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Issues Involved:
1. Statutory Restriction on Capital Increase and Borrowing from Shareholders 2. Claim for Deduction of Interest Paid on Borrowed Capital 3. Nature of the Transaction: Loan vs. Distribution of Profits 4. Applicability of Section 10(2)(iii) and Section 10(2)(xv) of the Indian Income-tax Act Issue-wise Detailed Analysis: 1. Statutory Restriction on Capital Increase and Borrowing from Shareholders The company, a private limited entity with twenty-one shareholders, required additional funds due to large orders from military authorities. Due to statutory restrictions in 1944 on increasing capital, the company resolved to borrow from willing shareholders. The resolution allowed borrowing up to the paid-up value of their holdings in two installments, with a minimum interest rate of 6% or equivalent to the dividend rate recommended by the directors, whichever was higher. This resolution was unanimously passed, and by the end of March 1945, Rs. 75,000 was borrowed, with an additional Rs. 25,000 borrowed in 1948 under similar terms. 2. Claim for Deduction of Interest Paid on Borrowed Capital The company declared dividends of 10%, 20%, and 12% for the years 1947, 1948, and 1949 respectively, and paid corresponding interest rates on the borrowed sums. The company claimed the total interest paid as a deduction in computing its assessable income for the assessment years 1948-49, 1949-50, and 1950-51. The Department Authorities allowed only a 6% deduction, disallowing the excess interest. The Tribunal upheld this decision, stating that payments exceeding 6% were not justified on commercial grounds and were a device to distribute profits among shareholders. 3. Nature of the Transaction: Loan vs. Distribution of Profits The court examined whether the transaction was genuinely a loan or a disguised distribution of profits. It was established that the relationship between the company and the lending shareholders was that of debtor and creditor. The genuineness of the loans and payments was not disputed. The court concluded that the transaction was a loan, as the rights of the lenders were distinct from those of shareholders, and the interest paid was not a distribution of profits. The interest rate, though variable and linked to dividends, did not alter the nature of the transaction. 4. Applicability of Section 10(2)(iii) and Section 10(2)(xv) of the Indian Income-tax Act The court focused on whether the deduction claimed was permissible under Section 10(2)(iii) of the Act, which allows deductions for interest paid on capital borrowed for business purposes. The court found that once the genuineness of the loan and the payment of interest were established, there was no basis for limiting the deduction to a reasonable rate of interest as determined by the Tribunal. Section 10(2)(iii) did not provide for such a limitation. The court held that the interest payments were legitimate business expenses and should be fully deductible. Conclusion: The court concluded that the assessee's claim for deduction of the full amount of interest paid was within the scope of Section 10(2)(iii) and should have been allowed in full. The Tribunal's decision to limit the deduction to 6% was not justified. The court answered the referred question in the negative, in favor of the assessee company, and awarded costs of Rs. 250 to the assessee.
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