Disallowance under s.36(1)(iii) unjustified where no evidence of borrowed funds, interest paid, or diversion; common fund presumed firm's own

HC held that disallowance under s.36(1)(iii) for interest on borrowed capital was unjustified. The court found no evidence the firm advanced funds to the hotel out of borrowed money or paid interest to partners, and no finding of diversion of borrowed funds to non-business purposes. Where a common fund existed, presumption favored advances from the firm's own funds. The HC upheld the Appellate Tribunal's deletion of the additions and ruled no part of the interest should be disallowed.

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Issues Involved:
1. Disallowance of interest on borrowings not used for business purposes.
2. Determination of whether the borrowed funds were used for advancing loans to Savera Hotels (P.) Ltd.
3. Validity of the Appellate Tribunal's finding on the sufficiency of credit balance in the partners' accounts.

Summary:

Issue 1: Disallowance of Interest on Borrowings Not Used for Business Purposes
The Income-tax Officer (ITO) disallowed a portion of the interest paid by the assessee on borrowings, arguing that the funds were advanced to Savera Hotels (P.) Ltd. without charging interest, thus not used for business purposes. The ITO issued a notice u/s 148 and disallowed Rs. 72,769 towards interest. The Appellate Assistant Commissioner (AAC) partially upheld this, reducing the disallowance to Rs. 30,063, stating that the advance came proportionately from both borrowed and own funds.

Issue 2: Determination of Whether Borrowed Funds Were Used for Advancing Loans
The assessee contended that the funds advanced to the hotel were from the partners' credit balances, not borrowed funds. The Appellate Tribunal found that the partners' capital and current accounts had sufficient funds to cover the advances, and applied the presumption from CIT v. Gopikrishna Muralidhar [1963] 47 ITR 469, that where own and borrowed funds are mixed, it cannot be determined which funds were advanced. The Tribunal concluded that no part of the interest should be disallowed.

Issue 3: Validity of the Appellate Tribunal's Finding on Credit Balance
The Tribunal's finding that there was sufficient credit balance in the partners' accounts was challenged by the Revenue. The High Court noted that there was no evidence that the firm paid interest on the partners' credit balances, and no clear finding that borrowed funds were used for non-business purposes. The High Court upheld the Tribunal's decision, stating that the presumption that advances came from own funds was valid in the absence of contrary evidence.

Conclusion:
The High Court reframed and answered the questions in favor of the assessee, affirming that the Appellate Tribunal was correct in deleting the disallowance of Rs. 30,063 and holding that no part of the interest should be disallowed. The Tribunal's finding that the advances were not out of borrowed funds was based on valid and relevant materials. The Revenue's appeal was dismissed, with no order as to costs.

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