GST interest under Section 50(3) allowed as deduction being compensatory not penal nature under Section 37(1)

The ITAT Hyderabad allowed the assessee's appeal on two issues. First, regarding interest paid under Section 50(3) of the GST Act due to input tax credit mismatch, the ITAT held that such interest is compensatory, not penal in nature, and therefore allowable as deduction under Section 37(1). The AO and CIT(A)'s disallowance was directed to be deleted, relying on SC precedent that interest on tax arrears is compensatory. Second, concerning disallowance under Section 36(1)(iii) for interest-free advances, the ITAT found no nexus established between borrowed funds and advances. Following Reliance Industries SC judgment, where interest-free funds are available to cover advances, presumption arises that advances were made from such funds. The disallowance was held unsustainable and directed to be deleted.

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ISSUES:

Whether interest paid under Section 50(3) of the GST Act on delayed payment of GST is penal or compensatory in nature and whether it is allowable as a deduction under Section 37(1) of the Income Tax Act.Whether disallowance of interest expenditure under Section 36(1)(iii) of the Income Tax Act is justified on advances given to certain entities when such advances are claimed to be made out of interest-free funds rather than borrowed funds.

RULINGS / HOLDINGS:

The interest paid under Section 50(3) of the GST Act is "compensatory in nature" and not penal, as the provision "nowhere does it indicate that such interest is penal." Therefore, such interest is "allowable as a deduction under Section 37(1) of the Act," and the disallowance of Rs. 1,03,44,404/- is directed to be deleted.Where interest-free funds are available with the assessee sufficient to cover advances, a presumption arises that such advances have been made out of interest-free funds. The disallowance of Rs. 73,02,428/- under Section 36(1)(iii) of the Act is unsustainable in law in the absence of factual nexus or fund flow analysis establishing that advances were made from borrowed funds. Hence, the disallowance is directed to be deleted.

RATIONALE:

The Court applied the language of Section 50(3) of the GST Act, which mandates interest on "undue or excess claim of input tax credit" but does not characterize such interest as penal. The Court relied on the Supreme Court precedent in Lachmandas Mathuradas Vs. CIT, which held that interest on arrears of sales tax is compensatory and not penal, extending this rationale to GST interest.In respect of Section 36(1)(iii) disallowance, the Court applied the principle established by the Supreme Court in CIT v. Reliance Industries Ltd., which creates a presumption that advances are made from interest-free funds if such funds are sufficient. The Court emphasized the need for the Revenue to establish a direct nexus between borrowed funds and advances through factual evidence or fund flow analysis, which was absent. The Court rejected reliance solely on a statement without corroborative evidence.

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