The Commissioner exercised their authority under Section 263 of the Income Tax Act to revise an assessment order from the Assessing Officer regarding an individual taxpayer. The Assessing Officer had accepted the taxpayer's return without properly applying the law around Section 14A regarding the disallowance of expenses related to exempt income. The Commissioner found the Assessing Officer's order to be erroneous and prejudicial to revenue interests as they failed to disallow expenses related to the taxpayer's exempt mutual fund income as required by Section 14A. The taxpayer argued the order was correctly made, but the Commissioner determined the Assessing Officer did not properly apply their mind to Section 14A during the assessment. Therefore, the Commissioner was justified in revising the order under Section

1. 1
GOVERNMENT OF INDIA
INCOME TAX DEPARTMENT
OFFICE OF THE PRINCIPAL COMMISSIONER OF INCOME-TAX, CHENNAI-6 ,
Room No. 601, 6th Floor, New Block,
121, Mahathma Gandhi Road, Chennai-34.
***********
C.No.6119 (35)/PR CIT-6/2016-17 Dt : 04/01/2017
PROCEEDINGS UNDER SECTION 263 OF THE INCOME TAX ACT, 1961
REG: Income Tax Assessment – Assessment Year : 2012-13 –
Order under Section 263 of the Income Tax Act, 1961 - In the case of
Smt. Nirmala Santhanam (PAN: AAVPS8248P), New No.4, Old No.86,
4th
Main Road, Gandhi Nagar, Adyar, Chennai-20 – Reg.
******************
O R D E R:
The assessee is an individual filed her return of income for A.Y. 2012-13 on
30.09.2012 admitting total income of Rs.2,24,42,660/-. The case was selected to scrutiny and
notice u/s 143(2) was served on the assessee on 14.10.2013 and accordingly assessment
u/s 143(3) was completed on 04.02.2015, by accepting the income returned.
Para 2. From the records it was noticed that the AO had failed to made any disallowance
u/s 14A rw Rule 8D on account of the fact that the assessee claimed Rs.65.17 lakhs as exempt
income being derived from mutual funds. According to Section 14A rw Rule 8B(2)(iii) which
deals with the method of determining the amount of expenditure in relation to income not
includible in total income, and prescribes that 0.5% of average investments in relation to
income which is exempt has to be arrived at and added back to the total income. Since, the
AO has failed to apply his mind to this provision of law, a show cause notice u/s 263 was
issued on 08.12.2016. The assessee filed a written submission on 20.12.2016.

2. 2
Para 3. In the written submission filed on 22.12.2016, the assessee company has stated
as below:
“In the context of your proposed revision of assessment u/s 263 of the Income
Tax Act, 1961 for invoking section 14A on the presumption that the order passed
u/s 143 on 4th
February, 2015 without considering the issue of section 14A, is
erroneous in so far as also it is prejudicial to the interests of Revenue.
In response to your subject notice, I wish to bring to your attention that the
nondisallowance u/s 14A read with Rule 8D is a considered decision by the
Assessing officer as against your presumption that it was not considered as
noted in your notice in para 3. On the contrary the applicability of section 14A to
the facts of the case was queried by the Assessing officer during the
assessment proceedings and vide our Authorized Representative submission
on 6th
June, 2014 response was filed regarding the inapplicability of the
provisions of section 14A to the facts of the case. Copy of my Authorized
Representative response is enclosed for your immediate reference and
appreciation. The Assessing officer deliberated this issue during the
assessment proceedings. Now revisiting this issue by revision is not warranted
on the facts of the case.
On merits, we reiterate, with respect to applicability of section 14A of the Income
Tax Act 1961 and rule 8D of the IT rules in respect income earned by the
assessee which are exempt from Income Tax, it is submitted that:
 The sub section (1) of section 14A states to the effect that for the purpose
of computing Total Income, no deduction shall be allowed in respect of
expenditure incurred in relation to non-taxable income. Therefore,
basically this sub section is the charging provision.
 The sub sections (2) and (3) detail the procedure for determining such
expenditure, if any.
 Even the applicability of Rule 8D prescribed is subject to the
establishment by the Assessing officer of the incorrectness of our claim
with respect to such expenditure, if any.
 The jurisdictional court and various other courts have ruled upholding a
similar stand.
 Investments also do not feature in the balance sheet by only in Capital
Account.
In this view of the matter, the provisions of section 14A are in applicable to the
facts and circumstances of the case.
For the foregoing reasons, reopening of the assessment is ultra vires the Income
Tax Act and by this submission I request to restore the original assessment.”

3. 3
Para 4 Before proceeding further, it will be relevant to analyse as to when the jurisdiction
under Section 263 can be validly exercised :-
Revision oforders prejudicial to revenue.
263. (1) The Commissioner may call for and examine the record98
of any proceeding under this Act, and
if he considers that any order passed therein by the 99
[Assessing] Officer is erroneous in so far as98
it is
prejudicial to the interests of the revenue98
, he may, after giving the assessee an opportunity of being
heard and after making or causing to be made such inquiry as he deems necessary, pass such order
thereon as the circumstances of the case justify, including an order enhancing or modifying the
assessment,or cancelling the assessment98
and directing a fresh assessment.
1
[Explanation.—For the removal of doubts, it is hereby declared that, for the purposes of this sub-
section,—
(a) an order passed 2
[on or before or after the 1st day of June, 1988] by the Assessing Officer shall
include—
(i) an order of assessment made by the Assistant Commissioner 3
[or Deputy Commissioner]
or the Income-tax Officer on the basis of the directions issued by the 4
[Joint]
Commissioner under section 144A;
(ii) an order made by the 4
[Joint] Commissioner in exercise of the powers or in the
performance of the functions of an Assessing Officer conferred on, or assigned to, him
under the orders or directions issued by the Board or by the Chief Commissioner or
Director General or Commissioner authorised by the Board in this behalf under section
120;
(b) "record" 5
[shall include and shall be deemed always to have included] all records relating to any
proceeding under this Act available at the time of examination by the Commissioner;
(c) where any order referred to in this sub-section and passed by the Assessing Officer had been the
subject matter of any appeal 6
[filed on or before or after the 1st day of June, 1988], the powers
of the Commissioner under this sub-section shall extend 6
[and shall be deemed always to have
extended] to such matters as had not been considered and decided in such appeal.]
7
[(2) No order shall be made under sub-section (1) after the expiry of two years from the end of the
financial year in which the order sought to be revised was passed.]
(3) Notwithstanding anything contained in sub-section (2), an order in revision under this section may be
passed at any time in the case of an order which has been passed in consequence of, or to give effect to,
any finding or direction contained in an order of the Appellate Tribunal, 8
[National Tax Tribunal,] the
High Court or the Supreme Court.
Explanation.—In computing the period of limitation for the purposes of sub-section (2), the time taken in
giving an opportunity to the assessee to be reheard under the proviso to section 129 and any period during
which any proceeding under this section is stayed by an order or injunction of any court shall be excluded
3.1 The scope of Section 263 was examined as under:-
[2000] 109 TAXMAN 66 (SC)
SUPREME COURT OF INDIA*
Malabar Industrial Co. Ltd.
v.
Commissioner of Income-tax
D.P. WADHWA AND S.S. MOHAMMED QUADRI, JJ.
CIVIL APPEAL NO. 3646 OF 1993

4. 4
FEBRUARY 10, 2000
Section 263 of the Income-tax Act, 1961 - Revision - Of orders prejudicial to interests of
revenue - Assessment year 1983-84 - Whether in order to invoke section 263 Assessing
Officer’s order must be erroneous and also prejudicial to revenue and if one of them is
absent, i.e., if order of Income-tax Officer is erroneous but is not prejudicial to revenue or
if it is not erroneous but is prejudicial to revenue, recourse cannot be had to section 263(1) -
Held, yes - Whether if due to an erroneous order of ITO, revenue is losing tax lawfully
payable by a person, it will certainly be prejudicial to interests of revenue - Held, yes -
Assessee-company entered into agreement for sale of estate of rubber plantation - As
purchaser could not pay instalments as scheduled in agreement, extension of time for
payment of instalments was given on condition of vendee paying damages for loss of
agricultural income and assessee passed resolution to that effect - Assessee showed this
receipt as agricultural income - Resolution passed by assessee was not placed before
Assessing Officer - Assessing Officer accepted entry in statement of account filed by
assessee and accepted same - Commissioner under section 263 held that said amount was
not connected with agricultural activities and was liable to be taxed under head ‘Income
from other sources’ - Whether, where Assessing Officer had accepted entry in statement of
account filed by assessee, in absence of any supporting material without making any
enquiry, exercise of jurisdiction by Commissioner under section 263(1) was justified - Held,
yes
Section 2(1A) of the Income-tax Act, 1961 - Agricultural income - Assessee sold estate of
rubber plantation - Extension of time for payment of sale consideration was granted to
vendee on condition of vendee paying certain amount towards loss/damage of agricultural
income - Assessee claimed amount of damages as agricultural income - Tribunal found that
assessee had stopped agricultural operations and receipt under consideration did not relate
to any agricultural operation carried on by assessee - Whether receipt was rightly taxed
under head ‘Income from other sources’ - Held, yes
FACTS
The assessee-company entered into an agreement for sale of estate of rubber plantation. The
agreement provided, inter alia, for payment of the consideration in instalments as scheduled
therein. However, the purchaser could not adhere to the Schedules and on his request the
parties agreed to the extension of time for payment of the instalments on condition of vendee
paying compensation/damages for loss of agricultural income and other liabilities. Accordingly,
the assessee-company passed a resolution also to that effect and the purchaser paid the said
amount. In the return filed by it, the amount was noted as compensation and damages for loss
of agricultural income. The Assessing Officer accepted the same and endorsed nil assessment
for that year. Exercising his jurisdiction under section 263, the Commissioner held that the said
amount was unconnected with any agricultural operation activity and was liable to be taxed
under the head ‘Income from other sources’. The Tribunal dismissed the assessee’s appeal. On
reference, the High Court also favoured the department.
On appeal to the Supreme Court :
HELD

5. 5
A bare reading of section 263(1) makes it clear that the pre-requisite to exercise
of jurisdiction by the Commissioner suo motu under it, is that the order of the ITO
is erroneous insofar as it is prejudicial to the interests of the revenue. The
Commissioner has to be satisfied of twin conditions, namely, (i) the order of the
Assessing Officer sought to be revised is erroneous; and (ii) it is prejudicial to
the interests of the revenue. If one of them is absent - if the order of the ITO is
erroneous but is not prejudicial to the revenue or if it is not erroneous but is
prejudicial to the revenue - recourse cannot be had to section 263(1).
There can be no doubt that the provision cannot be invoked to correct each and every
type of mistake or error committed by the Assessing Officer; it is only when an order is
erroneous that the section will be attracted. An incorrect assumption of facts or an
incorrect application of law will satisfy the requirement of the order being
erroneous. In the same category fall orders passed without applying the
principles of natural justice or without application of mind.
The phrase ‘prejudicial to the interests of the revenue’ is not an expression of art
and is not defined in the Act. Understood in its ordinary meaning, it is of wide
import and is not confined to loss of tax. The scheme of the Act is to levy and
collect tax in accordance with the provisions of the Act and this task is entrusted
to the revenue. If due to an erroneous order of the ITO, the revenue is losing tax
lawfully payable by a person, it will certainly be prejudicial to the interests of the
revenue.
The phrase ‘prejudicial to the interests of the revenue’ has to be read in
conjunction with an erroneous order passed by the Assessing Officer. Every loss
of revenue as a consequence of an order of the Assessing Officer cannot be
treated as prejudicial to the interests of the revenue, for example, when an ITO
adopts one of the courses permissible in law and it has resulted in loss of
revenue; or where two views are possible and the ITO has taken one view with
which the Commissioner does not agree, it cannot be treated as an erroneous
order prejudicial to the interests of the revenue unless the view taken by the ITO
is unsustainable in law. It has been held by the Supreme Court that where a sum
not earned by a person is assessed as income in his hands on his so offering, the
order passed by the Assessing Officer accepting the same as such will be
erroneous and prejudicial to the interests of the revenue.
In the instant case, the Commissioner noted that the ITO passed the order of nil assessment
without application of mind. Indeed, the High Court recorded the finding that the ITO failed to
apply his mind to the case in all perspective and the order passed by him was erroneous. It
appeared that the resolution passed by the board of the appellant-company was not placed
before the Assessing Officer. Thus, there was no material to support the claim of the appellant
that the said amount represented compensation for loss of agricultural income. He accepted the
entry in the statement of the account filed by the appellant in the absence of any supporting
material and without making any inquiry. On these facts the conclusion that the order of the ITO
was erroneous was irresistible. Therefore, the High Court had rightly held that the exercise of
the jurisdiction by the Commissioner under section 263(1) was justified.
It was not shown at any stage of the proceedings that the amount in question was fixed or
quantified as loss of agricultural income and, admittedly, it was not so found by the Tribunal.
The further question whether it would be agricultural income within the meaning of section 2(1A)

6. 6
did not arise for consideration. It was evident from the order of the High Court that the findings
recorded by the Tribunal that the appellant stopped agricultural operation in November 1982
and the receipt under consideration did not relate to any agricultural operation carried on by the
appellant, were not questioned before it. Though the High Court was not correct in holding that
the amount was paid for breach of contract as indeed it was paid in modification/relaxation of
the terms of the contract, it was to be held that the High Court was justified in concluding that
the said amount was a taxable receipt under the head ‘Income from other sources’.
CASE REVIEW
Decision of the Kerala High Court in Malabar Industrial Co. Ltd. v. CIT [1992] 198 ITR 611
affirmed.
CASES REFERRED TO
Dawjee Dadabhov & Co. v. S.P. Jain [1957] 31 ITR 872 (Cal.), CIT v. T. Narayana Pai [1975] 98
ITR 422 (Kar.), CIT v. Gabriel India Ltd. [1993] 203 ITR 108 (Bom.), CIT v. Smt. Minalben S.
Parikh [1995] 215 ITR 81/ 79 Taxman 184 (Guj.), Venkatakrishna Rice Co. v. CIT [1988] 163 ITR
129 (Mad.), Rampyari Devi Saraogi v. CIT [1968] 67 ITR 84 (SC), Smt. Tara Devi Aggarwal v.
CIT [1973] 88 ITR 323 (SC) and CIT v. Raja Benoy Kumar Sahas Roy [1957] 32 ITR 466 (SC).
[2006] 100 ITD 173 (MUM.)
IN THE ITAT MUMBAIBENCH ‘H’
Mrs. Khatiza S. Oomerbhoy
v.
Income-tax Officer, Ward 17(3)(3)
K.K. BOLIYA, ACCOUNTANT MEMBER AND MS. SUSHMA CHOWLA, JUDICIAL MEMBER
IT APPEAL NOS. 3299 AND 3300 (MUM.) OF 2005 [ASSESSMENT YEARS 1997-98 AND 1998-99]
FEBRUARY 27, 2006
Section 263 of the Income-tax Act, 1961 - Revision - Of orders prejudicial to interest of revenue -
Assessment years 1997-98 and 1998-99 - Whether powers vested in Commissioner under section 263 are
extraordinary powers and completed assessment proceedings cannot be reopened unless there is some
cogent material to show that there is total non-application of mind on part of Assessing Officer or that
Assessing Officer has committed any glaring mistake of fact or law - Held, yes - Whether where
during reassessment proceedings, Assessing Officer raised several queries regarding computation of
income under head ‘Capital gains’ and in response assessee had filed detailed replies explanations
supported by various documents which were duly considered by Assessing Officer, it c ould not be
assumed that there was non- application of mind on part of Assessing Officer and, therefore,
Commissioner was not justified in interfering with order passed by Assessing Officer by invoking his
jurisdiction under section 263 - Held, yes
FACTS
For the relevant assessment years, assessments of assessee were completed under section 143(3) read
with section 147 assessing income under the head ‘Capital gains’. The Commissioner, while exercising
powers under section 263, set aside assessment orders on grounds that the Assessing Officer had
granted excess benefit under section 54; and that he had accepted cost of construction of a building
without applying his mind and referring to valuation cell.
On appeal :
HELD
The fundamental principles which emerge from the several cases regarding the
powers of the Commissioner under section 263 may be summarized below :

7. 7
(i )The Commissioner must record satisfaction that the order of the Assessing
Officer is erroneous and prejudicial to the interests of the revenue. Both the
conditions must be fulfilled.
(ii )Section 263 cannot be invoked to correct each and every type of mistake or
error committed by the Assessing Officer and it is only when an order is
erroneous, that the section will be attracted.
(iii )An incorrect assumption of facts or an incorrect application of law will suffice
for the requirement of order being erroneous.
(iv )If the order is passed without application of mind, such order will fall under
the category of erroneous order.
(v )Every loss of revenue cannot be treated as prejudicial to the interests of the
revenue and if the Assessing Officer has adopted one of the courses
permissible under law or where two views are possible and the Assessing
Officer has taken one view with which the Commissioner does not agree, it
cannot be treated as an erroneous order, unless the view taken by the
Assessing Officer is unsustainable under law.
(vi )If while making the assessment, the Assessing Officer examines the
accounts, makes enquiries, applies his mind to the facts and circumstances
of the case and determines the income, the Commissioner, while exercising
his power under section 263, is not permitted to substitute his estimate of
income in place of the income estimated by the Assessing Officer.
(vii )The Assessing Officer exercises quasi-judicial power vested in him and if he
exercises such power in accordance with law and arrives at a conclusion,
such conclusion cannot be termed to be erroneous simply because the
Commissioner does not feel satisfied with the conclusion.
(viii )The Commissioner, before exercising his jurisdiction under section 263,
must have material on record to arrive at a satisfaction.
(ix )If the Assessing Officer has made enquiries during the course of assessment
proceedings on the relevant issues and the assessee has given detailed
explanation by a letter in writing and the Assessing Officer allows the claim
on being satisfied with the explanation of the assessee, the decision of the
Assessing Officer cannot be held to be erroneous simply because in his
order he does not make an elaborate discussion in that regard.
The jurisdiction under section 263 cannot be utilized as an instrument for reopening concluded
proceedings on flimsy grounds or on assumptions.
In the instant case during the course of re-assessment proceedings, the Assessing Officer raised several
relevant queries regarding computation of income under the head ‘Capital gains’ and in response to such
queries, the assessee filed detailed replies/explanations supported by documents like valuation reports,
copy of development agreement, etc. In the order passed by him, the Assessing Officer ha d referred to
the relevant facts and also referred to the deduction claimed by the assessee under section 54.
The Bombay High Court, in the case of CIT v. Gabrial (India) Ltd. [1993] 203 ITR
188/ 71 Taxman 585 has clearly held that if the Assessing Officer has raised

8. 8
queries and the assessee has filed written submission/explanation, merely
because there is no elaborate discussion in the Assessing Officer’s order, it
cannot be said that such order becomes erroneous. In the instant case, new
material came to the notice of the Commissioner and he made certain
assumptions without any basis or material. The powers vested in the
Commissioner under section 263 are extraordinary powers and completed
assessment proceedings cannot be reopened unless there is some cogent
material to show that there is total non-application of mind on the part of the
Assessing Officer or that the Assessing Officer has committed any glaring
mistake of fact or law. The assessee filed proper explanations with regard to the cost of
construction, assessee’s claim for deduction under section 54 and the valuation, which was ‘supported by
valuation report of registered valuer’. The entire materi al was available before the Assessing Officer
during the course of the assessment proceedings. As a matter of fact, all the material was filed before the
Assessing Officer in response to the queries raised by him. There was hardly any basis to assume that
there was non-application of mind on the part of the Assessing Officer. Considering the entire facts and
circumstances, the Commissioner had wrongly invoked his jurisdiction under section 263 and, therefore,
common order passed under section 263 for the assessment years 1997-98 and 1998-99 was to be
quashed. [Para 8]
In the result the assessee’s appeal stood allowed. [Para 9]
CASES REFERRED TO
Malabar Industrial Co. Ltd. v. CIT [2000] 243 ITR 83/ 109 Taxman 66 (SC) (para 5), CIT v. Gabrial India
Ltd. [1993] 203 ITR 108/ 71 Taxman 585 (Bom.) (para 5), Girdharilal B. Rohra v. CIT [2004] 86 TTJ
(Mum.) 177 (para 5), Triveni Engg. Works Ltd. v. Dy. CIT [2004] 87 TTJ (Delhi) 93/[2003] 131 Taxman
32 (Delhi) (para 5) and Bipin P. Shah v. ITO [IT Appeal No. 5992 (Mum.) of 2003, dated 31-3-2005] (para
5).
Para 5: The principles emerging from the judgment of the Apex Court also
analysed by the Mumbai Bench of the Honorable ITAT are as under:-
The fundamental principles which emerge from the several cases regarding the
powers of the Commissioner under section 263 may be summarized below :
(i )The Commissioner must record satisfaction that the order of the Assessing
Officer is erroneous and prejudicial to the interests of the revenue. Both the
conditions must be fulfilled.
(ii )Section 263 cannot be invoked to correct each and every type of mistake or
error committed by the Assessing Officer and it is only when an order is
erroneous, that the section will be attracted.
(iii )An incorrect assumption of facts or an incorrect application of law will suffice
for the requirement of order being erroneous.
(iv )If the order is passed without application of mind, such order will fall under
the category of erroneous order.
(v )Every loss of revenue cannot be treated as prejudicial to the interests of the
revenue and if the Assessing Officer has adopted one of the courses
permissible under law or where two views are possible and the Assessing

9. 9
Officer has taken one view with which the Commissioner does not agree, it
cannot be treated as an erroneous order, unless the view taken by the
Assessing Officer is unsustainable under law.
(vi )If while making the assessment, the Assessing Officer examines the
accounts, makes enquiries, applies his mind to the facts and circumstances
of the case and determines the income, the Commissioner, while exercising
his power under section 263, is not permitted to substitute his estimate of
income in place of the income estimated by the Assessing Officer.
(vii )The Assessing Officer exercises quasi-judicial power vested in him and if he
exercises such power in accordance with law and arrives at a conclusion,
such conclusion cannot be termed to be erroneous simply because the
Commissioner does not feel satisfied with the conclusion.
(viii )The Commissioner, before exercising his jurisdiction under section 263,
must have material on record to arrive at a satisfaction.
(ix )If the Assessing Officer has made enquiries during the course of assessment
proceedings on the relevant issues and the assessee has given detailed
explanation by a letter in writing and the Assessing Officer allows the claim
on being satisfied with the explanation of the assessee, the decision of the
Assessing Officer cannot be held to be erroneous simply because in his
order he does not make an elaborate discussion in that regard.
Para 6. Before proceeding further the assessee’s submissions need to be dealt with
vis-a-vis the current legal position with respect to disallowances u/s 14A:
The Delhi High Court in Maxopp Investment Ltd. v. Commissioner of
Income-tax (347 ITR 372) has opined that section 14A was inserted by the
Finance Act, 2001, with retrospective effect from Aril 1, 1962. Prior to the
introduction of section 14A, the law was that when an assessee had a
composite and indivisible business which had elements of both taxable and
non-taxable income, the entire expenditure in respect of the business was
deductible and, in such a case, the principle of apportionment of the
expenditure relating to the non-taxable income did not apply. However,
where the business was divisible, the principle of apportionment of the
expenditure was applicable and the expenditure apportioned to the "exempt"
income or income not exigible to tax, was not allowable as a deduction. Sub-

10. 10
section (1) of section 14A clearly stipulates that for the purposes of
computing the total income under Chapter IV, no deduction shall be allowed
in respect of expenditure "incurred" by the assessee "in relation to" income
which does not form part of the total income under the Act. The expression
"in relation to" is, ordinarily, of wide import. In the normal course, the
expression would have an expansive meaning unless, of course, the context
would otherwise suggest. The context does not suggest that a narrow
meaning ought to be given to the expression. The provision was inserted by
virtue of the Finance Act, 2001, with retrospective effect from April 1, 1962.
In other words, it was the intention of Parliament that it should appear in the
statute book, from its inception, that expenditure incurred in connection with
income which does not form part of total income ought not to be allowed as a
deduction. The factum of making the provision retrospective makes it clear
that Parliament wanted that it should be understood by all that from the very
beginning, such expenditure was not allowable as a deduction. Of course, by
introducing the proviso it made it clear that there was no intention to reopen
finalised assessments prior to the assessment year beginning on April 1,
2001.
The expression "in relation to" does not have any embedded object. It simply
means "in connection with" or "pertains to". If the expenditure in question has
a relation or connection with or pertains to exempt income it cannot be
allowed as a deduction even if it qualifies under other provisions of the Act.
The actual expenditure that is in contemplation under section 14A(1) of the
Act is the "actual" expenditure in relation to or in connection with or
pertaining to exempt income. The corollary to this is that if no expenditure is

11. 11
incurred in relation to the exempt income, no disallowance can be made
under section14A of the Act.
Sub-sections (2) and (3) were inserted by the Finance Act, 2006, with
effect from April 1, 2007. However, the expression "such method as
may be prescribed" got meaning only by the introduction of rule 8D of
the Income-tax Rules,1962.
Sub-section (2) of section 14A of the Act provides the manner in which
the Assessing Officer is to determine the amount of expenditure
incurred in relation to income which does not form part of the total
income. The requirement of the Assessing Officer embarking upon a
determination of the amount of expenditure incurred in relation to
exempt income would be triggered only if the Assessing Officer returns
a finding that he is not satisfied with the correctness of the claim of the
assessee in respect of such expenditure. Therefore, the condition
precedent for the Assessing Officer entering upon a determination of
the amount of the expenditure incurred in relation to exempt income is
that the Assessing Officer must record that he is not satisfied with the
correctness of the claim of the assessee in respect of such
expenditure.
Sub-section (3) is nothing but an offshoot of sub-section (2) of section
14A. Sub-section (3) applies to cases where the assessee
claims that no expenditure has been incurred in relation to income
which does not form part of the total income under the Act. In other
words, sub-section (2) deals with cases where the assessee specifies a
positive amount of expenditure in relation to income which does not

12. 12
form part of the total income under the Act and sub-section (3) applies
to cases where the assessee asserts that no expenditure had been
incurred in relation to exempt income. In both cases, the Assessing
Officer, if satisfied with the correctness of the claim of the assessee in
respect of such expenditure or no expenditure, as the case may be,
cannot embark upon a determination of the amount of expenditure in
accordance with any prescribed method, as mentioned in sub-section
(2) of section 14A of the Act. It is only if the Assessing Officer is not
satisfied with the correctness of the claim of the assessee, in both
cases, that the Assessing Officer gets jurisdiction to determine the
amount of expenditure incurred in relation to such income which does
not form part of the total income under the Act in accordance with the
prescribed method. The prescribed method is the method stipulated in
rule 8D of the Rules. While rejecting the claim of the assessee with
regard to the expenditure or no expenditure, as the case may be, in
relation to exempt income, the Assessing Officer would have to
indicate cogent reasons for the same. It is, therefore, clear that
determination of the amount of expenditure in relation to exempt
income under rule 8D would only come into play when the Assessing
Officer rejects the claim of the assesseein this regard.
If one examines sub-rule (2) of rule 8D, the method for determining the
expenditure in relation to exempt income has three components. The
first component is the amount of expenditure directly relating to
income which does not form part of the total income. The second is
being computed on the basis of the formula given therein in a case
where the assessee incurs expenditure by way of interest which is not

13. 13
directly attributable to any particular income or receipt. The formula
essentially apportions the amount of expenditure by way of interest
(other than the amount of interest included in clause (i)) incurred
during the previous year in the ratio of the average value of investment,
income from which does not or shall not form part of the total income,
to the average of the total assets of the assessee. The third component
is an artificial figure-one half per cent. of the average value of the
investment, income from which does not or shall not form part of the
total income, as appearing in the balance-sheets of the assessee, on
the first day and the last day of the previous year. It is the aggregate of
these three components which would constitute the expenditure in
relation to exempt income and it is this amount of expenditure which
would be dis-allowed under section 14A of the Act. It is, therefore, clear
that in terms of the rule, the amount of expenditure in relation to
exempt income has two aspects-(a) direct, and (b) indirect. The direct
expenditure is straightaway taken into account by virtue of clause (i) of
sub-rule (2) of rule 8D. The indirect expenditure, where it is by way of
interest,is computed through the principle of apportionment.
Section 14A even prior to the introduction of sub-sections (2) and (3) would
require the Assessing Officer to first reject the claim of the assessee with
regard to the extent of such expenditure and such rejection must be for
disclosed cogent reasons. It is then that the question of determination of
such expenditure by the Assessing Officer would arise. The requirement of
adopting a specific method of determining such expenditure has been
introduced by virtue of sub-section (2) of section 14A. Prior to that, the
assessee was free to adopt any reasonable and acceptable method. So,

14. 14
even for the pre-rule 8D period, whenever the issue of section 14A arises
before an Assessing Officer, he has, first of all, to ascertain the correctness
of the claim of the assessee in respect of the expenditure incurred in relation
to income which does not form part of the total income under the Act. Even
where the assessee claims that no expenditure has been incurred in
relation to income which does not form part of the total income, the
Assessing Officer will have to verify the correctness of such claim. In
case, the Assessing Officer is satisfied with the claim of the assessee
with regard to the expenditure or no expenditure, as the case may be,
the Assessing Officer is to accept the claim of the assessee in so far as
the quantum of disallowance under section 14A is concerned. In such
even-tuality, the Assessing Officer cannot embark upon a
determination of the amount of expenditure for the purposes of section
14A(1). In case, the Assessing Officer is not, on the basis of the
objective criteria and after giving the assessee a reasonable
opportunity, satisfied with the correctness of the claim of the assessee,
he shall have to reject the claim and state the reasons for doing so.
Having done so, the Assessing Officer will have to determine the
amount of expenditure incurred in relation to income which does not
form part of the total income under the Act. He is required to do so on
the basis of a reasonableand acceptablemethod of apportionment.
Order of the Appellate Tribunal in ITO v. Daga Capital Management P. Ltd.
[2009]312 ITR (AT) 1 (Mumbai) [SB] partly affirmed.
6.1. Thereafter, the Kerala High Court in Commissioner of Income-tax
v. Dhanalakshmy Bank Ltd. (344 ITR 259), has observed that Section 14A
of the Income-tax Act, 1961, was inserted by the Finance Act, 2001, with

15. 15
retrospective effect from April 1, 1962. The object of section 14A is to
ensure that so much of the expenditure incurred for earning income
that does not constitute total income of the assessee, should not be
allowed. In other words, when income is outside the tax net,
expenditure incurred for earning such income also should not be
allowed to be set off in the computation of taxable income. Sub-
sections (2) and (3) were introduced to the main section by the Finance
Act, 2006, with effect from April 1, 2007. Subse-quently, rule 8D was
prescribed by the Government for the purpose of sub-section (2) of
section 14A from 2007-08 onwards. By virtue of the subsequent
legislation, now there is a precise formula for working out the
disallowance to be made under section 14A even if assessees do not
have separate accounts showing the expenditure incurred on
investments made for earning tax-free income. By subsequent
amendment through sub-section (2) and by prescribing rule 8D therein
specific guidelines are prescribed for disallowance in cases where
separate accounts are not available on the expenditure incurred for
earning tax-free income. These are, therefore, only clarificatory
provisions and the main clause of section 14A applies for all periods
after its introduction in the statute which authorises the officer to make
disallowance of the expenditure incurred for earning tax-free income,
irrespective of whether the assessee maintained separate accounts or
not.
FACTS OF THE CASE :

16. 16
The assessees were all scheduled banks engaged in the banking business
and in the course of banking business they were also engaged in the
business of investment in bonds, securities and in shares which earned the
assessees interest from such securities and bonds and also dividend on
investments in shares of companies and from units of the UTI, etc., which
are tax-free. The assessee-banks did not have separate accounts for the
expenditure incurred towards interest paid on funds borrowed such as
deposits utilised for investment in securities, bonds and shares which yielded
tax-free income. In the absence of separate accounts for investments which
earned tax-free income, the Assessing Officer worked out a formula which
was the average cost of deposit in the year under consideration and applying
it he made proportionate disallowance of interest attributable to the funds
invested to earn tax-free income. The Tribunal set aside the order. On
appeal to the High Court :
The Hon’ble Court
Held,
allowing the appeal, (i) that the disallowance made by the Assessing Officer
was valid.
6.2. The Calcutta High Court in Dhanuka and Sons v. Commissioner of
Income-tax (339 ITR 319), has observed that the object of section 14A of
the Income-tax Act, 1961, is to disallow the direct and indirect
expenditure incurred in relation to income which does not form part of
the total income.

17. 17
FACTS OF THE CASE :
The assessee earned dividend income apart from income from trading in
shares, interest and commission. The Assessing Officer found that the
assessee had claimed deduction of interest paid, but that part of the interest
payment was attributable to investment in shares income from which is
exempted under section 10(34). He, therefore, partly disallowed the interest.
This was upheld by the Commissioner (Appeals) and the Tribunal. On
appeal :
The Hon’ble Court
Held,
dismissing the appeal, that the mere fact that those shares were old ones
and not acquired recently was immaterial. The assessee had to show
the source of acquisition of those shares by its hands at the relevant
point of time without taking the benefit of any loan. In the absence of
any such materials placed by the assessee, the authorities below
rightly held that a proportionate amount should be disallowed having
regard to the total income and the income from the exempt source. In
the absence of any material disclosing the source of acquisition of
shares which was within the special knowledge of the assessee, the
assessing authority tooka reasonable approach in assessment.
The Kolkata Bench of the Hon’ble Tribunal in Assistant Commissioner of Income-tax,
Circle 10, Kolkata v. Champion Commercial Co. Ltd., [2012] 26 taxmann.com 342
(Kol.), observed in a case where :

18. 18
 The assessee was engaged in the business of trading in chemicals and dyes.
• During the scrutiny assessment proceedings, the Assessing Officer noted that the assessee
had earned tax exempt dividend income of Rs. 6.63 lakh. However, the assessee did not
show any expenditure related to such dividend income for disallowance under section
14A.
• On being questioned, the assessee explained,
- that it had total turnover of Rs. 35 crore from its business of chemicals and dyes and it
had not traded in shares at all;
- that it had its own capital of Rs. 8.09 crore, borrowing of Rs. 4.05 crore whereas total
investment in shares was only Rs. 5.40 crore, which showed that entire investment
in the shares was out of own interest-free capital;
- that it had paid interest of around Rs. 41 lakh on the borrowings whereas its interest
income was Rs. 2.20 lakh;
- that the provisions of section 14A could not be invoked on the facts of the instant case
as there were no expenses directly relatable to earning of exempt income and
there was no expenditure incurred in relation to earning of exempt income and as
'the dividend income was directly debited to assessee's bank account for which no
expenditure was required to be incurred.
- that the provisions of section 14A, read with rule 8D can only be invoked when there
is actually an expenditure in relation to exempt income.
• The Assessing Officer rejected the explanation of the assessee and proceeded to determine
the disallowance under section 14A, read with rule 8D, relying upon the order of the
Special Bench of the Tribunal in ITO v. Daga Capital Management (P.) Ltd. [2009] 117
ITD 169 (Mum.).
• Aggregate of the disallowance under clauses (i ), (ii) and (iii) of rule 8D(2) was arrived at Rs.
30.81 lakh by the Assessing Officer.
Assessee's grievance
• Grievance of the assessee was that the disallowance should have been deleted in entirety
on ground that the Assessing Officer had not recorded a specific satisfaction to the effect
that the claim of the assessee, i.e., no expenditure was incurred on earning the tax
exempt dividend, was incorrect.

19. 19
AS OBSERVED BY THE BENCH :
“6. Let us take up assessee's grievance first, as it challenges the very application of Section 14 A
to the facts of the case before us, because the Assessing Officer has not recorded a specific
satisfaction to the effect that claim of the assessee, i.e. no expenditure is incurred on earning the
tax exempt dividend, is incorrect. We see no substance in this plea. We find that section 14A(2)
provides that, "(t)he Assessing Officer shall 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" and section 14A(3) provides that, "(t)he 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". While a
lot of emphasis is placed by the learned counsel on wordings of Section 14A(2) which refer to the
need of Assessing Officer's satisfaction to the effect that the claim made by the assessee is
incorrect, it simply overlooks the provisions of Section 14A(3) which state that a disallowance
under section 14A(2) can also be made in a case in which assessee claims that no expenditure
has been incurred for earning the tax exempt income. Therefore, a plain reading of the statutory
provisions of Section 14A(2) and (3) shows that when assessee offers a disallowance under
section 14A, the provisions of Section 14A(2), read with rule 8D cannot be invoked unless the
Assessing Officer is satisfied about incorrectness of the disallowance so offered, but when
assessee does not offer any disallowance under section 14 A on his own, the provisions of
section 14A(2) read with rule 8D can be invoked without there being any need to express
satisfaction about incorrectness of such a claim. That apart, as learned Commissioner (DR)
Shri Mahapatra rightly points out, when assessee is paying interest on borrowings and the
assessee is not able to show that investment in shares are out of internal accruals or non
interest bearing funds, and in the light of by Hon'ble jurisdictional High Court in the case of
Dhanuka & Sons v. CIT [2011] 339 ITR 319/ 201 Taxman 105/ 12 taxmann.com 227 (Cal.)
(Mag.), disallowance under section 14 A can indeed be made. In Dhanuka & Sons' case
(supra), Their Lordships have, inter alia, observed as follows:

20. 20
9. In the case before us, there is no dispute that part of the income of the assessee from its
business is from dividend which is exempt from tax whereas the assessee was unable to
produce any material before the authorities below showing the source from which such
shares were acquired
10. In our opinion, the mere fact that those shares were old ones and not acquired
recently is immaterial. It is for the assessee to show the source of acquisition of those
shares by production of materials that those were acquired from the funds available in the
hands of the assessee at the relevant point of time without taking benefit of any loan. If
those shares were purchased from the amount taken in loan, even for instance, five or ten
years ago, it is for the assessee to show by the production of documentary evidence that
such loaned amount had already been paid back and for the relevant assessment year, no
interest is payable by the assessee for acquiring those old shares. In the absence of any
such materials placed by the assessee, in our opinion, the authorities below rightly held
that proportionate amount should be disallowed having regard to the total income and the
income from the exempt source. In the absence of any material disclosing the source of
acquisition of shares which is within the special knowledge of the assessee, the assessing
authority took a most reasonable approach in assessment.
7. In the light of the views so expressed by Hon'ble jurisdictional High Court, we hold that the
provisions of Section 14A r.w.r. 8D were rightly invoked on the facts of this case. As the views of
Hon'ble jurisdictional High Court legally bind us, see no need to deal with the judgments of
Hon'ble non jurisdictional High Courts and coordinate benches of this Tribunal, as cited before
us. Suffice to reiterate that in any event, in a situation in which assessee does not offer any
disallowance under section 14A in respect of a tax exempt income, the provisions of Section
14A(2), read with rule 8D can be invoked under section 14A(3). None of the judicial precedents
cited before us anyway deal with this scenario, which is applicable on the facts of this case.”
On perusal of the decisions of Hon’ble High Courts and the Benches of the Hon’ble
Tribunal it is clear that section 14A read with Rule 8D can be invoked by the AO in the
following circumstances :-
(i) Non-maintenance of separate accounts in respect of expenditure incurred to derive
exempt income.

21. 21
(ii) It is immaterial whether the investment was made in earlier years as a nexus
between exempt income and expenditure exists during the year.
(iii) It is immaterial whether exempt income was earned during the year or not.
(iv) It is immaterial whether any expenditure in the nature of interest has been incurred
relating to / not relating to the exempt income yielding investment.
(v) As in the instant case, where the assessee does not offer any disallowance u/s.
14A despite incurring interest expenditure, thereafter fails to prove the nexus
between non-interest bearing funds vis-a-vis the investment, the AO need not
record any kind of satisfaction. There is no bar in invoking the provisions of
section 14A(2) read with rule 8D in such cases.
From the aforesaid, and in relation to the instant case, it is very clear that the Assessing Officer
has failed to examine the applicability of Section 14A r.w. Rule 8D in line with the prevailing legal
position as established by various judicial forums of the country. He has blindly accepted the
explanation of the assessee that there are no loans taken during the year and investments do not
feature in the balance sheet but only in capital account . The assessee is found to have earned
exempt income from dividend during the year as under:
Name of the Company Amount
Reliance Growth Fund – Dividend Plan 7,41,840
Reliance Mutual Fund 23,93,887
Franklin Templeton Flexi Cap Fund 33,81,817
Total 65,17,544
On examination of records, the Assessing Officer has failed to call for material and examine
as to whether funds in relation to investments in mutual funds was acquired with interest free
funds, the only condition on which the applicability of Section 14A rw Rule 8D can be ruled
out. The status of the current assessment is that the assessee has failed to establish, on

22. 22
account of lack of verification and application of mind on the part of the Assessing Officer, the
nexus between the interest free funds and the investments made by her. In such a case
disallowance u/s 14A rw Rule 8D is mandatory has held by various judicial platforms whose
views have been narrated in detail in the body of this order. Therefore, in conclusion the
Assessing Officer has failed to make a complete verification with respect to this aspect and has
passed the assessment order without proper and diligent application of mind and hence in my
considered opinion the assessment order so passed is both erroneous and prejudicial to the
interest of the revenue. Accordingly the assessment order is hereby set aside u/s 263 of the
Act, with a direction to the Assessing Officer to examine the aspect of disallowance u/s 14A rw
Rule 8D as outlined in the body of this order, and pass a fresh order after granting opportunity
to the assessee, within stipulated time. The assessee can furnish documents which were not
available at the time of assessment in the records of the Assessing Officer for fresh
examination.
It is ordered accordingly
(HARSH PRAKASH)
Principal Commissioner of Income Tax-6
Chennai
To
The Assessee
Copy to:
(1) The Addl/Joint Commissioner of Income Tax, Non-Corporate Range-15,
Chennai
(2) The ITO, Corporate Ward-15(1), Chennai
(3) Office Copy