New Income-tax Act, 2025 is set to replace the decades-old framework Income-tax Act, 1961, from April 1, 2026. This new Act comes a fresh set of rules that could quietly change how your investments are taxed. One such provision in the newly notified rules might catch many taxpayers off guard and that is – even tax-free income may now increase your effective tax outgo.
At the centre of this shift is the newly notified Rule 14 under the Income-tax Rules, 2026, which lays down how expenses linked to exempt income will be treated. And the key number here is 1%.
The 1% rule: What exactly has changed?
As per the notification issued on March 20, 2026, Rule 14 states that any expenditure related to income that does not form part of total income will be disallowed. This includes two components:
-Direct expenses linked to exempt income
-1% of the average value of investments generating (or capable of generating) exempt income
Importantly, the total disallowance cannot exceed the actual expenditure claimed by the taxpayer.
In simple terms, this means that even if your income, say dividends or certain investments, is tax-free, the tax department may still attribute a notional cost to it and disallow that portion from your deductions.
Why ‘tax-free’ doesn’t always mean zero tax impact
This is where the rule changes perception.
CA Hita Desai, Partner, NPV & Associates LLP, explains the nuance clearly: “The 1% formula does not create a standalone tax but standardises disallowance only where expenditure exists or is inferred.”
So, you are not being taxed directly on exempt income. But if you incur, or are assumed to incur, expenses to earn that income, those expenses won’t be allowed as deductions.
The result? Your taxable income increases indirectly, and so does your tax liability.
In fact, Desai highlights that exempt income may carry an indirect tax cost in cases where administrative or financial expenses are present, thereby impacting post-tax returns.
When does this rule actually apply?
A key clarification in the rules is that this is not an automatic disallowance.
As the notification makes clear, the rule applies only when expenditure is claimed or is considered to have been incurred in relation to exempt income.
This means, if you genuinely have no expenses linked to exempt income, there should ideally be no disallowance. However, the Assessing Officer can still question your claim and apply the prescribed method if not satisfied.
Real impact: Who should be careful?
This rule is especially relevant for investors earning dividends or tax-free returns, those with large portfolios of exempt investments and taxpayers claiming administrative or financial expenses.
Even if the income itself is exempt, the associated costs—real or presumed—can reduce your deductions.
What should taxpayers do now?
The new framework puts a clear focus on documentation and planning.
Desai advises: “Taxpayers should focus on maintaining robust documentation to substantiate that no expenditure has been incurred, wherever applicable.”
She also adds that clear segregation of investment activities, funding sources, and administrative costs becomes critical.
In practical terms, this means keep clear records of how investments are funded, avoid mixing personal and investment-related expenses, review your portfolio not just for returns, but post-tax efficiency.
Summing up…
The new income tax regime is not just about lower rates or fewer deductions—it’s also about closing grey areas.
The 1% rule reinforces a simple idea – if you earn income, even tax-free income, any cost associated with it cannot be ignored. And that’s the real shift taxpayers need to understand before filing returns under the new law from April 2026.
Disclaimer: This article is for informational purposes only and does not constitute professional tax advice. Tax laws and regimes are subject to frequent changes by the government. Readers should verify details with official Income Tax Department notifications or consult a Chartered Accountant before making any financial decisions.