No disallowance of interest for loan advanced to Sister Concern out of Share Capital and Reserves

Grounds of appeal by Revenue:

The Revenue, in ITA No. 7758/Mum/2010 & ITA No. 1364/Mum/ 2011, has raised the following grounds of appeal: –

1. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) erred in deleting the addition of Rs.18,50,000/- being interest disallowed u/s. 36(1)(iii) of the I.T. Act, 1961, overlooking the failure of the assessee to substantiate that the amounts borrowed were for the purpose of the assessee’s business.

2. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) erred in placing reliance on the case of M/s. S.A. Builders Ltd. [288 ITR 21 (SC)] despite the fact that the assessee’s case is distinguishable on facts in so far as commercial expediency has not been proved to be the motive behind diversion of interest-bearing borrowed funds to sister concern by the assessee.”

Contentions/Observation by AO/Revenue:

AO noticed that assessee had made investment of `110 lakhs in the shares of its subsidiary company, i.e. Edicon Pneumatic Tools Co. Pvt. Ltd., which included advance against shares of `109 lakhs. During the year under consideration assessee had further advanced loan of `75 lakhs to Edicon Pneumatic Tools Co. Pvt. Ltd. The AO was of the view that assessee had made interest free advances to its subsidiary company of `185 lakhs for non business purposes* although assessee had paid interest of 19,43,204/- and finance charges to secured/unsecured loans of `6,82,252/-. Assessee was asked to explain as to why proportionate interest relating to interest free loans & advances and investment made for non business purposes should not be disallowed under section 36(1)(iii) of the Act.

The AO noted that the share capital of assessee was `20 lakhs, which was with the company for the past several years and the same had already been utilised in application of funds in the earlier years.

The AO also noted that in A.Y. 2005-06 similar disallowance was made in the hands of the assessee. The AO further held that where the amounts borrowed by the assessee were advanced to its subsidiary without interest then the same cannot be said to have been borrowed for the purpose of assessee’s own business. Further, the claim of the assessee that investment was made for the purpose of business was also not accepted, since the subsidiary company was an altogether different entity. The AO thus held that disallowance of `18,50,000/- was warranted under section 36(1)(iii) of the Act.

*Section 36 (1) (iii) allows interest expense only on funds borrowed for business purposes. The AO in this is of the view that the by investing funds in 100% subsidiary the company has not utilized the funds for its business purposes, but used the same to invest, consequently interest expenses (proportionate to investments ) is intended to be disallowed.

Reply/Argument of the Assessee:

In reply assessee stated that the said investment was made in 100% subsidiary company by way of share capital of `1 lakh and share application money of `109 lakhs and advance of `75 lakhs. The said investment was claimed to have been made out of Capital & Reserves and surplus of the company and it was claimed that no disallowance under section 36(1)(iii) of the Act was warranted.

The learned counsel for the assessee pointed out that the total Capital & Reserve and surplus of the assessee as on the close of the year was 3 crores and even the bank loan had reduced to `57 lakhs. The first plea of the learned counsel for the assessee was that the said investment with the subsidiary was made out of its own Capital & Reserves and surplus. Another plea raised by the learned counsel was that the investment was made by the assessee with its own subsidiary, who was in the same line of business with same Directors. The next plea raised by him was that the income earned by the subsidiary goes to the holding company, hence the said investment was made for business purposes. Reliance in this regard was placed upon the ratio laid down by the Hon’ble Supreme Court in the case of S.A. Builders Ltd. vs. CIT 288 ITR 21 (SC).

Observation and Decision by Ld CIT (A):**

The CIT(A) noted that the loans and advances have been advanced to 100% subsidiary of the assessee, which was also carrying on the same business as the assessee. Further, the finding of the CIT(A) was that the money had been utilised by the said subsidiary company for business purposes. Hence, as per the CIT(A) the advances were made in furtherance of the business requirements of the assessee and it cannot be held that the same were utilised for non business purposes, where the advances were made to 100% subsidiary, which was in the same business as that of the assessee. Since the subsidiary had utilised the said amount for business purposes, the CIT(A) held that no disallowance is warranted under section 36(1)(iii) of the Act.

**CIT (A) allowed the claim of assessee and the same is challenged by Revenue

ITAT Observations:

We have heard the rival submissions and perused the record. The issue arising in the present appeal is in relation to computation of disallowance, if any, under the provisions of section 36(1)(iii) of the Act. The assessee had made certain advances to its 100% subsidiary. During the year under consideration assessee had advanced loan of `75 lakhs to Edicon Pneumatic Tools Co. Pvt. Ltd. In the earlier year assessee had made investment of `110 lakhs in the shares of its subsidiary company. The Directors of the assessee firm were also Directors of the subsidiary company and the business carried on by the subsidiary company was the same as that carried on by the assessee. The claim of assessee before the AO was that the said investment was made for business purposes, hence no disallowance of interest was warranted under section 36(1)(iii) of the Act. The first advance was made by assessee to its subsidiary company vis-a-vis investment in the shares of the said subsidiary company in A.Y. 2005-06. It was claimed by the assessee that the said investment was out of its share capital. However, the AO dismissed the contention of the assessee and made disallowance under section 36(1)(iii) of the Act. The CIT(A) noted that both the assessee and its subsidiary were in the business of manufacturing of mining tools. The advance made by the assessee was utilised for the business of the subsidiary company, hence, in turn, relying upon the ratio laid down by the Hon’ble Supreme Court in the case of S.A. Builders Ltd. (supra) it was held that the said advance was because of commercial expediency and hence no part of interest was disallowable under section 36(1)(iii) of the Act. The addition made by the AO was `2,21,731/- and because the small tax effect no appeal was filed before the Revenue against the said order.

In the instant year, assessee had further advanced `75 lakhs to its subsidiary company. A perusal of the Balance Sheet filed for A.Y. 2006-07 at pages 1 to 5 of the paper book reflects that though the capital of the assessee company remained at `20 lakhs but the Reserves and surpluses are at `3,27,67,981/- as against `3,07,55,969/- declared in the preceding year. The profit declared by assessee for the year under consideration before taxation was `34,73,256/-. In the totality of the above said facts and circumstances, where the assessee had established availability of funds of its own and also where the investment was made in 100% subsidiary of the assessee, which in turn was engaged in the same line of business and had utilised the funds for its business, the existence of commercial expediency stands proved***. In case the connection between the lender and the borrower is of commercial expediency, then in view of the ratio laid down by the Hon’ble Supreme Court in SA Builders Ltd. (supra), no disallowance is warranted under section 36(1)(iii) of the Act.

***Held in S.A. Builders Ltd. (SC).

Decision by ITAT:

In view thereof we hold that there is no justification for disallowing interest under section 36(1)(iii) of the Act and uphold the order of the CIT(A). We dismiss the grounds of appeal Nos. 1 & 2 raised by Revenue.

Analysis:

• The first arguments which has been considered was regarding the source of advances in the 100% subsidiary comapy, which the assessee company argued to be out of reservs and suplus, which could not be contradicted by the Revenue. Where the borrowed funds were not at all used for investments in subsidiary company, there is no disallowance u/s 36 (1) (iii). In the present case the Revenue could not contradict the same.
  

• The second ground which was placed by assessee company, used the funds for business purposes. “For the purpose of business” has very wide connotation (Held in Madhav Prasad Jatia Vs CIT, ITR 559-SC). Hence the purpose of investing in sister concern or otherwise, can be concluded as for the purpose of business. In the present case the business line and 100% holding of assessee company proved that, the investment was warranted by business expediency, as there was business interest and the investments were not made to dividend income on investments, but to carry on business. Had there been investment with a motive to earn dividend/interest the decision would have been different, since the business expediency test would not have been fulfilled.