ITAT Limits Disallowance Under Rule 8D(2)(iii) to Investments Yielding Exempt Income and Deletes Section 36(1)(iii) Penalty

The ITAT Kolkata reversed the CIT(A)'s disallowance under Rule 8D(2)(iii), directing the AO to restrict the disallowance to only those investments that actually yielded exempt income, in line with Cal HC precedents. The disallowance of 0.5% on the average value of all equity investments irrespective of exempt income was set aside. Regarding interest-free loans advanced to associates/subsidiaries, the ITAT held that the assessee demonstrated sufficient own interest-free funds and commercial expediency for such advances. Consequently, the disallowance under section 36(1)(iii) confirmed by the CIT(A) was deleted, following the Bombay HC ruling in Reliance Utilities & Power Ltd. Both grounds raised in the appeal were allowed.

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ISSUES:

Whether disallowance under section 14A of the Income Tax Act read with Rule 8D of the Income Tax Rules should be computed on the basis of all investments or only those investments which yielded exempt income during the relevant assessment year.Whether the amendment to section 14A of the Income Tax Act by the Finance Act, 2022, including the inserted non-obstante clause and explanation, applies retrospectively to assessment years prior to 01.04.2022.Whether disallowance of interest under section 36(1)(iii) of the Income Tax Act is justified on interest-free advances made to associate or subsidiary companies, particularly when the assessee had sufficient own funds and the borrowed funds were not utilized for such advances.

RULINGS / HOLDINGS:

The disallowance under section 14A read with Rule 8D shall be computed by considering only those investments which yielded exempt income during the year; the disallowance cannot be made on all investments indiscriminately. The Tribunal held that "the disallowance under Rule 8D(2)(iii) shall be @0.5% of average value of all equity investments irrespective of the fact whether these investments actually yielded any exempt income or not" is incorrect and directed the Assessing Officer to restrict disallowance accordingly.The amendment to section 14A by the Finance Act, 2022, including the inserted explanation and non-obstante clause, is prospective in operation and cannot be applied retrospectively to assessment years prior to 01.04.2022. The Tribunal followed the decision that "the amendment by the Finance Act, 2022 ... cannot be presumed to have retrospective effect."The disallowance of interest under section 36(1)(iii) on interest-free advances to associate/subsidiary companies is not sustainable where it is demonstrated that the advances were made out of own funds sufficient to cover such advances and the borrowed funds were specifically utilized for other business purposes. The Tribunal accepted the principle that "where both own funds and borrowed funds are available, a presumption arises that interest-free advances are made out of own funds" and that advances made for commercial expediency cannot be disallowed.

RATIONALE:

The Tribunal applied the legal framework under section 14A of the Income Tax Act and Rule 8D of the Income Tax Rules, relying on binding precedents from the jurisdictional High Court which held that disallowance under section 14A should be restricted to investments yielding exempt income. The Tribunal rejected the reliance on the Finance Act, 2022 amendment for prior years, following authoritative rulings that such amendments are prospective.Regarding the interest disallowance under section 36(1)(iii), the Tribunal applied settled legal principles affirmed by High Courts and Tribunals that a presumption arises favoring the assessee when own funds are sufficient to cover interest-free advances, and that borrowed funds earmarked for specific business purposes cannot be presumed diverted. The Tribunal also relied on the principle of commercial expediency, as established in Supreme Court precedents, that business-related advances are not liable to disallowance merely because they are interest-free.There was no dissent or doctrinal shift noted; the Tribunal adhered to established statutory interpretation and judicial precedents, ensuring consistency with jurisdictional High Court rulings.

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