It is for the assessee-company to prove that the borrowals were utilised for its own business and that the diversion to the sister firm was out of its capital.
A company has paid-up capital and reserves. It has borrowed heavily from financial institutions and is paying huge interest on the loans. At the same time, it has advanced loans to sister concerns without charging interest. How is the assessing officer (AO) to deal with the claim for deduction of interest paid on borrowals under Section 36(1)(iii) of the Income-Tax Act, 1961? There are several ways of looking at the matter.
If the company has adequate interest-free funds by way of proprietary capital or deposit from customers, there can be an inference that borrowed funds are not diverted for non-business purposes. This was the view of the Allahabad High Court in CIT vs Prem Heavy Engineering Works (P) Ltd (285 ITR 554). The court had cited a number of precedents in support of its ruling.
Utilisation in business
Where the funds of the company are so mixed-up that it is not possible to identify the extent of borrowing utilised in such loans, the Madras High Court felt, in K. Somasundaram and Brothers vs CIT (238 ITR 939), that a proportionate amount could be disallowed. If the amount diverted was subsequently brought back into the business and utilised, the company could thereafter claim the interest paid as a deduction. But so long as the diversion continues, the company would be disentitled.
Now comes a leading judgment of the Punjab and Haryana High Court in CIT vs Abishek Industries Ltd (286 ITR 1). In this case, the AO disallowed claims made for interest paid under Section 36(1)(iii) of the Act on the ground that the company had made interest-free advances to its sister concerns. As the Tribunal decided the matter against the Revenue, the matter was taken to the court.
In an exhaustive judgment on the subject, the court dealt with the case from several angles. It pointed out that the entire money in a business entity comes from a common kitty. The money received as share capital, term loans, working capital loan, sale proceeds, etc., do not have different colour. Whatever be the receipts, they have the colour of business receipts with no separate identification. The only reason to disallow the interest paid on the borrowing to the extent the amount is lent to a sister concern without carrying any interest for non-business purposes would be that the company has some loans or other interest-bearing debts to be repaid.
In case the company had some surplus amount, which, according to the company, could not be repaid prematurely to any financial institution, still, the same is required either to be circulated and utilised for business or invested in a manner that generates income and not diverted to sister concerns free of interest. The sister concern would be enjoying the benefits of the assessee-company's borrowings. It cannot possibly be held that the funds to the extent diverted to sister concerns free of interest were required by the assessee-company for its business, and loans to that extent raised.
"We do not," said the High Court, "subscribe to the theory of direct nexus of the funds between borrowings of the funds and diversion thereof for non-business purposes. Rather, there should be nexus of use of borrowed funds for the purpose of business to claim deduction under Section 36(1)(iii) of the Act. That being the position, there is no escape from the finding that interest being paid by the assessee to the extent the amounts are diverted to sister concerns on interest-free basis are to be disallowed."
A different view
It is for the assessee-company to prove that the borrowals were utilised for its own business and that the diversion to the sister firm was out of its capital. The High Court pointed out that in fact the capital of the company stood exhausted in setting up of the unit.
"A presumption may be raised in a given case as to why an assessee who for the purpose of running its business is required to borrow money from banks and other financial institutions, would be giving loan to its subsidiary companies and that too when it pays heavy interest to its lenders, it would claim no or little interest from its subsidiaries."
The Punjab and Haryana High Court chose to disagree with the Delhi, Allahabad, Calcutta and Madhya Pradesh High Court decisions. It cited the Supreme Courts Ruling in the McDowell case (154 ITR 148) in support of its views. The judgment of the Punjab and Haryana High Court needs to be considered at length, both by the Revenue and financial advisors, whenever matters concerning the interpretations of Section 36(1)(iii) of the Act come up for study.
T. C. A. Ramanujam (The author is a former Chief Commissioner of Income-Tax.)