2022 (12) TMI 572 - AT - Income Tax

Establishing Nexus Between Borrowed Funds and Investments Crucial for Interest Expense Deductions

The Tribunal emphasized the requirement of establishing a direct nexus between borrowed funds and investments to justify the disallowance of interest ... Disallowance pertaining to the interest credited to the account - disallowance u/s. 36(1)(iii) - direct link or nexus between the borrowed funds and investment in shares - AO was of the view that in terms of provisions of section 36(1)(iii) the deduction for interest was admissible only when the capital is borrowed directly for the purpose of business whereas, the investment in unquoted shares was not relating to the business of the assessee - HELD THAT:- As basic contention of the Ld. AR that interest free funds were not utilised for the purpose of investing in shares of the sister concern does not stand proved. Taking the logic further, the inference that if the assessee has sufficient surplus funds, then it is to be assumed that the investments were made from surplus funds would also hold not true. Also that on one hand it is the assessee's contention that the borrowings were made for the purpose of investing in shares coupled with the arguments that these investments were strategic in nature and on the other hand, it has been contended that the inference should be that the investments were made out of surplus funds. Thus, there is an apparent contradiction in the stand taken by the assessee. It is not clearly brought out either from the assessment order or from the Ld. CIT(A)'s order as to whether there is a direct nexus or link between the borrowed funds and the investments. A clear and direct nexus has to be established between the loan funds and the investments before a disallowance u/s. 56(1)(iii) of the Act is made. If there is a direct nexus between the loan funds and such investments, then the proposition that if the assessee had surplus funds with it, then the investment would be presumed to have been made from such surplus funds would not hold good and then the disallowance u/s. 36(1)(iii) of the Act would be fully justified. However, if there is no direct link between the borrowed funds and the investments, then the presumption would were in favour of the assessee. Restore this issue to the file of the AO with a direction to verify as to whether there is any direct link or nexus between the borrowed funds and investment in shares. If it is so found, then the impugned disallowance shall hold good. Appeal of the assessee stands allowed for statistical purposes. Issues:1. Disallowance of interest expenses under section 36(1)(iii) of the Income Tax Act, 1961.2. Determination of the utilization of loan for interest expenses and its relevance to business activities.3. Appeal against the order of the Ld. Commissioner of Income Tax (Appeals)-5, Ludhiana for assessment year 2016-17.Analysis:Issue 1: Disallowance of interest expenses under section 36(1)(iii) of the Income Tax Act, 1961.The Assessing Officer (AO) disallowed the interest expenses claimed by the assessee under section 36(1)(iii) of the Act, stating that the investment in unquoted shares was not related to the business of the assessee. The AO made a disallowance of Rs. 27,59,600/- and completed the assessment at a taxable income of Rs. 30,73,490/-. The Ld. CIT(A) also upheld the disallowance. The assessee challenged this decision before the Tribunal, arguing that sufficient interest-free funds were available for investment. The Tribunal observed that a direct nexus must be established between the borrowed funds and the investments to justify a disallowance under section 36(1)(iii). The Tribunal directed the AO to verify this nexus and provide the assessee with an opportunity to present its case before making a final decision.Issue 2: Determination of the utilization of loan for interest expenses and its relevance to business activities.The AO questioned the utilization of the loan for which interest had been paid and its connection to the business activities of the assessee company. The AO contended that the investment in shares of a sister concern was not related to the business of the assessee. The assessee argued that the investments were strategic and made from interest-free funds available with the company. The Tribunal noted the contradictory stands taken by the parties and emphasized the need for a direct link between the borrowed funds and the investments to justify a disallowance. The Tribunal remanded the issue to the AO for further verification.Issue 3: Appeal against the order of the Ld. Commissioner of Income Tax (Appeals)-5, Ludhiana for assessment year 2016-17.The assessee appealed against the order of the Ld. CIT(A) challenging the addition of Rs. 27,59,600/- in respect of the disallowance of interest under section 36(1)(iii). The Tribunal allowed the appeal for statistical purposes and directed the AO to re-examine the issue to establish a direct nexus between the borrowed funds and the investments before making a final decision on the disallowance.In conclusion, the Tribunal's decision focused on the need for a clear and direct nexus between the borrowed funds and the investments to justify the disallowance of interest expenses under section 36(1)(iii) of the Income Tax Act, 1961. The Tribunal remanded the issue to the AO for further verification and provided the assessee with an opportunity to present its case before a final decision is made.