The sticky issue of loan to sister concerns and interest thereon
A controversial area is allowance of interest on monies borrowed before or after advancing interest-free funds to a sister concern.
Interest paid in respect of capital borrowed for business or profession is deductible while computing income from business or profession.
Clause (iii) of Section 36(1) deals with such deduction. In this context, a controversial area is allowance of interest on monies borrowed before or after advancing interest-free funds to a sister concern.
Some of the decisions have been favourable to the assessee based on facts, and courts have been more or less consistent in deciding the issue in favour of the Revenue.
In K. Somasundaram & Bros vs CIT (1999 238 ITR 939 Madras), the Madras High Court held the amounts borrowed by the firm and advanced to relatives of partners without charging interest as diversion of borrowed funds for non-business use. Accordingly, interest on monies borrowed was held as inadmissible.
Similar findings can be found in CIT vs M. S. Venkateswaran (1996 222 ITR 163 Madras) and CIT vs P. Ganu Rao and Sons (1990 185 ITR 324 Madras).
The Kerala High Court, in CIT vs V. I. Baby & Co (2002 254 ITR 248 Kerala), held that the firm advanced its funds for non-business purposes and later borrowed funds from bank on interest for business purposes, and so it was justified to disallow interest in proportion to the advances made.
The Delhi High Court, in CIT vs Motor General Finance Ltd (2002 254 ITR 449 Delhi), held that the onus of proving the amounts advanced to a sister concern represents its own funds lies with the assessee.
The Allahabad High Court, in CIT vs H. R. Sugar Factory (P) Ltd (1991 187 ITR 363 Allahabad), decided in favour of the Revenue by asking the assessee to explain as to why the interest should not be disallowed on the large borrowings, with huge advances having been given to the directors at a very low rates of interest.
The Orissa High Court, in Indian Metals & Ferro Alloys Ltd vs CIT (1992 193 ITR 344 Orissa), held that the assessee must establish the actual financial liquidity on the date of advancing funds with low interest or without interest, as the case may be.
Contrary decisions favouring assessee can be found in CIT vs Tin Box Co (2003 260 ITR 637 (Del); CIT vs Radico Khaitan Ltd (2005 274 ITR 354 Allahabad); CIT vs Britannia Industries Ltd (2006 280 ITR 525 Calcutta) and R. D. Joshi & Co vs CIT (2001 251 ITR 332 MP).
In these cases, the Tribunal found that the assessee had enough of own funds before advancing the same to sister concerns or interested parties, with or without interest.
For a better understanding of the issue, consider balance-sheets at two different dates as presented in the accompanying table.
In the example, the assessee deploys its capital, accumulated profits and borrowings in its own business activity. However, after borrowing Rs 200 from the bank or financial institution, the assessee gives Rs 300 as loan to an allied concern. The assessee, prima facie, diverts the entire borrowed funds to the allied concern for low or nil interest, even though it had to pay interest on the fresh borrowings at 10 per cent.
If the assessee had advanced money with resources not liable for interest and thereafter borrowed money (liable for interest), the assessee could establish that the amounts advanced have no interest burden and, hence, the interest on amounts borrowed subsequently eligible for deduction in toto. However, this argument too can be rejected if the rationale of the decision in the V. I. Baby & Co case is applied.
In CIT vs Abhishek Industries Ltd (2006 286 ITR 1 P&H) it was held that where the borrowed capital is meant for business purposes and where the loan is advanced without interest to a sister concern, the interest on borrowing is eligible for disallowance.
In this case, Rs 16.48 lakh was disallowed towards interest on borrowings, attributable to interest-free advances given to the sister concern for non-business purposes by the assessee.
The court held that the onus is on the assessee to show that the borrowings were used for business purposes. The court held that the nexus between borrowing for interest and advances made without interest is not on the Revenue.
If the assessee has sufficient interest-free funds, such as capital, accumulated profits, reserves etc., advancing money to a sister concern without interest will not have any tax implication.
Availability of share capital and accumulated profits are not sufficient enough to justify the advancing of money to an allied concern, with or without interest, if a borrowal is made subsequently.
However, if there is a good time gap between advancing and acceptance of loan, then it is possible to argue that there was no diversion of interest-bearing loan to non-business purposes.
Despite the Kerala High Court ruling in V. I. Baby & Co, if the assessee can prove that sufficient resources were available at the time of advancing money (without interest or with low interest), then the subsequent borrowing with efflux of time may be allowed as an expenditure without upholding the argument that if the assessee had not advanced loan earlier it need not have gone in for interest-bearing loan subsequently.
This reasoning, to a large extent, would provide some relief to taxpayers who look upon allied concerns too in the overall perspective, though in law they are assessed separately.
V. K. Subramani
(The author is an Erode-based chartered accountant.)