(iv) Important case laws.
2. MEANING AND CONCEPT
The bare reading of Section 36(1)(iii) is as follows:
“36(1) The deductions provided for in the following clauses shall be allowed in respect of the matters dealt with therein, in computing the income referred to in Section 28 –
( i ) and ( ii )******
(iii) the amount of the interest paid in respect of capital borrowed for the purposes of the business or profession :-
Provided that any amount of the interest paid, in respect of capital borrowed for acquisition of an asset for extension of existing business or profession (whether capitalized in the books of account or not); for any period beginning from the date on which the capital was borrowed for acquisition of the asset till the date on which such asset was first put to use, shall not be allowed as deduction.
Explanation. – Recurring subscriptions paid periodically by shareholders, or subscribers in Mutual Benefit Societies which fulfill such conditions as may be prescribed, shall be deemed to be capital borrowed within the meaning of this clause.”
The sub section has three important words or phrases that are core to understanding of this Section i.e. (i) Interest, (ii) Borrowed and, (iii) For the purpose of business or profession. In the following paras we would elucidate the meaning of these with reference to this particular section.
(i) Meaning of “Interest” – The definition of “interest” in Section 2(28A) means “interest payable in any manner in respect of any moneys borrowed or debt incurred ”. But for Section 36(1)(iii), “interest” is restricted to that on money borrowed and not on debt incurred. In simple words, the essence of interest is that it is a payment which becomes due because the creditor has not had his money at his disposal. It may be regarded either as representing the profit he might have made if he had had the use of his money, or conversely, the loss he suffered because he had not that use. The general idea is that he is entitled to compensation for the deprivation.
(ii) Concept of “borrowed” – Provisions of Section 36(1)(iii) concern capital borrowed and not other debts or liability. A loan of money undoubtedly results in a debt, but every debt does not involve a loan. Liability to pay a debt may arise from diverse sources and a loan is one of such sources. The legislature has, under this clause, permitted as an allowance interest paid on capital borrowed for the purposes of the business; and the capital, in this context, means money and not any other asset purchased on credit [Bombay Steam Navigation Co. Pr. Ltd. v. CIT, 56 ITR 52 (SC)].
(iii) The phrase “for the purpose of business” – The expression “for the purpose of business” occurs in Section 36(1)(iii) and also in Section 37(1). A similar expression with different wording also occurs in Section 57(iii) which reads as “for the purpose of making or earning income”. This issue came up for consideration before the Supreme Court and the Hon’ble Supreme Court while giving judgment in the case of Madhav Prasad Jatia V. CIT, (SC) 118 ITR 200 has established that the expression occurring in Section 36(1)(iii) is wider in scope than the expression occurring in Section 57(iii). Thus, meaning thereby that the scope for allowing a deduction under Section 36(1)(iii) would be much wider than the one available under Section 57(iii).
This phrase, as held by many legal pronouncement, is the most important yardstick for the allowability of deduction Under Section 36(1)(iii) of Income Tax Act, 1961. While explaining the meaning of this phrase the Hon’ble Supreme Court in the case of S. A. Builders Ltd. Vs. CIT(A), Chandigarh reported in 288 ITR 1 has used the word “commercial expediency”. By using this phrase Hon’ble Supreme Court has given a new dimension and clarified the concept further. In the judgment the Supreme Court has defined commercial expediency as “an expression of wide import and includes such expenditure as a prudent businessman incurs for the purpose of business. The expenditure may not have been incurred under any legal obligation, but yet it is allowable as a business expenditure, if it was incurred on grounds of commercial expediency”. Further, following this judgment the High Court of Delhi, in the case of Punjab Stainless Steel Inds. Vs. CIT 324 ITR 396, has further elaborated “The commercial expediency would include such purpose as is expected by the assessee to advance its business interest and may include measures taken for preservation, protection or advancement of its business interests, which has to be distinguished from the personal interest of its directors or partners, as the case may be. In other words, there has to be a nexus between the advancing of funds and business interest of the assessee-firm. The appropriate test in such a case would be as to whether a reasonable person stepping into the shoes of the directors/partners of the assessee-firm and working solely in the interest of the assessee-firm/ company, would have extended such interest free advances. Some business objective should be sought to have been achieved by extending such interest free advances when the assessee-firm/company itself is borrowing funds for running its business”.
Thus, for allowance of a claim for deduction of interest under this provision following three conditions are there:
(i) The money, that is capital, must have been borrowed by the assessee
(ii) It must have been borrowed for the purpose of business.
(iii) The assessee must have paid interest on the borrowed amount i.e. he has shown the same as an item of expenditure.
The above mentioned three conditions have been established legally by Supreme Court judgment in the case of Madhav Prasad Jatia Vs. CIT, (1979) 118 ITR 200 (SC).
3. Proviso to Section 36(1)(iii)
The proviso to Section 36(1)(iii) was inserted by Finance Act, 2003 w.e.f. 01.04.2004 relating to A.Y. 2004-05 and subsequent years. This was inserted to disallow interest on moneys borrowed for acquiring a capital asset till the date on which the asset was brought to use even if it is for extension of existing business. Following facts are important for consideration.
4. Important Issues
(I) Interest on borrowed capital used for interest free loans.
The law on this issue is settled after the Hon’ble Supreme Court judgment in the case of S. A. Builders Ltd. v. CIT (Appeals)  288 ITR 1 (SC), in which the concept of “commercial expediency” was used. Thus, where the funds of the business a diverted for interest free loans the main criteria for permissibility of interest on those funds are based on whether it was for commercial expediency or not. The phrase “commercial expediency” has following important traits as established by case laws cited supra:
The Hon’ble Supreme Court has also delved into the case where there would be mixed fund at the disposal of the assessee. It further clarifies that under Section 36(1)(iii) the ultimate use of the fund is important. It may not be relevant as to whether the advances have been extended out of the borrowed funds or out of mixed funds which include borrowed funds. The test to be applied in such cases is not the source of the funds but the purpose for which the advances are extended.
One important case law on this issue is Punjab Stainless Steel Ltd. 324 ITR 396 (Delhi High Court), in this the hon’ble High Court has given a finding which is in favour of revenue and has clearly distinguished Munjal Sales Corporation Vs. CIT, 298 ITR 298. In fact, the Ahmedabad Bench of ITAT has also followed this principle in Inamulhaq S. Iraki Vs. Addl. CIT, Range-2, Ahmedabad in ITA No. 243/Ahd/201 1 for A.Y. 2007-08 dated 31.01.2012. In this judgment the Hon’ble ITAT has squarely followed Hon’ble Delhi High Court decision Punjab Stainless Steel Ltd. 324 ITR 396, the relevant para (11) is reproduced below for the sake of ready reference.
“We find that as per this judgment of Hon’ble Delhi High Court, where mixed funds are used for the purpose of giving interest free advances, the only relevant test is as to whether such interest free advances are due to commercial expediency or not. In the present case also, the funds are mixed funds and the assessee could not establish any commercial expediency and hence, in our considered opinion, this issue is squarely covered against the assessee by this judgment of Hon’ble Delhi High Court and respectfully following the same, this issue is decided against the assessee”.
(II) Interest on borrowing utilized for earning non assessable / exempt income.
The issue is whether to allow the interest on borrowing utilized for exempt income or non assessable income. The primary condition for allowing deduction of interest in the computation of business income is that the interest was paid on capital borrowed for the purpose of business or profession. If the borrowed capital is utilized not in the business whose income is assessable, but in earning some non assessable or exempt income, the interest paid thereon, is not an allowable deduction under these provisions. This analogy flows from Section 14A inserted in Chapter IV of the Act, by the Finance Act, 2011 with retrospective effect from 01.04.1962, which is intended to safeguard the interest of the Revenue on account of wrong claim of expenditure relating to exempt income against taxable income. The Section 14A postulates that only expenditure which is relatable to taxable income should be deducted in computing the total income. Hence, expenditure which is incurred to earn exempt income should not be considered in the computation of total income. This would result in double advantage to the assessee.
Direct judgment which covers this issue is H.T. Conville Vs. CIT 4 ITR 137. Where a borrowing is specifically meant for use in a new industrial undertaking covered by Section 10B, such interest would go to reduce the eligible relief. It was, therefore, decided in Procon Systems P. Ltd. V. ITO 296 ITR 636 (Mad) that such interest cannot be reduced from eligible profits, because it has already been allowed as a business deduction.
(III) Section36( 1 )(iii)vis-à-visexplanation8toSection43( 1)
Section 36(1)(iii) allows deduction of the amount of interest paid in respect of capital borrowed for the purposes of business. The deduction is granted under the section, once it is established that the borrowing is for the purposes of business and that the interest is paid on such borrowings. A proviso has been inserted by the Finance Act, 2003, w.e.f. 01.04.2004, to provide that any amount of interest paid in respect of capital borrowed for acquisition of an asset for extension of existing business or profession, whether capitalized or not, for any period beginning from the date on which the capital was borrowed for such acquisition till the date on which such asset was first put to use, shall not be allowed as deduction. Interest for the period up to the date of putting the asset to its first use will not be allowed in cases of extension w.e.f. A.Y. 2004-05.
Interest for the period subsequent to the date of putting the asset to first use, is not allowed to be capitalized as part of the ‘actual cost’ for the purposes of claiming depreciation and other allowances. This is provided by Explanation 8 which is inserted in under Section 43(1) by the Finance Act, 1986 with retrospective effect from 01.04.1974.
Thus in case of an “extension” there are two facts which are evident:
Thus an issue emerges in respect of the eligibility for claim of interest in cases where an asset is not put to use during the year. One view is that such interest shall be allowed once it is established that the borrowing is for the purposes of the existing business, while the other view, strongly relying on Explanation 8 to under Section 43(1), holds that interest for the period up to the date of use is not allowable as deduction. The issue is partly resolved by the proviso in Section36(1)(iii). Further, this issue is resolved by the judgment in Core Health Care Ltd. Vs. DCIT (SC) 298 ITR 194. In this judgment Hon’ble Supreme Court has brought out the following interpretations for resolving the above mentioned issue:
1. Section 36(1)(iii) has to be read on its own terms. It is a code by itself. Section 36(1)(iii) is attracted when the assessee borrows the capital for the purpose of his business. It does not matter whether the capital is borrowed in order to acquire a revenue asset or a capital asset, because all that the section requires is that the assessee must borrow the capital for the purpose of his business. There by meaning that the transaction of borrowing is not the same as the transaction of investment.
From the above mentioned discussion the following can be safely concluded.
a. The interest on borrowings used for capital expenditure relating to a totally new business apart from existing business is to be capitalized as pre-commencement expenditure as held in the case of CIT Vs. Vadilal Dairy International Ltd. 328 ITR 544 (Guj.)
Thus following these judgments the Assessing Officer can question the wisdom of assessee in choice of investment and whether the investment was genuine or not.
(V) Interest on borrowings for purchasing shares
Under this topic the discussion is further sub-divided in following three sub headings i.e. (a) Section 36(1)(iii) vis-à-vis Section 57(iii), (b) whether dividend on preference shares can be equated with interest on borrowed capital and (c) the case of Circular trading.
(a) Section 36(1)(iii) vis-à-vis Section 57(iii)
Where borrowings are made for purchase of shares, question often arises whether interest paid should be allwed as deduction under Section 36(1)(iii) or under Section 57(iii). Here it would be worthwhile to mention that income by way of dividends on shares, whether held on investment portfolio or as stock-in-trade, is specifically assessable, under Section 56(2)(i), as “Income from other sources”. Where the shares are held, although on investment portfolio, as an integral part of business, interest on such borrowings is allowable under Section 36(1)(iii). Thus, the qualifying factor in this case is to ascertain whether the borrowings for purchasing shares is an integral part of business of assessee.
Interest can be allowed under Section 36(1)(iii) only if the assessee proves that it was for the purpose of business. But if the shares are acquired not as an investment for earning income therefrom, the inference may well be different as was found in CIT Vs. Amritaben R. Shah 238 ITR 777 (Bom), where it was held that a taxpayer borrowing money to acquire controlling interest in a company would not be entitled to deduction of interest on borrowings. In coming to the conclusion, the High Court followed precedents which are worth noting. The Gujarat High Court in Sarabhai Sons (P) Ltd. V. CIT 201 ITR 464, found that where the dominant purpose of expenditure is not for earning income, it could not be allowed as a deduction. In Chinai and Co. Pvt. Ltd. V. CIT 206 ITR 616 (Bom), expenses incurred in fighting another group of shareholders to protect investments in erstwhile managed company was held to be not admissible as business expenditure.
(b) Whether dividend on preference shares can be equated with interest on borrowed capital.
From the provisions of Sections 85 and 205 of the Companies Act, 1956, it is clear that the preference share capital is a contribution to the capital of the company by its subscribers or shareholders and is not a ‘borrowing’ by the company subject to payment of interest. Similarly, for the very said reason the dividend which is paid to such shareholders is to be paid only out of the profits earned by the company. In common parlance, it can be equated with the share income derived by the shareholders out of the profits of the company. Therefore, by no stretch of imagination the dividend sought to be paid can be equated with or treated as ‘interest’ paid on the borrowed capital. In that view of the matter, the assessee-company is not entitled to deduction of the liability on account of dividend on preference shares by invoking the provisions of Section 36(1)(iii). [Kriloskar Electric Co. Ltd. v. CIT,228 ITR 674, 676 (Karn); Kirloskar Electric Co. Ltd. v. CIT,228 ITR 676, 678 (Karn)].
(C) The case of Circular Trading
Interest on borrowed capital for purposes of business is a deductable expenditure under Section 36(1)(iii), where the assessee is dealing in shares. But what happens when it is proved that the borrowings were merely an arrangement by way of circular trading solely with a view to avoid tax. This issue was examined by Supreme Court in CIT Vs. Ashini Lease Finance P. Ltd. 309 ITR 320 (SC) whereby the decision given by Gujarat High Court was set-aside by Hon’ble Supreme Court. In this case, the assessee, borrowed funds from the concerns in the same Torrent group for purchase of equity shares of AEC. During the relevant year, the total investment made by the assessee in the take over and acquisition of business of AEC amounted to only Rs. 22,59,969. In addition, the Assessing Officer also found that after acquiring the shares of the company by the group, the same shares of AEC were sold at Rs. 63,57,925 and ultimately AEC Ltd. had been taken over by the Torrent group. The record indicated, prima facie, that the assessee-company had acquired the shares of AEC, through finances arranged mainly from the Torrent group (sister companies) along with two other companies only to enable the Torrent group to acquire and take over the business of AEC. It was on these facts, the prima facie inference was that it is not a normal trade borrowings, but merely an arrangement by way of circular trading solely with a view to avoid tax. The Supreme Court, therefore, felt that the High Court was not justified in holding that the Tribunal in allowing the deduction had taken a decision on the facts, and that there was no substantial question of law for determination by the High Court. There was a substantial question of law in the light of the inference drawn from admitted facts. The issue was sent back to the High Court for a decision in accordance with law. Thus, if there is a case where it can be proved that the borrowings made are not part of normal trade borrowings and it is merely an arrangement by way of circular trading among companies under the same group, then interest on such borrowings can be disallowed.
(VI) Interest on borrowed capital in the case of Firms.
This issue arises in the case of Firms whereby Section 36(1) (iii) is to be read with Section 40(b)(iv). In this case, if the assessee is a Firm, then to claim deduction in respect of interest paid on capital borrowed from third party (apparently partners), the Firm is required to established two things:
It is important to note that Section 36(1) refers to ‘Other Deductions’ whereas Section 40 comes under the heading ‘Amounts not Deductible’. Therefore, Sections 30 to 38 are for ‘Other Deductions’ whereas Section 40 is a limitation on that deduction. It is important to note that Sections 28 to 43C essentially deal with Business Income. Sections 30 to 38 deal with Deductions. Sections 40A and 43B deal with Business Disallowances. Keeping in mind the said scheme the position is that Sections 30 to 38 are deductions which are limited by Section 40. Therefore, even if an assessee is entitled to deduction under Section 36(1)(iii), the assessee (firm) will not be entitled to claim deduction for interest payment exceeding 18/12 per cent per se. This is because Section 40(b)(iv) puts a limitation on the amount of deduction under Section 36(1) (iii ) [Munjal Sales Corp Vs CIT (SC) 298 ITR 298].
(VII) Distinction between Sections 36(1)(iii) and 3 7(i)
Section 37(1), which is a residuary general provision, may have application to any expenditure (including interest) which is not of the nature described in Sections 30 to 36. To an extent, Section 36(1)(iii) and Section 37(1), so far as the allowance of interest is concerned, run parallel to each other. But later, they do differ and it can then be discerned whether a given case falls within the phraseology of Section 36(1)(iii) or Section 37(1). Comparing the two, we may see –
Section 36(1)(iii) Section 37(1)
|It must be interest on capital (moneys) borrowed.|
|It may be interest even on any debt incurred.|
|The borrowings must be for the “purpose of the business”.|
|The debt incurred must be and exclusively for the purposes of the business.|
|The borrowed amount may be utilized for even procuring a capital asset related to the business|
|The debt incurred must not utilized for procuring a capital asset so as to fall within the gamut of “capital expenditure”|
One thing is certain that there can be no double deduction – once under Section 36(1)(iii) and again under Section 37(1)– for one and the same amount of interest. (VIII) Burden of Proof
The burden of proving, that the moneys borrowed has not been utilized for non business purpose and the lending has all ingredients of “commercial expediency”, is on the assessee. There are various case laws which supports this contention viz. CIT Vs. Coimbatore Salem Transport P. Ltd.61 ITR 480 (Mad), Indian Metals & Ferro Alloys Ltd. Vs. CIT,193 ITR 344 (Ori), CIT Vs Abhishek Ind (P&H) 286 ITR 1. In the case of R. Dalmia Vs. CIT 133 ITR 169 (Del.) the Hon’ble High Court decided that “Where the interest paid concerns the borrowed money for business as well as non business purposes, the claim may be disallowed in its entirety if no adequate material is adduced by the assessee to determine that portion of interest which pertains to business purposes”.
(IX) The extent of disallowance under Section 36(1)(iii)
The Assessing Officer is often confronted with a question as to the extent of disallowance when it is proved that the borrowings were utilized for non business purposes. In such situations, there could be two possible scenario :
(1) Where there is only borrowed fund and no composite or mixed fund. In such cases, the disallowance is to be made at the full rate of interest payable on such borrowed money. The amount of interest, if any, realized from such utilization is not to be taken into account for ascertaining the extent of the disallowance [CIT Vs. India Silk House, 152 ITR 79 (Mad)].
(2) Where there is composite or mixed fund, in such a case, the Assessing Officer is required to co-relate between the nature of feeding fund with utilization of such fund. After this co-relation the Assessing Officer may devise methods based on factual analysis of the source of fund with the utilization of fund to arrive at the figure of part disallowance of interest expenditure. In this case, there cannot be full disallowance of interest payable by the assessee. Where the funds are mixed up, so that it is not possible to identify the extent of borrowings utilized for such loans, proportionate amount could be disallowed as held in K. Somasundaram and Brothers Vs. CIT 238 ITR 939 (MAD).
(X) No allowance for pre-commencement interest
Section 36 falls within the code for computation of business income. Unless a business is actually commenced, no deduction under these provisions can be claimed in respect of interest on moneys borrowed for the period prior to such commencement [Ritz Continental Hotels Ltd. v. CIT,114 ITR 554(Cal)].
(XI) No allowance in case of cessation of business
Where the business has ceased to be carried on, no deduction can be claimed in respect of interest on borrowings [Assam Biscuit Mfg. Co. Ltd. v. CIT,185 ITR 535 (Gauh)].
(XIII) No allowance on sham or colourable transactions.
It is true that an assessee is entitled to arrange his affairs in such a way as to reduce his tax liability by all legal ways but the arrangement ultimately adopted must be genuine and not sham. If the object of the borrowing was illusory or colourable and not genuinely for business purposes, these provisions will have no application [Govan Bros. v. CIT, (1963) 48 ITR 930, 941 (All)].
(XIII)The Companies Act, 1956
It would be worthwhile to examine the provisions in the Companies Act, 1956 with regard to loans to sister concerns / companies under the same management. The Companies Act, 1956 deals with this issue in Section 370, 370A and 371. In fact it lays down very stringent conditions for making any loans to companies under the same management. The relevant part of Section 370 is reproduce to give an idea about the provision whereby it says that “ any body corporate, unless the making of such loan, the giving of such guarantee or the provision of such security has been previously authorized by a special resolution of the lending company ”. Thus it talks about making special resolution before giving any loan to related companies. Further, Section 371 deals with penalty for contraventions to any conditions given in Section 370. Thereafter, Section 372A deals with Inter-Corporate loans and investments.
It would be not out of place to take strength from these provisions to make good assessments.
5. Important Case Laws
The following are some important case laws apart from what is discussed in above paragraphs. The illustrations give out cases in favour of revenue where interest on borrowed capital was held not allowable.
(i) Bombay Steam Navigation Co. P. Ltd. V. CIT 56 ITR 52 (SC).
Payment of interest by a company on unpaid price of the assets taken over is not an affordable expense.
(ii) Lachhiram Puranmal Vs. CIT 119 Taxman 1 (MP)
Interest paid on borrowed capital was held not deductible where such capital was utilized for the purpose of agricultural land which was admittedly not a business investment.
(iii) Malwa Mills Karmchari Paraspur Sahkari Sanstha Ltd. Vs. CIT 140 ITR 379 (MP).
Assessee having two units, A and B, made advances from unit A and unit B. Interest debited in unit B held not allowable because the entity was the same.
(iv) CIT Vs. Ahmedabad Mfg. & Calico Printing Co. Ltd. (Guj.) 215 ITR 735
Payment of betterment charges is capital expenditure. Therefore, payment of interest on annual installments of the betterment charges will have to be regarded as capital expenditure, because it has no direct nexus with the day-to-day running of the business of the assessee.
(v) East India Pharmaceutical Works Ltd. Vs. CIT (SC) 224 ITR 627
The interest that is paid by the assessee on any sum borrowed by him for payment of income tax is not deductible from his net income since it is only application of profits and not expenditure incurred to earn profits.
(vi) Saraspur Mills Ltd. Vs. CIT (Guj.) 226 ITR 533
Interest paid for late payment of Income Tax is not deductible as it is not incurred for the purpose of carrying on of the business. The interest takes colour from the nature of the principal.
(vii) Auto Sales Vs. CIT 227 ITR 790 (All)
Interest on gifted amount remaining with the assessee firm in the name of the donee to whom gift was made by book entries and the donor partner not having sufficient credit balance to his account, held not allowable because such a transaction of gift could not be treated as a genuine one.
(viii) Bharat Commerce and Industries Ltd. Vs. CIT (SC) 230 ITR 733
For VDIS Tax paid in installments with interest, the interest is not deductible as business expenditure or as interest on borrowed capital.
(ix) Saswad Mali Sugar Factory Ltd. Vs. CIT 236 ITR 706 (Bom)
Interest on capital for purchase of machinery, which was leased out and income therefrom was assessed under the head “Income from other sources”, was held not deductible under Section 36(1)(iii) in view of the finding recorded by the Tribunal that the assessee’s intention was not to carry on business, but to let out the business assets as income yielding properties.
(ix) CIT Vs. Indian Express Newspaper (Madurai) P. Ltd. 238 ITR 70 (Mad).
Interest paid on amount borrowed by the assessee company and transferred to the investment company floated by it which in turn transferred to same to an associate company of the assessee company which was engaged in the construction of a building was held not deductible because the borrowed amount was not used for the purposes of the assessee’s business.
xi) CIT Vs. Ramkant Mishra 252 ITR 210 (Cal.)
Interest on cash credit, which have not been explained, has been held not allowable in spite of the fact that no addition was made on account of unexplained cash credit.
(xii) JCT Ltd. Vs. DCIT (Calcutta) 276 ITR 115
Section 36(1)(iii), read with Sections 43(1) and 37(1), of the Income-tax Act, 1961 – Interest on borrowed capital – Assessment years 1987-88 and 1988-89 – Whether interest paid on borrowed capital under deferred payment scheme for acquisition of plant and machinery for period relevant till asset was first put to use would not be eligible for deduction under Section 36(1)(iii) or Section 37(1) since it is includible in actual cost of acquisition of asset till asset was first put to use, in view of Explanation 8 to Section 43(1) – Held, yes.
(xiii) CIT Vs. Swapna Roy (All) 331 ITR 367
Borrowed funds were invested in financially fragile sister concerns. The court held that there was no intention to earn income but merely to assist sister concerns. Deductions of interest paid on such borrowings is not allowable.
Authored by –
JCIT (Sr AR)-IV, ITAT, Ahmedabad