2021 (12) TMI 1531 - AT - Income Tax

Interest on capital advances to partnership deductible as business expense; s.14A and Rule 8D disallowance not warranted

Deepak Nagindas Shah Versus ACIT, Circle – 19 (1), Mumbai

ITAT allowed the appeal, holding that interest paid on funds invested as capital in a partnership at 9% per annum was deductible because the advances were ... Disallowance of interest paid - whether the assessee is allowed to claim deduction of interest paid in excess of interest earned from said investment as capital contribution? - HELD THAT:- In the instant case, the assessee has invested funds bearing interest rate of 9% per annum into partnership firm as capital contribution and earned interest at the rate prescribed in partnership deed. It cannot be disputed that money has been advanced for the purpose of the business expediency. Thus, respectfully following the ratio laid down in the case of SA Builders Limited [2006 (12) TMI 82 - SUPREME COURT] we are of the opinion that no disallowance of interest could be made in the case of the assessee as money has been advanced for the purpose of the business expediency of the assessee. The respective grounds raised by the assessee are accordingly allowed. Disallowance in terms of section 14A read with Rule 8D(2)(iii) of the Rules - HELD THAT:- The section 14A(1) prescribe not allowing deduction of expenditure related to exempted income. The section 14A(2) prescribe how the said expenditure relatable to exempted income can be apportioned out of the expenditure claimed. The legislature has prescribed method of such apportionment under Rule 8D of Rules. Computation of income under the head ‘profit and gains of the business’, we find that assessee has not claimed any kind of expenditure against the exempted income from share of profit of from the firms. The interest expenditure has already been held by us in preceding paras as incurred for business purpose. Assessee has also not claimed any expenditure against dividend income. In such circumstances issue of disallowance of expenses does not arise. When the assessee has not claimed any expenses under the head profit and gains of the business, the disallowance made by the AO invoking section 14A read with rule 8D is not warranted. Appeal of the assessee is allowed. ISSUES PRESENTED AND CONSIDERED 1. Whether interest paid on borrowed funds, which were advanced as capital contribution/loan to related partnership concerns at a nominal return, is deductible under section 36(1)(iii) as expenditure incurred for the purpose of business when the advance was made as a matter of commercial expediency. 2. Whether disallowance under section 14A read with Rule 8D of the Income-tax Rules is warranted where the assessee has exempt income from share of profits of partnership firms and dividend income but has not claimed any business expenditure attributable to such exempt income in computing profit and gains of business. ISSUE-WISE DETAILED ANALYSIS Issue 1 - Deductibility of interest on borrowed funds advanced to related concerns as capital contribution/loan Legal framework: Section 36(1)(iii) permits deduction of interest on money borrowed for the purpose of the business or profession, except where the capital is borrowed for acquisition of an asset. The enquiry focuses on nexus between the expenditure (interest) and the purpose of the business; whether funds advanced to related entities can be regarded as deployed for business expediency so as to attract deduction. Precedent treatment: The Tribunal follows the principle in the Supreme Court decision (referred to by the Court) that interest on borrowed funds advanced to sister/related concerns is deductible if advanced as a measure of commercial expediency. The Supreme Court overruled/confined contrary views which required that borrowed capital be used in the assessee's own business to qualify for deduction, and endorsed the view that nexus to business purpose (which need not be the assessee's immediate business) is the relevant test. Interpretation and reasoning: The Tribunal found as a fact that borrowed funds at c.9% p.a. were invested as capital contribution/loan in partnership firms and that the advance was in furtherance of business expediency of the assessee. Although the return earned on the advance (nominal interest) was significantly lower than the interest paid on borrowed funds, the Tribunal held that the relevant consideration is commercial expediency and nexus to business, not a requirement that the funds be used directly in the assessee's own trading operations or that the return match the borrowing cost. The Tribunal applied the ratio that a prudent businessman may advance funds to related concerns for business reasons and the revenue cannot substitute its view for commercial expediency when nexus is established. Ratio vs. Obiter: The holding that interest is deductible where funds borrowed are advanced to related concerns as a measure of commercial expediency is treated as ratio and followed by the Tribunal. Observations about the rate differential and commercial reasons for advancing funds are part of the reasoning supporting the ratio. Conclusion: Disallowance of interest equal to the difference between interest paid on borrowings and interest received on advances (i.e., Rs. 34,64,023) was not sustainable. The Tribunal allowed the grounds challenging that disallowance and held the interest deductible under section 36(1)(iii) since the advance was for business expediency. Issue 2 - Application of section 14A r.w. Rule 8D where exempt income exists but no expenses claimed against such exempt income in business computations Legal framework: Section 14A(1) states that no deduction shall be allowed in respect of expenditure incurred in relation to exempt income. Section 14A(2) and Rule 8D prescribe the method by which expenditure attributable to exempt income can be apportioned and disallowed. Rule 8D contains both direct/apportionment and deemed indirect expense components (including Rule 8D(2)(iii) for indirect expenses allocation). Precedent treatment: The Ld. CIT(A) relied on a Special Bench decision (referred to in the record) treating indirect expenses allocable under Rule 8D(2)(iii) as requiring disallowance where dividend/exempt income is shown. The Tribunal examined the factual matrix of claimed expenses and the method of computation by the assessee. Interpretation and reasoning: The Tribunal observed that although exempt income (share of profits from partnership firms and dividend income of Rs. 2,77,155) was shown, the assessee had not claimed any expenditure under the head 'profit and gains of business' attributable to the share of profits or the dividend income. The interest expenditure that was on the record had already been held to be incurred for business purpose (and deductible) as per Issue 1. Given that no expenditure had been claimed against the exempt income, the premise for invoking section 14A/Rule 8D - i.e., that expenditure was incurred in relation to earning exempt income and should be apportioned or disallowed - did not arise in the facts of this case. The Tribunal thus rejected the Assessing Officer's disallowance under Rule 8D(2)(iii) in circumstances where the AO had already purported to disallow interest for diversion of interest-bearing funds (an adjustment which the Tribunal ultimately set aside) and where no other expenses were charged against the exempt income. Ratio vs. Obiter: The Tribunal's conclusion that section 14A disallowance is not warranted where the assessee has not claimed any expenditure against exempt income in the profit and gains of business computation is applied to the facts and stands as the operative ratio for this appeal. Observations contrasting the CIT(A)'s reliance on the Special Bench decision and explaining why that reliance did not mandate disallowance in the present factual matrix are explanatory and fact-specific; the Tribunal did not lay down a broad departure from Rule 8D jurisprudence beyond the factual finding. Conclusion: The Tribunal set aside the disallowance of Rs. 7,21,341 made under section 14A r.w. Rule 8D(2)(iii) because the assessee had not claimed any business expenditure against the exempt share of profits or the dividend income; accordingly, no apportionment/disallowance under section 14A was warranted on the facts. Cross-reference The conclusions on Issues 1 and 2 are interrelated: the finding that interest expenditure was incurred for bona fide business purposes (and hence deductible) directly informed the Tribunal's treatment of the section 14A claim because the principal alleged expenditure that the Assessing Officer sought to apportion/disallow was the same interest cost which the Tribunal found deductible. Final disposition The Tribunal allowed the appeal, reversing the disallowance of interest under section 36(1)(iii) and setting aside the section 14A/Rule 8D disallowance in view of the factual findings and application of the commercial-expediency principle; these holdings rest on (a) established precedent recognizing commercial expediency as the test for deductibility where funds are advanced to related concerns, and (b) the absence of any claimed business expense attributable to exempt income for the purpose of invoking section 14A adjustments.