Is tax-free income really tax-free for investors?

But as Robert A. Heinlein said, “There ain’t no such thing as a free lunch.” Exempt, or ‘tax-free’ income is required to be disclosed in the return of income. Higher tax-exempt income increases the likelihood of one’s tax return being selected for intense scrutiny. If a case is selected for scrutiny or assessment, this tax-free income usually becomes the subject of a thorough verification by the Income Tax Assessing Officer.

Not many of us know that in the Income Tax Act, there is an important section 14A, which disallows proportionate expenditure incurred in earning tax-free income. Therefore, if a person earns tax-exempt income, say interest income, on any tax-exempt bond, then any expenditure incurred by such person in earning such exempt interest income, such as brokerage or portfolio management fee, is deductible. Payment declined in return. Income. And this section is applicable even when one is not carrying on business or profession.

This issue becomes more problematic when the taxpayer has not actually incurred any expenses that can be directly attributed to earning tax-free income. This is because of a peculiar Rule 8D in the Income Tax Rules, which provides for the computation mechanism for disallowance. At present, 1% of the annual average of the monthly average of the opening and closing balances of investments providing tax-free income can be added back to one’s income on a deemed basis, by the Assessing Officer.

Think about it. A person, Mr. X, invests 10 lakh in tax free bonds issued by PFC and earns tax free interest income 65,000 during the year and discloses this exempt interest income in his return of income. Apart from this investment in tax free bonds of PFC Mr. X has also invested in 90 lakhs in various interest/income earning instruments like Bank Fixed Deposits, Debt Securities and Dividend Paying Mutual Funds, and duly pays applicable taxes on such income as per its applicable slab rate.

If selected for scrutiny in tax assessment, the tax authority may disallow 1% of the total value of the investment Amount of 1 crore of Mr. X 1 lakh, by invoking section 14A read with rule 8D. It is important to note here that the correct application of Rule 8D mandates that the disallowance of 1% should be made only in respect of the investment having any tax-free income and not on the entire investment. Hence, in this case, the rejection should have been limited to 1% of the investment. 10 lakh in tax free bonds, ie, 10,000. However, ground-level experience suggests that in most such cases, the income tax authorities are considering the entire value of the taxpayer’s investment and not just the investment yielding tax-free income.

So, to earn tax-free interest income of 65,000 on PFC’s tax free bonds, Mr. X faces exorbitant income tax liability 1 lakh, higher than the exempted income. Such undue hardship is also faced by a majority of investors earning some tax-free income, and whose cases are selected for income-tax assessment. Taxpayers are now more apprehensive about the possible tax implications of their tax-free income rather than their taxable income, as Rule 8D has been wrongly applied by the assessing authorities.

An example of earning tax-free income is from tax-free bonds, which are a means of raising capital by the government and large financial institutions like NHAI, PFC, IRFC, to develop infrastructure and revive demand in the country. It must be ensured that for the short-sighted purpose of meeting revenue collection targets, the much larger, more important and long-term objective of enhancing the country’s development trajectory should not be jeopardized and hindered by such malpractices. The concerned authorities in the Ministry of Finance should give due consideration to this undue hardship faced by the investors in their tax assessment, merely because of the fact that they have earned some tax-exempt income.

Mayank Mohanka is the founder of TaxAaram India and partner of SM Mohanka & Associates