and considered it in its order.Key Evidence: The audit objection explicitly requested remedial action under Section 147 for the under-assessment related to Section 14A disallowance.Application of Law to Facts: The reopening was within time limits and based on valid reasons. The Tribunal and CIT(A) considered the audit objection and the facts surrounding the exempt income and related expenditure.Treatment of Competing Arguments: The Revenue contended reopening was justified and audit objection was valid; the assessee contested the quantum of disallowance but did not challenge reopening itself.Conclusions: The reopening was valid and properly considered.Issue (d) and (e): Applicability of Rule 8D and sufficiency of interest-free fundsRelevant Legal Framework: Rule 8D prescribes the method for computing disallowance under Section 14A, including formulas for interest expenditure and administrative expenses. The availability of interest-free funds can reduce disallowance.Court's Interpretation and Reasoning: The CIT(A) and Tribunal accepted that the assessee had sufficient interest-free funds, negating the need to disallow interest expenditure under Rule 8D(2)(ii). However, administrative expenses were disallowed as per Rule 8D(2)(iii).Key Evidence: The assessee's financial statements showing interest income exceeding interest expenditure, and investments funded by own capital.Application of Law to Facts: The Tribunal correctly applied Rule 8D, considering the ratio of borrowed funds and interest-free funds to exempt income and disallowing only administrative expenses.Treatment of Competing Arguments: Revenue argued for full disallowance regardless of interest-free funds; the assessee argued that own funds were sufficient. The Tribunal sided with the assessee.Conclusions: Disallowance limited to administrative expenses was appropriate.Issue (f): Effect of High Court remand and Tribunal's reconsiderationCourt's Interpretation and Reasoning: The High Court quashed the Tribunal's earlier order and remanded the matter to enable Revenue to point out audit objections accepted by it. The Tribunal, upon reconsideration, took the audit objection into account but still dismissed the Revenue's appeal on merits.Conclusions: The Tribunal complied with the High Court's directions and gave a reasoned order dismissing the Revenue's appeal.3. SIGNIFICANT HOLDINGS'The Assessing Officer made disallowance of proportionate interest expenditure considering interest debited in Profit & Loss account for Rs. 69,60,614/- and the assessee earned interest income of Rs. 1,22,46,901/-. The disallowance of interest expenditure under Rule 8D(2)(ii) of the Act made by the Assessing Officer for Rs. 39,73,432/- was rightly deleted by the CIT(A) and administrative expenses to that extent amounting to Rs. 4,61,744/- under Rule 8D(2)(iii) of the Act was rightly disallowed by the CIT(A). Thus, the appeal of the Revenue is dismissed.'Core principles established include:(a) Disallowance under Section 14A must be computed strictly in accordance with Rule 8D, with due regard to the availability of interest-free funds and nexus of expenditure to exempt income;(b) Administrative expenses incurred in relation to exempt income are disallowable under Rule 8D(2)(iii) even if interest expenditure disallowance is not warranted;(c) Reopening under Section 147 based on audit objections is valid if within time limits and supported by reasons;(d) The burden lies on the Revenue to establish the nexus between expenditure and exempt income to justify disallowance under Section 14A.Final determinations:- The Assessing Officer's disallowance of Rs. 44,35,176/- under Section 14A was excessive;- The CIT(A)'s restriction of disallowance to Rs. 4,61,744/- (administrative expenses) was correct;- The Revenue's appeal against the CIT(A)'s order was dismissed;- The reopening of assessment was valid and properly considered;- The Tribunal complied with the High Court's remand and gave a reasoned order dismissing the Revenue's appeal.