2005 (4) TMI 546 - HC - Income Tax

Disallowed expenditure of interest paid on debenture - Entire Interest paid as on date of allotment of debenture - Whether, the ITAT was right in law in holding that the assessee was not entitled to the deduction of interest paid by it on the debentures issued by it ? - HELD THAT - In the present case, it is an admitted position between the parties that, the payer company is carrying on business, it had borrowed capital by way of debenture issued for such business, and it had paid interest in respect of such capital borrowing. The payer company, therefore, has satisfied all the conditions necessary for invoking Section 36(1)(iii) of the Act and is thus, entitled to deduction of interest paid while computing its income from profits and gains of business. The contention raised on behalf of Revenue that interest would accrue only on a day-to-day basis does not merit acceptance in light of the fact that the parties have specifically provided for a particular rate of interest as well as the manner of payment. Once that is so, it is not possible to rewrite the same and state that interest would accrue, or liability to pay interest would accrue over the entire period of debenture i.e. six years. If this is not possible, the entire interest payment made in the initial year of allotment cannot be artificially spread over the period of six years for the purposes of allowing deduction. Thus, the Tribunal was not right in holding that the assessee i.e. the payer company was not entitled to deduction of interest paid by it on the debentures issued by it in the assessment year under consideration. At this stage, it is stated by learned Advocate for the appellant company that pursuant to the impugned order of Tribunal if any claim is made by each of the payer companies in any of the subsequent years on the basis of proportionate payment in accordance with the order of the Tribunal, the respective assessee companies shall have no objection if the claims which might have been allowed are withdrawn and additions made to the said extent considering that the entire claim of deduction of interest paid is allowed in Assessment Year 1995-96.

Issues Involved:
1. Taxability of interest income in the hands of the individual assessee.
2. Deduction of interest paid by the company on debentures.
3. Applicability of Section 36(1)(iii) and Section 43(2) of the Income-tax Act, 1961.
4. Interpretation of terms of debenture contracts and their impact on tax treatment.
5. Relevance of the Supreme Court decision in Madras Industrial Investment Corporation Limited.
6. Proper accounting treatment under mercantile system of accounting.

Issue-wise Detailed Analysis:

1. Taxability of Interest Income in the Hands of the Individual Assessee:
The individual assessee invested in debentures and declared only proportionate interest income for the accounting period. The Assessing Officer added the entire interest income, arguing that the full amount had been received during the relevant period. The CIT (Appeals) upheld this addition, stating that the entire interest income had accrued and was received during the accounting period. The Tribunal, however, held that only proportionate interest was taxable, relying on the principles of commercial accounting and the Supreme Court decision in Madras Industrial Investment Corporation Limited. The High Court disagreed, stating that the entire interest income was taxable in the year of receipt, as per the terms of the debenture contract.

2. Deduction of Interest Paid by the Company on Debentures:
The payer company claimed a deduction for the total interest paid on debentures, arguing that it was a revenue expenditure under Section 36(1)(iii) of the Income-tax Act. The Assessing Officer disallowed the majority of the interest, allowing only a proportionate deduction. The CIT (Appeals) and the Tribunal upheld this proportionate allowance, applying the Supreme Court's decision in Madras Industrial Investment Corporation Limited. However, the High Court ruled that the company was entitled to deduct the entire interest paid in the year of payment, as it had fulfilled its contractual obligations and the payment was made as per the terms of the debenture.

3. Applicability of Section 36(1)(iii) and Section 43(2) of the Income-tax Act, 1961:
Section 36(1)(iii) allows a deduction for interest paid on capital borrowed for business purposes. The High Court noted that the payer company had satisfied all conditions under this section, as it had borrowed capital through debentures and paid interest accordingly. Section 43(2) defines 'paid' to include actual payment or incurring of liability according to the accounting method employed. The High Court held that the payer company had both incurred the liability and made the actual payment, thus meeting the requirements of Section 36(1)(iii).

4. Interpretation of Terms of Debenture Contracts and Their Impact on Tax Treatment:
The debenture contract specified that interest was payable up front on the date of allotment. The High Court emphasized that the terms of the contract must be adhered to and cannot be rewritten by any third party, including the Revenue or the Court. The Court ruled that the entire interest payment made on the date of allotment should be allowed as a deduction in the year of payment, as per the contract terms.

5. Relevance of the Supreme Court Decision in Madras Industrial Investment Corporation Limited:
The Revenue relied on this decision to argue for proportionate deduction of interest. However, the High Court clarified that this decision pertained to Section 37(1) of the Act, which deals with general business expenditure, and not to Section 36(1)(iii). Since the payer company's claim was under Section 36(1)(iii), the principles of Section 37(1) were not applicable. The Court thus ruled in favor of allowing the entire interest deduction in the year of payment.

6. Proper Accounting Treatment Under Mercantile System of Accounting:
The individual assessee argued that under the mercantile system, only proportionate interest should be taxable. The High Court refuted this, stating that even under the mercantile system, cash receipts must be considered for taxable income. The Court noted that the entire interest had been received during the relevant period and thus was taxable in that year. The Tribunal's reliance on the Supreme Court decision was misplaced, as it did not apply to the facts of this case.

Conclusion:
The High Court ruled in favor of the payer company, allowing the entire interest deduction in the year of payment. It also held that the entire interest income was taxable in the hands of the individual assessee in the year of receipt. The appeals were allowed, and the Tribunal's orders were set aside. The Court emphasized adherence to the terms of the debenture contract and clarified the correct application of relevant sections of the Income-tax Act.

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