Interest expenditure Disallowance u/s 36(1)(iii)-Allahabad High Court says business expediency not a must, earlier Division Bench decision was not a good law

Interest expenditure Disallowance u/s 36(1)(iii) for interest free loan-Allahabad High Court says business expediency not a must, earlier Division Bench decision was not a good law, pronounced in ignorance.

ABCAUS Case Law Citation:
ABCAUS 1166 (2017) (03) HC

The Grievance:
The appellant assessee was aggrieved by part of the Tribunal’s order rejecting the claim of interest expenditure under section 36(1)(iii) of the Income Tax Act, 1961 (‘Act’) when admittedly the assessee had interest free funds available with it

Important Case Laws Cited/relied upon:
CIT Vs. M/s Radico Khaitan
CIT, Agra Vs. Krishna Murari Lal Agarwal
CIT, Lucknow Vs. M/S Appolo Trade Links
CIT Vs. Sahu Enterprises (P) Ltd
Hero Cycles Private Ltd. Vs. CIT Central Ludhiana

Brief Facts of the Case:
The Assessing Officer (‘AO’) had disallowed part expenditure claimed by the assessee, towards interest on fund borrowed by it for business purpose by making an ad-hoc disallowance under Section 36 (1)(iii) of the Act.

According to the AO the assessee was not eligible to claim interest expenditure on the interest bearing loan of Rs. 58 lacs taken by it as the assessee as per its books had interest free loans given for non business purpose amounting to Rs. 92.75 lacs. The assessee’s explanation that the interest free loans had been given by it from interest free advances available with it and that it also had available Rs. 1.80 crores by way of partner’s capital was rejected with the observation that the assessee had failed to substantiate it.

Upon appeal to the Commissioner of Income Tax (Appeals), the assessee further clarified that out of Rs. 92.75 lacs standing in its books as interest free loans given by it, it had, in the relevant assessment year given out only Rs. 75,000/- and that the balance of Rs. 92 lacs had been given out as interest free loans in earlier years. The assessee further clarified that in the relevant previous year it had available with it Rs. 39,45,705/- by way of interest free advances from customers that were sufficient to give a loan of Rs. 75,000/- in that year.

However CIT(A) required the assessee to explain the purpose of making such loans. The assessee explained that the loans had been given to the business concerns owing to commercial expediency and not to any individual for their personal use. It was also submitted by the assessee that proving commercial expediency is required only when borrowed funds are diverted as interest free advance but no such requirement, as expected to be proved when there are sufficient owned funds.

The CIT (Appeals) however, rejected the claim made by the assessee by relying on a Division Bench judgment of the Allahabad High Court in the case of Sahu Enterprises (P) Ltd wherein it had been held that,

“the test to be applied in such cases is not the source of the funds but the purpose for which the loans were extended.”

Thus the CIT(A) was of the view that for the purpose of claim made under Section 36 (1) (iii) it would be irrelevant to examine whether the assessee had his own funds and that it was be relevant for the assessee to establish business purpose for making such a loan.

The Tribunal also rejected the claim of the assessee that it had interest free funds available in the shape of partners capital.

Observations made by the High Court:
The Hon’ble High Court observed that there were two aspects;

• the quantum of interest free advance given by the assessee in the previous year relevant to the assessment year 2010-11 and
• the amount of own funds or non interest bearing funds available with the assessee for the purpose of making the interest free advance in the previous year.

The Court noted that the CIT (Appeals) had disallowed the grounds of appeal raised in view of a judgment of the Division Bench in which the Court had observed that the test commercial expediency would have to be applied irrespective of the source of the fund from which interest free advance had been made.

However, the Court observed that apparently, while making the above said observation, the earlier judgments of the Court had not been brought to the Court’s knowledge and were thus not considered.

The Court observed that in its earlier three judgments it has been consistently held that the conditions of Section 36 (1)(iii) of the Act are complied with if the assessee has sufficient funds other than the borrowed money for giving the interest free advances.

It was further noted that the issue has now been conclusively resolved by the Hon’ble Supreme Court wherein the Apex Court on disallowance u/s 36(1)(iii) held that the company had reserve/surplus to the tune of almost 15 crores and, therefore, the it could in any case, utilise those funds for giving advance to its Directors.

The High Court Thus opined that the three earlier division bench judgments are good law and the later division bench decision in Sahu Enterprises (P) Ltd. so far as it holds that the test of business expediency must be satisfied by the assessee irrespective of the source of funds (from which it may have made interest free loans) is not good law being inconsistent with the law laid down by the Supreme Court. Besides the fact that the judgement in the case of Sahu Enterprises (P) Ltd. was pronounced in ignorance of or without considering the earlier categorical and consistent view of this court expressed in three earlier division bench pronouncements.

Held:
On a principle of law it is no longer open to the revenue to disallow interest expenditure under section 36(1)(iii), if it is established as a fact that interest free loans were given by the assessee from its own funds or from funds which are not part of its interest bearing borrowings.