No businessman can be compelled to maximise his profit
January, 06th 2007
Quite unusually, it was commercial expediency that scored over taxman's nitpicking in a recent verdict of the apex court: S.A. Builders Ltd vs Commissioner of Income Tax (Appeals), Chandigarh.
The company had transferred, out of its cash credit account, `a huge amount of Rs 82 lakh to its subsidiary company SAB Credits Ltd'. And the taxman disallowed interest paid to the extent of Rs 5.7 lakh, saying it was proportionate to the amount diverted out of borrowed funds to sister concern without charging any interest. SA appealed before the Commissioner, who directed the AO (Assessing Officer) to calculate disallowance of interest only relating to the sum of Rs 18 lakh, which had `a clear nexus with the borrowed funds', while `the balance amount had been paid out of the receipts from other parties to whom no interest had been paid.'
Both the company and the Revenue filed appeals before the Income Tax Appellate Tribunal (ITAT). It ruled in favour of the Department, saying that the assessee had advanced the entire amount of Rs 82 lakh by utilising the overdraft account, and hence disallowance made by the AO was justified. An aggrieved SA approached the High Court but in vain. For, the court ruled that the tribunal's order did not suffer from `any factual or legal infirmity'. And, so, the case went up to the Supreme Court.
There, it was Nidhesh Gupta who argued for SA, while Ravindra Srivastava spoke for the Department. Gupta submitted that the High Court had erred in failing to consider the fact that SA had made the advances to its sister concern by withdrawals from its bank accounts in which there was sufficient credit balance as the company had received payments from its clients. "The appellant had received these payments from its clients and had deposited these in the account out of which advances were subsequently made to the sister concern."
Justices S. B. Sinha and Markandey Katju of the apex court heard the submissions and observed that the approach of the High Court and the authorities below, to the question of allowability of interest on borrowed funds, was not correct. Why so? Because Section 36(1)(iii) of the Income-Tax Act, 1961, spoke of `the amount of interest paid in respect of capital borrowed for the purposes of the business or profession'. The phrase `for the purpose of business' is wider in scope than `for the purpose of earning income, profits, or gains', noted the court, citing a 1979 verdict in the Madhav Prasad Jantia case.
"In our opinion, the High Court in the impugned judgment, as well as the Tribunal and the income-tax authorities have approached the matter from an erroneous angle. In the present case, the assessee borrowed the fund from the bank and lent some of it to its sister concern (a subsidiary) as interest-free loan. The test, in our opinion, in such a case is really whether this was done as a measure of commercial expediency," reads a snatch from the text of the decision dated December 14, 2006.
Atherton case applied
The apex court said that decisions relating to Section 37 of the Act too will apply to Section 36(1)(iii), because Section 37 used the expression `for the purpose of business'. The phrase includes `expenditure voluntarily incurred for commercial expediency' and `it is immaterial if a third party also benefits thereby'. The judges drew attention to a 1925 precedent, Atherton vs British Insulated & Helsby Cables Ltd, in which the House of Lords had held `that in order to claim a deduction, it is enough to show that the money is expended, not of necessity and with a view to direct and immediate benefit, but voluntarily and on grounds of commercial expediency and in order to indirectly facilitate the carrying on the business'.
Applying the test in the Atherton case, the apex court said that the High Court and other authorities should have enquired as to whether the interest-free loan was given to the sister company (which is a subsidiary of the assessee) as a measure of commercial expediency. In what should have far-reaching implications, the Supreme Court explained commercial expediency as `an expression of wide import' that includes `such expenditure as a prudent businessman incurs for the purpose of business'. The expenditure may not have been incurred under any legal obligation, but yet it is allowable as business expenditure if it was incurred on grounds of commercial expediency, added the apex court.
Three other cases of interest that find mention in the verdict are:
Madhav Prasad Jantia vs CIT: In this case, `the borrowed amount was donated to a college with a view to commemorate the memory of the assessee's deceased husband after whom the college was to be named'. The apex court had decided that the interest on the borrowed fund in such a case could not be allowed. Why? Because, the borrowed amount was donated for some sentimental or personal reasons and not on the ground of commercial expediency.
Phaltan Sugar Works Ltd vs Commissioner of Wealth-Tax: The Tribunal had ruled in favour of the assessee, saying that interest was deductible as the amount was advanced to the subsidiary company as a measure of commercial expediency. Agreeing with this view, the apex court rejected the Bombay High Court ruling, which was that interest be allowed if the assessee borrowed capital for its own business.
CIT vs Dalmia Cement (Bharat) Ltd: In this case, the Delhi High Court had said that once it was established that there was nexus between the expenditure and the purpose of the business (which need not necessarily be the business of the assessee itself), the Revenue cannot justifiably claim to put itself in the armchair of the businessman or in the position of the board of directors and assume the role to decide how much is reasonable expenditure having regard to the circumstances of the case.
Accordingly, "the High Court and the other authorities should have examined the purpose for which the assessee advanced the money to its sister concern, and what the sister concern did with this money, in order to decide whether it was for commercial expediency," but, lo, that was not done, noted the Supreme Court.
Crux of the verdict
The heart of the verdict lies in this paragraph: "No businessman can be compelled to maximise his profit. The income-tax authorities must put themselves in the shoes of the assessee and see how a prudent businessman would act. The authorities must not look at the matter from their own viewpoint but that of a prudent businessman. As already stated above, we have to see the transfer of the borrowed funds to a sister concern from the point of view of commercial expediency and not from the point of view whether the amount was advanced for earning profits."
Caveat, though, applies. For, the decision is not that, in every case, interest on borrowed loan has to be allowed if the assessee advances it to a sister concern. "It all depends on the facts and circumstances of the respective case," pointed out the Supreme Court. "For instance, if the directors of the sister concern utilise the amount advanced to it by the assessee for their personal benefit, obviously it cannot be said that such money was advanced as a measure of commercial expediency."
The penultimate paragraph of the verdict speaks of a simple test, as follows: "Where it is obvious that a holding company has a deep interest in its subsidiary, and hence if the holding company advances borrowed money to a subsidiary and the same is used by the subsidiary for some business purposes, the assessee would, in our opinion, ordinarily be entitled to deduction of interest on its borrowed loans."
Commenting about the decision, V. K. Subramani, a practising chartered accountant specialising in direct taxes, observes that the comparative study of Section 37(1) with Section 36(1)(iii) is not only interesting but lends weight to commercial expediency, and therefore capable of providing the much needed relief to taxpayers at large. "Also, the decision of the apex court to set aside the High Court decision for fresh decision by the Tribunal in the light of observations of the apex court is a rarity," says Subramani.