Disallowance under section 14A
of Income-tax Act

Direct Taxes

New Rule 8D – A lesson in tight rope walking?

1. Over period of time, Rules have traditionally played hand maids to Statutory Provisions. This is discipline that was religiously followed both by the law makers and the judiciary. Rules were always meant to be subservient to the Statute. A conflict between the Statute and the Rules was therefore always resolved in favour of the former.
   
   The role of Rules, as subordinate legislation, was well understood. Even where Rules were created not by delegated legislation, but by the law makers themselves, they did not enjoy the same force as a principal enactment. This principle was well observed by the Gujarat High Court in its tax decision in the case of CIT vs. Satellite Engineering Ltd. [1978] as reported in 113 ITR 208, 223 (Guj).

2. Even in the mode of interpretation, Courts have noted that Rules cannot travel beyond the main Statute and have to be read subject to the provisions of the Statute itself. All India Lakshmi Commercial Bank Officers Union vs. Union of India [1984] 150 ITR 1, 7. (Del).
   Rules were thus read consistent with the provisions of the Act and if a rule goes beyond what the Act contemplates, the Rule has no option but to yield to the Act.
   
   The guiding principle is that it is the section which must control and govern the rule and the rule must be interpreted in the light of the section and not vice versa. CIT vs. New Citizen Bank of India [1965] 58 ITR 468, 484 (Bom).
   
   Lastly, Statutory rules must be interpreted in the light of the section for the purpose of which they are made.

3. An interesting issue has just come to the fore on account of the new Income Tax Rule 8D. This rule has been prescribed by the Central Board of Direct Taxes and notified vide notification No. 45/2008 dated 24th March 2008 for the purpose of section 14A of the Income-tax Act, (2008) 299 ITR (St.) 88.

4. As we are aware, section 14A provides for disallowance of expenditure in relation to income not includible in total income.
   
   Sub-section [2] is pertinent. This sub-section enjoins on the Assessing Officer to determine the amount of expenditure incurred in relation to such income which does not form part of the total income under this Act in accordance with such method as may be prescribed, if the Assessing Officer, having regard to the accounts of the assessee, is not satisfied with the correctness of the claim of the assessee in respect of such expenditure in relation to income which does not form part of the total income under this Act.
   
   Sub-section [3] then provides that the provisions of sub-section (2) shall also apply in relation to a case where an assessee claims that no expenditure has been incurred by him in relation to income which does not form part of the total income under this Act:

   The new Rule 8D reads as under :—
   8D “Method for determining amount of expenditure in relation to income not includible in total income.
   
   (1) Where the Assessing Officer, having regard to the accounts of the assessee of a previous year, is not satisfied with—

   (a) the correctness of the claim of expenditure made by the assessee; or
   
   (b) the claim made by the assessee that no expenditure has been incurred, in relation to income which does not form part of the total income under the Act for such previous year, he shall determine the amount of expenditure in relation to such income in accordance with the provisions of sub-rule (2).

   (2) The expenditure in relation to income which does not form part of the total income shall be the aggregate of following amounts, namely:—

   (i) the amount of expenditure directly relating to income which does not form part of total income;
   (ii) in a case where the assessee has incurred expenditure by way of interest during the previous year which is not directly attributable to any particular income or receipt, an amount computed in accordance with the following formula, namely:—
   A x B / C
   Where
   A = amount of expenditure by way of interest other than the amount of interest included in clause (i) incurred during the previous year;
   
   B = the average of value of investment, income from which does not or shall not form part of the total income, as appearing in the balance sheet of the assessee, on the first day and the last day of the previous year;
   
   C = the average of total assets as appearing in the balance sheet of the assessee, on the first day and the last day of the previous year;
   
   (iii) an amount equal to one-half per cent of the average of the value of investment, income from which does not or shall not form part of the total income, as appearing in the balance sheet of the assessee, on the first day and the last day of the previous year.”

   3. For the purposes of this rule, the ‘total assets’ shall mean, total assets as appearing in the balance sheet excluding the increase on account of revaluation of assets but including the decrease on account of revaluation of assets.”

5. At first glance, the new rule may appear fearsome. But, this may not be so. We have seen above that there is enough authority to subdue a rule by interpreting the same is context of the statutory provision to which it is subordinate.

6. The issue addressed in this article is whether the Assessing Officer is duty bound to determine the disallowance of expenditure by resorting to the method prescribed u/r 8D merely because he disagrees with the working of the disallowance on its correctness, when any other scientific working is still possible based on the information in book of account.
   
   In short, even if the accounts are reliably maintained and a determination of disallowance of the expenditure is possible on some decent scientific method, whether a resort can be made by the Assessing Officer to the rule of thumb method prescribed in Rule 6D?

7. In the first place, the assessee, on his own, is not obliged to compute the disallowance as per the method prescribed in rule 8D. The assessee is entitled to work out the disallowance by any scientific method based on the information in his accounts. The Rule 8D is meant for the Assessing Officer’s determination of the expenditure and not for the assessee.

8. The Assessing Officer has to be first dissatisfied with the correctness of disallowable expenditure calculated by the Assessing Officer. It is a mandatory condition in section 14A that this dissatisfaction is reached “having regard to the accounts of the assessee”. Even Rule 8D agrees that the Assessing Officer should be dissatisfied “having regard to the accounts”. In short, he cannot disregard the accounts in making his inquiry whether the disallowance worked by the assessee is correct.
   
   If, having regard to the accounts, he feels that the disallowance calculated by the assessee can be corrected by reworking it scientifically, he need not invoke the provisions of rule 8D. This is more particularly so, when the books of account provide the means to work out the disallowance correctly.
   
   If, there are no accounts or the accounts are unreliable and requires to be rejected, rule 8D cannot be invoked as this rule itself depends on accounts [the balance sheet figures] for its calculation.

9. According to me, Rule 8D can be invoked only when it is not possible to work out the disallowance correctly having regard to the accounts, say due to the complexity involved in the accounts or lack of some vital information.
   
   This interpretation, I feel, will assign due weightage and justice to the expression “having regards to the accounts” . Rule 8D is meant as a measure of last resort only; i.e., when it is not possible to work out the disallowance correctly having regard to the accounts.
   
   Even if the working of the disallowance made by the assessee is wrong, the Assessing Officer must take due regard to the accounts and find out whether the disallowance can be worked on basis of accounting principles. This, he is expected to do so honestly and only when this possibility is exhausted, he must resort to the determination by Rule 8D.

10. The above interpretation, dear readers, I feel, will align Rule 8D with the provisions in section 14A. Interpretation of Rules in alignment with the statute is sometimes veritably a lesson in tightrope walking. The rope is the statute, the walker is the Rules and the balancing stick is the principle of interpretation that Rules must confirm to the provisions of the principal enactment.