2013 (3) TMI 13 - HC - Income Tax

Disallowance of equivalent of interest on borrowed capital which was debit balances existing in the names of directors and their family members - ITAT deleted the addition - Held that - It is established that the borrowed funds on interest will have to be utilized only for the purposes of business. But in the case in hand, it was not done so. Had the Directors or relatives have repaid the loan to the Company, certainly proportionate borrowing liability might have been reduced. It makes no difference that the loan was borrowed in the earlier assessment years. The principle of res judicata is applicable as per the ratio laid down in CIT vs. Brij Lal Lohiya 1971 (7) TMI 13 - SUPREME COURT . Further, in the case of Radha Swami Satsang vs. CIT 1991 (11) TMI 2 - SUPREME COURT it was observed that where a fundamental aspect permitting through the different assessment years had been found as a fact, one way or the other and parties have allowed that decision to be sustained by not challenging the order, it would not be at all to appropriate to allow the decision to be changed in the subsequent orders, but in the instant case, it is evident that borrowers i.e. Director and relatives have made no attempt to repay the amount. They utilized the interest free advances for their personal purposes, which has no connection with the business activity of the Company. In other words, the funds were utilized for the purpose of non-business purposes. At the same time, a huge amount has been borrowed @ 20% interest. No attempt was made to reduce the said borrowing. 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. The business interest of the assessee has to be distinguished from the personal interest of its directors or partners, as the case may be. Thus there has to be a nexus between the advancing of funds and business interest of the assessee. 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 and working solely in the interest of the assessee, would have extended such interest free advances. Some business objective should be sought to have been achieved by extending such interest free advance when the assessee itself is borrowing funds for running its business. It may not be relevant as to whether the advances have been extended out of the borrowed funds or out of the mixed funds, which included borrowed funds. The test to be applied in such cases is not the source of the funds but the purpose for which the advances were extended. In the light of above discussion,impugned order passed by the Tribunal is set aside and restored the order passed by the assessing officer in this regard for the assessment years mentioned above - against assessee.

Issues Involved:
1. Deletion of disallowance of equivalent interest on borrowed capital due to debit balances of directors and their family members.
2. Justification for deleting disallowance of interest on borrowed capital based on prior assessment years.
3. Allowance of interest claimed by the assessee on borrowed funds linked to non-business withdrawals.
4. Consideration of personal withdrawals by directors' ascendants as adverse evidence for disallowance of interest.

Detailed Analysis:

Issue 1: Deletion of Disallowance of Equivalent Interest on Borrowed Capital
The High Court examined whether the Income Tax Appellate Tribunal (ITAT) was justified in deleting the disallowance of equivalent interest on borrowed capital due to debit balances existing in the names of directors and their family members. The department argued that the omission by the assessing officer in previous years (1991-92 and 1992-93) should not preclude the officer from adding back the same based on available material. The Court noted that the interest-free advances were used by directors for personal purposes, including constructing residential houses not used for company business. The Court concluded that the borrowed funds should be utilized solely for business purposes, and the directors made no effort to repay the loans, thus justifying the disallowance of interest.

Issue 2: Justification for Deleting Disallowance Based on Prior Assessment Years
The Court addressed whether the ITAT was justified in deleting the disallowance of interest on borrowed capital merely because it was not added back in preceding years. The Court emphasized that each assessment year is a distinct unit, and the principle of res judicata does not apply to income tax proceedings. However, the Court also acknowledged the rule of consistency, stating that if a fundamental aspect permeates through different assessment years and has been found correct, it should not be changed in subsequent years without justifiable grounds. The Court found no change in circumstances or new material to warrant a different view and upheld the disallowance.

Issue 3: Allowance of Interest Claimed by the Assessee
The Court examined whether the ITAT was justified in allowing the interest claimed by the assessee on borrowed funds despite evidence linking these funds to non-business withdrawals. The department argued that the company borrowed funds at a high interest rate (20%) while allowing directors to use interest-free advances for personal purposes. The Court referred to Section 36(1)(iii) of the Income Tax Act, which allows deduction of interest on capital borrowed for business purposes. The Court found that the borrowed funds were not used for business purposes, and the directors made no attempt to repay the loans, thus justifying the disallowance of interest.

Issue 4: Consideration of Personal Withdrawals by Directors' Ascendants
The Court considered whether personal withdrawals by the directors' ascendants should be construed as adverse evidence for disallowance of proportionate interest on borrowed funds. The department argued that the personal withdrawals had no connection with the company's business activities. The Court noted that the directors and their relatives used the advances for personal purposes, and the company borrowed funds at a high interest rate, resulting in losses. The Court concluded that the funds were utilized for non-business purposes, justifying the disallowance of interest.

Conclusion:
The High Court set aside the ITAT's orders and restored the assessing officer's disallowance of interest on borrowed funds for the assessment years in question. The Court emphasized that borrowed funds must be utilized solely for business purposes, and personal use by directors and their relatives without repayment efforts justified the disallowance of interest. The appeals filed by the department were allowed.

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