Borrowed funds used for non-business diversion are not deductible, and estimated telephone expense disallowance may be sustained.

Interest on borrowed funds is deductible under Section 36(1)(iii) only to the extent the borrowings are used for business purposes, and the assessee must show such business use. Where borrowed monies are diverted interest-free to sister concerns for non-business purposes, the related interest is not deductible, and the source of the diverted amount is not decisive. The text also notes that an estimated disallowance of telephone expenses at partners' residences may be sustained where the same proportionate approach has been consistently applied and no sound basis is shown for a different estimate.

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Issues: (i) Whether interest paid on borrowed funds diverted to sister concerns for non-business purposes was disallowable under Section 36(1)(iii) of the Income-tax Act, 1961; (ii) Whether the estimated disallowance of a portion of telephone expenses incurred at the residence of the partners was sustainable.

Issue (i): Whether interest paid on borrowed funds diverted to sister concerns for non-business purposes was disallowable under Section 36(1)(iii) of the Income-tax Act, 1961.

Analysis: Deduction of interest under Section 36(1)(iii) is available only where borrowed funds are used for business purposes. Once the assessee claims such deduction, the burden lies on the assessee to show that the borrowed monies were applied for business use. Where funds are advanced to sister concerns without interest for non-business purposes while the assessee continues to incur interest liability on borrowings, the interest relatable to such diversion is not deductible. The source of the diverted amount is not decisive, because business receipts form a common pool and the decisive question is the use of borrowed funds. The assessee also failed to establish a sufficient justification for the interest-free diversion.

Conclusion: The disallowance of interest was upheld against the assessee.

Issue (ii): Whether the estimated disallowance of a portion of telephone expenses incurred at the residence of the partners was sustainable.

Analysis: The disallowance was made on an estimate by applying a proportionate cut to the total expenses. The estimation had been followed consistently with the approach adopted for the earlier assessment year, and no basis was shown for substituting a different estimate.

Conclusion: The estimated disallowance of telephone expenses was upheld against the assessee.

Final Conclusion: The core challenge to the disallowance of interest failed, the estimated disallowance of telephone expenses was sustained, and only a limited issue concerning the effect of the disallowance in the hands of the partners was sent back for further consideration.

Ratio Decidendi: Interest on borrowings is not deductible to the extent borrowed funds are diverted without interest for non-business purposes, and the assessee bears the burden of proving business use of the borrowed funds.

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