INTEREST PAID IN RESPECT OF CAPITAL BORROWED FOR THE PURPOSE OF BUSINESS OR PROFESSION [SECTION 36(1)(iii)]

The interest paid on capital borrowed for business/profession is eligible for deduction under Section 36(1)(iii). But if the borrowed capital is used for personal purpose, then the interest on such borrowal is not eligible for deduction. Also, if the nexus between the borrowed capital and personal use or diversion to other investments is established, then such interest is not eligible for deduction from the business income.

Text of section 36(1)(iii)

“36 (1) (iii) the amount of the interest paid in respect of capital borrowed for the purposes of the business or profession:

Provided that any amount of the interest paid, in respect of capital borrowed for acquisition of an asset whether capitalised in the books of account or not; for any period beginning from the date on which the capital was borrowed for acquisition of the asset till the date on which such Asset was first put to use, shall not be allowed as deduction.

Explanation. – Recurring subscriptions paid periodically by shareholders, or subscribers in Mutual Benefit Societies which fulfill such conditions as may be prescribed, shall be deemed to be capital borrowed within the meaning of this clause.

Clause (iii) of Section 36(1) contains three ingredients, namely, Interest, Borrowed and Purpose of Business. Let us understand them in general parlance as well as in the light of Hon'ble Supreme Court's verdict in Madhav Prasad Jatia v. CIT (1979) 118 ITR 200 :1 Taxman 477 (SC).

Meaning of “Interest”

The first ingredient of the section is "Interest". It is a consideration paid either for use of money or for forbearance in demanding it after it has fallen due. The word 'Interest' is an inclusive definition and includes interest on unpaid purchase price, payable in any manner which would include interest payable by means of an irrecoverable letter of credit. [CIT v. Vijay Ship Breaking Corpn. v. CIT (2003) 261 ITR 113 : 129 Taxman 120 (Guj)

The word "Interest" in a given context –

Summarized provisions of Section 2(28A) and Section 36(1)(iii) of the Act as follows,

Section 2(28A) Interest payable in any manner in respect of any sums of money borrowed or debt incurred…….

Section 36(1)(iii) The amount of the interest paid in respect of capital borrowed for the purpose of the business or profession…….

Section 2(28A) defines Interest in a wider sense whereas Section 36(1)(iii) in a restrictive manner and extends only to "Money Borrowed" and not "on debt incurred."

The definition of “interest” in Section 2(28A) means “interest payable in any manner in respect of any moneys borrowed or debt incurred ”.But for Section 36(1)(iii), “interest” is restricted to that on money borrowed and not on debt incurred. In simple words, the essence of interest is that it is a payment which becomes due because the creditor has not had his money at his disposal. It may be regarded either as representing the profit he might have made if he had had the use of his money, or conversely, the loss he suffered because he had not that use. The general idea is that he is entitled to compensation for the deprivation.

Concept of “borrowed”

The second ingredient of the section is "Borrowed." Provisions of Section 36(1)(iii) concern with capital borrowed but no other liabilities. A borrowed capital is undoubtedly a debt but all debts have not involved a loan or borrowal.

In one of the oldest precedents, the Hon'ble Supreme Court held that the term borrowed money must be construed in its natural and ordinary meaning and implies a real borrowing and a real lending. Lakshmanier & Sons v. Income Tax and Express Profits Tax Commissioner (AIR 1953 SC 145)

Hon'ble Supreme Court's observation in Bombay Steam Navigation Co. (P) Ltd. v. CIT (1965) 56 ITR 52, held that the Legislatures intention is just to permit interest paid on borrowed capital "exclusively' for the purpose of the business and in that context, borrowed capital means money and not any other asset purchased on credit.

The Hon'ble Gujarat High Court in Arun Family Trust v. CIT 298 ITR 437 clearly states that the existence of a loan transaction or a loan agreement between parties with an established role of creditor and debtor is a pre-condition under Section 36(1) (iii).

Provisions of Section 36(1)(iii) concern capital borrowed and not other debts or liability. A loan of money undoubtedly results in a debt, but every debt does not involve a loan. Liability to pay a debt may arise from diverse sources and a loan is one of such sources. The legislature has, under this clause, permitted as an allowance interest paid on capital borrowed for the purposes of the business; and the capital, in this context, means money and not any other asset purchased on credit.

[Bombay Steam Navigation Co. (P) Ltd. v. CIT (1965) 56 ITR 52 (SC)]

The phrase “for the purpose of business”

This phrase, as held by many legal pronouncement, is the most important yardstick for the allowability of deduction Under Section 36(1)(iii) of Income Tax Act, 1961. While explaining the meaning of this phrase the Hon’ble Supreme Court in the case of S. A. Builders Ltd. v. CIT(A), Chandigarh reported in 288 ITR 1 has used the word “commercial expediency”. By using this phrase Hon’ble Supreme Court has given a new dimension and clarified the concept further. In the judgment the Supreme Court has defined commercial expediency as “an expression of wide import and includes such expenditure as a prudent businessman incurs for the purpose of business. The expenditure may not have been incurred under any legal obligation, but yet it is allowable as a business expenditure, if it was incurred on grounds of commercial expediency”. 

Further, following this judgment the High Court of Delhi, in the case of Punjab Stainless Steel Inds. v. CIT 324 ITR 396, has further elaborated “The commercial expediency would include such purpose as is expected by the assessee to advance its business interest and may include measures taken for preservation, protection or advancement of its business interests, which has to be distinguished from the personal interest of its directors or partners, as the case may be. In other words, there has to be a nexus between the advancing of funds and business interest of the assessee-firm. The appropriate test in such a case would be as to whether a reasonable person stepping into the shoes of the directors/ partners of the assessee-firm and working solely in the interest of the assessee-firm/ company, would have extended such interest free advances. Some business objective should be sought to have been achieved by extending such interest free advances when the assessee-firm/company itself is borrowing funds for running its business”.

The expression “for the purpose of business” occurs in Section 36(1)(iii) and also in Section 37(1). A similar expression with different wording also occurs in Section 57(iii) which reads as “for the purpose of making or earning income”. This issue came up for consideration before the Supreme Court and the Hon’ble Supreme Court while giving judgment in the case of Madhav Prasad Jatia v. CIT 118 ITR 200  (SC) has established that the expression occurring in Section 36(1)(iii) is wider in scope than the expression occurring in Section 57(iii). Thus, meaning thereby that the scope for allowing a deduction under Section 36(1)(iii) would be much wider than the one available under Section 57(iii).

Conditions for allowance of a claim for deduction of interest under section 36(1)(iii)

For allowance of a claim for deduction of interest under this provision, following three conditions are there:

(i)   The money, that is capital, must have been borrowed by the assessee

(ii)   It must have been borrowed for the purpose of business.

(iii)  The assessee must have paid interest on the borrowed amount i.e. he has shown the  same as an item of expenditure.

The above mentioned three conditions have been established legally by Supreme Court judgment in the case of Madhav Prasad Jatia v. CIT (1979) 118 ITR 200 (SC).

Interest for the period	Treatment of interest
Prior to commencement of business	Interest is to be added to actual cost of the asset
After commencement of business but before asset is put to use
After asset is put to use	Interest is allowed under section 36(1)(iii)

Borrowed money used partly for business purpose:

If borrowed money is utilised in earning non assessable income, interest on such borrowing shall not be allowed as deduction.

Interest paid to relative:

Interest paid to relative is allowed as deduction subject to section 40A(2) i.e. if the interest paid is in excess of market rate then excess portion shall be disallowed.

Interest on borrowed capital used for interest free loans

The law on this issue is settled after the Hon’ble Supreme Court judgment in the case of S. A. Builders Ltd. v. CIT (Appeals) (2007) 288 ITR 1 (SC), in which the concept of “commercial expediency” was used. Thus, where the funds of the business a diverted for interest free loans the main criteria for permissibility of interest on those funds are based on whether it was for commercial expediency or not. The phrase “commercial expediency” has following important traits as established by case laws cited supra:

(i)          Such purpose as is expected by the assessee to advance its business interest.

(ii)    May include measures taken for preservation, protection or advancement of its       business interests.

(iii)    To be distinguished from the personal interest of its directors or partners, as the case may be.

(iv)    There has to be a nexus between the advancing of funds and business interest of the assessee. Some business objective should be sought to have been achieved by extending such interest free advances when the assessee­ firm/company itself is borrowing funds for running its business.

The Hon’ble Supreme Court has also delved into the case where there would be mixed fund at the disposal of the assessee. It further clarifies that under Section 36(1)(iii) the ultimate use of the fund is important. It may not be relevant as to whether the advances have been extended out of the borrowed funds or out of mixed funds which include borrowed funds. The test to be applied in such cases is not the source of the funds but the purpose for which the advances are extended.

One important case law on this issue is Punjab Stainless Steel Ltd. 324 ITR 396 (Delhi High Court), in this the hon’ble High Court has given a finding which is in favour of revenue and has clearly distinguished Munjal Sales Corporation v. CIT 298 ITR 298. In fact, the Ahmedabad Bench of ITAT has also followed this principle in Inamulhaq S. Iraki v. Addl. CIT, Range-2, Ahmedabad in ITA No. 243/Ahd/201 1 for assessment year 2007-08 dated 31.01.2012. In this judgment the Hon’ble ITAT has squarely followed Hon’ble Delhi High Court decision Punjab Stainless Steel Ltd. 324 ITR 396, the relevant para (11) is reproduced below for the sake of ready reference.

“We find that as per this judgment of Hon’ble Delhi High Court, where mixed funds are used for the purpose of giving interest free advances, the only relevant test is as to whether such interest free advances are due to commercial expediency or not. In the present case also, the funds are mixed funds and the assessee could not establish any commercial expediency and hence, in our considered opinion, this issue is squarely covered against the assessee by this judgment of Hon’ble Delhi High Court and respectfully following the same, this issue is decided against the assessee”.

Interest on borrowed capital – Advance to subsidiaries - Presumption is that the advance was from the interest free generated or available with the company - Disallowance of interest was held to be not valid.

Dismissing the appeal of the revenue the Court held that; when the advance made to subsidiaries the presumption is that the advance was from the interest free generated or available with the company hence disallowance of interest was held to be not valid. (Related Assessment years  2003-04 to 2006-07) - [CIT v. Reliance Industries Ltd (2018) 161 DTR 420 (Bom)]

Interest on borrowed capital - Allowable

No disallowance under section 36(1)(iii) / 14A where interest-free funds are sufficient to cover interest-free loans / investments

If the interest free funds available to the assessee are sufficient to meet its investment, it could be presumed that the investments are made from the interest free funds available with the assessee and not from borrowed funds.

FACTS:

Assessee had given interest-free loans to its subsidiaries as on 31-03-2003 aggregating Rs. 6,716.12 crores and as on 31-03-2002 was 2,988.98 crores; thus the incremental loans given during the year amounted to Rs. 3,727.14 crores. The net profit after tax and before depreciation exceeded not only the differential/incremental loan given to subsidiaries during the year but also exceeds the total interest free loans of Rs. 6,716.12 crores given to the subsidiaries as on 31-3-2003.

BOMBAY HIGH COURT’S DECISION:

It is already settled principle by this Court in the case of Reliance Utilities & Power Ltd that if there were funds available both interest free and overdraft / or loans taken, then presumption would arise that investment would be out of interest free funds generated or available with the company.

It was held that if interest free funds were sufficient to meet the investments made, in that case a presumption is established that the borrowed capital was used for the purpose of business and the interest expenditure is deductible under section 36(1)(iii) of the Act.

The Tribunal held that the interest free fund available to the assessee is sufficient to meet its investment. It can be presumed that investments were made from interest free funds available with the assessee. This position clearly emerges from the record and for the current assessment year as well. There is no perversity when nothing contrary to the factual material was brought on record by the Revenue.

SUPREME COURT’S DECISION:

The High Court has noted the finding of the Tribunal that the interest free funds available to the assessee were sufficient to meet its investment. Hence, it could be presumed that the investments were made from the interest free funds available with the assessee. The Tribunal has also followed its own order for Assessment Year 2002-03. In view of the above findings, we find no reason to interfere with the judgment of the High Court. [CIT v Reliance Industries (2019) 410 ITR 466 (SC)

Interest on borrowed capital – Where money was advanced to the subsidiary out of reserves and not out of interest paid borrowings, interest paid on borrowings was deductible

Dismissing the appeal of the revenue the Court held that; deduction in respect of interest was allowable as it was ascertained that no interest bearing funds were used for advancing the sums to the subsidiary company and that the assessee had sufficient reserves. (Related Assessment years :  1996-97, 1997-98) - [CIT v. Golden Tobacco Ltd. (2017) 399 ITR 653 : 248 Taxman 101 (Bom)]

If there are sufficient interest free funds available to the assessee to meet its investment and at same time the assessee has raised a loan, it can be presumed that the investments were from the interest free funds available

Interest on borrowed capital—If there are sufficient interest free funds available to the assessee to meet its investment and at same time the assessee has raised a loan, it can be presumed that the investments were from the interest free funds available, since, in the present case, the investments have been presumed to be made out of own funds, clearly no interest expenditure has been incurred for making the same and therefore, no question of allowability /disallowability of the same arises under section 36(1)(iii). (Related Assessment year : 2010-11) – [Kissan Fats Ltd. v. DCIT (2017) 162 ITD 404 (ITAT Chandigarh)]

The Hon'ble Supreme Court in Hero Cycles Private Ltd. v. CIT by applying its own principles laid down in S. A. Builders Ltd. v. CIT (2007) 288 ITR 1 : 158 Taxman 74 (SC),, held that interest - free loans advanced to a subsidiary company, satisfies the test of "commercial expediency" and entitled the assessee to deduct interest expenses. - [Hero Cycles Private Ltd. v. CIT (2010) 323 ITR 518 : 189 Taxman 50 (P&H)]

Interest on borrowed capital - not allowable

Interest on borrowed capital-Capital borrowed for acquisition of asset-Asset not put to use in relevant accounting year, interest was not deductible.

Dismissing the appeal of the assesse, the Court held that; asset not put to use in relevant accounting year, interest was not deductible. Insertion of proviso to section 36(1)(iii), w.e.f 01.04.2004 (Related Assessment year  2009-10) - [Thukral Regal Shoes v. CIT (2017) 391 ITR 119 (2016) /290 CTR 596 : 241 Taxman 361  (P&H)]

Estimate of net profit rate- Interest on borrowed capital is not allowable

Deduction on account of interest on borrowed capital is not allowable where income is estimated by applying net profit rate. (Related Assessment year 1990-91) - [Lali Construction Co. v. ACIT (2015) 229 Taxman 286 (P&H)]

Interest on borrowed capital –Not utilized for the purpose of business-Kept idle-Not entitled deduction.

Assessee borrowed unsecured loan from friends and relatives and paid interest thereupon. It was found that such borrowed funds were lying idle in an almirah and were never utilised for business purpose. Assessee was not entitled to deduction of interest paid on said loan. (ITA No. 203 of 2005 dated 10.09.2014) (Related Assessment year  2001-02) - [Tulsi Ram Bhagwan Das Mandi Ghanshyamganj .v. CIT (2015) 228 Taxman 308(Mag.)(All)]

Interest on borrowed capital-Finding that borrowed capital was used for expansion of existing business-Interest deductible

Held that it was an expansion of the existing business. The interest payments were, therefore, deductible. Applied the ratio in DCIT v. Core Health Care Ltd. (2008) 298 ITR 194 (SC). - [CIT v. Nirma Ltd. (2014) 367 ITR 12 : 52 taxmann.com 88 (Guj)]

Interest on borrowed capital-Interest not charged because recovery of principal amount was difficult - Notional interest could not be disallowed

Dismissing the appeal of the revenue the Court held that in view of the findings recorded by the CIT(A) as well as the Tribunal, there was no justification for making an addition under section 36(1)(iii) of the Act. The assessee had not charged any interest on the amount advanced to Nalanda Spinners as the amount advanced to Nalanda Spinners was not returned for which a civil suit was filed and with the assistance of influential people, it was recovered. Moreover, for the assessment years 2006-07 and 2007-08, similar additions had been deleted which had attained finality. (Related Assessment year 2008-2009) - [CIT v. Suraj Dev Dada (2014) 367 ITR 78 : 224 Taxman 189 (Mag.) (P & H)]

Interest on borrowed capital - Sufficient funds available with assessee company - No disallowance can be made

Assessing Officer while working out the fund and utilization thereof, concluded that interest bearing funds were utilized for making interest free advances. He therefore disallowed the claim of interest on borrowed fund amounting to Rs. 7,97,83,057/-. Held that, the share capital and the reserves and surplus together with the accumulated depreciation would far exceed the loans and advances made to the above said three concerns. The percentage of loans and advances in relation to the own funds of the assessee company would be 0.012% as on 1.4.94 and 0.0135% as on 31.3.95. In other words there were sufficient funds available with the company on which no interest was paid and out of which the loans and advances to the above said concerns could be made. There is no clear evidence that the interest bearing loans taken by the assessee company for the purpose of its own business have been diverted for non-business purposes. No direct nexus has been proved either by the Assessing Officer between the interest bearing loans taken and the interest free advances given.With abovementioned facts and applyingthe decision of Munjal Sales corporation (298 ITR 298) (SC), no disallowance could be made. (Related Assessment year 2002-03) - [ACIT .v. Gujarat Narmada Valley Fertilizers Co. Ltd. (2014) 222 Taxman 28 (Mag.) :  42 taxmann.com 579 (Guj)]

Interest on borrowed capital-Rate of interest - Disallowance of interest exceeding 18 per cent was held to be not justified

Assessee paid interest to creditors as well as trade partiesupto 30 days at the rate of 18 per cent and beyond 30 days at the rate of 21 per cent and claimed deduction of the same. A.O. disallowed interest exceeding that where payment was made within 30 days, interest was paid at the rate of 18 per cent and in other cases interest was paid at the rate of 21 per cent. CIT(A) deleted the addition. Affirming the view of CIT(A) Tribunal held thatthe rate of interest chargeable for delayed payments are mentioned in the invoices itself. This clearly establishes payment policy of the assessee-company. (Related Assessment year 2009-10) - [ITO v. Axon Global (P) Ltd. (2014) 146 ITD 473 : (2013) 38 taxmann.com 392 (ITAT Jodhpur)]

Interest on borrowed capital - Usance interest and buyers line of credit - No disallowance can be made

Usance interest (6.79 per cent) and interest on the buyers line of credit availed from bank (6.9 per cent) was agreed to be paid at international Libor which was much lower than the rate of interest of 13.50 per cent charged for CC limit availed from bank in Indian rupee. Assessing Officer’s objection regarding higher level of stock of imported items was satisfactorily met by the assesee. Relevant international transactions of assessee company with its foreign holding company were accepted by TPO in his transfer pricing analysis. Assessing Officer was not justified in disallowing expenditure towards usance interest and BLC interest. (Related Assessment years 2002-03 to 2004-05) - [ITO v. Ricoh India Ltd. (2014) 98 DTR 435 (ITAT Mumbai)]

Deduction of interest on borrowed capital – Section 36(iii)

It was held that interest deduction can be claimed even when the monies borrowed has been given to its sister concern as an interest free loan if it was commercially expedient to do so. The word commercial expediency includes such expenditure as a prudent business man incurs for the purpose of its business. The Supreme Court held that if the directors of the sister concern utilize the amount advance to it by assessee for its personal benefit, obviously it cannot be said that such money was advance as a measure of commercial expediency.  However, when the holding company has deep interest in its subsidiary and the loan advance is used the for the purpose of the business of the subsidiary, then the assessee would ordinarily be entitled to deduction on its borrowed loans.   The Supreme Court further held that the decisions relating to section 37 will also be applicable to section 36(i)(iii) as the expression “for the purpose of business” is same. - [S. A. Builders Ltd. v. CIT (A) (2007) 288 ITR 1 (SC)]

Interest on borrowed capital - Interest free advances to sister concerns, held not allowable as business expenditure

Facts regarding borrowings made immediately before the loans to subsidiaries were granted noticed by the Assessing Officer would establish a direct nexus with the borrowings made by the assessee and loans granted by the assessee. If interest free loans were not made, then at least to the extent the assessee need not have borrowed from other entities. Borrowals purportedly made for meeting the day to day needs of business, to that extent could have been met from internal resources itself. Such funds then cannot be taken to be having been used for or invested in the business. To that extent there cannot be any claim for business expenditure. (Related Assessment year 1992-93) - [CIT v. Harrisons Malayalam Ltd. (2012) 210 Taxman 115 : 76 DTR 335 (Ker)]

The interest paid on borrowed sums of money to discharge income-tax liability is not deductible. [East India Pharmaceuticals Works Ltd. v. CIT (1997) 224 ITR 627 : 91 Taxman 185 (SC)]

Cessation of business – No deduction

It was held that no deduction can be claimed in respect of interest on borrowings. - [Assam Biscuit Mfg. Co Ltd. v. CIT (1990) 185 ITR 535 (Gau)]

Pre-commencement of business – No deduction

It was held that no deduction under said provisions can be claimed. - [Ritz Continental Hotels Ltd. v. CIT (1978) 114 ITR 554 (Cal)]

Sham transactions – Provisions have no application

If the object of the borrowing is just sham and proved itself, the provisions have no application. – [Govan Bros. v. CIT (1963) 48 ITR 930 (All)]