Arm's length foreign currency lending supports interest deduction where commercial expediency and foreign exchange gain are established.

Interest expenditure under section 36(1)(iii) cannot be disallowed merely because the assessee borrowed in Indian rupees at a higher rate while advancing a foreign currency loan to an overseas subsidiary at a lower rate. The transaction was accepted at arm's length, the comparable overseas lending rate was about 3% to 4%, and the 5% charge was within the arm's length range. The arrangement also generated foreign exchange gain that was offered to tax, and the record did not show lack of commercial expediency. In these circumstances, the borrowing cost could not be substituted to make a partial disallowance.

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Issues: Whether disallowance of interest expenditure under section 36(1)(iii) was justified where the assessee borrowed funds from its holding company, advanced a foreign currency loan to an overseas subsidiary at 5% interest, and earned foreign exchange gain on the transaction.

Analysis: The loan to the overseas subsidiary was advanced in foreign currency, while the borrowings from the holding company were in Indian rupees. The comparable interest rate in the borrower's jurisdiction was about 3% to 4%, and the assessee charged 5%, which was found to be within the arm's length range. The transfer pricing order accepted the international transaction as arm's length. The loan arrangement also yielded substantial foreign exchange gain, which was offered to tax, and the record did not establish absence of commercial expediency. In these circumstances, the Assessing Officer could not substitute the borrowing rate and disallow a part of the interest expenditure merely because the assessee had paid 15% on its own borrowings.

Conclusion: The disallowance under section 36(1)(iii) was not sustainable and was rightly deleted; the decision was in favour of the assessee.

Ratio Decidendi: Where a foreign currency lending transaction is accepted at arm's length and the borrowing and lending are commercially connected, interest expenditure cannot be disallowed merely by comparing the assessee's borrowing cost with the lower lending rate charged to the overseas subsidiary.

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