Interest deduction under s 36(1)(iii) disallowed where borrowed funds diverted to interest-free loans to partners' relatives

HC held for the Revenue that interest deduction under s 36(1)(iii) is disallowed to the extent borrowed funds were diverted from business purposes by advancing interest-free loans to partners' relatives. The court found diversion clearly established-borrowed monies had been invested in contracts, recovered, and then lent out interest-free-so interest attributable to the diverted amounts is not an allowable business deduction until those funds are brought back and used in the business. The appeal was decided against the assessee; parties to bear their own costs.

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Issues Involved:
1. Whether the interest amounts of Rs. 13,122 and Rs. 37,146 were allowable as deduction u/s 36(1)(iii) of the Income-tax Act, 1961, for the assessment years 1978-79 and 1979-80, respectively.

Summary:

Issue 1: Deductibility of Interest Amounts u/s 36(1)(iii)
The primary issue is the interpretation of section 36(1)(iii) of the Income-tax Act, 1961, concerning the assessment years 1978-79 and 1979-80. The assessee, a partnership firm engaged in construction, claimed deductions for interest payments of Rs. 1,58,354 and Rs. 2,26,180 for these years. The Assessing Officer found that the assessee had advanced monies to close relatives of the partners without charging any interest, indicating a diversion of borrowed funds. Consequently, interest deductions were disallowed to the extent of the amounts diverted.

Findings by Authorities:
- Assessing Officer: Determined a diversion of borrowed funds and disallowed interest deductions proportionate to the diverted amounts.
- Appellate Assistant Commissioner: Reduced the extent of disallowance but upheld the finding of diversion.
- Commissioner: Calculated the average interest rates and disallowed interest on the diverted amounts for both assessment years.
- Tribunal: Affirmed the orders of the lower authorities, leading the assessee to appeal to the High Court.

Assessee's Argument:
The assessee contended that there was no direct link between the borrowed funds and the interest-free advances to relatives. They argued that the advances were made from contract realizations, not borrowed funds, and cited the case of CIT v. Coimbatore-Salem Transport (Pvt.) Ltd. [1966] 61 ITR 480 to support their position.

Revenue's Argument:
The Revenue maintained that the Tribunal and lower authorities had correctly found a diversion of funds. They argued that the advances were made from contract realizations, which included borrowed funds, thus constituting a diversion. They cited the Supreme Court's decision in CIT v. Malayalam Plantations Ltd. [1964] 53 ITR 140 to explain the scope of "for the purpose of business."

High Court's Analysis:
The court emphasized that u/s 36(1)(iii), the capital borrowed must continue to be used for business purposes. The court rejected the assessee's argument that subsequent diversion of borrowed funds is inconsequential. It held that interest on borrowed amounts diverted for non-business purposes is not deductible. The court clarified that the timing of the diversion is immaterial; what matters is the fact of diversion.

Conclusion:
The High Court concluded that the assessee had indeed diverted borrowed funds for non-business purposes. Therefore, the interest paid on such diverted amounts could not be claimed as a business expenditure. The court answered the referred question in the affirmative, in favor of the Revenue and against the assessee, with each party bearing their respective costs.

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