Section 14A and Rule 8D: The Disallowance Formula, the 2022 Explanation, and What Maxopp and South Indian Bank Decided

Section 14A of the Income-tax Act, 1961 stops a business from claiming, against its taxable income, the expenses it incurs to earn income that is exempt. Rule 8D of the Income-tax Rules, 1962 sets the formula the Assessing Officer uses when the business’s own figure is not accepted. This note explains how the two work for FY 2025-26, what the Supreme Court decided in Maxopp and South Indian Bank, and what changes under the Income-tax Act, 2025.

Key Takeaways

• Section 14A disallows expenditure incurred in relation to exempt income. It applies only where the income does not form part of total income; a taxable receipt is outside it.
• Rule 8D(2) has two limbs: expenditure directly relating to exempt income, plus 1 per cent of the annual average of the monthly averages of the opening and closing balances of investments whose income is exempt. The total cannot exceed the total expenditure claimed.
• The Assessing Officer must first record satisfaction, having regard to the accounts, that the assessee’s own disallowance is not correct. Only then can Rule 8D be applied.
• Since the Finance Act, 2022, Section 14A applies even in a year in which no exempt income was earned, from Assessment Year 2022-23.
• Maxopp (Supreme Court, 2018): the purpose of holding an investment, including control, does not take it outside Section 14A.
• South Indian Bank (Supreme Court, 2021): where interest-free own funds exceed the investments in tax-free securities, no proportionate interest disallowance is warranted.
• From tax year 2026-27, the provision is Section 14 of the Income-tax Act, 2025.

What Section 14A Provides

Section 14A(1) provides that, notwithstanding anything to the contrary in the Act, “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”. The section was inserted by the Finance Act, 2001 with retrospective effect from 1 April 1962.

Sub-sections (2) and (3) were inserted by the Finance Act, 2006 with effect from 1 April 2007. Under Section 14A(2), the Assessing Officer determines the amount in the prescribed manner “if the Assessing Officer, having regard to the accounts of the assessee, is not satisfied with the correctness of the claim of the assessee”. Section 14A(3) applies the same process where the assessee claims that no expenditure was incurred. The prescribed method is Rule 8D.

Which Law Applies

The Income-tax Act, 2025 came into force on 1 April 2026. Under Section 536(2)(c) of that Act, the Income-tax Act, 1961 continues to apply to proceedings, including assessments, reassessments, penalties and appeals, in respect of any tax year beginning before 1 April 2026. FY 2025-26 and earlier years are therefore governed by Section 14A and Rule 8D.

From tax year 2026-27, the corresponding provision is Section 14 of the Income-tax Act, 2025, “Income not forming part of total income and expenditure in relation to such income”. Section 14(1) and (2) restate Section 14A(1) to (3), and Section 14(3) carries forward the rule that the section applies even where the exempt income has not accrued, arisen or been received in that tax year.

Which Income Is Still Exempt

Section 14A reaches only expenditure in relation to income that does not form part of total income, so the first question is which exempt income a business actually has. Several heads that were once common no longer qualify:

• Dividends from Indian companies: Section 10(34) does not apply to dividends received on or after 1 April 2020, other than dividends on which tax under Section 115-O or 115BBDA has been paid.
• Mutual fund units: Section 10(35) does not apply to income in respect of units received on or after 1 April 2020.
• Long-term capital gains on listed equity: Section 10(38) does not apply to transfers made on or after 1 April 2018; such gains are taxed under Section 112A.
• Buy-backs: Section 10(34A) and Section 115QA do not apply to a buy-back of shares on or after 1 October 2024.

Heads that remain exempt, where their conditions are met, include agricultural income under Section 10(1), a partner’s share in the total income of the firm under Section 10(2A), interest on bonds or securities notified under Section 10(15), and sums under a life insurance policy under Section 10(10D), subject to the premium limits in its provisos.

Rule 8D: The Current Formula

Rule 8D was inserted by the Income-tax (Fifth Amendment) Rules, 2008 (Notification No. 45/2008 dated 24 March 2008). Sub-rule (2) was substituted by the Income-tax (14th Amendment) Rules, 2016 (Notification No. 43/2016, S.O. 1949(E), dated 2 June 2016), in force from its publication in the Official Gazette. Under Rule 8D(1), the Rule applies where the Assessing Officer, having regard to the accounts of the assessee, is not satisfied with the correctness of the assessee’s claim, or with a claim that no expenditure was incurred.

The amount under Rule 8D(2) is the aggregate of:

1. Direct expenditure: the amount of expenditure directly relating to income which does not form part of total income; and
2. The 1 per cent limb: an amount equal to one per cent of the annual average of the monthly averages of the opening and closing balances of the value of investment, income from which does not or shall not form part of total income.

The cap: the amount so computed “shall not exceed the total expenditure claimed by the assessee”.

The 2008 version had three limbs: direct expenditure, a formula apportioning interest expenditure by the ratio of average exempt-income investments to average total assets, and one-half per cent of the average value of investments, with the averages taken on the first and last day of the year. The 2016 substitution removed the interest formula, replaced the half per cent limb with the 1 per cent limb on monthly averages, and added the cap.

Illustration

A company holds bonds notified under Section 10(15), so their interest is exempt. The annual average of the monthly averages of their opening and closing balances for FY 2025-26 is Rs 40 crore. It has identified Rs 3 lakh of expenditure directly relating to those bonds, and it has claimed total expenditure of Rs 25 lakh in the year.

• Direct expenditure: Rs 3 lakh
• 1 per cent of Rs 40 crore: Rs 40 lakh
• Aggregate: Rs 43 lakh, capped at the total expenditure claimed of Rs 25 lakh

If the Assessing Officer validly applies Rule 8D, the amount cannot exceed Rs 25 lakh. Whether Rule 8D can be applied at all depends on the satisfaction requirement below.

When the Assessing Officer Can Apply Rule 8D

Rule 8D is not automatic. Section 14A(2) and Rule 8D(1) allow it only where the Assessing Officer, having regard to the accounts, is not satisfied with the assessee’s own claim. In Maxopp, the Supreme Court held that “before applying the theory of apportionment, the AO needs to record satisfaction that having regard to the kind of the assessee, suo moto disallowance under Section 14A was not correct”.

The practical consequence is that a business’s own disallowance, computed and documented, is its strongest position. Where it exists, the Assessing Officer must record why, having regard to the accounts, it is not correct before moving to the formula.

What Maxopp Decided

In Maxopp Investment Ltd. v. CIT (Supreme Court, Civil Appeal Nos. 104-109 of 2015, decided 12 February 2018, 2018 INSC 131), a Bench of A. K. Sikri and Ashok Bhushan JJ. decided four points:

1. Purpose of holding is not relevant. The dominant purpose for which shares are acquired, including to gain control of the investee company, does not take them outside Section 14A where exempt income is earned.
2. Stock-in-trade is not excluded. The Court rejected the dominant intention test. Where exempt income is earned on shares held as stock-in-trade, Section 14A applies, and the expenditure incurred in acquiring those shares is apportioned on the facts of each case.
3. Satisfaction comes first, as set out above, and the Assessing Officer is to examine the nature of the loans taken for making the investment.
4. Rule 8D is prospective. It applies from the year in which it came into force.

The case concerned dividends that were then exempt under Section 10(34). Its principles apply to any income that is exempt today.

What South Indian Bank Decided

In South Indian Bank Ltd. v. CIT (Supreme Court, Civil Appeal No. 9606 of 2011, decided 9 September 2021, 2021 INSC 462), a Bench of Sanjay Kishan Kaul and Hrishikesh Roy JJ. considered whether interest could be proportionately disallowed under Section 14A where a bank’s interest-free own funds exceeded its investments in tax-free securities. The Court held:

• Where the assessee has mixed funds, the investment is to be considered as made out of the interest-free funds.
• If investments in tax-free securities are made out of common funds and the assessee has non-interest-bearing funds larger than those investments, a proportionate disallowance of interest under Section 14A cannot be made.
• There is no legal obligation on the assessee to maintain separate accounts for such investments.

The judgment is framed for assessee banks and approves High Court decisions to the same effect. It concerns the interest element. It does not displace the direct expenditure limb or the satisfaction requirement.

Years With No Exempt Income: The 2022 Explanation

Section 9 of the Finance Act, 2022 added a non-obstante clause to Section 14A(1) and an Explanation. The Explanation provides that the section “shall apply and shall be deemed to have always applied in a case where the income, not forming part of the total income … has not accrued or arisen or has not been received during the previous year … and the expenditure has been incurred during the said previous year in relation to such income”. The Memorandum explaining the Finance Bill, 2022 states that the amendment “will take effect from 1st April, 2022 and will accordingly apply in relation to the assessment year 2022-23 and subsequent assessment years”.

Before the amendment, the Delhi High Court had held in Pr. Commissioner of Income Tax-04 v. IL & FS Energy Development Company Ltd (ITA 520/2017, decided 16 August 2017, 2017:DHC:4465-DB) that no disallowance under Section 14A could be made where no exempt income was earned. In PCIT v. Era Infrastructure (India) Ltd (ITA 204/2022, decided 20 July 2022, 2022:DHC:2690-DB), the Delhi High Court held that the 2022 amendment, though worded “for removal of doubts”, “cannot be presumed to be retrospective” because it alters the law as it earlier stood.

For FY 2025-26, the Explanation applies as enacted: a year with no exempt income does not by itself take a business outside Section 14A.

Reporting and MAT

Where the accounts are audited, clause 21(h) of Form 3CD asks for the “amount of deduction inadmissible in terms of section 14A in respect of the expenditure incurred in relation to income which does not form part of the total income”.

For MAT, clause (f) of Explanation 1 to Section 115JB adds back to book profit “the amount or amounts of expenditure relatable to any income to which section 10 (other than the provisions contained in clause (38) thereof) or section 11 or section 12 apply”. MAT under Section 115JB does not apply to a company that has opted for Section 115BAA or 115BAB.

Penalty Exposure

Under-reported income attracts a penalty under Section 270A equal to 50 per cent of the tax payable on it (Section 270A(7)), or 200 per cent where the under-reporting results from misreporting (Section 270A(8)); the cases of misreporting are listed in Section 270A(9). Under Section 270A(6)(a), under-reported income does not include an amount for which the assessee offers a bona fide explanation and has disclosed all the material facts.

Checklist

1. List the income for the year that does not form part of total income, applying the cut-offs above.
2. List the investments whose income is exempt, and compute the monthly averages of their opening and closing balances.
3. Identify expenditure directly relating to that income.
4. Compute the Rule 8D(2) amount and apply the cap of total expenditure claimed.
5. Where interest is in issue, document interest-free own funds against the relevant investments.
6. Record the basis of your own disallowance, so that any rejection has to engage with it.
7. Report the Section 14A figure in clause 21(h) of Form 3CD where the accounts are audited, and compute the Section 115JB add-back under its own clause (f) where MAT applies.

FAQ

Q1. If a company earned no exempt income in the year, does Section 14A still apply?

Yes, from Assessment Year 2022-23. Under the Explanation inserted by the Finance Act, 2022, Section 14A applies where expenditure was incurred in relation to exempt income even if that income did not accrue, arise or get received in the year.

Q2. Can the Assessing Officer apply Rule 8D without examining the company’s own disallowance?

No. Under Section 14A(2) and Rule 8D(1), and as held in Maxopp, the Assessing Officer must first record satisfaction, having regard to the accounts, that the company’s claim is not correct.

Q3. Does Section 14A still matter for shares in Indian companies?

Less than it did. Dividends from Indian companies received on or after 1 April 2020 are taxable, unless tax under Section 115-O or 115BBDA was paid on them, and Section 14A does not reach expenditure on taxable income. Where shares do produce exempt income, Maxopp applies: the purpose of holding, including control, does not take them outside Section 14A.

Q4. Can the 1 per cent limb be computed on year-end balances?

No. Rule 8D(2)(ii) uses the annual average of the monthly averages of the opening and closing balances of the relevant investments.

Q5. Is the Rule 8D amount unlimited?

No. The proviso to Rule 8D(2) caps it at the total expenditure claimed by the assessee.

Q6. Which provision applies from tax year 2026-27?

Section 14 of the Income-tax Act, 2025, which restates Section 14A and keeps the rule for years with no exempt income in Section 14(3).

Related Posts

• CBDT FAQ on the Income-tax Act 2025 Transition: What Section 536 Saves From the 1961 Act
• Losses, Unabsorbed Depreciation and MAT/AMT Credit Under Section 536 of the Income-tax Act, 2025
• ITR Forms for AY 2026-27: Why FY 2025-26 Returns Are Filed Under the Income-tax Act, 1961

Need a Review of Your Section 14A Position?

If you run the finance function of a holding company, an NBFC, an investment company or any business with exempt income, and want your Section 14A and Rule 8D working reviewed, talk to an expert from the Tax Update India team.

Sources: Income-tax Act, 1961 (Sections 10, 14A, 112A, 115JB, 115QA, 270A) and Income-tax Rules, 1962 (Rule 8D), incometaxindia.gov.in; Notification No. 45/2008 dated 24 March 2008 and Notification No. 43/2016 dated 2 June 2016, CBDT; Finance Act, 2022 and Memorandum explaining the Finance Bill, 2022; Income-tax Act, 2025 (Sections 14 and 536); Form 3CD; judgments of the Supreme Court of India and the Delhi High Court cited above.

Disclaimer: This article is for general information only and does not constitute legal or tax advice. Tax positions depend on the facts of each case. Section numbers refer to the Income-tax Act, 1961 unless otherwise stated. Consult a qualified professional before acting on any information here.