Upfront payment of interest on debentures is deductible fully in year of payment

CA Manish Soni

A. Context: M/s Taparia Tools Limited (‘assessee’) issued debentures of Rs. 600 Lacs to various subscribers. The debenture holders were given following two options as regards payment of interest:-

• Interest @18% p.a. on a half yearly basis for 5 years or,
• One time upfront payment of Rs.55/- per debenture (FV Rs. 100/-).

Two subscribers out of six opted for upfront payment. The assessee made a payment of Rs. 272 Lacs in assessment year (‘AY’) 1996-97 and Rs. 55 Lacs in AY 1997-98 towards upfront payment of interest to these 2 subscribers. It made 2 different treatment of these upfront payments in financials and tax return respectively, which is mentioned as under:

 During assessment, the assessing officer (‘AO’) allowed 1/5th of total upfront payment as deduction in the year of payment and added back 4/5th to the income of assessee. The assessee lost the case from AO -> CIT(A) -> ITAT -> Bombay High Court (‘HC’).

B. Contentions of assessee:

• Treatment of interest in accounting is different from the Income-tax Act, 1961 (‘the Act’). Assessment was to be made in accordance with the Act.
• The assessee complied with all the below conditions under section 36(1)(iii) and therefore, deduction must be allowed.
  • The capital must be borrowed,
  • It must be borrowed for business purpose, and
  • Interest must be paid

C. Contentions of Revenue:

• The term of debentures was 5 years and the assessee had itself written off the upfront payment over 5 years in its financials.
• In the case of Madras Industrial Investment Corporation Limited Vs. CIT (1997) 4 SCC 666, it was held that discount on issue of debentures should be deductible over the life of debentures.
  

D. The Hon’ble SC, while upholding the view of the assessee, held as under:-

• Section 36(1)(iii) of the Act allows deduction of interest paid in respect of capital borrowed for the purposes of business or profession. Section 43(ii) of the Act defines the term paid as ‘actually paid or incurred according to the method of accounting’. It means that interest is deductible even if it is only incurred but not paid.
• Assessee was following mercantile system of accounting and therefore, interest can be claimed as deduction even if it was not actually paid but simply incurred. In the instant case, assessee had incurred as well as paid interest amount during the subject AY.
• The AO cannot disallow the deduction either on the ground that rate of interest is unreasonably higher or lower. He should have examined as to whether the interest on debentures was genuinely incurred for business purpose and not an illusionary and colourable transaction. The AO did not dispute the genuineness of upfront payment clause. Therefore, there is no dispute that interest has, in fact, been paid during the year.
• The AO erred by ignoring the terms of debentures (i.e. upfront payment or regular payment) while making the disallowance. He treated both options of interest (half yearly and upfront) at par, which is unsustainable. By doing so, the AO tampered with terms of issue, which was beyond his domain.
• The HC had gone wrong by applying ‘matching concept’ (the revenue and other incomes are to be matched with cost of resources consumed). The assessee had the option to pay interest either half yearly or upfront. By making upfront payment, the assessee benefited as compared with half yearly payment.
• There is no concept of deferred revenue expenditure in the Act except under specific sections viz. Section 35D etc.
• In was judicially held in the case of Bharat Earth Movers Vs. CIT (2000) 6 SCC 645 that if a business liability has arisen in the accounting year, the deduction should be allowed even if such a liability may have to be quantified and discharged at a future date. In the instant case, a quantified liability to pay upfront payment arisen and discharged in the accounting year.
• In the case of Madras Industrial Investment Corporation Limited, the assessee had himself wanted to spread the discount over a period of time. However, it was entitled to claim deduction in the very first year itself.
• However, if assessee himself wants to spread the interest on debentures over a period of ensuing years, it can be allowed.

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