Recording AO satisfaction must for exempt income disallowance u/s 14A(2) and Rule 8(D) – High Court

Recording AO satisfaction must for exempt income disallowance u/s 14A(2) and Rule 8(D) of the Income Tax Rules, 1962. High Court reverses ITAT judgment

ABCAUS Case Law Citation:
ABCAUS 2042 (2017) (08) HC

Important Case Laws Cited/relied upon by the parties:
Godrej and Boyce Mfg. Co. Ltd. v. CIT [2010] 328 ITR 81 (Bom)
CIT v. Taikisha Engineering India Limited (2015) 370 ITR 338 (Del)
CIT v. Holcim India Pvt. Ltd. (2014) 90 CCH 681 (Del)
Principal Commissioner of Income Tax v. Bharti Overseas Pvt. Ltd. [2016] 237 Taxmann 417 (Del)
CIT, Jalandhar-I v. Max India Limited [2016] 388 ITR 81 (P&H)
Maxopp Investment Limited v. CIT [2012] 347 ITR 272 (Del)
Boyce Manufacturing Co. Ltd v. CIT [2010] 328 ITR 81 (Bom)
ACB India Ltd. v. ACIT (2015) 374 ITR 108 (Del)
CIT v. Walfort Share and Stock Brokers P. Ltd. [2010] 326 ITR 1 (SC)

Brief Facts of the Case:

The Appellant-Assessee was engaged in the business of printing and publishing newspapers and periodicals. For the AY in question, the Assessee filed its return declaring a total income of Rs. 1,61,78,06,133/-. Thereafter, it filed a revised return on 30th March 2010 declaring a total income of Rs. 1,60,96,08,330/-.

The return filed was picked up for scrutiny and notice was issued by the Assessing Officer (‘AO’) to the Assessee under Section 143 (2) of the Income Tax Act along with a questionnaire.

During the relevant AY the Assessee had made certain investments in shares/mutual funds/bonds etc. The Assessee had received dividend income of Rs. 2,94,38,025 from mutual funds which was claimed as exemption under Section 10 (35) of the Act. In response to the questionnaire, the Assessee stated that all the investments from which dividend was received had been made by it out of its own funds and no borrowed funds had been utilized for the purpose. Accordingly, no interest expenditure had been incurred in relation to earning of exempt income.  

With respect to the administrative expenses, it was submitted that the income had been earned on units of mutual funds. There were only nineteen entries and investments were under the reinvestment schemes. Accordingly, no day-to-day activity was involved in relation to earning of exempt income. Income had been reinvested and accounting entries had been passed in the books of account only on redemption or switching over to another scheme. Nevertheless, the Assessee had made disallowance of Rs. 3 lakhs in the return of income in order to cover administrative expenses which could be reasonable said to have been incurred in relation to earning of exempt income.

The AO was of the view that in arriving at disallowable expenditure one by one correlation of expenditure for ascertaining if either of them have resulted into exempt income is not envisaged. Further, he observed investment were well informed and well coordinated management decisions involving not only inputs from various sources but also acumen of senior management functionaries. Therefore, cost was inbuilt into even the so called ‘passive’ investments.

The AO, accordingly, held that the assessee had incurred expenses to manage its investments and had failed to calculate such expenses in a reasonable manner to ascertain the true and correct picture of its income. The AO computed the total disallowance as under:

The CIT(A) held that the AO was justified in determining the administrative cost at 0.5% of the average value of the investments. Accordingly, disallowance of expenses to the tune of Rs. 2,08,21,695/- was held to be justified. However, the CIT (A) deleted the disallowance of the interest amount of Rs. 6,86,27,884/- on the basis that no term loan had been utilized for making investments.

ITAT reversed the order of the CIT (A) as regards disallowance of interest amount and remanded the matter to the AO for a fresh determination. Relying on a judgment of the Delhi High Court, the ITAT held that the disallowance on account of interest could not be deleted simply on the ground that the Assessee’s own capital and interest free funds were more than the funds invested in securities yielding exempt income. As regards the administrative expenses, it was held that once Rule 8D had come into force the disallowance was required to be computed with reference to mandate of Rule 8D (iii). However the ITAT reversed the order of the AO to the extent that Rs. 3 lakhs already disallowed by the Assessee was once again disallowed by the AO.

The ITAT further noted that during the AY in question, the Assessee had earned a total exempt income of Rs. 2.94 crore whereas the total disallowance made by the AO stood at Rs. 8.97 crore. Taking note of the Law laid down by the Delhi High Court that the disallowance under Section 14A could not exceed the amount of exempt income, the ITAT directed the AO to take the ratio of the said decision into consideration while computing finally disallowable amount under Section 14A of the Act.

Observations made by the High Court:

Failure of the AO to record satisfaction

The Hon’ble High Court observed that in order to disallow this expense the AO had to first record, on examining the accounts, that he was not satisfied with the correctness of the Assessee’s claim of Rs. 3 lakhs being the administrative expenses. This was mandatorily necessitated by Section 14 A (2) of the Act read with Rule 8D (1) (a) of the Rules.

It was observed that the AO simply stated that “in view of the facts and circumstances and legal position on the issue as discussed above, I am satisfied that the Assessee had incurred expenses to manage its investments which may yield exempt income, and Assessee grossly failed to calculate such expenses in a reasonable manner to ascertain to ascertain the true and correct picture of its income and expenses.”

The Hon’ble High Court opined that the above observations of the AO in the assessment order were of a broad general nature not with particular reference to the facts of the case on hand. The CIT (A) also failed to note that without the mandatory requirement, under Section 14A of the Act and Rule 8D of the Rules, of satisfaction being recorded being met, the question of applying Rule 8D (1) did not arise.

The High Court further observed that the ITAT too reproduced the contents of the assessment order which contains general observations regarding earning of exempt income. Those general observations could not be accepted as a recording by the AO of satisfaction regarding the claim of the Assessee after examining its accounts. Again, the ITAT simply repeated the assessment order where, again, no reasons have been provided but only a conclusion had been reached that the AO was “satisfied that the Assessee had incurred expenses to manage its investments which may yield exempt income, and Assessee grossly failed to calculate such expenses in a reasonable manner to ascertain the true and correct picture of its income and expenses.”

Disallowance of interest expenses

It was observed that from the explanation offered by the Assessee, it was plain that explanation offered was not discarded by the AO on facts that there was no part of the interest expenditure which did not bear a direct nexus to a loan that was already borrowed in some earlier year.

The Hon’ble High Court observed that it had in a previous judgment explained that if there is no interest expenditure “which is not directly attributable to any particular income or receipt”, then “the question of applying the formula” under Rule 8D (ii) of the Rules will not arise. In other words, one of the pre-requisites for the applicability of the formula Rule 8 D (2) (ii) of the Rules for determining the extent of disallowance of interest, is that there must some interest expense which is not attributable to any particular income or receipt.

It was noted that in the present case, the AO had not indicated which part of the interest expense falls in the above category.

Regarding the decision of the Court relied upon by the ITAT, the Hon’ble High Court observed that the said decision did not hold anything contrary to what had been contended by the assessee in the present case. If indeed the AO had undertaken the exercise as mandated by this Court in the case law relied by the ITAT, he would have come to the conclusion that the interest paid during the AY by the Assessee was entirely towards loans borrowed in earlier years which had not been utilised for making investments that yielded exempt income.

The Hon’ble High Court observed that it was surprising that the ITAT, by relying on the observation of the Court in the said decision, thought it fit to remand the matter to the AO for a fresh determination on the ground that the disallowance on account of interest under Rule 8D “could not be deleted simply on the ground that the assessee’s capital and interest free funds are more than the funds invested in securities yielding exempt income.”

The Hon’ble High Court opined that there was no necessity for the ITAT to have remanded the issue regarding disallowance of interest expenses under Section 14A to the AO for a fresh determination. The details placed on record by the Assessee, and particularly its audited accounts, demonstrated with sufficient clarity that no part of any interest bearing funds had been utilised during the AY in question for making investments that yielded exempt income.

Regarding the judgment relied by the Supreme Court, the Hon’ble High Court distinguished it and observed that the Supreme Court found no mention of the reasons which had prevailed upon the AO to hold that the claims of the Assessee, that no expenditure was incurred to earn dividend income, cannot be accepted and why the order of the ITAT for the earlier AYs were not acceptable to the AO, particularly, in the absence of any new fact or change of circumstances. Further, the Supreme Court held that no basis has been disclosed establishing a reasonable nexus between the expenditure disallowed and the dividend income received.

The Hon’ble High Court observed that the Assessee had been able to demonstrate that the AO has failed to establish any direct nexus between the investments made by the Assessee and the interest expenditure incurred. On the other hand , the Assessee was able to show that any interest expenditure incurred was in respect of various bank loans during the course of the AY in question. The AO also failed to deal with the assertion of the Assessee that it had sufficient own funds and, as such, had no occasion to use borrowed interest bearing funds for that purpose.

Held:

Disallowance of interest expenses

The ITAT erred in remanding the matter concerning deletion of disallowance of any interest under clause (ii) of Rule 8D (2) of the Act to the AO for fresh determination

Failure of the AO to record satisfaction

The AO failed to record proper satisfaction in terms of Section 14A (2) of the Act read with Rule 8D (1)(a) of the Rules and therefore, erred in calculating the disallowance at 0.5% on overall value of the investments as per the Rule 8D (2)(iii) of the Rules.

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