Partial disallowance of interest under section 36(1)(iii) overturned where partners were charged interest and no nexus found.

Partial disallowance of interest under section 36(1)(iii) was challenged on the basis that substantial interest income arose from interest charged to partners and there was no nexus between borrowings and interest-free advances. The charging of interest to partners was held to neutralise any allegation of diversion because the assessee was compensated for use of funds, rendering the existence of debit balances legally irrelevant. The appellate disallowance rested on assumption rather than evidence and conflicted with findings of availability of interest-free funds and absence of nexus; accordingly the disallowance could not be sustained.

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Issues: Whether the learned CIT(A) was justified in sustaining a partial disallowance of interest of Rs. 7,70,069/- under section 36(1)(iii) of the Income-tax Act, 1961, despite findings that (i) substantial interest-free funds were available, (ii) no nexus between borrowed funds and interest-free advances was established, and (iii) significant interest income (including interest from partners) neutralised the allegation of diversion.

Analysis: The appellate tribunal examined the factual findings recorded by the learned CIT(A), including acceptance that the assessee had interest-free funds substantially exceeding advances and that the Assessing Officer failed to establish a direct nexus between borrowed funds and interest-free advances. The tribunal also noted admitted interest income (largely interest charged to partners) which offset interest expenditure and effectively compensated the assessee for use of funds. The learned CIT(A)'s residual disallowance rested on an inference from a negative capital account balance without any fund-flow analysis or identification of specific diversion of borrowed funds. Given the accepted availability of interest-free and interest-compensated funds and absence of evidence showing diversion of borrowed funds to non-business advances, the presumption based solely on a negative capital balance was held to be legally unsustainable.

Conclusion: The partial disallowance of Rs. 7,70,069/- under section 36(1)(iii) is deleted and the assessee's appeal is allowed.

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