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Direct Tax Laws & International Taxation · Incomes which do not form part of Total Income

Expenditure Relating to Exempt Income: Disallowance Method

Updated 5 October 2026 · Fact-checked

Expenditure incurred to earn income that is not part of total income cannot be deducted. If the Assessing Officer is not satisfied with your claim, the disallowance is computed by the prescribed method: direct expenses, plus a proportion of indirect interest, plus 0.5% of the average value of exempt-income investments. Add the three parts and add back the total.

Understand Expenditure Relating to Exempt Income: Disallowance Method

Tax law lets you deduct expenses only against income that is taxed. If a rupee of income is exempt, the cost of earning it should not reduce taxable income. Otherwise you would earn tax-free income and also cut tax on your other income. This is the logic of the provision in the Income-tax Act, 2025 that denies deduction for expenditure in relation to income not includible in total income.

The Income-tax Rules, 2026 lay down the prescribed method for computing this disallowance. In your answer, name the provision and the prescribed method in words, as the question or your study material for the tax year gives them. Quote a section or rule number only when you are sure of it.

The practical problem is allocation. Some costs are clearly linked to exempt income, such as fees paid to manage an exempt investment. Many are not. Interest on a general loan or office overheads may support both taxable and exempt activity. The law therefore provides a prescribed method in the Income-tax Rules, which fixes a formula so that the amount is not left to guesswork.

The sequence matters. First, check whether you have claimed any expenditure in relation to exempt income. Then check whether the Assessing Officer, having regard to your books of account, is satisfied with your own allocation. If he is satisfied, your figure stands. If he is not satisfied, or you made no claim of any such expenditure, the prescribed method applies. The provision applies even if no exempt income was earned in the year, so the existence of exempt-income investments is enough to trigger the computation.

The computed amount is disallowed while computing the income of the relevant head, usually profits and gains of business or profession. It is an add-back. It does not change the amount of exempt income, which stays outside total income.

Typical exempt incomes you will meet in questions are interest on tax-free bonds, agricultural income, a partner's share of profit from a firm, and other receipts that your study material lists as not forming part of total income. Dividends from domestic companies are taxable in the shareholder's hands, so treat a dividend as exempt only where the question or a specific provision says it is. The computation is the same whichever exempt income is involved. Always read the question for the data: direct expenses, interest, investment values and total assets.

Key rules to remember

Total disallowance by the prescribed method
Disallowance = (i) + (ii) + (iii)
Applies when the Assessing Officer is not satisfied with the assessee's claim about expenditure relating to exempt income, or when the assessee claims that no such expenditure was incurred.
Part (i): Direct expenditure
(i) = Expenditure directly relating to income that does not form part of total income
Take the full amount of costs identifiable with the exempt income. Do not apportion this part. Interest directly attributable to exempt income is taken here.
Part (ii): Interest not directly attributable
(ii) = A × B ÷ C
A = interest expenditure not directly attributable to any particular income or receipt. Exclude interest directly attributable to any particular income, including exempt income whose interest is already taken in part (i), so that nothing is counted twice. B = average of the value of investments, income from which does not or shall not form part of total income, at the beginning and at the end of the tax year, that is (opening value + closing value) ÷ 2. C = average of the total assets shown in the balance sheet at the beginning and at the end of the tax year, that is (opening + closing) ÷ 2. This part applies only if you have incurred interest expenditure not directly attributable to any particular income.
Part (iii): Administrative charge
(iii) = 0.5% × B
B is the same average of the opening and closing value of exempt-income investments as in part (ii). It is a flat estimate of indirect administrative cost.

How to solve Expenditure Relating to Exempt Income: Disallowance Method questions

Use this order for any question on disallowance of expenditure relating to exempt income. It keeps your working clean and earns step marks even if one figure is wrong.

  1. 1Identify the exempt income and the investments or assets that yield it. Note whether the question gives exempt income earned in the year. The disallowance applies even if none was earned.
  2. 2Check the facts on satisfaction. If the assessee's own allocation is accepted, use it. If the question says the officer is not satisfied, or the assessee claims no expenditure, move to the prescribed method.
  3. 3Compute part (i): list expenses directly related to the exempt income and total them.
  4. 4Compute part (ii): find A by removing from total interest the interest directly attributable to any particular income, including interest directly attributable to exempt income that you have already taken in part (i). Then take B and C as given, or compute each as the average of the opening and closing values for the tax year. Apply A × B ÷ C.
  5. 5Compute part (iii): take 0.5% of B.
  6. 6Add (i) + (ii) + (iii). This is the total disallowance. It replaces the assessee's figure; it is not an extra amount on top of it. Where the amount the assessee has already disallowed relates to the same expenditure, it counts towards this total, so the further add-back needed in the computation is the difference. A higher voluntary disallowance is the assessee's own offer; do not reduce it and do not add the formula amount on top of it.
  7. 7Show the result in the right head, usually business income, and state that exempt income stays outside total income.
  8. 8Close with a one-line conclusion in provision, facts and conclusion form.

Quickest way: Three-line shortcut for the exam hall

When to use it: Use when the question gives you B and C directly, or gives clean opening and closing balances. It suits MCQs and short written answers.

  1. Write A, B and C at the top, with units in rupees. Cross out interest that is directly attributable, so A is clean.
  2. Calculate A × B ÷ C first, then 0.5% of B. Add the direct expenses last.
  3. Check the reasonableness: part (ii) should be a fraction of A equal to B ÷ C, and part (iii) should be small compared with B. If part (ii) exceeds A, you have swapped B and C.

Common mistakes in Expenditure Relating to Exempt Income: Disallowance Method

  • Using total interest as A instead of only the interest not directly attributable.

    Students see 'interest' in the formula and pick up the full interest figure from the profit and loss account.

    Fix: Subtract interest directly attributable to any particular income before applying the formula. This covers a loan taken for a taxable business unit and also interest directly linked to exempt investments, which belongs in part (i) and must not be counted again in A.

  • Applying 0.5% to total assets or to the exempt income.

    The 0.5% looks like a general overhead rate.

    Fix: The 0.5% applies only to B, the average value of investments whose income is exempt.

  • Skipping the computation because no exempt income was earned in the year.

    Students think no income means no disallowance.

    Fix: The provision applies even where no exempt income was earned or received in the year. Compute on the investments that are capable of yielding exempt income.

  • Adding the formula amount on top of the assessee's voluntary disallowance, so the same expenditure is disallowed twice.

    Students treat the formula amount as an extra disallowance instead of the total one.

    Fix: The total disallowance is the formula amount. It replaces the assessee's figure, so what the assessee has already added back on the same expenditure counts towards it. The further add-back in the computation is the difference. A higher voluntary disallowance is simply the assessee's own offer and is not reduced by the officer.

  • Reducing exempt income by the disallowed expenditure.

    Students try to compute 'net' exempt income.

    Fix: Exempt income is not included in total income at all. The disallowance only denies a deduction from taxable income.

Worked examples

Example 1

Rohan Traders, a proprietary concern, earns business profit before the relevant adjustments. It holds tax-free bonds whose interest is exempt. In the year, the books show direct expenses of ₹40,000 in relation to the bond investment, total interest of ₹12,00,000 (of which ₹4,00,000 is directly attributable to a loan for the taxable trading unit), the average of the opening and closing value of the tax-free bonds is ₹8,00,000 (B) and the average of the opening and closing total assets is ₹80,00,000 (C). The Assessing Officer is not satisfied with the claim that no expenditure relates to exempt income. Compute the disallowance.

Show the solution
  1. Provision: the expenditure relating to income not forming part of total income is disallowed, using the prescribed method because the officer is not satisfied.
  2. Part (i): direct expenditure = ₹40,000.
  3. Part (ii): A = ₹12,00,000 − ₹4,00,000 = ₹8,00,000. Then A × B ÷ C = 8,00,000 × 8,00,000 ÷ 80,00,000 = ₹80,000.
  4. Part (iii): 0.5% × ₹8,00,000 = ₹4,000.
  5. Total = ₹40,000 + ₹80,000 + ₹4,000 = ₹1,24,000.

Answer: ₹1,24,000 is disallowed and added back in computing business income. The interest on the tax-free bonds stays outside total income.

Example 2

Meghna Ltd holds investments that yield exempt income. Total interest paid in the year is ₹30,00,000 and none is directly attributable to any particular income. The average of the opening and closing value of the investments is ₹2,40,00,000 and the average of the opening and closing total assets is ₹12,00,00,000. There are no direct expenses. Meghna voluntarily disallowed ₹2,00,000 in its computation. The Assessing Officer is not satisfied. Find the total disallowance and the further add-back needed.

Show the solution
  1. Part (i): no direct expenditure, so ₹0.
  2. Part (ii): A = ₹30,00,000, B = ₹2,40,00,000, C = ₹12,00,00,000. B ÷ C = 0.20. So A × B ÷ C = ₹30,00,000 × 0.20 = ₹6,00,000.
  3. Part (iii): 0.5% × ₹2,40,00,000 = ₹1,20,000.
  4. Total disallowance = ₹0 + ₹6,00,000 + ₹1,20,000 = ₹7,20,000. This is the amount that must be disallowed in all, and it replaces Meghna's own figure.
  5. Already disallowed by the assessee = ₹2,00,000, which counts towards the total. Further add-back needed = ₹7,20,000 − ₹2,00,000 = ₹5,20,000.

Answer: Total disallowance is ₹7,20,000. Since ₹2,00,000 is already disallowed, the further add-back needed is the difference of ₹5,20,000.

Exam tips

  • Read the satisfaction condition in the facts. A question that says the officer has accepted the assessee's allocation tests whether you know the formula is not automatic.
  • Write A, B and C with labels before substituting. Examiners give step marks for each part of the formula.
  • In MCQs, check whether interest is already split between directly attributable and general. The trap is usually in the value of A.
  • Show the add-back in the business income computation and state that exempt income is excluded from total income. This links the topic to the computation chapters.
  • If the question says the assessee already disallowed some amount, always compare it with the computed figure and add back only the shortfall.

Practice questions from Incomes which do not form part of Total Income

Expenditure Relating to Exempt Income: Disallowance Method in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Expenditure Relating to Exempt Income: Disallowance Method: frequently asked questions

Does the disallowance apply if no exempt income was earned in the year?

Yes. The provision applies even where no exempt income was earned or received in the year. The computation depends on the investments that yield or can yield exempt income, not on income actually received.

When does the prescribed method apply instead of the assessee's own figure?

It applies when the Assessing Officer, having regard to the books of account, is not satisfied with the assessee's claim about expenditure relating to exempt income, or when the assessee claims that no expenditure was incurred. If the officer is satisfied, the assessee's own allocation can stand.

What is the difference between exempt income and taxable income for expenditure allocation?

Expenditure against taxable income is deductible if it meets the conditions for the relevant head. Expenditure against exempt income is not deductible at all. The formula allocates mixed expenditure between the two.