Interest disallowance on capital advances deleted where sufficient interest-free funds existed and no nexus with borrowings was proved.

Interest on borrowed funds is disallowable only where the revenue establishes a direct nexus between the borrowings and non-business advances, or shows absence of commercial expediency. Where sufficient interest-free funds are available, a presumption arises that capital advances are made from those funds. On the financial statements, the assessee had substantial interest-free funds and the capital advances were comparatively small; the revenue did not prove that borrowed funds were diverted to the impugned advances. The advances were also stated to be for purchase of capital goods for business purposes. The ITAT Mumbai deleted the disallowance of interest under section 36(1)(iii).

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Issues: Whether the disallowance of interest of Rs. 68,14,949/- under Section 36(1)(iii) of the Income-tax Act, 1961 on account of alleged diversion of interest-bearing funds towards capital advances is sustainable.

Analysis: Applicable law provides that interest on borrowed funds is allowable only if such funds are used for the purposes of business; disallowance arises if borrowed funds are diverted to non-business purposes or interest-free advances lacking commercial expediency. Where sufficient interest-free funds are available, a presumption arises that advances are made from such interest-free funds unless revenue establishes direct nexus between borrowings and the advances. The relevant financial statements show interest-free funds (equity and reserves) of Rs. 12,856.52 lacs, capital advances of Rs. 653.88 lacs, profit after tax of Rs. 3,654.86 lacs, operating profit before working capital changes of Rs. 5,124.78 lacs, and net cash from operations of Rs. 3,117.60 lacs. On these facts, the presumption in favour of interest-free funds applies and the revenue has not produced material establishing nexus between borrowed funds and the impugned advances; the advances were asserted to be for purchase of capital goods for business purposes and no evidence was placed to show non-business use or lack of commercial expediency.

Conclusion: Disallowance of Rs. 68,14,949/- under Section 36(1)(iii) of the Income-tax Act, 1961 is deleted and the appeal is allowed in favour of the assessee.

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