It does not pay to give friendly loans to business associates and sister concerns without charging interest, where the creditor has borrowed funds and is liable to pay interest thereon. Deductibility of the interest paid becomes legally controversial on the ground that the borrowing is not for a business purpose because the funds are in turn advanced interest free to others.

Section 36(1)(iii) of the Income-Tax Act, 1961 provides for deduction of interest in respect of loans raised for business purposes. Once the assessee claims such deduction in the books of account, the onus would be on the assessee to satisfy the Assessing Officer that loans raised by the assessee were used for business purposes. If it transpires that the assessee had advanced funds to its sister concerns or any other person without any interest or at a concessional rate, the onus would be on the assessee to justify the advancing of loans to sister concerns.

Common kitty

Generally, the entire money in a business entity comes to a common kitty. The moneys received as share capital, as term loans, as working capital loan, as sale proceeds, etc., do not have different colours. Whatever are the receipts in the business, they have the colour of business receipts and no separate identity.

This point was considered by the Punjab and Haryana High Court in C.I.T v. Abhishek Industries Ltd (286 I.T.R. 1). The facts in this case were that the assessee, a public limited company, filed its return of income for the assessment year 1993-94 showing its income as "nil". Subsequently, a revised return was filed declaring a loss of Rs 4.53 crore. The assessment was completed assessing the loss at Rs 96.81 lakh, inter alia, disallowing interest under Section 36(1)(iii) of the Act on the ground of interest-free advances made by the assessee to its sister concerns for non-business purposes and treating receipts of sales tax subsidy by the assessee as revenue receipt.

The assesee's explanation was rejected that the loans were given out of the company's own funds represented by share capital and that no borrowed funds had been utilised in giving the interest-free loans, that the interest-free loans were advanced to the sister concerns before the commencement of production and also after the commencement of production. The Tribunal held in favour of the assessee.

High Court observations

The High Court observed that it did not 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 escaping 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.If the plea of the assessee is accepted that the interest-free advances made to the sister concerns for non-business purposes were out of its own funds in the form of capital introduced in business that again would not be acceptable, according to the Court.

After the loans are raised, when a substantial amount is diverted to the sister concerns for non-business purposes without interest, the interest on borrowings cannot be claimed as a deduction. Such a plea of the assessee may be acceptable only at a stage when no loan has been raised by the assessee at the time of disbursement of funds.

Burden on assessee firm

Section 106 of the Indian Evidence Act or the principles analogous thereto places the burden in respect thereof upon the assessee company as the facts are within its special knowledge.

However, a question 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. Further, when it pays heavy interest to its lenders, why would it not claim interest from its subsidiaries?

The Court considered the judgments of different High Courts wherein it was held that to sustain disallowance of interest, there must be a clear nexus between the borrowing for which interest is paid and giving an advance without interest. In other words, if the interest-free advance is made out of the businessmen's own funds, there would be no justification for disallowance.

This has been held by the Delhi High Court in C.I.T v. Tin Box Co. (260 I.T.R.637) and C.I.T v. Orissa Cement Ltd.(252 I.T.R. 878); the Allahabad High Court in C.I.T v. Radico Khaitan Ltd.(274 I.T.R. 354) and C.I.T v. Prem Heavy Engineering Works P. Ltd.(285 I.T.R. 554; All); the Calcutta High Court in C.I.T v. Britannia Industries Ltd.(280 I.T.R. 525); and the Madhya Pradesh High Court in R.D. Joshi and Co. v. C.I.T. (251 I.T.R. 332).

The Punjab and Haryana High Court held in the Abhishek Industries Ltd case that it did not agree with the aforesaid judgments that if the amount is advanced from a mixed account of share capital and sales proceeds or profits, the revenue had not been able to establish nexus of the funds advanced to the sister concerns with the borrowed funds. Once it is borne out from the record that the assessee borrowed certain funds on which liability to pay tax is being incurred and, on the other hand, certain amounts had been advanced to sister concerns or others without carrying any interest or without any business purpose, the interest is to be disallowed under Section 36(1)(iii) of the Act.

Supplementing diverted cash

Such borrowings to that extent cannot possibly be held for the purpose of business but for supplementing the cash diverted without deriving any benefit out of it. Accordingly, the assessee will not be entitled to claim deduction of the interest on the borrowings to the extent those are diverted to sister concerns or other persons without interest.

The aforesaid decision of the Punjab and Haryana High Court would undoubtedly be taken in appeal to the Supreme Court. The Apex Court should set the controversy at rest in view of the cleavage in judicial thinking. Until then, a businessman will have to carry the risk of interest being disallowed where he has borrowed funds and advanced any amount to associates either interest-free or at a reduced rate of interest, despite the fact that he may have substantial amounts of proprietary funds comprising capital and accumulated profits.

H. P. Ranina
(The author, a Mumbai-based advocate specialising in tax laws)