Interest disallowance on diverted borrowed funds raised a question of law and was directed to be referred.

Borrowed funds were advanced to directors and connected concerns either interest-free or at a rate below the assessee's borrowing cost, raising a legal issue on disallowance of interest under section 36(1)(iii) of the Income-tax Act, 1961. The High Court treated the controversy over allowability of interest on capital borrowed for business purposes as a question of law, not merely a factual dispute, and held that it was fit for reference under section 256(1). The Tribunal was directed to state the case and refer the question in favour of the Revenue.

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Issues: Whether, on the facts and in the circumstances of the case, a question of law arose from the Tribunal's order concerning disallowance of interest under section 36(1)(iii) of the Income-tax Act, 1961, so as to warrant a reference under section 256(1).

Analysis: The borrowed funds were advanced to directors and concerns connected with them either without interest or at a rate lower than the rate at which the assessee itself was paying interest on borrowings. In these circumstances, the controversy as to allowability of interest on capital borrowed for business purposes was not merely factual and did give rise to a question of law fit for reference.

Conclusion: The question was held to arise in law, and the Tribunal was directed to refer it along with the statement of the case, in favour of the Revenue.

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