The expenditure incurred in relation to exempt income are not allowed. The rationale behind   that is to prevent tax payers from setting off expenses incurred to earn tax free income against other income which is taxable. What this   means therefore is that a tax payer must, in the first place , having tax free income and must have actually incurred expenses to earn such tax free income. The next step then would be to quantify such expenses. This article is basically an attempt to guide our audience regarding expenditure incurred in relation to exempt income and its tax issues. Tax treatment for expenses incurred to earn exempt income. LEGAL ISSUES This provision applies to income falling under Chapter IV. For the purposes of computing the total income under, no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to exempt income. 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 expenditure in relation to exempt income, the Assessing Officer shall determine the amount of expenditure incurred in relation to such exempt income in accordance with Rule 8D. This provision shall also apply in relation to a case where in assessee claims that no expenditure  has been incurred by him in relation to exempt income. METHOD OF CALCULATION RULE 8D – Method for determining amount of expenditure in relation to income not includible in total income. 1)      If the Assessing Officer, having regard to the accounts of the assessee of a previous year, is not satisfied with: a)      The correctness of the claim of expenditure made by the assessee; or b)      The claim made by the assessee that no expenditure has been incurred in relation to exempt income, he shall determine the amount of expenditure in relation to such exempt income as under: 2)      The expenditure in relation to income which does not form part of the total income shall be aggregate of the following amounts:- a)      The amount of expenditure directly relating to income which does not form part of total income. b)      In a case where the assessee has incurred expenditure by way of interest during the previous year which is not directly attributable to any particular income or receipt, an amount computed in accordance with the following formula, namely A = amount of expenditure by way of interest other than the amount of interest included in clause (a) incurred during the previous year; B = the average value of investment, income from which does not or shall not form part of total income, as appearing in the balance sheet of the assessee, on the first day and the last day of the previous year. C = the average of total assets appearing in the balance sheet of the assessee as on the first day and  the last day of the previous year. An amount equal to 0.5% of the average of the value of investment, income from which does not or shall not form part of the total income, as appearing in the balance sheet of the assessee. Total asset shall mean, total asset as appearing in the balance sheet excluding the increase on account of revaluation of asset but including the decrease on account of revaluation of the asset. SOME INTERESTING CASE STUDIES  CIT vs HERO CYCLES LIMITED  The assessee company earned dividend income, which was exempted under section 10 (34) and (35). The Assessing Officer made certain addition to the income of the assessee by way of disallowance under section 14A(3), being expenditure incurred for earning exempt income. It was found that the entire investment in shares, debenture redemption etc and said funds were ostensibly without burden of interest expenditure. Held disallowance under section 14A requires finding of incurring of expenditure. Where it is found that for earning exempted income no expenditure has been incurred, disallowance under section 14A cannot stand. Merely because the assessee had incurred interest expenditure on funds borrowed for the  main unit (manufacturing of cycles and parts of two wheelers in multiple units), it would not ispo facto invite the disallowance under section 14A, when there was no evidence to show that such interest bearing funds had been invested in the investments which had generated the tax exempt dividend income. CIT vs Walfort Share & Stock Brokers (P) Ltd.(2010) 192 TAXMAN 211(SC) Expenditure incurred in section 14A refers to expenditure on rent, taxes, salaries, interest, etc, in respect of which allowances are provided for under section 30 to 37; a return of investment or a pay back is not ‘expenditure incurred’ in terms of section 14A. For attracting section 14A, there has to be a proximate cause for disallowance, which is its relationship with tax exempt income and since pay-back or return on investment is not such proximate cause, section 14A is not applicable in such cases. CONCLUSION The implications of this decision would be very harsh on those tax payers who have borrowings and who have invested in shares and mutual funds. In such cases, even if the investments are long term and/or strategic ones and even if there is no income actually accruing or received during a year, there would still be a disallowance of part of the interest paid based on the formula laid down in Rule 8D. Click here to read our earlier article on this topic. Thanks for reading for this article. Please feel free to write to us, We want to hear it all!Suggestions? Complaints? Feedback? Requests?  at [info@taxmantra.com] or call us at +91 88208208 11. We would be more than happy to assist you.