Absence of objective dissatisfaction under Section 14A(2) precludes Assessing Officer from applying Rule 8D.

ORDER

Makarand Vasant Mahadeokar, Accountant Member.- This appeal by the assessee is directed against the order dated 15.10.2025 passed by the learned Commissioner of Income-tax (Appeals), National Faceless Appeal Centre, Delhi [“learned CIT(A)”], under section 250 of the Income-tax Act, 1961 [“the Act”], for the assessment year 2020-21. The impugned order arises from the assessment order dated 19.09.2022 passed under section 143(3) read with section 144B of the Act.

2.1. At the outset, it is noted that the present appeal is stated to have been filed with a delay of 85 days. The assessee has filed a petition seeking condonation of the said delay, duly supported by an affidavit of Shri Sandeep Gaglani, Authorised Signatory and Finance Head, India, of the assessee-company.

2.2. It is stated in the petition and the supporting affidavit that the impugned order was passed by the learned CIT(A) on 15.10.2025. The Managing Director of the assessee-company was travelling out of station and, consequently, there was a delay in execution of the requisite authorisation in favour of Shri Sandeep Gaglani for filing the present appeal. The assessee has stated that the delay was neither intentional nor deliberate and that it occurred for the reasons set out in the petition and the affidavit. The assessee has accordingly prayed that the delay be condoned and the appeal be admitted for adjudication on merits.

2.3. We have considered the explanation furnished by the assessee and perused the petition as well as the supporting affidavit. The delay is not inordinate, and the explanation furnished by the assessee does not indicate any deliberate inaction or want of bona fides. Refusal to condone the delay would result in the assessee being denied an adjudication of its grievance on merits. Having regard to the entirety of the circumstances and in the interest of substantial justice, we are satisfied that the assessee was prevented by sufficient cause from filing the appeal within the prescribed period. The Departmental Representative (DR) raised no objection in condoning the delay.Accordingly, the delay of 85 days is condoned and the appeal is admitted for adjudication on merits.

3. The assessee has raised the following grounds of appeal:

1. On the facts and circumstances of the case and in law, the Ld. CIT(A) erred in upholding a disallowance under Section 14A read with Rule 8D of the Act without considering the fact that the AO had mechanically invoked Rule 8D, i.e., without recording the mandatory satisfaction as required under Section 14A (2) of the Act.

2. The Ld. CIT(A) and AO failed to appreciate that the appellant had already made a reasonable suo-moto disallowance under Section 14A and, without examining the correctness of the same with reference to the accounts, proceeded to apply Rule 8D arbitrarily.

3. Without prejudice to the above, no disallowance of interest expenditure could be made under Rule 8D(2)(ii) as the appellant had sufficient own funds far in excess of the investments yielding exempt income.

4. The appellant craves leave to add, alter, amend or withdraw any of the above grounds of appeal.

4.1. The assessee is a private limited company engaged in the manufacture and supply of PVC stabilisers and polymer additives. The assessee filed its original return of income for the year under consideration on 29.01.2021, declaring a total income of Rs.59,90,39,932/-. Thereafter, the assessee filed a revised return of income on 30.03.2021. The revised returned income, as reflected in the computation forming part of the assessment order, was Rs.58,80,35,430/-. The case was selected for complete scrutiny under CASS and the statutory notices were issued to the assessee. In response thereto, the assessee furnished the details and explanations called for by the Assessing Officer.

4.2. The controversy in the present appeal is confined to the disallowance under section 14A read with Rule 8D. The Assessing Officer noticed that the assessee had earned dividend income of Rs.1,17,29,599/- during the relevant previous year. In its computation of income, the assessee had made a suo motu disallowance of Rs.3,48,550/- under section 14A of the Act.

4.3. During the assessment proceedings, the assessee explained that Kotak Wealth Management had been entrusted with the management of its investment portfolio. According to the assessee, it had not incurred any direct expenditure or paid any interest for making the investments and earning the exempt income. However, considering the time spent by its accounts executive and Head-Finance in attending to communications, paperwork and accounting relating to the investments, the assessee identified salary expenditure of Rs.3,48,550/- as attributable to the investment activity and disallowed the same under section 14A of the Act.

4.4. The Assessing Officer did not accept the computation furnished by the assessee. In paragraph 5.3(i) of the assessment order, the Assessing Officer observed that the assessee did not maintain separate bank accounts for its investment and business transactions and that the accounts relating to expenditure and investment were maintained jointly. According to the Assessing Officer, there was a merger of the flow of funds, inter-bank transfers and intermingling of funds used for investments and expenditure. The Assessing Officer further observed that the assessee had not established a direct nexus demonstrating that the investments had been made exclusively out of surplus funds.

4.5. The Assessing Officer thereafter discussed the provisions of section 14A and Rule 8D and the object underlying the disallowance of expenditure incurred in relation to income not forming part of the total income. After such discussion, the Assessing Officer recorded in paragraph 5.3(xi) of the assessment order that he was satisfied that the assessee’s case qualified for disallowance under section 14A read with Rule 8D.

4.6. The assessee furnished the monthly opening and closing balances of the investments. The annual average of the monthly averages of the opening and closing balances of investments was determined at Rs.44,24,50,489/-. The Assessing Officer computed the disallowance under Rule 8D at Rs.44,24,505/- and, after reducing the suo motu disallowance of Rs.3,48,550/- already made by the assessee, made an additional disallowance of Rs.40,75,955/-.

4.7. Before finalising the assessment, the Assessing Officer issued a show-cause notice dated 22.03.2022. In its reply dated 25.03.2022, the assessee contended that there was a direct nexus between the investments in mutual funds and its own funds and surplus. It was further contended that the assessee had not borrowed any term loan or working-capital loan for making the investments. The Assessing Officer rejected the explanation on the ground that the assessee maintained common books of account and bank accounts, involving a large number of transactions, and had claimed interest expenditure of Rs.10,83,361/-. The additional disallowance of Rs.40,75,955/-proposed in the show-cause notice was accordingly finalised.

5. Aggrieved by the additional disallowance made under section 14A read with Rule 8D, the assessee preferred an appeal before the learned CIT(A). Before the learned CIT(A), the assessee contended that the Assessing Officer had mechanically invoked Rule 8D without recording objective satisfaction as to why the suo motu disallowance of Rs.3,48,550/- was incorrect. It was submitted that such satisfaction was a statutory precondition for invoking the computational mechanism under Rule 8D. The assessee further contended that the actual interest expenditure on borrowings during the year was only Rs.4,726/- and that the investments had been made out of surplus funds. The assessee accordingly contended that no further disallowance was warranted.

6. The learned CIT(A) did not accept the contentions of the assessee. The learned CIT(A) held that the Assessing Officer had recorded objective dissatisfaction by referring to the maintenance of common books and bank accounts, the intermingling of funds, the large number of transactions and the total interest expenditure of Rs.10,83,361/- debited to the profit and loss account.

7. The learned CIT(A) further held that the assessee had failed to establish, through a specific fund-flow statement or other cogent material, that the investments yielding exempt income had been made exclusively out of non-interest-bearing funds. The contention that the interest expenditure on borrowings was only Rs.4,726/- was rejected on the ground that the relevant amount considered by the Assessing Officer was the total interest expenditure of Rs.10,83,361/- debited to the profit and loss account. The learned CIT(A) accordingly upheld the application of Rule 8D and confirmed the additional disallowance of Rs.40,75,955/-. The appeal of the assessee was consequently rejected.

8. During the course of hearing before us the learned AR invited our attention to the detailed written submissions filed before the learned CIT(A). He submitted that the assessee had received exempt dividend income of Rs.1,17,29,599/- from investments in mutual funds. No borrowed funds had been utilised for making such investments and, consequently, no interest expenditure had been incurred in relation thereto. The expenditure having a possible relation with the investment activity principally consisted of the time spent by the employees of the assessee in authorising purchases and redemptions, attending to correspondence, and making telephone calls and emails concerning the investments. Taking these activities into consideration, the assessee had voluntarily disallowed Rs.3,48,550/- under section 14A.

9. The learned AR submitted that the entire investmentmanagement function had been entrusted to M/s Kotak Wealth Management. Decisions concerning investment and redemption of mutual funds were taken on the advice of the said investment adviser. M/s Kotak Wealth Management did not charge any fee or commission from the assessee because it was remunerated directly by the respective mutual fund houses by way of trail commission. It was, therefore, submitted that the assessee had not incurred any direct expenditure for obtaining investment advisory services.

10. Referring to the nature of the dividend income, the learned AR submitted that the dividend was directly credited to the bank account of the assessee and no independent action or process was required to be undertaken for claiming or receiving the same. The dividend income was therefore passive in nature. The assessee had neither appointed any employee exclusively for investment activity nor incurred any incremental staff or administrative expenditure for earning the exempt income. It was further asserted that fewer than 50 transactions involving the purchase and redemption of mutual funds had taken place during the relevant year.

11. The learned AR explained that, notwithstanding the above factual position, the assessee had prudently identified the proportionate salary cost of the Finance Head, India, and the Accounts Executive, along with communication expenses, as expenditure relatable to the investment activity. The working placed before the learned CIT(A) was as follows:

12. On this basis, the learned AR submitted that the suo motu disallowance of Rs.3,48,550/- was reasonable and sufficient to cover the expenditure that could possibly be attributed to the earning of exempt income. There was, therefore, no justification for making any further disallowance.

13. As regards the interest expenditure of Rs.10,83,361/-referred to by the Assessing Officer, the learned AR submitted that the said amount comprised the following:

14. The learned AR submitted that the interest of Rs.46,410/-under sections 234A, 234B and 234C had already been disallowed in the computation of income. Similarly, the interest of Rs.10,32,225/- payable on delayed payments to MSME suppliers had also been disallowed by the assessee under section 23 of the Micro, Small and Medium Enterprises Development Act, 2006. Thus, according to the learned AR, no deduction had been claimed in respect of the aggregate amount of Rs.10,78,635/-.

15. The balance amount of Rs.4,726/- represented interest on the utilisation of the bank cash-credit facility. The learned AR submitted that even this expenditure had no direct or indirect nexus with the investments in mutual funds. There were no longterm or short-term borrowings at the beginning or at the end of the relevant year. The interest-free shareholders’ funds available with the assessee as of 31.03.2020 were stated to be approximately Rs.213.06 crore/-, whereas the tax-free investments as of that date were approximately Rs.55.19 crore/-. The average shareholders’ funds during the year were stated to be approximately Rs.191.32 crore/-, which were substantially higher than the peak mutual fund investments of approximately Rs.55.30 crore/-. It was accordingly contended that the investments were made entirely out of the assessee’s own surplus funds.

16. The learned AR further submitted that the Assessing Officer had rejected the assessee’s explanation principally on the ground that separate bank accounts were not maintained for the investment and business transactions and that there was intermingling of funds. According to the learned AR, there was no statutory requirement to maintain separate books of account or bank accounts for investment activity. The audited financial statements, computation of income and other material furnished during the assessment proceedings sufficiently demonstrated the availability of interest-free funds far in excess of the investments.

17. The learned AR also pointed out an internal inconsistency in the assessment order. At one place, the Assessing Officer had recorded that the assessee had earned dividend income of Rs.1,17,29,599/-. However, while discussing the applicability of section 14A, the Assessing Officer proceeded on the premise that the assessee had not earned exempt income during the relevant year. According to the learned AR, this contradiction demonstrated that the submissions and material furnished by the assessee had not been properly examined and that Rule 8D had been invoked mechanically.

18. Adverting to section 14A(2), the learned AR submitted that the Assessing Officer could resort to the prescribed method under Rule 8D only after examining the accounts of the assessee and recording an objective dissatisfaction as to the correctness of the claim made by the assessee. The dissatisfaction must be supported by cogent reasons and must identify the particular inaccuracy in the assessee’s computation or allocation of expenditure. General observations regarding common bank accounts, intermingling of funds and the absence of separate accounts could not satisfy this statutory requirement.

19. The learned AR submitted that the Assessing Officer had not pointed out any specific defect in the basis adopted by the assessee for quantifying the suo motu disallowance of Rs.3,48,550/-. The Assessing Officer had also not demonstrated that any particular expenditure debited to the profit and loss account had been incurred in relation to the exempt income. In the absence of such examination and objective dissatisfaction, the invocation of Rule 8D and the consequential additional disallowance were stated to be unsustainable.

20. To support his contention, the learned AR relied upon the decisions in Asstt. CIT v. Iqbal M. Chagala  (Mumbai),H.T. Media Ltd. v. Pr. CIT 399 ITR 576 (Delhi),CIT v. Sociedade De Fomento Industrial (P.) Ltd.   6/[2020] 429 ITR 358 (Bombay), Kodagu District Co-operative Central Bank Ltd. v. Asstt. CIT 431 ITR 356 (Karnataka) andACIT v. Reliance Industrial Investments and Holdings Ltd.  (Mumbai – Trib.).

21. Per contra, the learned DR relied upon the orders of the authorities below. He invited our attention to paragraph 5.3 of the assessment order and submitted that the Assessing Officer had duly recorded the reasons for rejecting the computation furnished by the assessee. The learned DR particularly referred to the observations that the assessee did not maintain separate bank accounts for investment and business transactions; that the accounts relating to expenditure and investment were maintained jointly; that there was intermingling and interlacing of funds; and that the assessee had failed to establish a direct nexus demonstrating that the investments had been made exclusively out of surplus funds.

22. Per contra, the learned DR relied upon the orders of the authorities below. He invited our attention to paragraph 5.3 of the assessment order and submitted that the Assessing Officer had duly recorded the reasons for rejecting the computation furnished by the assessee. The learned DR particularly referred to the observations that the assessee did not maintain separate bank accounts for investment and business transactions; that the accounts relating to expenditure and investment were maintained jointly; that there was intermingling and interlacing of funds; and that the assessee had failed to establish a direct nexus demonstrating that the investments had been made exclusively out of surplus funds.

23. The learned DR further referred to the discussion in the assessment order concerning the object and scope of section 14A and the applicability of Rule 8D. Particular reliance was placed upon paragraph 5.3(xi) of the assessment order, wherein the Assessing Officer recorded that he was satisfied that the assessee’s case qualified for disallowance under section 14A read with Rule 8D. On this basis, the learned DR submitted that the statutory requirement of recording dissatisfaction stood satisfied and that the additional disallowance confirmed by the learned CIT(A) did not call for interference.

24. We have considered the rival submissions and perused the material available on record. It is undisputed that the assessee earned exempt dividend income of Rs.1,17,29,599/- from investments in mutual funds and made a suo motu disallowance of Rs.3,48,550/- under section 14A of the Act. The assessee did not take the position that no expenditure whatsoever had been incurred in relation to the exempt income. It identified the proportionate salary cost of the Finance Head, India, and the Accounts Executive, together with communication expenditure, as expenditure attributable to the investment activity. The working placed before the authorities below quantified the proportionate salary expenditure at Rs.3,33,505/- and communication expenditure at Rs.5,000/-, aggregating to Rs.3,38,505/-. The assessee nevertheless disallowed a higher amount of Rs.3,48,550/-. Thus, the Assessing Officer was not confronted with a bare or unsupported claim. The assessee had made a positive disallowance supported by an identifiable basis.

25. Section 14A(2) does not make Rule 8D the starting point of the exercise. The Assessing Officer must first examine the claim made by the assessee, having regard to its accounts. It is only when he records an objective dissatisfaction concerning the correctness of that claim that the prescribed method becomes operative. A statement that the assessee’s case qualifies for disallowance under section 14A, without demonstrating why the computation furnished by the assessee is incorrect, does not satisfy this statutory condition.

26. Before the learned CIT(A), the assessee had relied upon Godrej & Boyce Manufacturing Company Ltd. v. Dy. CIT [2017]  394 ITR 449 (SC),Maxopp Investment Ltd. v. CIT 402 ITR 640 (SC), Pr. CIT v. Tata Capital Ltd. [2025] 475 ITR 559 (Bombay), Kalyani Steels Ltd. v. Addl. CIT [IT Appeal No. 1733 (PN) of 2012, dated 30.01.2014], and Asian Paints Ltd. v. Asstt. CIT [2024]   (Mumbai – Trib.)/ITA No. 268/Mum./2018, dated 05.03.2024. These decisions were cited for the limited but fundamental proposition that the Assessing Officer must examine the assessee’s claim with reference to its accounts and record reasons for finding it incorrect before applying Rule 8D. In Godrej & Boyce Manufacturing Co. Ltd., the Hon’ble Supreme Court held that what the law postulates is the requirement of satisfaction on the part of the Assessing Officer that, having regard to the accounts of the assessee, he is not satisfied with the correctness of the assessee’s claim, and that only thereafter would section 14A(2) and (3), read with Rule 8D, become applicable. In Maxopp Investment Ltd. (supra)the Hon’ble Supreme Court, in paragraph 41, similarly observed 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.”

27. The Hon’ble jurisdictional High Court in Tata Capital Ltd., in paragraph 7, held that “The most fundamental requirement, therefore, is the Assessing Officer should record his dissatisfaction with the correctness of the claim of Assessee in respect of the expenditure and to arrive at such dissatisfaction, he should give cogent reasons.” The Coordinate Bench in Kalyani Steels Ltd., in paragraph 8, held that “the invoking of rule 8D of the Rules in order to compute the disallowance u/s 14A of the Act is neither automatic and nor is triggered merely because assessee has earned an exempt income.” In Asian Paints Ltd., the Coordinate Bench, in paragraph 12, observed that “the satisfaction as required to be recorded under the provisions of section 14A of the Act is not limited to merely disagreeing with the submission of the assessee and requires that the AO should also provide the basis for reaching such a conclusion, after having regard to the accounts of the assessee.”The learned CIT(A), however, referred to Maxopp Investment Ltd. only for the general applicability of section 14A and the principle of apportionment. The requirement stated in paragraph 41 of that decision, as also the ratios of the other decisions cited by the assessee, was neither dealt with nor distinguished.

28. Before us, the learned AR placed further reliance upon certain decisions which we proceed to examine.

29. In Sociedade De Fomento Industrial (P.) Ltd. (supra), the assessee had invested in mutual funds and asserted that the investments had been made out of surplus funds. The Revenue sought to infer that borrowed funds and common expenditure had been utilised. The Hon’ble jurisdictional High Court held that the application of section 14A and Rule 8D is not automatic and that the onus lies upon the Revenue to establish a proximate relationship between the expenditure and the exempt income. Paragraphs 19 and 20, which directly govern the present controversy, read as under:

“19. Here, on facts, the Tribunal noted that the AO only discussed the provisions of section 14A(l) but has not justified how the expenditure the Assessee incurred during the relevant year related to the income not forming part of its total income. The AO, according to the Tribunal, straightaway applied Rule 8D. Indeed, there must be a proximate relationship between the expenditure and the tax-exempt income. Only then would a disallowance have to be effected. This Court, we may note, on more than one occasion, has held that the onus is on the Revenue to establish that there is a proximate relationship between the expenditure and the exempt income. That is, the application of section l4A and rule 8D is not automatic in each and every case, where there is income not forming part of the total income. No doubt, the expenditure under section 14A includes both direct and indirect expenditure, but that expenditure must have a proximate relationship with the exempted income. Surmise or conjecture is no answer.

20. We may further reiterate that before rejecting the disallowance computed by the Assessee, the Assessing Officer must give a clear finding with reference to the Assessee’s accounts as to how the other expenditure claimed by the Assessee out of the non-exempt income is related to the exempt income.”

30. The decision in H.T. Media Ltd. (supra) is closely comparable on facts. The assessee therein had voluntarily disallowed Rs.3,00,000/- as administrative expenditure attributable to exempt income and explained that the amount had been determined with reference to the cost of its finance department. The Assessing Officer did not examine that computation but recorded general observations concerning the management of investments and thereafter applied Rule 8D. The Hon’ble Delhi High Court held in paragraphs 34, 35, 37, 38 and 40 as under:

“34. The Assessee had explained that Rs. 3 lakhs was being disallowed voluntarily as an “expenditure which could be attributable for earning the said income.” The Assessee explained that the disallowance had been determined on the basis of cost of finance department in the ratio of exempt income to total turnover. On that basis the disallowance in AY 2005-06 was upheld by CIT (A) at Rs. 1 lakh. The disallowance for this AY was worked out as Rs. 1,42,404/-and since the Assessee had already made a disallowance of Rs. 3 Lacs, no further disallowance was called for.

35. In order to disallow this expense the AO had to first record, on examining the accounts, that he was not satisfied with the correctness of the Assessee’s claim of Rs. 3 lakhs being the administrative expenses. This was mandatorily necessitated by Section 14 A (2) of the Act read with Rule 8D (1) (a) of the Rules.

37. In the considered view of this Court, the above observations of the AO in the assessment order are of a broad general nature not with particular reference to the facts of the case on hand.

38. The Court is also unable to agree with Mr. Singh that on this aspect there are concurrent findings of both the CIT (A) as well as the ITAT. The CIT (A) disallowed the exempt expenses by merely repeating what the AO had stated about the cost that is built into so called ‘passive’ investments and simply recorded that the AO was bound to Rule 8D and, therefore, was justified in determining administrative costs at 0.5%. Here again, the CIT (A) failed to note that without the mandatory requirement, under Section 14A of the Act and Rule 8D of the Rules, of satisfaction being recorded being met, the question of applying Rule 8D (1) did not arise.

40. Consequently on the aspect of administrative expenses being disallowed, since there was a failure by the AO to comply with the mandatory requirement of Section 14 A (2) of the Act read with Rule 8D (1) (a) of the Rules and record his satisfaction as required thereunder, the question of applying Rule 8D (2) (iii) of the Rules did not arise. The question framed in ITA 549 of 2015 is answered accordingly.”

31. The ratio of H.T. Media Ltd. is particularly significant because the assessee before us has also quantified the disallowance with reference to the proportionate cost of personnel in its finance and accounts functions. As in that case, the Assessing Officer here has made broad observations about investment activity without examining the employee-cost computation actually furnished by the assessee.

32. In Iqbal M. Chagla (supra), the Assessing Officer had presumed that a part of the salary, telephone and administrative expenditure must relate to exempt income and applied the formula under Rule 8D without establishing the basis of the proposed disallowance. The Coordinate Bench held in paragraph 7 as under:

“The assessee had not claimed any expenditure in its profit and loss account, so, if the onus was on the Assessing Officer to prove that out of the expenditure incurred under various heads were related to earning of exempt income. Not only this he had to give the basis of such calculation. In any manner disallowance of Rs. 16.35 lakhs, as against the total expenditure of Rs. 13 lakhs (app.) claimed by the assessee in the profit and loss account, is not justified. The provisions of rule 8D cannot and should not be applied in a mechanical way. Facts of the case have to be analysed before invoking them.”

33. In Kodagu District Co-operative Central Bank Ltd. (supra), the Assessing Officer computed a disallowance under Rule 8D merely with reference to the average value of investments. The Hon’ble Karnataka High Court found that the Assessing Officer had neither determined the expenditure nor recorded reasons concerning the correctness of the assessee’s claim. The operative part of paragraph 5 reads as under:

“Thus, from perusal of the order passed by the Assessing Officer, it is evident that the Assessing Officer has not determined the amounts of the expenditure and has not recorded any reasons with regard to correctness of the claim made by the assessee in respect of such expenditure, in relation to the income which does not form part of the total income of the assessee. The Assessing Officer before embarking upon determination of the amount of expenditure incurred in the light of the exempted income, has to record a finding that he is not satisfied with the correctness of the claim of the assessee in respect of such expenditure. The aforesaid mandatory requirement has not been fulfilled by the Assessing Officer before disallowing the assessee under section 14A of the Act.”

34. The decision in Reliance Industrial Investments and Holdings Ltd. (supra) is the closest with reference to the Rule applicable for the year under consideration. That decision concerned assessment years 2018-19 to 2020-21. The assessee had made a suo motu disallowance, whereas the Assessing Officer, being of the view that it was not computed in accordance with Rule 8D, proceeded to determine a substantially higher disallowance at one per cent of the annual average of the monthly average value of investments under Rule 8D(2)(ii). The assessee had explained the basis of its disallowance, the availability of surplus interest-free funds and the nature of expenditure which could not be attributed to exempt income. The Coordinate Bench held in paragraph 46 as under:

“A reading of sub section (2) of section 14A makes it clear that the A.O. has to record his satisfaction regarding the correctness of suo motu disallowance made by the assessee having regards to the books of accounts. Even Rule 8D also prescribes the same condition. In the facts of the present appeal, as could be seen from the submissions made by the assessee before the A.O., the assessee had stated that it had enough surplus interest free funds available with it to take care of the investments. Therefore, no part of interest expenditure can be attributed for earning of exempt income. The assessee had further stated that the expenditure incurred towards man power supply services having been recovered from the concerns to whom man power was supplied, there is no question of disallowing any part of such expenditure. The assessee had further stated that certain investments made in subsidiaries have not yielded any exempt income. Hence, should not be considered while working out the average value of investment. The assessee has also justified the suo motu disallowance. A reading of the assessment order does not reveal that the A.O. has recorded his dissatisfaction that suo motu disallowance made by the assessee is incorrect having regard to its books of account. The observations of the A.O. are general in nature. He has not even considered the specific submissions of the assessee that expenditure incurred on man power supply has subsequently been recovered as also the fact that investments made in subsidiaries have not yielded any exempt income during the year, hence, should not form part of the average value of investment. Thus, in our view, the A.O. has not recorded satisfaction as required by section 14A(2) of the Act.”

35. The cumulative ratio of the decisions relied upon before us is that the existence of exempt income or the fact that the suo motu disallowance does not correspond to the amount produced by the formula under Rule 8D does not, by itself, permit the Assessing Officer to apply that formula. He must first examine the assessee’s accounts and the stated basis of the disallowance, identify the expenditure or defect omitted from the computation, and record an objective dissatisfaction supported by reasons. General observations concerning the management of investments, common accounts or the possibility of expenditure do not meet this requirement.

36. Tested on the above principles, the observations in paragraph 5.3(i) of the assessment order do not constitute the satisfaction contemplated under section 14A(2). The observations that the assessee did not maintain separate bank accounts, that investment and business funds were intermingled and that the assessee had not established a direct nexus between the investments and surplus funds concern the source of the investments. They do not examine the correctness of the assessee’s computation of Rs.3,48,550/- based upon proportionate employee cost and communication expenditure. The Assessing Officer did not identify any employee, administrative expense, investment-management expense or other item debited to the profit and loss account that had been omitted from the assessee’s computation. Nor did he demonstrate why the percentages applied to the salary cost of the Finance Head, India, and the Accounts Executive were incorrect.

37. Even with regard to the source of investments, the material explanation furnished by the assessee was not examined. The assessee stated that its interest-free shareholders’ funds as on 31.03.2020 were approximately Rs.213.06 crore/-, whereas its tax-free investments on that date were approximately Rs.55.19 crore/-. The average shareholders’ funds were stated to be approximately Rs.191.32 crore/-, as against the peak mutual fund investments of approximately Rs.55.30 crore/-. These figures were neither controverted nor shown to be incorrect.

38. The Assessing Officer also referred to the total interest expenditure of Rs.10,83,361/-. The assessee, however, explained that Rs.46,410/- represented interest under sections 234A, 234B and 234C and Rs.10,32,225/- represented interest on delayed payments to MSME suppliers. Both amounts had already been disallowed in the computation of income. The balance interest expenditure was only Rs.4,726/- relating to a bank cash-credit facility. The assessment order does not controvert this breakup or establish any nexus between the interest expenditure of Rs.4,726/- and the mutual fund investments. The learned CIT(A) characterised the contention concerning Rs.4,726/- as misleading without dealing with the detailed breakup or the fact that the aggregate amount of Rs.10,78,635/- had already been disallowed.

39. The reasoning in the assessment order also contains material internal inconsistencies. In paragraph 5.1, the Assessing Officer acknowledged that the assessee had earned dividend income of Rs.1,17,29,599/-. In paragraph 5.3(viii), however, he proceeded to reject an alleged contention that no exempt income had been earned during the year, although no such contention had been advanced by the assessee. The assessment order also refers to investments in shares, whereas the investments under consideration were in mutual funds. In this background, the statement in paragraph 5.3(xi) that the Assessing Officer was satisfied that the assessee’s case qualified for disallowance under section 14A read with Rule 8D is merely a conclusion regarding the general applicability of the provision. It is not a reasoned dissatisfaction with the correctness of the assessee’s computation having regard to its accounts.

40. The learned CIT(A) treated the maintenance of common books and bank accounts, the intermingling of funds, the number of transactions and the debit of total interest expenditure of Rs.10,83,361/- as sufficient satisfaction. In doing so, the learned CIT(A) merely endorsed the general observations of the Assessing Officer without examining whether they demonstrated any defect in the salary-based computation furnished by the assessee. The authorities cited before the learned CIT(A) were not dealt with in the context in which they had been relied upon, and the subsequent binding decision in Tata Capital Ltd. was neither followed nor distinguished.

41. We also note that Rule 8D(2) was substituted by the Income-tax (Fourteenth Amendment) Rules, 2016, with effect from 02.06.2016. For A.Y. 2020-21, the applicable Rule provided for the aggregate of direct expenditure under clause (i) and one per cent of the annual average of the monthly averages of the opening and closing balances of the value of the relevant investments under clause (ii), subject to the prescribed ceiling. The learned CIT(A), however, discussed Rule 8D(2)(ii) as an interest component and Rule 8D(2)(iii) as an administrative component, which was the structure of the Rule prior to its substitution. This is an additional infirmity in the impugned order. The decisive defect, however, is anterior to the computation. In the absence of a legally sustainable dissatisfaction under section 14A(2), the Assessing Officer could not proceed to the prescribed formula.

42. In view of the foregoing discussion, we hold that the assessee had made a positive and reasoned suo motu disallowance of Rs.3,48,550/- based upon the proportionate employee cost and communication expenditure attributable to the investment activity. The Assessing Officer neither examined that computation with reference to the accounts nor identified any specific expenditure omitted therefrom. The observations concerning common bank accounts, intermingling of funds and absence of separate accounts did not establish that the assessee’s computation was incorrect. The explanation regarding the composition of the interest expenditure and the availability of substantial own funds was also not properly examined. The internal inconsistencies in the assessment order further show that part of the reasoning was unrelated to the actual facts of the assessee’s case. The learned CIT(A) did not cure these deficiencies.

43. Consequently, the condition precedent prescribed under section 14A(2) for invoking Rule 8D was not satisfied. The additional disallowance of Rs.40,75,955/- made by the Assessing Officer and sustained by the learned CIT(A) cannot be upheld. We accordingly direct the Assessing Officer to delete the additional disallowance of Rs.40,75,955/-. The suo motu disallowance of Rs.3,48,550/- made by the assessee shall remain undisturbed.

44. Ground Nos.1 and 2 are accordingly allowed. In view of the deletion of the entire additional disallowance, Ground No.3, being an alternative ground, has become academic and requires no separate adjudication. Ground No.4 is general in nature and requires no adjudication.

45. In the result, the appeal of the assessee is allowed.