The officer has disallowed under s.14A more than seventeen times the exempt income I actually earned, and he has done the same in a year where I earned none - how much of that survives, and does the 2022 amendment change the answer?
The client is a private limited company manufacturing auto components, assessed at a circle in Coimbatore. It is a partner in an LLP that distributes its products, holds shares in two wholly owned subsidiaries, and carries mutual fund units and a portfolio of listed shares as stock-in-trade. Paid-up capital and free reserves stood at Rs 2,40,00,00,000 on 31 March 2023 against borrowings of Rs 46,00,00,000 taken for plant. Two assessments are in appeal. For AY 2021-22 the return filed on 15 February 2022 declared Rs 3,86,00,000. The LLP made a loss, so there was no exempt income at all and no s.14A disallowance was offered; the order dated 22 September 2023 disallowed Rs 98,20,000. For AY 2023-24 the return filed on 30 October 2023 declared Rs 4,62,00,000 and offered Rs 2,10,000 against a share of LLP profit of Rs 6,40,000 exempt under s.10(2A). The order dated 18 March 2026 records one sentence, that the disallowance offered is not acceptable, and applies the formula to the whole investment schedule of Rs 1,12,40,00,000 - subsidiaries Rs 68,00,00,000, LLP capital Rs 4,40,00,000, listed stock-in-trade Rs 32,00,00,000 and mutual fund units Rs 8,00,00,000 - producing Rs 1,12,40,000. In both years the figure was also added to book profit under clause (f) of Explanation 1 to s.115JB. For AY 2023-24 penalty under s.270A was initiated for misreporting and the s.270AA application rejected on that ground.
Build the monthly investment schedule for both years yourself before drafting a single ground: each investment, its cost, the date it was acquired, the head under which its income is taxable, and whether any income came in at all that year. Almost every point in this file is decided by that schedule - what belongs in the average, whether there was exempt income, whether the cap bites, what could have been debited to profit and loss. Arguing the satisfaction point first, without the schedule, gets a remand and the same order back two years later.
The Explanation inserted in s.14A by the Finance Act 2022 provides that the section applies whether or not exempt income has accrued, arisen or been received in the year. Four High Courts in this library hold it prospective: it was inserted with effect from 1 April 2022, calling a provision an Explanation or saying it is for the removal of doubts does not make it retrospective where it in truth changes the law, and the Memorandum to the Finance Bill said so expressly. It therefore governs AY 2022-23 onwards. For AY 2021-22 the earlier position holds - the section speaks of expenditure in relation to income which does not form part of total income, which presupposes income actually received or receivable in that year - and the whole Rs 98,20,000 goes. For AY 2023-24 that argument is not available at all, because the company did earn exempt income and the Explanation governs the year anyway.
Sub-rule (2) of the Rule is not reached at all until the officer has first recorded the satisfaction the section and sub-rule (1) require, on the accounts. A High Court has held that where the officer never explained why the voluntary disallowance was unreasonable or unsatisfactory the recomputation cannot stand, and another has held that where the assessee's consistent case, given in answer to the officer's notice, is that no expenditure was incurred, the officer must proceed under the enquiry sub-section to collect material or evidence to determine what expenditure was in fact incurred rather than going straight to the formula. The Supreme Court has said the same twice over: the officer must record satisfaction before rejecting the assessee's own computation, and sub-section (1) still requires proof that the expenditure sought to be disallowed was in fact incurred in relation to the exempt income. One sentence saying the offered figure is not acceptable is not that.
A High Court has held that a disallowance which works out to the whole of, or more than, the exempt income cannot stand, because by no stretch can the section or the Rule be read to mean that the entire tax exempt income is to be disallowed; it set aside a disallowance of about 110 per cent of the dividend earned. Here the figure is more than seventeen times the exempt income. The library's own concept page on the section after the 2022 amendment states the cap as part of the position. On that footing alone AY 2023-24 falls from Rs 1,12,40,000 to at most Rs 6,40,000, and the real contest becomes the difference between the company's own Rs 2,10,000 and that ceiling - a fight worth Rs 4,30,000, not Rs 1,12,40,000.
Only investments whose income does not form part of total income go into the average. A High Court set aside a computation in which the officer, instead of adopting the average value of tax exempt investments, factored in the total investment. On this schedule the mutual fund units of Rs 8,00,00,000 and the subsidiary shares of Rs 68,00,00,000 have no business in it: dividend from a domestic company has been taxable in the shareholder's hands since AY 2021-22, so neither holding can yield income that does not form part of total income. Strip them out and the base falls from Rs 1,12,40,00,000 to Rs 36,40,00,000, and the formula figure from Rs 1,12,40,000 to Rs 36,40,000 - still above the cap, which is why both grounds are needed.
The Supreme Court has held that where interest-free own funds exceed the investment in tax-free securities a presumption arises that the investment came out of those funds, and that the officer cannot substitute an estimated proportionate figure for it. Here own funds of Rs 2,40,00,00,000 stand against an entire investment schedule of Rs 1,12,40,00,000 and against exempt-income-yielding investments of Rs 36,40,00,000, so the presumption is available on the face of the audited balance sheet and should be pleaded with those three figures set out. The Supreme Court decision on dividend from a company that had paid distribution tax makes the same point from the other end: the section applies, but sub-section (1) still requires proof that the expenditure was incurred in relation to the exempt income, and an estimate is not proof.
A High Court has held that a disallowance under this section is a notional disallowance and that the amount cannot be added back to book profit under clause (f) by taking recourse to it, because clause (f) can operate only on amounts actually debited to the profit and loss account. A Special Bench of the Tribunal had already held that the clause (f) addition has to be worked out on its own, without resorting to the computation under the section read with the Rule. On this file nothing was debited to the profit and loss account as expenditure relating to the LLP share, so on the company's own accounts the clause (f) addition is nil, and the ground is short: the officer has carried a notional figure across instead of finding an actual debit.
A Tribunal Bench has dealt with exactly this: a fund that overstated its own disallowance in its return by more than a crore and then wanted it corrected. The Bench held that the bar on entertaining a claim not made in a return is confined to the powers of the Assessing Officer, while a High Court has held that the appellate authorities are competent to entertain such a claim, and it restored the issue to the officer. Another Bench applied the same distinction to a book-profit reduction raised by letter during the assessment: the bar operates against the officer and not against an appellate authority, and where the material was before the first appellate authority he should have examined it.
A High Court has quashed a penalty order and directed the officer to grant immunity on facts that are this file: the only addition was a recomputation of a disallowance under this section which the assessee had itself estimated and disclosed, both sides worked from the same details and reached different figures, and the officer nevertheless labelled it misreporting and refused immunity. Behind that sits the Supreme Court: a disallowance does not automatically carry penalty, because the provision needs either concealment or particulars that are factually false, and where everything was disclosed truthfully and only the legal claim was untenable there is nothing inaccurate.
The year with no exempt income is usually won outright while it is a pre-AY 2022-23 year, and that is the strongest head in this file. The year with exempt income usually comes down to the exempt income or near it - the cap and the average argument together do most of the work, and a residual disallowance somewhere between the company's own figure and the exempt income is the common landing. The satisfaction ground on its own more often produces a fresh computation than a deletion. The book-profit addition is deleted more often than not, but on the strength of one High Court and a Tribunal Special Bench rather than settled law. The penalty usually falls with the quantum; the immunity application is the thing most often lost by inadvertence, because the appeal is filed first and the option closes.
