1998 (8) TMI 59 - HC - Income Tax

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 ... Deduction u/s 36(1)(iii) - partnership firm - Interest On Borrowed Capital - diversion of borrowed funds - advancing monies to close relatives of the partners without charging any interest - HELD THAT:- The amount borrowed for the business remains a liability for the business till its discharge. The fact that the amount borrowed may have been invested in the purchase of machinery or utilised as working capital or used in any other way does not in any way affect the liability for repayment of the amount borrowed. So long as the money borrowed is used in the business, interest paid on such borrowing is a proper charge on the business and is allowable as an expenditure. Under section 36(1)(iii) of the Act amounts diverted not being used for the purposes of the business, interest relating to the operation diverted cannot be treated as an item of permissible deduction in the computation of income. In cases, where the diversion takes place after the borrowed monies had been initially invested in the business, such diversion must be clearly established and should not be a matter of mere speculation. In this case, the facts are sufficiently clear to warrant the finding that there has been a diversion, it is the assessee's own case that the amounts lent as advances without interest are nearly three times the amount of capital lying to the credit of the partners in the firm. The amount so lent, according to the assessee, came out of the contract earnings. The amount borrowed, according to the assessee was invested in the execution of the contracts. It is clear, therefore, that the assessee had invested the borrowed funds in the execution of the contracts, had recouped the money so invested presumably with profits as well on executing the contract. The amount realised on the execution thus, included the amount which the assessee had borrowed and invested. When the assessee decided to lend a substantial part of those funds interest-free to the relatives of the partners, it was clearly not a business purpose. The assessee clearly diverted the funds which had been borrowed, had been invested in the contract work, after the investment was recovered and was available either for the purposes of the business or by way of repayment of the loan. The assessee did neither, but chose to divert the money for non-business purposes. After such diversion, the interest paid on the capital borrowing to the extent of the amounts diverted can no longer be an item of expenditure which can be claimed for deduction as an item of business expenditure. If the amounts diverted was subsequently brought back into the business and utilised in the business, the assessee could thereafter claim the interest paid as a deduction. But so long as the diversion continues the assessee would be disentitled. The arguments which had been advanced for the assessee before the Commissioner and the Tribunal that the amount in the advance from out of the amounts shown as amounts payable to the sundry creditors had not been advanced before the Assessing Officer. The version placed before the Assessing Officer is the more credible one. The amount diverted could only have come out of the contract realisations, as it is not the assessee's case that it had sold goods obtained from the sundry creditors and lent the amount realised from such sale to the relatives of the partners to whom monies had been advanced without interest. Our answer to the question referred to us, therefore, is in the affirmative, in favour of the Revenue and against the assessee. Parties shall bear their respective costs. 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.