2006 (12) TMI 82 - SC - Income Tax

Borrowed amount advanced by assessee to his sister concern as interest free loan held that interest on such loan will be allowable as deduction u/s 36(1)(iii), only if such loan has been advanced for purpose of business as a measure of commercial expediency.

Summary

Issues Involved:
1. Disallowance of interest on borrowed funds advanced to a subsidiary company.
2. Determination of commercial expediency in advancing interest-free loans.
3. Correct approach to interpreting Section 36(1)(iii) of the Income Tax Act, 1961.

Detailed Analysis:

Issue 1: Disallowance of Interest on Borrowed Funds Advanced to a Subsidiary Company

During the assessment year, the Assessing Officer observed that the assessee had transferred Rs. 82 lakhs to its subsidiary, M/s. SAB Credits Limited, from a cash credit account with a huge debit balance. The officer disallowed a proportionate interest of Rs. 5,66,729/- on the grounds that the borrowed funds were diverted without charging interest. The Commissioner of Income Tax (Appeals) partially accepted the assessee's claim, reducing the disallowance to interest related to Rs. 18 lakhs, which had a clear nexus with the borrowed funds. Both the assessee and the Revenue appealed to the Tribunal, which upheld the Assessing Officer's disallowance. The High Court also dismissed the assessee's appeal, affirming the Tribunal's findings.

Issue 2: Determination of Commercial Expediency in Advancing Interest-Free Loans

The High Court and the Tribunal failed to consider whether the interest-free loan to the subsidiary was given as a measure of commercial expediency. The Supreme Court emphasized that the test is whether the loan was advanced for commercial expediency, not necessarily for earning profits. The Court highlighted that commercial expediency includes expenditures voluntarily incurred for business purposes, even if a third party benefits. The Tribunal and other authorities should have examined the purpose of the loan and its use by the subsidiary to determine if it was for commercial expediency.

Issue 3: Correct Approach to Interpreting Section 36(1)(iii) of the Income Tax Act, 1961

Section 36(1)(iii) allows deduction of interest paid on capital borrowed for business purposes. The Supreme Court noted that the expression "for the purpose of business" is broader than "for the purpose of earning income." The Court cited precedents, including Madhav Prasad Jatia vs. CIT, which held that the borrowed funds must be used for commercial expediency to qualify for deduction. The Court disagreed with the Bombay High Court's view that interest deduction is only allowed if the borrowed capital is used in the assessee's own business. Instead, the correct approach is to assess if the funds were advanced as a measure of commercial expediency.

Conclusion:

The Supreme Court allowed the appeals, setting aside the judgments of the High Court, Tribunal, and other authorities. The matter was remanded to the Tribunal for a fresh decision, focusing on whether the interest-free loan was given for commercial expediency. The Court clarified that not all interest on borrowed funds advanced to a sister concern is deductible; it depends on the specific facts and circumstances. The authorities must evaluate the purpose and use of the loan from the perspective of commercial expediency. The decision only addressed the issue of interest deduction on borrowed funds, leaving other points dealt with by the authorities intact.