A Delhi-based taxpayer recently won a major tax dispute after challenging a large addition made by the Income Tax Department. The case involved how expenses linked to tax-free income should be treated under the law. While the taxpayer had already made a small adjustment on his own, tax officials applied a stricter formula and added a much larger amount to the taxable income.
The matter went through several stages before finally reaching the Income Tax Appellate Tribunal (ITAT) in Delhi, where the taxpayer got partial relief and a clear ruling on how such cases should be handled.
Dispute Over Tax-Free Income
The taxpayer reported tax-exempt income of about Rs 81.56 crore in his income tax return, as per The Economic Times. Along with this, he claimed finance costs of Rs 117.28 crore. Since expenses related to tax-free income cannot be deducted, the taxpayer voluntarily disallowed Rs 49.51 lakh under Section 14A of the Income Tax Act. This calculation was supported by a certificate from a chartered accountant.
The auditor noted that exempt income made up around 18 per cent of the total income. Based on this, direct expenses and a portion of indirect expenses were added back, leading to the Rs 49.51 lakh disallowance shown in the return.
Tax Department Applies Stricter Rule
The Assessing Officer did not accept this calculation. Using Rule 8D of the Income Tax Rules, the officer recalculated the disallowance and added Rs 17.09 crore to the taxpayer’s income, according to Economic Times. This higher addition was later upheld by the Commissioner of Income Tax (Appeals).
Challenging this, the taxpayer moved to the ITAT Delhi. Advocates represented the taxpayer during the hearing.
What ITAT Delhi Said
An tax expert reportedly explained that the Tribunal first checked whether the tax officer had properly recorded dissatisfaction with the taxpayer’s calculation, as required by law. ITAT agreed that the officer had done this step correctly.
However, the Tribunal found fault in how the disallowance was calculated. It said Rule 8D cannot be applied to all investments. Only those investments that actually earned tax-free income during the year should be considered.
ITAT relied on earlier rulings, including Delhi High Court judgments, to support this view. The Tribunal noted that applying 1 per cent on the value of all investments, even those that earned no exempt income, was against settled law.
Relief For The Taxpayer
ITAT directed the Assessing Officer to recalculate the disallowance by limiting it only to investments that generated exempt income. Because of this, the taxpayer succeeded in getting a large reduction in the Rs 17 crore addition. The appeal was partly allowed.
Why This Ruling Matters
Section 14A is meant to stop taxpayers from claiming expenses linked to tax-free income. But the Tribunal made it clear that the rule must be applied carefully and only where it truly applies. This case reinforces that tax officers cannot blindly apply formulas without checking whether investments actually earned exempt income during the year.
