No Satisfaction Recorded for Section 14A and Arbitrary Pro-Rata Royalty Expenditure Allocation Remanded

By | October 12, 2026
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No Satisfaction Recorded for Section 14A and Arbitrary Pro-Rata Royalty Expenditure Allocation Remanded

Issue

  1. Whether an additional disallowance under Section 14A read with Rule 8D can be made without the Assessing Officer recording objective dissatisfaction regarding the correctness of the assessee’s suo motu disallowance.
  2. Whether Section 115BBF(2) permits a blanket disallowance of general business expenditure based on an indiscriminate pro-rata allocation ratio of royalty income to total revenue.

Facts

  • Section 14A Disallowance:
    • For Assessment Year 2017-18, the assessee declared income under normal provisions and book profit under Section 115JB, having earned exempt dividend income and made a suo motu disallowance.
    • The Assessing Officer (AO) applied Rule 8D(2)(ii) to compute a further disallowance, proceeding on the incorrect premise that no suo motu disallowance was made by the assessee.
    • The AO recorded general observations without examining the correctness of the actual disallowance offered by the assessee, and the disallowance calculated by the AO was lower than what the assessee had already offered.
  • Section 115BBF Royalty Expenditure Allocation:
    • The assessee (manufacturing water-soluble films and bio-compostable products) declared operating revenue of ₹31.60 crores, which included royalty revenue of ₹22.86 crores (72.35% of total revenue).
    • Assuming that all total expenses of ₹16.38 crores were charged against non-royalty business streams, the AO applied a straight 72.35% ratio and disallowed ₹11.85 crores under Section 37(1) read with Section 115BBF(2).

Decision

  • Section 14A Disallowance Deleted:
    • Recording objective dissatisfaction with the assessee’s claim having regard to the books of account is a jurisdictional condition for invoking Rule 8D.
    • Since the AO failed to record proper dissatisfaction and since the AO’s computed disallowance was less than the suo motu disallowance, the additional disallowance and its consequential adjustment to book profits under Section 115JB were ordered to be deleted [In favour of assessee].
  • Section 115BBF Allocation Remanded:
    • Section 115BBF(2) does not authorize an indiscriminate allocation of all Profit & Loss items merely based on gross receipt ratios.
    • The matter was remanded to the AO to identify eligible royalty income, exclude expenses already disallowed elsewhere, analyze the nexus of each class of expenditure, and recompute expenses attributable to qualifying royalty income [Matter Remanded].

Key Takeaways

  • Prerequisite of Satisfaction under Section 14A: The AO cannot automatically invoke Rule 8D without first considering the assessee’s suo motu disallowance and recording clear, objective dissatisfaction regarding its accuracy.
  • No Arbitrary Allocation under Section 115BBF: Expense allocation against concessional royalty income must be established through direct nexus and specific examination, rather than a mathematical pro-rata formula applied to gross revenue.
IN THE ITAT MUMBAI BENCH ‘A’
Arrow Greentech Ltd.
v.
Assistant Commissioner of Income-tax
SMT. BEENA PILLAI, Judicial Member
and Jagadish, Accountant Member
IT Appeal No. 7815 (Mum) of 2025
[Assessment year 2017-18]
SEPTEMBER  17, 2026
Yogesh Thar, CA for the Appellant. Manoj Kumar, CIT-DR for the Respondent.
ORDER
Jagadish, Accountant Member.- This appeal by the assessee is directed against the order dated 26.09.2025 passed by the National Faceless Appeal Centre, Delhi [hereinafter referred to as ‘the learned CIT(A)’], under section 250 of the Income-tax Act, 1961 (‘the Act’), arising from the assessment order dated 18.12.2019 passed by the Assistant Commissioner of Income-tax, Circle 9(1)(2), Mumbai (‘the Assessing Officer’) under section 143(3) of the Act for the assessment year 2017-18.
2. The assessee has raised the following grounds of appeal:
“1. On the facts and in the circumstances of the case and in law, the Appellant respectfully challenges the order dated 26.09.2025 passed under section 250 of the Act upholding the assessment order dated 18.12.2019 passed under section 143(3) of the Act.
2. Disallowance under section 14A read with Rule 8D – Rs. 11,64,635/-
(a) The learned CIT(A) erred in upholding the disallowance of Rs. 11,64,635/- under section 14A of the Act.
(b) The learned CIT(A) erred in observing that the Appellant had not offered any suo motu disallowance, without appreciating that the Appellant had already disallowed Rs.16,86,936/- in its return of income.
(c) The learned CIT(A) failed to appreciate that Rule 8D could be invoked only after recording satisfaction regarding the incorrectness of the Appellant’s claim, which satisfaction was not recorded by the Assessing Officer.
3. Ad hoc disallowance of expenses under section 115BBF(2) – Rs. 11,84,86,000/-
(d) The learned CIT(A) erred in upholding the ad hoc disallowance of Rs. 11,84,86,000/- under section 115BBF(2) of the Act.
(e) The learned CIT(A) failed to appreciate that section 115BBF(2) was not applicable in the manner adopted by the Assessing Officer.
(f) The learned CIT(A) failed to appreciate that the Appellant’s books were
audited under section 44AB and that no defect was pointed out therein; hence, the expenditure could not be bifurcated on an ad hoc basis.
(g) The learned CIT(A) failed to appreciate that the expenditure debited to the Profit and Loss Account related to the manufacturing and trading activities and that the turnover ratio was not an appropriate basis for determining expenditure attributable to royalty income.
4. The Appellant denies its liability to interest under sections 234B and 234C of the Act.
5. The Appellant craves leave to add, alter, amend, delete, rescind or withdraw any of the above grounds.”
3. Briefly stated, the assessee is engaged in the manufacture of water-soluble films and bio-compostable products. It filed its return of income on 30.11.2017 declaring total income of Rs. 14,57,96,930/- under the normal provisions and book profit of Rs. 2,75,05,088/-. The case was selected for scrutiny and the assessment was completed under section 143(3) at a total income of Rs. 26,54,47,563/-. The Assessing Officer made a disallowance of Rs. 11,64,635/- under section 14A read with Rule 8D and a further disallowance of Rs.11,84,86,000/- under section 37 read with section 115BBF(2). The learned CIT(A) confirmed both additions. The assessee is, therefore, in appeal before us.
4. Ground no. 1 is general and does not require separate adjudication.
5. Ground no. 2 concerns the disallowance under section 14A read with Rule 8D. The Assessing Officer noticed exempt dividend income of Rs. 70,15,868/-. Proceeding on the premise that the assessee had not made any disallowance in its computation of income, he applied Rule 8D(2)(ii) and computed one per cent of the annual average of the monthly averages of investments at Rs. 11,64,635/-. This amount was added both while computing income under the normal provisions and while computing book profit under section 115JB. The learned CIT(A) affirmed the action of the Assessing Officer on the ground that the assessee had not positively demonstrated the suo motu disallowance claimed by it.
6. The learned Authorised Representative submitted that the very foundation of the impugned disallowance is factually incorrect. Our attention was drawn to Schedule 3 of the computation of income and to the reply furnished during assessment proceedings, which show that the assessee had itself disallowed Rs. 16,86,936/- in relation to exempt income. It was submitted that the Assessing Officer neither considered this amount nor examined its correctness before invoking Rule 8D. The learned Departmental Representative relied upon the orders of the authorities below.
7. We have considered the rival submissions and perused the material on record. Section 14A(2), as applicable to the year under consideration, permits the Assessing Officer to determine expenditure in accordance with the prescribed method only if, having regard to the accounts of the assessee, he is not satisfied with the correctness of the assessee’s claim. The requirement is not an empty formality. The Assessing Officer must first notice the claim actually made by the assessee, examine it with reference to the accounts and record why it is not correct. Only thereafter can the machinery of Rule 8D be applied.
8. In the present case, the computation of income placed on record shows a suo motu disallowance of Rs.16,86,936/-. The Assessing Officer nevertheless proceeded throughout on the contrary premise that no amount had been disallowed. The general observations recorded in paragraph 3.3 of the assessment order address a claim of nil expenditure and do not examine the correctness of the actual disallowance of Rs.16,86,936/-. The Assessing Officer thus did not consider the assessee’s claim at all, much less record dissatisfaction with that claim having regard to the accounts. The jurisdictional condition for applying Rule 8D was therefore not fulfilled. We also note that the further disallowance computed by the Assessing Officer at Rs.11,64,635/- is itself lower than the disallowance already offered by the assessee. In these facts, no additional disallowance was called for. We accordingly direct the Assessing Officer to delete the further disallowance of Rs. 11,64,635/-, including the consequential adjustment made on this account while computing book profit under section 115JB. The assessee’s own disallowance of Rs. 16,86,936/- shall remain undisturbed. Ground no. 2 is allowed.
9. Ground no. 3 relates to the disallowance of Rs.11,84,86,000/- in connection with royalty income offered under section 115BBF. The Assessing Officer noticed total operating revenue of Rs. 315.984 million, including royalty revenue of Rs. 228.610 million, and worked out royalty revenue at 72.35 per cent of total operating revenue. He further noticed total expenditure of Rs. 163.771 million. Since, according to him, the assessee had charged the entire expenditure against its other business streams, he attributed 72.35 per cent of the total expenditure to royalty revenue and disallowed Rs. 11,84,86,000/- under section 37 read with section 115BBF(2). The learned CIT(A) agreed that expenditure attributable to royalty income taxable at the concessional rate could not again reduce income taxable at the normal rate and affirmed the disallowance.
10. Before us, the learned Authorised Representative did not dispute that expenditure properly attributable to royalty income governed by section 115BBF has to be identified in accordance with law. His principal objection was to the basis and quantum adopted by the Assessing Officer. It was submitted that total royalty income of Rs. 22,86,09,908/-arose from eight patents, but royalty of only Rs.12,52,61,284/- relating to six patents was offered under section 115BBF at the prescribed rate. Royalty of Rs. 10,33,48,625/- relating to the remaining two patents was offered as business income under section 28 because the patents had not been granted as on 31.03.2017. Consequently, royalty governed by section 115BBF constituted about 39.66 per cent of the operating revenue and not 72.35 per cent. It was further submitted that, out of the total expenditure of Rs. 16,37,70,000/-, expenditure aggregating to Rs. 2,34,87,110/- had already been disallowed under various provisions and could not again form part of the allocation base. Several items, including raw materials, stock-in-trade, factory charges, labour charges, electricity, water charges, repairs and maintenance, were stated to have no nexus with royalty income. The learned Authorised Representative also tendered additional evidence in the form of a certificate issued by a practising Chartered Accountant estimating, with reference to the books, expenditure relatable to royalty income. He requested that the certificate and supporting records be examined by the Assessing Officer. Without prejudice, reliance was placed on Jt. CIT v. American Express Bank Ltd. [2012] 24  149 TTJ 683/138 ITD 288/19 ITR(T) 650 (Mumbai). The learned Departmental Representative supported the orders below and submitted that any fresh evidence and factual allocation would require verification by the Assessing Officer.
11. We have considered the rival submissions. Section 115BBF(1) provides a special rate of tax on qualifying royalty income from a patent developed and registered in India. Sub-section (2), which begins with a non obstante clause, provides that no deduction in respect of any expenditure or allowance shall be allowed under any provision of the Act in computing the income referred to in section 115BBF(1)(a). Thus, expenses having a nexus with the qualifying royalty stream cannot be used to reduce the other business income while the corresponding gross royalty enjoys the special rate. At the same time, the amount to be so excluded must rest on relevant facts and a reasonable nexus. Section 115BBF(2) does not authorise an indiscriminate allocation of every item in the Profit and Loss Account merely in the ratio of gross receipts.
12. The Assessing Officer adopted 72.35 per cent by taking the entire royalty of Rs. 22,86,09,908/- as the numerator. The assessee’s specific contention is that only Rs.12,52,61,284/- was offered under section 115BBF and that the balance royalty of Rs. 10,33,48,625/- was assessed at the normal rate. This distinction has a direct bearing on the allocation. The Assessing Officer also applied the percentage to the gross expenditure of Rs. 16,37,70,000/- without examining whether the base included expenditure already disallowed or expenditure exclusively connected with manufacturing and trading operations. These matters require verification from the return, computation, patent-wise royalty details, ledgers and books of account. The Chartered Accountant’s certificate now produced is relevant to that inquiry and goes to the root of the quantum. Since the lower authorities had no occasion to verify it and the assessee itself seeks such verification, we admit the additional evidence under Rule 29 of the Income-tax (Appellate Tribunal) Rules, 1963, in the interest of substantial justice.
13. We accordingly set aside the finding of the learned CIT(A) on the quantum of disallowance and restore this limited issue to the file of the Assessing Officer. The Assessing Officer shall verify the additional evidence and the underlying books and records; first identify the royalty income actually chargeable under section 115BBF; exclude from the allocation base expenditure already disallowed elsewhere; examine the nature and nexus of each material class of expenditure; and thereafter recompute only the expenditure, if any, attributable to the qualifying royalty income in accordance with section 115BBF(2). An expenditure shall not be attributed merely because royalty forms part of the consolidated revenue, nor shall the same expenditure be disallowed twice. The assessee shall be afforded a reasonable opportunity of being heard and shall furnish all supporting records called for. We have expressed no view on the final amount to be disallowed. Ground no. 3 is allowed for statistical purposes.
14. Ground no. 4, relating to interest under sections 234B and 234C, is consequential. The Assessing Officer shall recompute the interest, if any, while giving effect to this order. Ground no. 5 is general and requires no adjudication.
15. In the result, the appeal filed by the assessee is partly allowed for statistical purposes.