Is tax-free income really tax-free for investors?
3 min read 22 Mar 2023, 11:08 PM ISTHigher tax-free income can lead to increased scrutiny by income tax authorities
PremiumThe word ‘tax-free’ by itself sounds so alluring and when succeeded by another magical word, ‘income’, it becomes all the more tempting for investors. ‘Tax’ plays a very critical role in one’s investment decisions as it is the post-tax return, and not just the return simplicitor, which determines the real and actual return on one’s investments.
But as Robert A. Heinlein has said, “There ain’t no such thing as a free lunch." The exempt, or ‘tax-free’, income is required to be disclosed in the return of income. Higher tax-free income increases the probability of selection of one’s tax return for deeper scrutiny. If the case gets selected for scrutiny or assessment, then this tax-free income usually becomes the subject matter of deeper verification by the income tax assessment officer.
Not many of us know that in the Income Tax Act, there is one important section 14A, which disallows the proportionate expenditure incurred in earning the tax-free income. So, if one earns any tax-free income, say interest income on any tax-free bonds, then any expenditure incurred by such person in earning such exempt interest income, such as brokerage or portfolio management fees paid, is disallowed in the return of income. And this section is applicable even if one is not carrying on any business or profession.
The issue becomes more problematic when the taxpayer has actually not incurred any such expenditure which can be attributed directly to the earning of tax-free income. This is because of one peculiar Rule 8D in the Income Tax Rules, which provides for the computation mechanism for disallowance. Currently, 1% of the annual average of monthly averages of opening and closing balances of investments, yielding tax-free income, can be added back to one’s income on deeming basis, by the assessing officer.
Picture this. An individual, Mr. X, invests ₹10 lakh in tax free bonds issued by PFC and earns a tax-free interest income of ₹65,000 during the year and discloses this exempt interest income in his return of income. In addition to this investment in tax free bonds of PFC, Mr. X has also made investments of ₹90 lakh in various interest/income bearing instruments like bank fixed deposits, debt securities and dividend paying mutual funds, and duly pays the applicable tax on such income, as per his applicable slab rate.
If selected for scrutiny in tax assessment, the tax officer may disallow 1% of the total value of investments of ₹1 crore of Mr. X, amounting to ₹1 lakh, by invoking section 14A read with Rule 8D. Here it is important to note that correct application of Rule 8D mandates that disallowance of 1% has to be made only in respect of investments yielding any tax-free income and not the entire investments. So, in this case, the disallowance should have been restricted to 1% of investments of ₹10 lakh in tax free bonds, i.e., ₹10,000. However, ground-level experience shows that in a majority of such cases, the income tax officers are blanketly considering the entire value of investments of the taxpayers, for the purpose of making additions, and not the investments yielding only tax-free income.
So, for earning a tax-free interest income of ₹65,000 on tax free bonds of PFC, Mr. X faces an exorbitant income tax liability of ₹1 lakh, even larger than the exempt income itself. Such undue hardship is also faced by a majority of investors earning some tax-free income, and whose cases get selected for income tax assessment. Taxpayers now fear more about the probable tax implications of their tax-free income rather than their taxable income because of the incorrect application of Rule 8D by the assessing authorities.
One example of earning tax exempt income is from tax-free bonds, which are capital raising instruments of the government, and big financial institutions like NHAI, PFC, IRFC, for the development of infrastructure facilities in the country and for revival of demand. It should be ensured that for the short-sighted objective of completion of revenue collection targets, the far bigger, and much more significant and long-term objective of augmenting the country’s growth trajectory should not be jeopardized and hampered by such misdemeanors. Authorities concerned in the finance ministry should take due consideration of this undue hardships faced by investors in their tax assessments, just on account of the fact that they have earned some tax-free income.
Mayank Mohanka is the founder of TaxAaram India, and a partner at S M Mohanka & Associates
