1996 (9) TMI 167 - AT - Income Tax

Summary

Issues Involved:
1. Entitlement to deduction of Rs. 19,17,643 disallowed by the Assessing Officer out of interest payments.
2. Whether the advances to the subsidiary company were made out of borrowed funds or profits of the company.
3. Applicability of section 36(1)(iii) of the Income-tax Act regarding interest payments on borrowed funds used for business purposes.
4. Validity of notional disallowance of interest.
5. Relevance of separate bank accounts for gross revenues in determining the use of borrowed funds.

Issue-wise Detailed Analysis:

1. Entitlement to Deduction of Rs. 19,17,643:
The primary issue was whether the assessee was entitled to a deduction of Rs. 19,17,643, which the Assessing Officer disallowed. The disallowance was based on the observation that the assessee had made interest-free loans to its wholly-owned subsidiary, Dharmayug Investments Ltd., while simultaneously incurring substantial interest payments on its borrowings. The Assessing Officer reasoned that if the funds had not been diverted as interest-free loans, the assessee could have saved interest expenses.

2. Advances to Subsidiary Company:
The assessee contended that the advances to the subsidiary were not made out of borrowed funds but from the profits of the company. The CIT (Appeals) and the Tribunal, however, found that the appellant company had drawn overdrafts from various banks and sustained heavy liabilities towards interest payments. The Tribunal noted that the assessee's claim of maintaining a separate bank account with a credit balance for making advances was an attempt to reduce tax liability, and such a device could not be approved.

3. Applicability of Section 36(1)(iii):
The assessee argued that the interest payments on borrowed funds should be allowed under section 36(1)(iii) of the Income-tax Act, as the borrowings were used for business purposes. The Tribunal, however, upheld the disallowance, stating that the advances were not trade advances and that the assessee did not have sufficient profits or own funds to make the advances. The Tribunal emphasized that the liability to taxation does not depend on the expedient of opening a separate bank account.

4. Validity of Notional Disallowance:
The Tribunal's order was recalled to adjudicate whether the notional disallowance of interest by the revenue was justified. The Tribunal found a contradiction in its earlier order, which had acknowledged that the borrowings were used for business purposes but still upheld the notional disallowance. Upon reconsideration, the Tribunal sustained the disallowance, citing the lack of sufficient profits or own funds to make the interest-free advances.

5. Relevance of Separate Bank Accounts:
The Tribunal rejected the assessee's argument that the advances were made from a separate bank account where gross revenues were deposited. The Tribunal held that such an arrangement was a "sleight of hand" and could not shield the assessee from the disallowance. The Tribunal referred to the decisions of the Bombay High Court and the Apex Court, which held that interest on borrowed capital is deductible only if the capital is used for business purposes and not for making interest-free advances to subsidiaries.

Conclusion:
The Tribunal dismissed the appeal, sustaining the disallowance of Rs. 19,17,643. The Tribunal concluded that the advances to the subsidiary were made out of borrowed funds, and the simple expedient of opening a separate bank account did not alter the fact that the assessee did not have sufficient non-interest-bearing funds to make the advances. The Tribunal's decision was consistent with the principles laid down by the jurisdictional High Court and the Apex Court regarding the use of borrowed funds for business purposes.