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 ... Deductibility of interest under section 36(1)(iii) of the Income-tax Act - interpretation of the expression 'for the purposes of the business' - diversion of borrowed funds - requirement of continuing use of borrowed capital in the business - nexus between expenditure and businessDeductibility of interest under section 36(1)(iii) of the Income-tax Act - interpretation of the expression 'for the purposes of the business' - nexus between expenditure and business - Scope of section 36(1)(iii): whether interest on capital borrowed is allowable where the borrowed amount was initially used in the business but subsequently diverted - HELD THAT: - The court explained that section 36(1)(iii) permits deduction of interest only where the capital borrowed is 'for the purposes of the business' and, crucially, continues to be used in the business. The provision assumes not merely that borrowed money was at some time invested in the business, but that it remains employed for business purposes; interest is allowable because the business derives continuing benefit from the borrowed amount. If the capital borrowed has been diverted to non-business uses so that it is no longer employed in the business, interest on that portion cannot be regarded as an expenditure 'for the purposes of the business'. Allowing interest after diversion would permit assessees to borrow, use funds temporarily in business, later divert them for non-business purposes while continuing to charge interest against business income, which would frustrate the object of the section. The court therefore adopted the determinative legal principle that continued use of the borrowed capital in the business is an essential precondition for deductibility of interest under section 36(1)(iii).Interest is deductible only insofar as the borrowed capital continues to be used for business purposes; interest on amounts diverted from the business is not allowable.Diversion of borrowed funds - deductibility of interest under section 36(1)(iii) of the Income-tax Act - Application of the principle to the facts: whether diversion of borrowed funds to interest-free advances to relatives was established for assessment years 1978-79 and 1979-80 and whether interest disallowance was justified - HELD THAT: - On the facts the court found the diversion to be clearly established. The assessee itself admitted advances to relatives without interest, the advances were substantially larger than partners' capital balances and were stated to have come out of contract realisations which necessarily included the borrowed funds previously invested in the contracts. The tribunal and revenue authorities had found, on the material before them, that borrowed amounts (having been invested in contract work and recouped on realisation) were thereafter lent interest-free for non-business purposes instead of being retained for business use or applied to repay the loans. Given that diversion was shown and not speculative, the interest attributable to the diverted amounts could not be treated as a business deduction. The courts below therefore rightly disallowed interest to the extent relatable to the diverted funds for the respective assessment years.Findings of diversion were properly recorded and the disallowance of interest relating to the diverted amounts for 1978-79 and 1979-80 is upheld.Final Conclusion: The reference is answered for the Revenue: the court held that interest under section 36(1)(iii) is deductible only while the borrowed capital continues to be used for business purposes, and on the facts the diversion of borrowed funds into interest free advances to relatives justified disallowance of the claimed interest for AY 1978-79 and 1979-80; parties to bear their own 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.