Borrowed funds routed as "subsidiary investment" to finance another company's construction led to s.36(1)(iii) interest disallowance.

The dominant issue was whether interest on borrowed capital was deductible under s. 36(1)(iii) where the borrowings were routed as an "investment" in a subsidiary but, in substance, funded another company's construction activity. The HC held that the apparent interposition of a separate legal entity was not decisive; the corporate veil could be lifted to ascertain the real character of the transaction where a device was used to evade tax. On the facts, the sum was an advance diverted for the benefit of a third party and not used for the assessee's business or profession, so the interest was not allowable. The Tribunal's deletion of disallowance was set aside; the reference was answered for the Revenue.

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Issues Involved:
The judgment involves the issue of disallowance of interest attributable to borrowals diverted to another company through a subsidiary, under section 36(1)(iii) of the Income Tax Act for the assessment year 1971-72.

Details of the Judgment:

Disallowance of Interest:
The Income-tax Officer disallowed a deduction claimed by the assessee under section 36(1)(iii) for interest paid in respect of capital borrowed for business purposes. The disallowance was based on the finding that the assessee had been diverting borrowed funds to its associate company in Bombay through a subsidiary company. The subsidiary company, Ace Investments Limited, was used as a conduit to channel funds to the Bombay company for construction purposes. The Assessing Officer noted various discrepancies, including the lack of separate operations by the subsidiary, absence of staff, and the circular flow of funds between the entities.

Appeal and Tribunal Decision:
The Commissioner of Income-tax (Appeals) accepted the assessee's argument that the investment in the subsidiary should not be considered a diversion of funds. The Tribunal also upheld this view, emphasizing the separate legal entities of the assessee and the subsidiary. The Tribunal highlighted the lack of evidence to prove fraudulent intent or sham transactions. It noted that without concrete proof of fraud or tax evasion, the arrangement between the entities could not be disregarded.

Revenue's Contention and Final Decision:
The Revenue contended that the investment in the subsidiary was a diversion of borrowed funds, as evidenced by the immediate transfer of funds to the Bombay company. The Revenue argued that the subsidiary lacked genuine business activities and was merely a vehicle for fund transfer. The Court held that the true character of the transaction was an advance to the Bombay company, not a legitimate investment by the assessee. The Court emphasized that the corporate veil could be lifted to reveal the actual nature of transactions, especially in cases of tax evasion. Consequently, the Court ruled in favor of the Revenue, disallowing the claimed deduction of interest.

In conclusion, the Court decided against the assessee, upholding the disallowance of interest and awarding costs to the Revenue.

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