Section 57(iii): Interest on Borrowed Funds Deductible Against Taxable Interest Income: ITAT Surat

Ankit Hemantbhai Desai Vs DCIT-Circle-1(3) (ITAT Surat)

Summary : The ITAT Surat allowed Ankit Hemantbhai Desai’s appeal for AY 2018–19 and deleted the interest disallowance of ₹61,75,253 sustained by the CIT(A). The individual declared total income of ₹1,00,98,710, including ₹38,56,811 under “Income from other sources”. He reported interest of ₹1,06,89,792 from parties and claimed interest expenditure of ₹71,71,538 under Section 57(iii) of the Income-tax Act, 1961. The Assessing Officer disallowed the full claim, questioning the use of borrowed funds, the absence of TDS on interest paid to Bindal Estate Private Limited and whether Shridhar Construction Private Limited had declared the corresponding interest. The CIT(A) allowed ₹9,95,098 paid to Shweta Desai, a non-resident from whose interest the assessee had deducted TDS under Section 195, but sustained the balance.

On Section 194A, the assessee initially cited current-year gross receipts of ₹2,10,000. The Revenue pointed out that the proviso to Section 194A(1) looks to the preceding year. At the Bench’s direction, the assessee furnished records showing gross receipts of ₹8,40,000 for the preceding AY 2017–18. The Tribunal found that this amount fell below the applicable limit and held that the individual had no obligation to deduct TDS under Section 194A on the interest paid to resident payees.

On the use of borrowed funds, the assessee relied on a comparative fund-flow analysis showing the deployment of interest-bearing and interest-free funds in earning interest. He submitted that fresh borrowings were used mainly to replace earlier loans. The Revenue cited a ₹2.2 crore borrowing from Shridhar, which the AO said was used partly for a ₹1 crore investment in tax-exempt mutual funds and partly to repay an interest-free loan from Hemant Desai. The Tribunal considered the overall fund position, the assessee’s interest-bearing advances and the interest actually earned. It accepted that part of the borrowing repaid the interest-free loan but found that this payment alone did not establish diversion to a purpose unrelated to earning taxable interest. The Revenue had produced no cogent evidence of such diversion.

The Tribunal also rejected the allegation that the ₹52,27,304 interest payable to Shridhar was a false claim. Although the amount did not appear in Shridhar’s individual ledger account in the assessee’s books, the balance sheet separately showed it as “Interest Payable – Shridhar” under current liabilities. Records furnished at the Bench’s direction showed that Shridhar had declared the corresponding interest income to the Income-tax Department. The Tribunal found sufficient nexus between the expenditure and the earning of taxable interest, held that Section 57(iii) was satisfied and allowed the appeal.

Cases Discussed

• Best Trading and Agencies Ltd. v. DCIT, Circle 11(2), Bangalore, [2020] 119 taxmann.com 129, ITA Nos. 191 of 2011 and 32 of 2012, decided on 26 August 2020 (Karnataka High Court). The assessee cited the decision on the nexus between interest payable to lenders and interest earned on deposits made from funds arising out of a restructuring.
• CIT (Large Tax Payer Unit) v. Reliance Industries Ltd., [2019] 102 taxmann.com 52, Civil Appeal Nos. 35 and 37–39 of 2019, decided on 2 January 2019 (Supreme Court). The assessee invoked the decision by analogy on the inference available where sufficient interest-free funds were available for investments.
• CIT (LTU) v. Reliance Industries Ltd., [2017] 86 taxmann.com 24 (Bombay High Court). The assessee relied on the treatment of sufficient interest-free funds when examining the disallowance of borrowing costs under Section 36(1)(iii).
• CIT v. Smt. Sushila Devi Khadaria, [2009] 319 ITR 413, [2009] 183 Taxman 275, decided on 16 March 2009 (Bombay High Court). The assessee cited the decision for the relevance of an indirect connection between genuine financing costs and the income earned.
• Seth R. Dalmia v. CIT, [1977] 110 ITR 644, (1977) 4 SCC 329, decided on 21 September 1977 (Supreme Court). The written submissions quoted the Court’s approval of the view that an indirect connection can establish the requisite nexus where the expenditure is incurred to earn income.
• CIT v. H.H. Maharani Shri Vijaykuverba Saheb of Morvi, [1975] 100 ITR 67, decided on 10 July 1974 (Bombay High Court). The case appears in the passage reproduced from Seth R. Dalmia on the purpose of expenditure and its connection with the income sought to be earned.

FULL TEXT OF THE ORDER OF ITAT SURAT

Feeling aggrieved by the order of first appeal dated 12.06.2024 passed by learned Commissioner of Income-Tax (Appeals)-NFAC, Delhi [“Ld. CIT(A)”], which in turn arises out of the assessment-order dated 21.04.2021 passed by learned Assessment Unit of Income-tax Department [“Ld. AO”] u/s 143(3) of Income-tax Act, 1961 [“the Act”] for Assessment-Year [“AY”] 2018-19, the assessee has filed this appeal on following ground:

“The Ld. CIT(A) has erred and was not just and proper on the facts of the case and in law in confirming the disallowance of interest to the extent of Rs. 61,75,253/-”

2. The background facts leading to present appeal are as under:

(i) The assessee is an individual earning income from salary, business and other sources.

(ii) For AY 2018-19, the assessee filed return of income declaring a total income of Rs. 1,00,98,710/-, which included taxable income of Rs. 38,56,811/- under the head ‘Income from other sources’ computed as under:

The detail of major amounts comprising the aforesaid interest expenditure claimed by assessee, are available at Page 96 of Paper-Book as under:

(iii) The case of assessee was selected for scrutiny assessment and the Ld.AO issued notices u/s 143(2)/142(1) which the assessee complied with. Ultimately, the Ld. AO completed assessment u/s 143(3) r.w.s. 144B after disallowing interest expenditure of Rs. 71,71,538/- claimed by assessee u/s 57(iii) in computing taxable income from other sources. The Ld. AO made aforesaid disallowance, inter alia, for these reasons:

(a) Interest of Rs. 52,27,304/- was paid to ‘M/s Shridhar Constructions Private Limited’ but the said party had not declared interest income in its books, therefore the deduction claimed by assessee to that extent was false.

(b) Remaining interest of Rs. 9,46,949/- was paid to ‘M/s Bindal Estate Private Limited’ and Rs. 9,95,098/- to ‘Ms. Shweta Desai’. The assessee deducted TDS out of interest paid to Ms.Swetha Desai but, however, did not deduct TDS out of interest paid to ‘M/s Bindal Estate Private Limited’. Therefore, disallowance is attracted for TDS default also.

(c) Further, the interest expenditure was not incurred wholly and exclusively for the purpose of earning income.

(iv) Aggrieved, the assessee carried matter in first appeal whereupon the Ld. CIT(A) partly reversed the AO’s action. He allowed deduction of interest of Rs. 9,95,098/- paid to Ms. Shweta Desai while upholding the rest of disallowance.

(v) Still aggrieved, the assessee has come in present appeal before us.

3. Before us, the Ld. AR for assessee filed following Written-Submission:

4. Further, during the course of hearing, the Ld. AR made oral submissions, which were broadly in the nature of re-iteration of the written-submission reproduced above, as under:

(i) He referred Pages 95-96 of Paper-Book (re-produced in preceding para) wherein the complete details of the interest of Rs. 1,06,89,792/- earned by assessee from different parties on loans/advances given and the interest of Rs. 71,69,351/- paid to different parties on loans borrowed, are given. Referring to the details of interest paid, Ld. AR submitted that ‘Ms. Shweta Desai’ was a non-resident during the year, hence the assessee deducted TDS u/s 195 as required by law. However, all other payees were residents in India and therefore there was no obligation upon assessee to deduct TDS u/s 194A as alleged by lower authorities. Ld. AR explained that the assessee was not required to deduct TDS u/s 194A because the assessee is individual and the turnover/gross receipts of assessee from business/profession during the year were only Rs. 2,10,000/- [Page 20 of Paper-Book – Computation of Total Income] which did not exceed the monetary limit prescribed in section 44ADA [Proviso to section 194A(1)].

(ii) He referred Page 22 of Paper-Book where a chart showing availability of funds from different sources vis-à-vis the application of funds for different purposes, with comparative figures of current year as well as preceding year, is placed. Analysing the data given in chart, Ld. AR attempted to demonstrate a broad picture of assessee’s financials. He presented analysis of interest-free funds and interest-bearing funds available with assessee vis-à-vis the segmental details of utilization of those funds for different purposes like fixed assets, investments, giving loans, etc. By his analysis, he sought to demonstrate two-fold aspects, namely:

(a) The assessee mainly utilized the borrowed funds for giving interest-bearing loans. At the same time, the assessee also utilized his own/interest-free funds for giving loans so as to earn interest income. That is why, the interest income earned by assessee was as high as Rs. 1,06,89,792/- whereas the interest expenditure claimed as deduction was much lesser at Rs. 71,71,538/-.

(b) Majority of the borrowed loans were old as taken in earlier years. During current year, the borrowals were made mainly to repay the old loans which were taken in earlier years for giving interest bearing loans.

With this analysis, Ld. AR contended that the assessee had utilized borrowed loans for the purpose of giving interest-bearing loans. Therefore, the interest expenditure was necessarily incurred for the purpose of earning interest income and allowable as deduction.

5. With above submissions, Ld. AR contended that the Ld. AO was wrong in disallowing entire interest of Rs. 71,71,538/- and thereafter the Ld. CIT(A) was also wrong in upholding disallowance partly. He requested that on facts, the assessee’s entire claim must have been allowed and no disallowance was warranted.

6. Per contra, Ld. DR for revenue made following submissions:

(i) In so far as the requirement of deducting TDS u/s 194A is concerned, the Proviso to section 194A(1) does not refer to the turnover/gross receipts of business/profession of “current year”, rather it refers to the turnover/gross receipts of “preceding year” for deciding the applicability of TDS. However, the assessee’s turnover/gross receipts of the “preceding year” are not clear from the available documents. Therefore, the Ld. AR’s contention in this regard cannot be accepted.

(ii) He emphasized the observations made by Ld. AO in Paras 4.2 & 4.3 of assessment-order regarding movement of funds. The Ld. AO has particularly observed that the assessee took a loan of Rs. 2.2 crore from M/s Shridhar Construction Private Limited which was partly invested to the extent of Rs. 1 crore in tax-exempt mutual funds and partly utilized for repayment of an interest-free loan taken from ‘Hemant Desai’. Hence, according to Ld. AR, the assessee had not utilized the interest-bearing borrowed funds for giving interest-bearing loans.

(iii) He submitted that before AO, the assessee claimed ‘fund replacement theory’ i.e. the new borrowals had been used for repayment of old loans but the Ld. AO has rejected assessee’s submission.

(iv) He submitted that, in Para 5.2 of assessment-order, the Ld. AO has made a very crucial observation that ‘M/s Shridhar Construction Private Limited’ had not declared corresponding interest income and therefore the interest of Rs. 52,27,304/- claimed by assessee as payable to the said party, was false. He referred to the Page 2 of Paper-Book where the Ledger A/c of ‘M/s Shridhar Construction Pvt. Ltd.’ extracted from assessee’s own books of account, is placed. He demonstrated that the assessee has himself not accounted for interest in the Ledger A/c of party.

7. In rejoinder, Ld. AR for assessee made following submissions:

(i) He drew our attention to the Balance-Sheet of assessee available at Page No. 16 of Paper-Book. He showed that the assessee had shown “Interest Payable – Shridhar – Rs. 52,27,304/-” as a separate line item under the heading “Current Liabilities” and that is why the interest payable to M/s Shridhar Construction Pvt. Ltd. was not passed through Ledger A/c of said party.

(ii) He submitted that M/s Shridhar Construction Pvt. Ltd. had declared interest income earned from assessee to Income-tax Department.

8. Thereafter, the Bench directed the Ld. AR to file following documents:

(i) The documents of preceding AY 2017-18 to show the turnover/gross receipt of business/profession for deciding the applicability of TDS under Proviso to section 194A(1).

(ii) The documents to show the status of interest income declared by ‘M/s Shridhar Construction Pvt. Ltd.’ to Income-tax Department.

9. Subsequently, after conclusion of hearing, the Ld. AR filed following documents:

10. We have considered rival contentions of both sides and perused the orders of lower-authorities as well as the material held on record to which our attention has been drawn. The assessee in present case is aggrieved by the disallowance of interest expenditure claimed in return made by Ld. AO and partly upheld by Ld. CIT(A). The Revenue authorities have made disallowance on two-fold basis, namely (i) the alleged default in deduction of tax at source u/s 194A out of interest payment and (ii) the interest expenditure claimed by assessee is not incurred for the purpose of earning income.

11. As regards the first basis of disallowance i.e. the non-deduction of TDS u/s 194A, we find merit in the submission of the Ld. AR. The assessee is an individual and as per the material filed by assessee pursuant to the direction given by Bench (re-produced in earlier para), the turnover/gross receipts from business/profession in the preceding AY 2017-18 were Rs. 8,40,000/- which did not exceed the monetary limit prescribed for the purpose of the Proviso to section 194A(1). Accordingly, the assessee was not liable to deduct tax at source u/s 194A in respect of the interest payments made to resident payees. Consequently, this basis adopted by lower authorities does not have merit and rejected.

12. As regards the second basis of disallowance i.e. the interest expenditure was not incurred wholly and exclusively for the purpose of earning income, at first we find that the assessee had earned interest income of Rs. 1,06,89,792/- from parties against which the interest expenditure of Rs. 71,71,538/- was claimed. Thus, the interest income earned by assessee is about 150% of interest expenditure. Then, the assessee has also placed on record a fund-flow analysis demonstrating the availability and utilisation of interest-free as well as interest-bearing borrowed funds. The Ld. AO has primarily relied upon certain specific movements of funds, particularly the utilisation of loan received from M/s Shridhar Construction Private Limited, to conclude that the borrowed funds were diverted towards tax-exempt investments and repayment of an interest-free borrowing. In our considered view, however, the allowability of expenditure u/s 57(iii) is required to be examined having regard to the overall facts and the purpose for which the expenditure was incurred and cannot be decided merely by tracing an isolated movement of funds without considering the overall fund position. The material placed on record demonstrates that the assessee was engaged in giving loans for earning interest income and had, in fact, earned substantial interest income therefrom. The fund-flow analysis placed on record also demonstrates that the assessee had both interest-free and interest-bearing funds available with him and had deployed funds for various purposes including giving interest-bearing loans. In such circumstances, the mere fact that a particular borrowing was utilised for a particular payment cannot, by itself, establish that the borrowing was diverted for a non-income-earning purpose, particularly when the overall fund position and subsequent deployment of funds are considered. The Revenue has not brought any cogent material on record to establish that the interest-bearing borrowings, to the extent of the interest expenditure claimed, were utilised for purposes wholly unconnected with the earning of such income. In this regard, although we agree with the Revenue’s observation that the assessee had utilised part of the interest-bearing funds borrowed from ‘M/s Shridhar Construction Private Limited’ for repayment of the interest-free loan earlier taken from ‘Hemant Desai’, however such utilisation, by itself, cannot be regarded as sufficient to conclude that the interest-bearing borrowing was utilised for a purpose wholly unconnected with the earning of taxable interest income. The manner in which the assessee manages or restructures his overall fund position including replacement of one borrowing by another, is a matter of his financial decision and in the absence of any material demonstrating that the relevant borrowing was diverted for a purpose having no nexus with the activity of earning taxable interest income, the deduction of interest expenditure cannot be denied merely on the basis of such fund movement.

In present case, the Revenue has not brought any cogent material to establish such diversion.

13. We further find that the specific factual basis adopted by the Ld. AO for treating the interest of Rs. 52,27,304/- payable to ‘M/s Shridhar Construction Private Limited’ as false, is demolished by assessee. The Ld. AR for assessee has at first shown that though the assessee had not recorded the corresponding interest entry in the Ledger A/c of said party, the assessee had separately accounted for same and disclosed the amount as “Interest Payable – Shridhar” under the head “Current Liabilities” in Balance-Sheet. Furthermore, pursuant to the specific direction of Bench, the Ld. AR/assessee has furnished records of the said party (re-produced in earlier para) to establish that the corresponding interest income had been declared by said party to Income-tax Department.

14. Thus, on an overall consideration of the facts including the substantial interest income earned by the assessee, the fund-flow position and the absence of any cogent material demonstrating diversion of the relevant borrowings for purposes wholly unrelated to earning taxable interest income, we are satisfied that the interest expenditure claimed by the assessee bears sufficient nexus with the activity of earning such income and satisfies the conditions prescribed u/s 57(iii) of the Act. The disallowance sustained by Ld. CIT(A) is, therefore, not justified and the same is deleted.

The ground raised by the assessee is allowed.

15. In result, this appeal is allowed.

Order pronounced in open court on 14/09/2026