2025 (4) TMI 1126 - AT - Income Tax

Disallowance of interest due to some interest free advance given by the assessee - HELD THAT - The assessee has not paid any interest to partners capital and the balance in average is more than Rs. 200 lakh. The assessee received loans and advances from relatives to the extent of Rs. 1.79 lakh that too without interest to the assessee. Some more loans and advances were received by the assessee against which no material shows that the assessee has paid interest. Assessee s factory is situated at Burhanpur which constructed on the land which belongs to Shri G.N. Bhattad who is one of the partners in assessee s firm. In the interest of assessee s business the money has been paid to Shri G.N. Bhattad failing which Shri G.N. Bhattad would have forced the assessee to vacate the land. Shri G.N. Bhattad is said to be father of one of the partners and also the real uncle of the partners of the assessee firm. Therefore the money being rotated was within the family members of the assessee firm. Since the assessee has not paid any interest on capital of approx. Rs. 200 lakh the amount of Rs. 44.27 lakh or average balance of Rs. 67.47 lakh is hereby treated as capital advance and treating the same as interest paid on advance is not correct. Accordingly AO was not justified in making addition on account of upholding the addition made by the AO on account of disallowance of interest due to some interest free advance given by the assessee is not justified. Decided in favour of assessee.

1. ISSUES PRESENTED and CONSIDERED

The core legal questions considered in this appeal are:

(a) Whether the learned Commissioner of Income Tax (Appeals) was justified in confirming the disallowance of interest amounting to Rs. 7,63,780 made by the Assessing Officer on account of interest-free advances given by the assessee to a related party;

(b) Whether the interest-free advances given to the landlord, who is also a related party, constitute a business expedient or a diversion of interest-bearing funds for non-business purposes;

(c) Whether the assessee's contention that no new interest-free advances were given in the year under consideration and that the advances should be treated as capital advances or withdrawals of capital is sustainable;

(d) Whether the disallowance under section 36(1)(iii) of the Income Tax Act, 1961 ("the Act") is applicable in the facts and circumstances of the case.

2. ISSUE-WISE DETAILED ANALYSIS

Issue (a) and (b): Justification of disallowance of interest on interest-free advances given to related party

Relevant legal framework and precedents: Section 36(1)(iii) of the Income Tax Act, 1961 disallows interest expenditure incurred on borrowed funds used for non-business purposes. Precedents cited by the learned CIT(A) include ITAT decisions where disallowance was upheld if interest-bearing funds were diverted for non-business use. Conversely, relief has been granted where advances were made from interest-free funds or capital and no diversion of interest-bearing funds was established.

Court's interpretation and reasoning: The Assessing Officer found that the assessee had given substantial interest-free advances to Shri Govind N. Bhattad, a related party and landlord of the factory premises, without charging any interest. The AO observed that the firm paid interest @12%-15% on unsecured loans taken from other creditors, but did not charge interest on these advances. The AO calculated interest of Rs. 7,62,780 on the amount of advances given to Shri Govind N. Bhattad, treating the funds as borrowed funds diverted for non-business purposes, and disallowed the corresponding interest expenditure under section 36(1)(iii).

The assessee contended that the advances were made out of its own capital (aggregate partner capital exceeding Rs. 2 crores), and that the advances were business expedient to avoid eviction from the factory premises owned by Shri Govind N. Bhattad. The advances were interest-free by mutual agreement, given the nominal rent paid and the relationship between the parties. The assessee also argued that no new interest-free advances were made in the year under consideration and that the advances should be treated as capital advances.

The Assessing Officer rejected these contentions, holding that the assessee failed to establish a nexus between the capital funds and the advances given, noting that the capital was invested in non-productive assets and the firm borrowed interest-bearing funds from other creditors. The AO also rejected the contention that the advances were linked to the rental arrangement, observing that rent was paid at Rs. 7,000 per month and no agreement existed for reduced rent or interest-free advances.

The learned CIT(A) upheld the AO's disallowance, relying on the absence of evidence to prove that interest-bearing funds were not diverted and rejecting the assessee's reliance on certain ITAT precedents on the facts of the case.

Key evidence and findings: The ledger account showed a reduction in advances from Rs. 82.86 lakhs to Rs. 44.26 lakhs during the year. The assessee's capital balance was approximately Rs. 1.7 crores, with no interest paid on partners' capital. Loans and advances were also received by the firm, some interest-free. The factory was situated on land owned by Shri Govind N. Bhattad, who was related to the partners. The assessee claimed the advances were made to avoid eviction and to enable the business to continue on the premises.

Application of law to facts: The Tribunal observed that since the assessee had not paid any interest on partners' capital and the capital balance was substantial, the advances to Shri Govind N. Bhattad could be treated as capital advances rather than diversion of interest-bearing borrowed funds. The familial relationship and business expediency supported the assessee's contention. The Tribunal also noted that the amount of advances was rotated within family members and that the assessee had received interest-free loans from relatives. Therefore, the disallowance of interest paid on borrowed funds to the extent of the interest-free advances was not justified.

Treatment of competing arguments: The AO and CIT(A) emphasized the absence of direct evidence linking the advances to capital funds and relied on the fact of interest-bearing funds being used for non-business purposes. The assessee emphasized the substantial capital base, the familial relationship, the business necessity of the advances, and absence of interest on capital as supporting factors. The Tribunal accepted the assessee's arguments as more consistent with the facts and law.

Conclusions: The Tribunal held that the Assessing Officer was not justified in making the addition on account of disallowance of interest under section 36(1)(iii) as the advances were effectively capital advances and part of the business arrangement with a related party landlord. The disallowance was therefore set aside.

Issue (c): Whether no new interest-free advances were given in the year under consideration, and the effect thereof

The assessee contended that the advances were made in earlier years and no fresh interest-free advances were given during the year under consideration. The advances should thus be treated as capital advances or withdrawals of capital rather than loans attracting interest disallowance. The AO did not accept this contention, focusing on the fact that interest-bearing funds were used for non-business purposes regardless of timing of advances.

The Tribunal noted the absence of any fresh advances in the year and the substantial capital base of the firm, concluding that the advances were part of a long-standing arrangement and should be treated as capital advances. This further supported the rejection of the disallowance.

Issue (d): Applicability of section 36(1)(iii) of the Income Tax Act, 1961

Section 36(1)(iii) disallows interest expenditure on borrowed funds used for non-business purposes. The AO applied this provision, disallowing interest paid on loans to the extent of interest-free advances given to Shri Govind N. Bhattad. The Tribunal found that the advances were not made out of borrowed funds but from capital funds and were business expedient, thus not attracting disallowance under this section. The Tribunal emphasized the need for a clear nexus between borrowed funds and non-business use to justify disallowance, which was absent in this case.

3. SIGNIFICANT HOLDINGS

"The amount of Rs. 44.27 lakh or average balance of Rs. 67.47 lakh is hereby treated as capital advance and treating the same as interest paid on advance is not correct."

"Since the assessee has not paid any interest on capital of approx. Rs. 200 lakh, the money being rotated was within the family members of the assessee firm."

"The Assessing Officer was not justified in making addition on account of upholding the addition of Rs. 7,63,780, made by the Assessing Officer on account of disallowance of interest due to some interest free advance given by the assessee is not justified."

Core principles established include:

- Interest disallowance under section 36(1)(iii) requires a clear nexus between borrowed funds and their diversion for non-business purposes.

- Interest-free advances given from capital funds, especially within related parties and for business expediency, cannot be treated as diversion of interest-bearing funds.

- Absence of interest on partners' capital and substantial capital base supports the treatment of advances as capital advances rather than loans attracting interest disallowance.

- Familial relationships and business necessity are relevant factors in determining the nature of advances and applicability of interest disallowance.

Final determination: The Tribunal allowed the appeal, set aside the addition of Rs. 7,63,780, and held that the disallowance under section 36(1)(iii) was not justified on the facts of the case.

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