Interest disallowance under Section 36(1)(iii) deleted as advances covered by sufficient interest-free funds to subsidiary (1)(iii)

ITAT Chennai allowed the assessee's appeals and deleted the disallowance of interest made on advances to its wholly owned subsidiary. It held that the AO and CIT(A) erred in concluding that the assessee lacked own funds, noting that substantial interest-free share application money, share capital and reserves were available, aggregating to over Rs. 45 crore. As the assessee had sufficient interest-free funds to cover the advances, no presumption of diversion of interest-bearing borrowings could be drawn. The proportionate interest disallowance was held perverse and unsustainable in law.

---

---

1. ISSUES PRESENTED AND CONSIDERED

1.1 Whether disallowance of proportionate interest under section 36(1)(iii) on investments and advances made to a wholly owned subsidiary was justified on the ground of diversion of borrowed funds to non-business purposes.

2. ISSUE-WISE DETAILED ANALYSIS

Issue 1: Disallowance of proportionate interest under section 36(1)(iii) on investments/advances to subsidiary

(a) Legal framework (as discussed)

2.1 The disallowance was made by applying section 36(1)(iii) of the Income-tax Act, 1961, on the reasoning that interest-bearing borrowings were diverted towards non-business investments/advances in the wholly owned subsidiary, warranting proportionate disallowance of interest on such amounts.

2.2 The Tribunal examined and applied the judicial principles laid down by various High Courts and the Supreme Court that where an assessee possesses sufficient interest-free funds to cover the impugned investments/advances, a presumption arises that such investments/advances are made out of interest-free funds, and no disallowance of interest under section 36(1)(iii) is warranted. Reliance was placed on:

(i) CIT v. Reliance Utilities and Power Ltd. (Bom)

(ii) CIT v. Hotel Savera (Mad)

(iii) CIT v. Tin Box Co. (Del)

(iv) CIT (LTU) v. Reliance Industries Ltd. (SC)

(b) Interpretation and reasoning

2.3 The Assessing Officer noted that the assessee had invested Rs. 19.62 crore in equity shares and advanced Rs. 7.57 crore to its wholly owned subsidiary, while having substantial bank borrowings of Rs. 150.89 crore on which interest was claimed. On the premise that the assessee had no accumulated profits or reserves sufficient for such investments/advances, the Assessing Officer presumed diversion of borrowed funds for non-business purposes and disallowed proportionate interest at 12.5% on the aggregate of such investments and advances.

2.4 The Assessing Officer further held that the ultimate objective of the assessee was acquisition of a capital asset (the subsidiary company), and that various payments made, including settlement of loans of another entity on behalf of the subsidiary's previous shareholder, formed part of the cost of acquisition of such capital asset, thereby treating the underlying funds as diverted from business borrowings.

2.5 The Commissioner (Appeals) affirmed the disallowance, relying upon the same factual presumption of absence of own funds and diversion of borrowed funds, and sustained the computation of proportionate interest disallowance on investments and advances to the subsidiary.

2.6 The Tribunal examined the assessee's balance sheet as on 31.03.2008 and found that the assessee had interest-free own funds - comprising share capital, share application money and reserves & surplus - aggregating to Rs. 45.48 crore, namely:

- Share capital: Rs. 7,06,31,000

- Share application money: Rs. 30,90,50,000

- Reserves & surplus: Rs. 7,51,84,580

2.7 The Tribunal contrasted the above interest-free funds of more than Rs. 45 crore with the total of investments and advances to the subsidiary amounting to Rs. 27.20 crore (Rs. 19.62 crore in equity shares plus Rs. 7.57 crore in advances), and held, on facts, that sufficient interest-free funds were available to fully cover the said investments/advances.

2.8 The Tribunal noted that the assessee's audited financial statements had been accepted by the tax authorities and no defects or infirmities were pointed out by the Assessing Officer or the Commissioner (Appeals). On that basis, the Tribunal held that the assessee was in possession of mixed funds and, in such circumstances, the legal presumption as settled by the cited judgments squarely applied in favour of the assessee.

2.9 Applying the ratio of the High Courts and the Supreme Court, the Tribunal held that where interest-free funds available with the assessee are sufficient to cover the investments/advances, it must be presumed that the impugned investments/advances were made out of such interest-free funds, and no disallowance of interest under section 36(1)(iii) can be made merely on the basis of presumptive diversion of borrowed funds.

2.10 The Tribunal referred to and followed the principle reiterated by the Supreme Court in CIT (LTU) v. Reliance Industries Ltd., that when interest-free funds are sufficient to meet investments in subsidiaries, the presumption is that such investments are from interest-free funds and disallowance of interest is unwarranted. The Tribunal also cited a recent Tribunal decision applying the same presumption in a mixed funds situation.

2.11 On this factual and legal matrix, the Tribunal held that the findings of the Assessing Officer and the Commissioner (Appeals) that the assessee had no own funds to make the impugned investments/advances were contrary to the record and therefore perverse.

(c) Conclusions

2.12 The Tribunal concluded that:

(i) The assessee had sufficient interest-free own funds (share capital, share application money, reserves and surplus) exceeding the aggregate amount of investments and advances to the wholly owned subsidiary.

(ii) By applying the settled presumption in law for mixed funds, the impugned investments and advances to the subsidiary are to be treated as having been made out of interest-free funds.

(iii) The disallowance of proportionate interest under section 36(1)(iii) on such investments and advances, on the allegation of diversion of borrowed funds to non-business purposes, was not sustainable in law or on facts.

(iv) The orders of the Assessing Officer and the Commissioner (Appeals) making and sustaining the disallowance were erroneous and perverse.

(v) The additions on account of disallowance of interest in all the captioned assessment years were liable to be deleted.

2.13 The Tribunal accordingly set aside the orders of the lower authorities on this issue and directed deletion of the disallowance of interest in the lead assessment year, with the decision to apply mutatis mutandis to the other assessment years under appeal, thereby allowing all the appeals.

---