2013 (7) TMI 806 - HC - Income Tax

Interest deduction allowed on borrowed funds despite providing interest-free loans to associate concerns under commercial expediency test

Commissioner of Income-tax Versus Raghuvir Synthetics Ltd.

Commissioner of Income-tax Versus Raghuvir Synthetics Ltd. - 2011:GUJHC:31579 - DB, [2013] 354 ITR 222 The core legal question considered in this judgment is whether the disallowance of interest expense by the Assessing Officer on the ground that the assessee had given interest-free loans to associate concerns out of interest-bearing borrowed funds was justified in law and on facts. Specifically, the issue is whether the interest on borrowed funds used to provide interest-free loans to sister concerns can be disallowed as a business expense under the income tax provisions.The Court examined the following key issues:Whether the interest disallowance made by the Assessing Officer was sustainable given the facts and law.The applicability of the principle of commercial expediency in determining the allowability of interest expense on borrowed funds used for interest-free loans to associate concerns.The relevance of the availability of sufficient interest-free funds (such as equity capital and reserves) with the assessee to meet the advances made to sister concerns.The evidentiary burden on the Revenue to establish that borrowed funds were utilized for non-business purposes justifying disallowance.The precedential value of prior rulings, including the decision in Torrent Financiers and the Supreme Court ruling in S. A. Builders Ltd. v. CIT, on the question of allowability of interest on borrowed funds advanced interest-free to sister concerns.Regarding the disallowance of interest, the Assessing Officer had disallowed Rs. 18,66,000 on the ground that the assessee had advanced interest-free loans to associated entities, and hence the interest expense was not incurred wholly and exclusively for business purposes. The Commissioner of Income-tax (Appeals) and subsequently the Income-tax Appellate Tribunal (ITAT) set aside this disallowance.The Commissioner of Income-tax (Appeals) relied on the precedent from Torrent Financiers, holding that the advances to the associate concerns were not made during the relevant assessment year but in earlier years. Moreover, the Commissioner noted that the assessee had sufficient interest-free funds available, including equity capital and reserves, which were not subject to any interest liability. Therefore, the interest disallowance was not justified merely because some funds were advanced interest-free to sister concerns.The ITAT concurred with this view, emphasizing that the assessee's interest-free funds exceeded the amount of interest-free loans advanced. It found no evidence that borrowed funds, which attracted interest, were used for the interest-free advances. The Tribunal also noted the assessee's substantial equity share capital and reserves, which formed part of the interest-free funds. It concluded that the disallowance of interest on the borrowed funds was not sustainable solely on the basis that the advances were interest-free.The Court affirmed the ITAT's approach, holding that the Revenue had failed to produce any material to rebut the findings that the borrowed funds were not used for the interest-free advances. The Court emphasized that the interest disallowance cannot be sustained without evidence that the borrowed funds were actually utilized for non-business purposes.In analyzing the legal framework, the Court referred extensively to the Supreme Court's ruling in S. A. Builders Ltd. v. CIT. The apex court had clarified that the key test for allowability of interest on borrowed funds used to provide interest-free loans to sister concerns is whether such expenditure was incurred out of commercial expediency. The Supreme Court held that 'commercial expediency' is a broad concept encompassing expenditures that a prudent businessman incurs for business purposes, even if not legally obligated. The Court rejected the Revenue's approach of second-guessing business decisions or imposing its own view of what constitutes reasonable expenditure.The Supreme Court further observed that once a nexus between the expenditure and the business purpose is established, the Revenue cannot substitute its judgment for that of the assessee's management. The test is whether a prudent businessman would have acted similarly, not whether the transaction maximizes profits. This principle was directly applicable to the present case.Applying these principles, the Court found that the Commissioner of Income-tax (Appeals) and the ITAT correctly applied the test of commercial expediency and examined the facts in detail. The availability of substantial interest-free funds, including capital and reserves, indicated that the interest-bearing borrowed funds were not used for the interest-free advances. Consequently, the interest expense was incurred for business purposes and was allowable.The Court rejected the Revenue's contention that mere advancement of interest-free loans to associate concerns from borrowed funds warranted disallowance of interest. It underscored that the Revenue must produce evidence to establish misuse of borrowed funds or lack of business purpose, which was absent here.In conclusion, the Court held that the disallowance of Rs. 18,66,000 interest by the Assessing Officer was not sustainable. The question of law was answered in favor of the assessee and against the Revenue. The Court dismissed the tax appeal accordingly.Significant holdings include the following verbatim excerpt from the Supreme Court's ruling in S. A. Builders Ltd. v. CIT, relied upon by the Court:'The expression 'commercial expediency' is an expression of wide import and includes such expenditure as a prudent businessman incurs for the purpose of business. The expenditure may not have been incurred under any legal obligation, but yet it is allowable as a business expenditure if it was incurred on grounds of commercial expediency.''We have to see the transfer of the borrowed funds to a sister concern from the point of view of commercial expediency and not from the point of view whether the amount was advanced for earning profits.''No businessman can be compelled to maximize its profit. The income-tax authorities must put themselves in the shoes of the assessee and see how a prudent businessman would act.'Core principles established by the Court are:Interest on borrowed funds used to provide interest-free loans to associate concerns is allowable as a business expense if incurred out of commercial expediency.The existence of sufficient interest-free funds (capital, reserves) negates the presumption that borrowed funds were used for interest-free advances.The Revenue must produce evidence to show that borrowed funds were diverted for non-business purposes to justify disallowance.The test of commercial expediency requires the tax authorities to view the transaction from the perspective of a prudent businessman, not their own viewpoint.Final determinations on the issue are that the Assessing Officer's disallowance of interest was rightly set aside by the Commissioner of Income-tax (Appeals) and the ITAT, and the Court upheld these findings in favor of the assessee, dismissing the Revenue's appeal.