2010 (10) TMI 1068 - HC - Income Tax

Disallowance u/s 14A - expenditure incurred for earning the tax free income - In present case, The assessees are all Scheduled Banks engaged in the banking business and in the course of banking business they are also engaged in the business of investment in bonds, securities and in shares which earn the assessees interest from such securities and bonds and also dividend on investments in shares of companies and from units of U.T.I. etc., which are tax free. Section 14A was introduced to the Income-tax Act by Finance Act, 2001 with retrospective effect from 1-4-1962. This provision provide for disallowance of expenditure incurred by the assessee in relation to income which does not form part of the total income. HELD THAT - Since we find that the rational adopted by the AO to estimate the expenditure for the purpose of disallowance u/s 14A is not tenable, we feel the matter should be restored to the AO for making disallowance u/s 14A by reasonably estimating as nearly as possible the expenditure incurred for earning the tax free income. This should be done after giving opportunity to the assessee-Banks to suggest their own formula with reference to accounts for the purpose of arriving at the actual amount or near actual amount. The disallowance on estimated basis has to be done as above until rule 8D was framed and thereafter it is for the AO to make disallowance by following sub-section (2) of section 14A and rule 8D of the Income-tax Rules. Regard to disallowance of administrative expenditure - HELD THAT - considering the fact that there is no precise formula for proportionate disallowance, no disallowance is called for, for proportionate administrative cost attributable to earning of tax free income until rule 8D came into force. We, therefore, dispose of the appeals by setting aside the orders of the Tribunal and that of the first appellate authority on this issue and remand all the assessments back to the AO for reworking disallowance u/s 14A in the case of each assessee for each assessment year. The proportionate disallowance u/s 14A should be limited to only interest liability and not overheads or administrative expenditure; which should be considered for disallowance under rule 8D from 2007-08 onwards.

Summary

Issues Involved:
1. Proportionate disallowance of interest under Section 14A of the Income-tax Act for investments yielding tax-free income.
2. Methodology for estimating interest expenditure for earning tax-free income.
3. Applicability of administrative expenditure disallowance under Section 14A.

Detailed Analysis:

1. Proportionate Disallowance of Interest under Section 14A:
The central issue in the appeals is whether proportionate disallowance of interest paid by banks is warranted under Section 14A of the Income-tax Act for investments in tax-free instruments such as UTI shares and tax-free bonds. The assessees, all scheduled banks, earned substantial tax-free income from these investments. Section 14A, introduced by the Finance Act, 2001 with retrospective effect from 1-4-1962, disallows expenditure incurred to earn tax-free income. A proviso introduced by the Finance Act, 2002, effective from 11-5-2001, neutralized the retrospective effect by prohibiting reassessment for any assessment year before 1-4-2001. The disallowance under Section 14A applies to pending assessments and those from the assessment year 2001-02 onwards. The banks did not maintain separate accounts for the expenditure incurred on tax-free investments, leading the Assessing Officer to use an average cost of deposit formula to determine the disallowance.

2. Methodology for Estimating Interest Expenditure:
The Assessing Officer's methodology involved calculating the average cost of deposits and applying it to the funds invested in tax-free income-generating instruments. For instance, in the case of Catholic Syrian Bank Ltd. for the assessment year 2001-02, the officer disallowed Rs. 1,13,88,320/- as interest expenditure out of a total tax-free income of Rs. 2,48,25,538/-. The court upheld the principle of disallowance under Section 14A, emphasizing that the provision aims to prevent the deduction of expenditure incurred for earning tax-free income. The court noted that the subsequent introduction of sub-sections (2) and (3) to Section 14A and Rule 8D provided a precise formula for disallowance, applicable from 2007-08 onwards. The court ruled that the main clause of Section 14A applies to all periods after its introduction, authorizing disallowance irrespective of whether separate accounts are maintained.

3. Applicability of Administrative Expenditure Disallowance:
The court addressed the issue of disallowing administrative expenditure proportionately under Section 14A. It noted that until Rule 8D came into force, there was no precise formula for such disallowance. The court decided that no disallowance for proportionate administrative costs attributable to earning tax-free income should be made until Rule 8D's applicability from 2007-08 onwards. The court remanded the cases to the Assessing Officer to rework the disallowance under Section 14A, limiting it to interest liability and excluding overheads or administrative expenditure until Rule 8D's implementation.

Judgment Summary:
The court upheld the principle of disallowance under Section 14A for interest expenditure on tax-free investments, emphasizing that the provision aims to prevent the deduction of such expenditure. The court found the methodology used by the Assessing Officer for estimating interest expenditure to be flawed and remanded the cases for reassessment. The court ruled that no disallowance for administrative expenditure should be made until Rule 8D's applicability from 2007-08 onwards. The appeals were disposed of by setting aside the Tribunal and first appellate authority's orders and remanding the assessments back to the Assessing Officer for reworking the disallowance under Section 14A.