2025 (8) TMI 1645 - AT - Income Tax

Deletion of s.36(1)(iii) disallowance where bank charges and advances shown funded from non-borrowed sources, no nexus found

Kler Wines C/o Shri Tejmohan Singh, Advocate Versus The DCIT Circle-4 (1), Chandigarh

Kler Wines C/o Shri Tejmohan Singh, Advocate Versus The DCIT Circle-4 (1), Chandigarh - TMI ISSUES PRESENTED AND CONSIDERED 1. Whether expenditure classified as bank charges is liable to disallowance under Section 36(1)(iii) when claimed alongside interest expense debited to profit and loss account. 2. Whether Section 36(1)(iii) permits proportional disallowance of interest expense where an assessee shows loans/advances to related parties without charging interest, on the ground that borrowed funds were used to make such advances. 3. Whether the Assessing Officer (AO) and first appellate authority may infer utilization of interest-bearing borrowed funds for advances to related parties absent specific evidence of nexus between particular borrowings and the advances. ISSUE-WISE DETAILED ANALYSIS Issue 1 - Bank charges: applicability of Section 36(1)(iii) Legal framework: Section 36(1)(iii) disallows interest on capital or on borrowed funds if not incurred for business purposes; generally, only interest and expenses attributable to borrowing for business are susceptible to scrutiny under this section. Interpretation and reasoning: The Court noted that the P&L debit of Rs. 34,66,984 comprised two distinct components: bank interest (Rs. 17,40,161) and bank charges (Rs. 17,26,823). Bank charges related to routine operational services (cash handling, RTGS, cheque book charges) connected to the carrying on of the liquor business. Such bank charges are operational expenses, not interest on borrowed funds. Precedent treatment: The Court applied ordinary tax law distinction between interest and non-interest banking charges; no contrary authority was invoked or followed. Ratio vs. Obiter: Ratio - bank charges of a transactional/operational nature are not disallowable under Section 36(1)(iii) as interest-like expenditure; they remain deductible as business expenses unless specific statutory disqualification exists. Conclusion: The portion of the P&L entry attributable to bank charges cannot be disallowed under Section 36(1)(iii). Issue 2 - Proportional disallowance of interest where interest-free advances to related parties exist Legal framework: Section 36(1)(iii) permits denial of deduction for interest expenses if the interest-bearing borrowings are not employed for business purposes; where borrowed funds are used for making interest-free advances (especially to related parties), revenue may seek to disallow interest proportionate to such use, provided a sufficient nexus is established. Interpretation and reasoning: The AO made a mechanical proportional disallowance (12% of outstanding advances) on the premise that a prudent businessman would not borrow at interest and simultaneously make interest-free advances. The Tribunal examined ledgers, opening balances, repayment entries, dates of payments, and bank statements. It found that substantial balances in loans/advances were carry-forwards from the transfer of a sole proprietorship business to the company at book value; many advances were not fresh disbursements funded by the company's borrowings during the year. Where fresh payments were made (e.g., to one related entity), they were made out of existing cash/bank balances available at the beginning of the year. One payment of Rs. 80,00,000 to an individual was shown to have been made from the individual's bank account, not the company's funds. Precedent treatment: The Tribunal applied principle that the revenue must prove utilization of borrowed funds for making advances before invoking Section 36(1)(iii); precedents were not explicitly cited but the approach is consistent with established requirement of evidentiary nexus. Ratio vs. Obiter: Ratio - absent evidence that interest-bearing borrowings were actually utilised to make interest-free advances to related parties, proportional disallowance under Section 36(1)(iii) is not sustainable. Obiter - the AO's expectation of what a 'prudent businessman' would do cannot substitute for evidentiary proof of actual fund flow. Conclusion: The AO's proportional disallowance was unjustified because the assessee demonstrated (i) most advances were pre-existing liabilities transferred from a proprietorship; (ii) fresh payments were made from internal cash balances or non-company accounts; and (iii) no material establishing nexus between borrowings and advances existed. Therefore, disallowance under Section 36(1)(iii) must be deleted. Issue 3 - Burden and nature of proof required to establish nexus between borrowings and advances Legal framework: Tax disallowance under Section 36(1)(iii) requires the revenue to show that interest-bearing borrowings were used for non-business purposes (including making interest-free advances). This entails tracing of fund flows or other reliable evidence linking specific borrowings to specific advances. Interpretation and reasoning: The Tribunal emphasized evidentiary particulars - ledger balances, opening and closing entries, dates of payments, bank balances at the beginning of the year, and bank statements - to assess fund source. Mere suspicion or inference from concurrent existence of borrowings and inter-corporate/related-party advances is insufficient. The AO's reliance on an improbability premise without tracing of funds or counter-evidence was held inadequate. Precedent treatment: The Court adhered to the established evidentiary standard that nexus must be demonstrated; no precedent was overruled or distinguished. Ratio vs. Obiter: Ratio - revenue bears the onus to establish nexus by documentary evidence or clear tracing of funds; absence of such evidence requires deletion of the disallowance. Obiter - factual circumstances (carry-forwards from previous business, timing of payments, availability of cash) are determinative in tracing issues. Conclusion: The AO failed to discharge the burden of proof; therefore, invocation of Section 36(1)(iii) was not sustainable. Cross-reference and combined conclusion Bank charges are distinct from interest and not disallowable under Section 36(1)(iii) (see Issue 1). Where advances to related parties are shown to be carry-overs from a transferred proprietorship or paid out of existing cash/non-company accounts, and where no evidence establishes that interest-bearing borrowings funded those advances, proportional disallowance under Section 36(1)(iii) cannot be sustained (see Issues 2 and 3). The Tribunal therefore deleted the impugned addition.