Interest deduction denied on unsecured loans under section 36(1)(iii) despite deletion of principal addition

The ITAT Ahmedabad upheld the disallowance of interest on unsecured loans under section 36(1)(iii). While CIT(A) deleted additions under section 68 on technical grounds (loans pertaining to earlier years), interest deduction was denied due to assessee's failure to establish genuineness and creditworthiness of lenders. The tribunal held that deletion of principal addition does not automatically legitimize transactions. Interest deduction requires proof of genuine borrowing and business purpose. Assessee failed to provide evidence of loan repayments or genuine liability subsistence, justifying the disallowance despite banking channels and TDS compliance.

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The principal legal questions considered in these appeals pertain to the allowability of interest expenditure claimed by the assessee on unsecured loans during the assessment years 2017-18 and 2018-19. Specifically, the issues involve:

• Whether interest paid on unsecured loans can be disallowed when the principal loan amounts are treated as unexplained or non-genuine under section 68 of the Income Tax Act.
• Whether the deletion of additions under section 68 for the principal loan amounts, especially when carried forward as opening balances from earlier years, automatically legitimizes the interest claimed on such loans in the subsequent assessment years.
• The evidentiary burden on the assessee to establish the genuineness, creditworthiness of lenders, and the subsistence of loan liabilities to claim interest deduction under section 36(1)(iii) of the Act.
• The relevance and sufficiency of documentary evidence such as confirmations, repayment details, TDS deduction, and compliance with statutory notices under sections 133(6) and 131 of the Act in proving genuineness of loans.

Issue-wise Detailed Analysis:

1. Allowability of Interest on Unsecured Loans when Principal is Treated as Unexplained under Section 68

The legal framework governing this issue is section 68 of the Income Tax Act, which deals with unexplained cash credits, and section 36(1)(iii), which allows deduction of interest on borrowed capital genuinely used for business purposes. Judicial precedents consistently hold that unless the principal amount is accepted as genuine, interest paid thereon cannot be allowed as a deduction.

The Court examined the Assessing Officer's disallowance of interest on the basis that the principal unsecured loans were either unexplained or not genuine. For AY 2017-18, the AO treated certain unsecured loans as unexplained cash credits under section 68 and disallowed proportionate interest. For AY 2018-19, although no fresh loans were received, interest on opening balances of such loans was disallowed citing lack of genuineness and creditworthiness.

The CIT(A) upheld the disallowance, emphasizing that the genuineness of the loans had not been established despite deletion of additions under section 68 for principal amounts. The Court noted that deletion of additions under section 68 on technical grounds (such as loans being opening balances from earlier years not under scrutiny) does not confer automatic legitimacy to those loans or to interest claimed thereon.

The Court referred to the principle that the allowability of interest under section 36(1)(iii) is a fresh claim each year, contingent upon the existence of a genuine and subsisting liability. Mere absence of addition under section 68 in the relevant year does not entitle the assessee to claim interest deduction without proving genuineness.

The assessee's contention that interest cannot be disallowed without a fresh addition under section 68 was rejected as misconceived. The Court held that the burden to establish genuineness and creditworthiness lies on the assessee each year to claim interest deduction.

2. Evidentiary Burden and Proof of Genuineness and Creditworthiness

The Court scrutinized the evidence presented by the assessee, including the deduction of TDS on interest payments and credit to lenders' accounts. However, it was observed that the assessee failed to produce credible documentary evidence such as confirmations from lenders, repayment schedules, or any indication that the loans were serviced or repaid in subsequent years.

The Court specifically queried the assessee's representative about evidence of repayment or actual payment of interest, to which the latter admitted no such evidence was placed on record and argued such evidence was irrelevant. This stance was found contrary to settled legal principles that require demonstration of genuine subsistence of liability for interest deduction.

The Court also considered the assessee's reliance on judicial decisions which held that non-compliance by third parties with notices under sections 133(6) or 131 should not lead to adverse inference if other corroborative evidence exists. However, the Court distinguished those precedents on facts, noting that in the present case, no tangible evidence such as confirmations, PAN details, or repayment records were furnished. The absence of such evidence justified the AO's and CIT(A)'s findings of non-genuineness.

3. Effect of Deletion of Section 68 Addition on Interest Deduction

The Court analyzed the legal effect of deletion of additions under section 68 on the principal loan amounts. It observed that the CIT(A) deleted the additions on the ground that the loans pertained to earlier years not under scrutiny and hence the principle of res judicata does not apply. The Court emphasized that non-examination of earlier years' credits does not ipso facto prove their genuineness in the current year.

Accordingly, the deletion of principal additions under section 68 on technical or procedural grounds does not automatically entitle the assessee to claim interest deduction without independently establishing the genuineness and creditworthiness of the loans in the relevant year.

4. Application of Law to Facts and Treatment of Competing Arguments

The Court applied the legal principles to the facts of the case, noting that the assessee failed to discharge its onus under section 68 to prove the identity, creditworthiness, and genuineness of the lenders. The absence of confirmations, repayment evidence, or any commercial substance to the loans led to the conclusion that the interest claimed was not allowable under section 36(1)(iii).

The assessee's argument that interest should be allowed merely because no fresh addition under section 68 was made was rejected as contrary to settled law. The Court found the reasoning of the CIT(A) sound and supported by judicial precedents, and upheld the disallowance of interest in both assessment years.

Significant Holdings:

"It is settled law that the deletion of an addition under section 68 of the Act on technical grounds-namely, that the credit pertains to an earlier year and is carried forward as opening balance-does not automatically confer legitimacy upon the transaction."

"The allowability of interest under section 36(1)(iii) of the Act is a fresh claim each year and is contingent upon the existence of a genuine and subsisting liability."

"If the assessee fails to establish the genuineness of the underlying loan, the interest payable or paid thereon cannot be allowed. Mere routing of interest through banking channels or deducting TDS is not conclusive proof of allowability."

"The assessee's failure to bring on record evidence of repayment of the loans, even years after their receipt, reinforces the Revenue's contention that the alleged loans lack commercial substance."

"The reasoning adopted by the Ld. CIT(A) in both years-namely, that the assessee failed to discharge its burden to prove the genuineness and creditworthiness of the lenders, and that interest cannot be allowed on an unverified or fictitious liability-is sound and supported by settled judicial principles."

In conclusion, the Court dismissed the appeals and upheld the disallowance of interest amounting to Rs. 36,69,000 for AY 2017-18 and Rs. 38,94,295 for AY 2018-19, affirming that interest deduction under section 36(1)(iii) is not permissible in the absence of proof of genuineness and creditworthiness of the underlying unsecured loans.

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