No Section 36(1)(iii) Disallowance Where Own Funds Exceed Investments: ITAT Chennai

Thiruvalluvar Textiles (P) Ltd. Vs ACIT (ITAT Chennai)

The appeals before the Income Tax Appellate Tribunal, Chennai, arose from the orders of the Commissioner of Income Tax (Appeals) dated 24.01.2025 for Assessment Years 2008-09 to 2011-12. The common issue in all the appeals concerned the disallowance of interest on advances made by the assessee company to its wholly owned subsidiary, M/s. The Narasimha Mills Pvt. Ltd. (TNMPL). The disallowance amounted to Rs.3,40,04,077 for AY 2008-09, Rs.2,45,30,864 each for AYs 2009-10 and 2010-11, and Rs.4,92,34,816 for AY 2011-12. Since the issue was common, the Tribunal treated AY 2008-09 as the lead case and applied its findings mutatis mutandis to the remaining years.

For AY 2008-09, the assessee, engaged in the manufacture of cotton yarn, filed its return declaring a loss. The return was processed under Section 143(1), later selected for scrutiny, and an assessment under Section 143(3) was completed on 30.12.2010. Subsequently, the Commissioner of Income Tax set aside the assessment under Section 264 and directed the Assessing Officer to make a fresh assessment. During the fresh proceedings, the Assessing Officer noted that the assessee had invested Rs.19,62,46,913 in equity shares of TNMPL and advanced Rs.7,57,85,706 to the subsidiary. The Assessing Officer observed that the assessee had borrowed approximately Rs.150.89 crore for business purposes and claimed interest expenditure thereon. Since, according to the Assessing Officer, the assessee lacked accumulated profits or reserves sufficient to make the investments and advances, he presumed that borrowed funds had been diverted for non-business purposes. The Assessing Officer also recorded that the investments and advances were made in connection with acquiring TNMPL and treated the acquisition as a capital asset. On that basis, proportionate interest at 12.5% on both the investments and advances was disallowed.

The Commissioner of Income Tax (Appeals) upheld the Assessing Officer’s action, sustaining the disallowance of proportionate interest on the investments and advances after considering the remand report.

Before the Tribunal, the assessee challenged the disallowance on several grounds, principally contending that it possessed sufficient own funds to finance both the investments in and advances to its wholly owned subsidiary. The assessee relied upon its balance sheet as on 31.03.2008, which reflected shareholder funds of Rs.45.48 crore, comprising share capital, share application money exceeding Rs.30 crore, and reserves and surplus. Since the total investments and advances to TNMPL aggregated approximately Rs.27.20 crore, it was submitted that sufficient interest-free funds were available.

The Tribunal examined the audited balance sheet and found that the assessee possessed own funds exceeding Rs.45 crore, while the aggregate investment and advances to the subsidiary were less than Rs.28 crore. It observed that the Assessing Officer and the Commissioner (Appeals) had accepted the books of account and had not pointed out any defects in the audited financial statements. The Tribunal held that the assessee had mixed funds, including sufficient interest-free own funds, giving rise to the presumption that the investments and advances were made from those interest-free funds.

In support of this conclusion, the Tribunal relied upon the decisions in CIT v. Reliance Utilities and Power Ltd. (2009) 313 ITR 340 (Bom), CIT v. Hotel Savera (1999) 239 ITR 795 (Mad), and CIT v. TIN Box Co. (2003) 260 ITR 637 (Del). The Tribunal further referred to the Supreme Court decision in CIT (LTU) v. Reliance Industries Ltd., 410 ITR 466 (SC), which held that where interest-free funds are sufficient to meet investments, a presumption arises that the investments were made from those funds and no disallowance under Section 36(1)(iii) is warranted. The Tribunal also referred to the decision of the Mumbai Bench of the Tribunal in M/s. T. Bhimjyani Realty Pvt. Ltd., ITA No.4901/Mum/2024 for AY 2018-19, order dated 16.01.2025, which followed the same principle.

Applying these principles, the Tribunal held that the Assessing Officer and the Commissioner (Appeals) had erred in concluding that the assessee had no own funds for making the investments and advances. The Tribunal noted that the assessee had interest-free share application money of more than Rs.30 crore, share capital of Rs.7.06 crore, and reserves and surplus of Rs.7.51 crore, aggregating Rs.45.48 crore, which was sufficient to cover the investments and advances made to TNMPL. Accordingly, the Tribunal held that the proportionate interest disallowance was erroneous and perverse. The orders of the Assessing Officer and the Commissioner (Appeals) were set aside, and the Assessing Officer was directed to delete the additions made on this account in all the assessment years under appeal. The appeals filed by the assessee were allowed.

Cases Discussed

• M/s. T. Bhimjyani Realty Pvt. Ltd. (ITAT Mumbai), ITA No.4901/Mum/2024 for AY 2018-19, order dated 16.01.2025
• CIT (LTU) v. Reliance Industries Ltd. (Supreme Court), 410 ITR 466 (SC)
• CIT v. Reliance Utilities and Power Ltd. (Bombay High Court), (2009) 313 ITR 340 (Bom)
• CIT v. TIN. Box Co. (Delhi High Court), (2003) 260 ITR 637 (Del)
• CIT v. Hotel Savera (Madras High Court), (1999) 239 ITR 795 (Mad)

FULL TEXT OF THE ORDER OF ITAT CHENNAI

These are appeals preferred by the assessee against the orders of the Learned Commissioner of Income Tax (Appeals), (hereinafter referred to as “the Ld.CIT(A)”), Chennai-18, all dated 24.01.2025 for the Assessment Years (hereinafter referred to as “AY”) 2008-09 to 2011-12.

2. The sole issue permeating in all the appeals is regarding the disallowance of interest on the advance given by the assessee company to its wholly owned subsidiary M/s. The Narasimha Mills Pvt. Ltd., [M/s.TNMPL]. The quantum of disallowance for each year is noted as under:

3. Since both the parties agreed that the only issue is regarding the disallowance of interest on the advance given by the assessee to its subsidiary as noted supra, we take up the appeal for AY 2008-09 as the lead case and the result of which will be applicable mutatis mutandis for all other appeals for captioned assessment years.

4. The brief facts relating to AY 2008-09 are that the assessee is a company engaged in manufacture of cotton yarn. It filed its return electronically on 29.09.2008 declaring a loss of Rs.17,86,18,931/-. The return was e-processed u/s.143(1) of the Income Tax Act, 1961 (hereinafter referred to as ‘the Act‘) on 17.05.2009. Subsequently, the case was selected for scrutiny and the assessment was completed u/s.143(3) of the Act dated 30.12.2010. During the course of original assessment, the assessee company had submitted a revised computation statement, in which the company has admitted a loss of Rs.18,42,81,677/-. While passing order u/s.143(3) of the Act dated 30.12.2010, the loss was reduced to Rs.17,96,60,609/-. Subsequently, the assessment was set-aside by the Commissioner of Income Tax, Salem by order made u/s.264 of the Act dated 26.03.2013 directing the AO to make fresh assessment. Pursuant thereto, the AO examined the balance-sheet of the assessee company and noted that it had invested Rs.19,62,46,913/- in equity shares and advanced Rs.7,57,85,706/- to M/s The Narashima Mills (P) Limited (M/s.TNMPL). However, according to the AO, the assessee company didn’t have any accumulated profit neither to make investments nor to provide advances to the subsidiary company (M/s.TNMPL). Hence, he was of the opinion that there was a diversion of loan received from the banks for business purpose to non-business purpose. According to the AO, since the assessee company didn’t had reserve & surplus to make any investment/advances to M/s. TNMPL and instead had obtained various loans for the purpose of business to the tune of Rs.150.89 Crs. and had claimed interest expenditure for the loans obtained, the AO presumed that the only source of monies for making advances/investment to the subsidiary M/s.TNMPL was from the business loan. And therefore, he was of the view that the assessee company had diverted the business loan for the purpose of non-business and claimed proportionate interest expenditure on that advance/investment made to M/s.TNMPL, which assessee was ineligible. Further, the AO was of the view that the ultimate aim of the assessee was to purchase a capital asset i.e. M/s. TNMPL, for which, it is incurring or making payments in different heads and inter alia made the following findings:

The ledger account of the investment in equity shares in the books of account of the assessee company M/s. Thiruvalluvar Textiles (P) Ltd (TTPL) [cost of acquisition (Narasimha)] brings out the fact that the sum of Rs.19,62,46,913/-was made in two financial years i.e. F.Y.2006-07 & F.Y.2007-08. It is also observed that the assessee company was making payments on behalf of M/s. Ravikumar Properties (P) Ltd (RPPL) who had originally purchased the shares of NMPL from the original promoters. Later on, the assessee purchased shares of NMPL from RPPL as well as took over the loan from RPPL to Sundaram Finance Ltd (SFL). The assessee company TTPL settling the loans to SFL in the two financial years 2006-07 & 2007-08. In the F.Y.2006-07, the amount of Rs.4,40,17,765/- and in the F.Y.2007-08, the amount of Rs.15,22,29,148/-(14,66,00,993 + 56,28,155) and thus, the total of Rs.19,62,46,913/- paid to SFL on behalf of RRPL was taken as the cost of acquiring shares of face value of Rs.60 lakhs.

Similarly, monies advanced to NMPL was also done in two financial years 2006-07 & 2007-08 to the tune of Rs.1,03,19,876/- and Rs.6,54,65,830/-respectively. On 09.11.2007, the assessee NMPL had transferred the sum of Rs.19,62,46,913/-, which was paid to SFL on behalf of RPPL as investment in NMPL shares. Thus, the assessee company started making payments to The NMPL. in the F.Y.2006-07 with the intention of acquiring the capital asset, the company NMPL.

5. On the aforesaid reasoning, the AO was of the view that the assessee has diverted the loans meant for its own business to the non-business purposes in the form of investment in equity shares of M/s.TNMPL and advances to M/s.TNMPL. Hence, the proportionate interest @12.5% on the amount of investment in equity shares of Rs.19,62,46,913/- and advances of Rs.7,57,85,706/- was disallowed and added back to the profits and gains of the assessee company.

6. Aggrieved by the aforesaid action of the AO, the assessee preferred an appeal before the Ld.CIT(A) who was pleased to uphold the action of the AO disallowing proportionate interest on investment to the tune of Rs.2,45,30,864/- and disallowance of proportionate interest on advance to the tune of Rs.94,73,213/- after considering the Remand Report of the AO which has been reproduced at Page Nos.6 & 7 of the impugned order.

7. Aggrieved by the aforesaid action of the Ld.CIT(A), the assessee is before us.

8. We have heard both the parties and carefully perused the records including Paper Books filed by the assessee. The assessee is a company engaged in manufacture of cotton yarn. The assessee company is noted to have invested towards equity shares of M/s.TNMPL and also had advanced monies to it (M/s. TNMPL), its wholly owned subsidiary. The assessee company is noted to have obtained various loans for the purpose of business to the tune of Rs.150.89 Crs. and also claimed interest expenditure for the loans thus obtained. The AO taking note of the investment & advances given to M/s.TNMPL, presumed that the only source of monies for making advances/investment to the subsidiary M/s.TNMPL was from the business loan of Rs.150.89 Cr. And therefore, he was of the view that the assessee company had diverted the business loan for the purpose of non-business and had claimed proportionate interest expenditure on the advances/investment made in M/s.TNMPL which claim of expenditure was not allowable. Further, according to the AO, the ultimate aim of the assessee was for acquiring capital asset i.e. assessee company M/s.NMPL. And therefore, the proportionate interest @ 12.5% on the amount of investment in equity shares of Rs.19,62,46,913/- and advances of Rs.7,57,85,706/- was disallowed i.e. Rs.2,45,30,864/- and Rs.94,73,213/- total Rs.3,40,04,077/-. On appeal, the Ld.CIT(A) has confirmed the action of the AO.

9. The Ld.AR of assessee had assailed the action of the AO/Ld.CIT(A) on many fronts, but the main thrust of the contention of the assessee’s Counsel is that the assessee company had enough own funds to invest in the wholly owned subsidiary M/s.TNMPL to the tune of Rs.19,62,46,913/-and advance of Rs.7,57,85,706/-. In order to buttress this contention, the Ld.AR drew our attention to Page No.168 of the Paper Book wherein the balance-sheet of the assessee company is found placed which shows that the assessee company had own funds of more than Rs.45 Crs. The relevant portion of the balance as on 31.03.2008 is reproduced as under:

10. From the aforesaid balance-sheet, we note that the assessee had own funds of more than Rs.45 Crs. and the investments made in the wholly owned subsidiary is only less than Rs.28 Crs. i.e. Rs.19,62,46,913/- plus Rs.7,57,85,706/- [total Rs.27,20,32,619/-] According to us, the AO/CIT(A) erred in not appreciating that assessee had own funds of more than Rs 14 crores and share application money of more than Rs 30 crores, which is interest-free available with the assessee as shown in the audited financials, which results have not been found to suffer from any defect or infirmities by the AO/CIT(A). Having accepted the books of assessee company, we find that the assessee company was in possession of mixed funds which includes its own funds in sufficient quantity, which factual finding of ours, in turn raises presumption that its own funds were utilized for making interest-free advance or investment in its subsidiary M/s.TNMPL . For such a preposition, we rely on the following Hon’ble High Courts decisions:

• CIT v. Reliance Utilities and Power Ltd. (2009) 313 ITR 340 (Bom)
• CIT v. Hotel Savera (1999) 239 ITR 795 (Mad)
• CIT v. TIN. Box Co. (2003) 260 ITR 637 (Del)

11. The ratio laid by the Hon’ble High Courts (supra) been concurred by the Hon’ble Apex Court in CIT (LTU) v. Reliance Industries Ltd., reported in 410 ITR 466 (SC) wherein it was held by their Lordships ‘ ………  when interest-free funds was available with assessee is sufficient to meet investment, presumption is that investments in subsidiaries were out of interest-free funds and accordingly no disallowance u/s.36(1)(iii) of the Act was warranted”. In this regard, it would be gainful to refer to the same principle followed by the ITAT Mumbai Tribunal, in the case of M/s. T. Bhimjyani Realty Pvt. Ltd., in ITA No.4901/Mum/2024 for AY 2018-19 vide order dated 16.01.2025, wherein the Tribunal held as under:

4.1. The second legal principle followed by Ld CIT(A) is that if the assessee is having both interest free funds and interest bearing borrowed funds, then the presumption is that the investments have been made first out of interest free funds. In that case, the disallowance u/s 36(1)(iii) of the Act shall not arise. It has been so explained by Hon’ble Bombay High Court in the case of Reliance Utilities and Power (313 ITR 340)(Bom) as under:-

“10. If there be interest-free funds available to an assessee sufficient to meet its investments and at the same time the assessee had raised a loan it can be presumed that the investments were from the interest-free funds available. In ITA No. 4901/MUM/2024 our opinion the Supreme Court in East India Pharmaceutical Works Ltd.’s case (supra) had the occasion to consider the decision of the Calcutta High Court in Woolcombers of India Ltd.’s case (supra) where a similar issue had arisen. Before the Supreme Court it was argued that it should have been presumed that in essence and true character the taxes were paid out of the profits of the relevant year and not out of the overdraft account for the running of the business and in these circumstances the appellant was entitled to claim the deductions. The Supreme Court noted that the argument had considerable force, but considering the fact that the contention had not been advanced earlier it did not require to be answered. It then noted that in Woolcombers of India Ltd.’s case (supra) the Calcutta High Court had come to the conclusion that the profits were sufficient to meet the advance tax liability and the profits were deposited in the overdraft account of the assessee and in such a case it should be presumed that the taxes were paid out of the profits of the year and not out of the overdraft account for the running of the business. It noted that to raise the presumption, there was sufficient material and the assessee had urged the contention before the High Court. The principle therefore would be that if there are funds available both interest-free and overdraft and/or loans taken, then a presumption would arise that investments would be out of the interest-free fund generated or available with the company, if the interest- free funds were sufficient to meet the investments. In this case this presumption is established considering the finding of fact both by the CIT (Appeals) and ITAT.”

12. Therefore, in the light of the aforesaid findings of ours, it is found that the AO and the Ld.CIT(A) erred in making a finding that the assessee didn’t had any own funds to invest/advance to its wholly owned subsidiary i.e. M/s.TNMPL, when the fact was that assessee had share application fund to the tune of Rs.30,90,50,000/- (more than Rs.30 Cr.) which in any case is interest free & share capital of Rs.7,06,31,000/- and reserve & surplus of Rs.7,51,84,580/- [total Rs.45,48,65,580/-] and therefore had sufficient own funds to make investment/advances to its subsidiary M/s.TNMPL. Thus, the AO erred in making proportionate disallowance of interest which action of the AO/Ld.CIT(A) is erroneous being perverse and therefore set aside and accordingly, the AO is directed to delete the additions made on this account in all the captioned appeals.

13. In the result, appeals filed by the assessee are allowed.

Order pronounced on the 04^th day of July, 2025, in Chennai.