Delhi High Court held In the case of Vodafone South Ltd. vs. CIT that the netting of the interest paid on the borrowed sum against the interest income earned is allowed. There was a direct nexus between the earning of interest on the loan advanced by the Assessee and payment of interest to the bank. Since the interest paid to bank was in the nature of an expenditure wholly and exclusively incurred for the purpose of earning the interest income, it is permitted to be netted against such ‘income from other sources’ in terms of Section 57 (iii).
Facts of the Case
The Assessee is engaged in the business of providing cellular services in the Delhi Region. The assessee actually commenced its business form June, 2002. During the AY 2002-03 the Assessee availed of financing facilities from the HSBC Bank. HSBC’s offered the Assessee a combined credit limit of Rs.340 crores. The terms and conditions set out in the said sanction letter stated inter alia that the Assessee could advance the funds availed by it to any other concern, other than in the usual course of business, after receiving the bank‟s prior approval. Subsequent assessee availed a loan of Rs. 25 crores from HSBC at 11.60% interest p.a. immediately thereafter, on same date; the Assessee advanced a loan of Rs.25 crores to its holding company Sterling Cellular Limited (SCL) @ 11.75% interest p.a. The Assessee filed its return for AY 2002-03 declaring a loss of Rs. 35,69,97,065, which it subsequently revised at a profit of Rs. 1,00,690. In the revised return the Assessee showed income from other sources after adjusting interest expenses of Rs. 77.86 lakhs. The AO referred to the decision in Tuticorin Alkali Chemicals and Fertilizers Ltd. vs. CIT  6 SCC 117 and held that the interest paid to the bank would have been treated as business expenses but since the business was yet to commence they would form part of the pre-operative expenses to be capitalised. The interest earned from advancing of the loan to holding company would be taxed separately as income from other sources. The AO accordingly made an addition of Rs.78,86,987/- to the income of the Assessee for AY 2002-03.
For AY 2003-04 the Assessee filed its return declaring a loss of Rs. 2,62,87,59,740 after claiming setoff of interest income of Rs. 81,00,165 against the interest expenses. By referring to the decision of the Supreme Court in Tuticorin Alkali Chemicals and Fertilizers Ltd. v. CIT  6 SCC 117, the AO held that setting off the interest income of the pre-operative period against the interest expense was not allowed. It was held that “interest expense will form part of the pre-operative expenses pending capitalization and the interest income will be taxed separately as income from other sources.” The interest income of Rs. 81,00,165 was added to the income of the Assessee for AY 2003-04.
Held by CIT (A)
The CIT (A) upheld the order of AO. The CIT (A) held that “there is no nexus between the expenditure incurred and the income sought to be earned in the instant case.” Observing that the interest expense related to the pre-operative period and the giving of loan to SCL was not the business activity of the Assessee, the CIT (A) held that SCL on its own could have approached the bank for loan.
Held by ITAT
The ITAT upheld the order of CIT (A). The ITAT noted that the Assessee had commenced its business only in June 2002. The ITAT adopted the AO’s finding that the Assessee had made a total borrowing of Rs. 598,01,05,218 up to 31st March 2002 and that it was out of the aforementioned total borrowings that a sum of Rs. 25 crores had been advanced and interest earned thereon. The ITAT too observed that the Assessee was not engaged in the business of money lending. The interest income earned by the Assessee was to be considered under the head “income from other business‟. The Assessee’s contention that the interest expenditure incurred should be netted off against the interest income was held to be not sustainable.
Held by High Court
In Income Tax Act, 1922, corresponding to the section 57 (iii) was section 12.
In Eastern Investments Limited v. Commissioner of Income-Tax (1951) 20 ITR 1, the supreme court held that it was not necessary, for the purposes of Section 12 (2) of the 1922 Act, to show that the expenditure was a profitable one or that in fact any profit was earned. It was enough to show that “the money was expended not of necessity and with a view to a direct and immediate benefit to the trade, but voluntarily and on the ground of commercial expediency, and in order indirectly to facilitate the carrying on of the business.” It was further held that the mere fact that the conversion had the effect of diminishing the taxable income of the company was not a proper consideration particularly when the transaction was not challenged on the ground of fraud. The Court further explained that “most commercial transactions are entered into for the mutual benefit of both sides, or at any rate each side hopes to gain something for itself. The test for present purpose is not whether the other party benefited, nor indeed whether this was a prudent transaction which resulted in ultimate gain to the Appellant, but whether it was properly entered into as a part of the Appellant’s legitimate commercial undertakings in order indirectly to facilitate the carrying on of its business.
Subsequently in Commissioner of Income Tax v. Rajendra Prasad Moody (1978) 115 ITR 519 the Supreme Court addressed the question whether interest paid on money borrowed for investment in shares would be allowable as expenditure under Section 57 (iii) even where such shares had not yielded any dividend during the relevant AY. The Supreme Court explained that while Section 37 (1) of the 1961 Act provided for deduction of expenditure “laid out or expended wholly and exclusively for the purpose of the business or profession in computing the income chargeable under the head „profits or gains business or profession”, what was relevant for the applicability of Section 57 (iii) was the purpose of expenditure i.e. the expenditure must be laid out or expended wholly and exclusively for the purpose of “making or earning income”. It was not necessary that the expenditure “should fructify into any benefit by way of return in the shape of income.” The Supreme Court answered the question urged in the affirmative, i.e., in favour of the Assessee and against the Revenue.
In S.A. Builders Limited v. Commissioner of Income Tax (Appeals) Chandigarh (2007) 1 SCC 781, the Assessee company had advanced loans to its subsidiary without charging any interest. The loans were transferred out of the cash-credit account of the Assessee in which there was a debit balance. The AO disallowed the proportionate interest earned on the said loan out of the total interest paid to the bank by the Assessee. The disallowance for both the AYs, although partially modified by the CIT (A), was upheld by the ITAT which observed that there was no material on record to show that the Assessee had derived any business advantage by advancing the interest-free amounts to its subsidiary. The High Court upheld the order of the ITAT. Further the Supreme Court explained that expression „commercial expediency‟ was of wide import and included “such expenditure as a prudent businessman incurs for the purpose of business. The expenditure may not have been incurred under any legal obligation, yet it is allowable as business expenditure if it was incurred on grounds of commercial expediency.” In the said case, what was relevant was “whether the interest-free loan was advanced to the sister company (which was a subsidiary of the Assessee) as a measure of commercial expediency, and if it was, it should have been allowed.
In CIT v. Taj International Jewellers 2012 Law Suit (Del) 4834, the Assessee had availed loan from a bank and converted it into fixed deposit receipts (FDRs) on which it earned interest. This Court upheld the order of the ITAT which permitted the netting of the interest paid from the gross interest earned on the FDRs. It observed that “the interest paid was expenditure laid out and expended wholly and exclusively for the purpose of making or earning the interest income.
The Court notes that the Revenue was under a basic misconception that the Assessee was using a part of its ‘surplus’ borrowed funds to advance a loan to SCL, its holding company. As already noticed, the Assessee had not advanced a sum of Rs. 25 crores from the surplus funds already borrowed by it for the purpose of setting up its business. The facts of this case are, therefore, different from the facts in Tuticorin Alkali Chemicals and Fertilizers Ltd. v. CIT  6 SCC 117 where the company had invested its surplus funds borrowed for the purpose of its business in fixed deposits.
In the present case, the advancing of loan to SCL was a business decision taken by the Assessee out of commercial expediency. The sum of Rs. 25 crores drawn by the Assessee on 24th December 2001 in terms of HSBC’s sanction letter was transferred to SCL on the very same date. Without the facility of credit by the HSBC, the Assessee could not have advanced the loan to SCL. Therefore, there was a direct nexus between the earning of interest on the loan advanced by the Assessee to SCL and payment of interest to HSBC. The income earned on the loan advanced to SCL was rightly offered to tax by the Assessee as „income from other sources‟. Since the interest paid to HSBC on the loan availed was in the nature of an expenditure wholly and exclusively laid out for the purpose of earning the interest income, it ought to be permitted to be netted against such ‘income from other sources’ in terms of Section 57 (iii).
There is also merit in the contention of the Assessee that for AY 2003-04, the CIT (A) and the ITAT mechanically followed the earlier order for the AY 2002-03 although the business of the Assessee had commenced in June 2002. Since this was no longer a pre-operative phase, the interest paid to HSBC would in any event have been allowable as business expenditure under Section 36 of the Act for AY 2003-04.
Accordingly, appeal of the assessee allowed.