Interest deduction and exempt income rules: disallowance failed where own funds, not borrowed capital, financed the partnership investment.

Interest on borrowed capital is ordinarily deductible under section 36(1)(iii) where the borrowing is for a business investment, but section 14A bars deduction if the funds are used to earn exempt income. On the facts, the assessee had substantial own capital and the small loan reflected in the balance sheet did not show that the partnership investment was financed from borrowed funds. The record did not support the presumption of diversion for non-business purposes, so the disallowance of interest was unsustainable and the deletion by the first appellate authority was upheld.

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Issues: Whether disallowance of interest under section 36(1)(iii) was justified on the footing that the investment in the partnership firm was non-business in nature and allegedly made out of borrowed funds.

Analysis: The investment had to be examined from the businessman's perspective and interest on borrowed capital would ordinarily be deductible if the borrowing was for a business investment. However, the alleged return from the partnership was exempt income, and if borrowed funds had been used for earning such exempt income, section 14A would bar deduction of the related interest. On facts, the assessee had substantial own capital reflected in the balance sheet, while the only small loan shown did not establish that the impugned investment was financed out of borrowed funds. The material on record did not support the Assessing Officer's presumption that borrowed capital had been diverted for non-business purposes.

Conclusion: The disallowance of interest was not sustainable and the deletion made by the first appellate authority was upheld.

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