Interest on borrowed capital unjust check on liberal deduction vide proviso to section 36(1)(iii).

[C.A. DEV KUMAR KOTHARI]

Deduction of interest was liberally allowed  while computing business income. And it is so necessary also because merely because some assets are held and carried in stock or as capital work-in- progress does not add to the value of assets. Expansion being a necessity to survive in competition and to maintain viability interest on capital borrowed for expansion should also allowed. This helped profitable assessees to expand business and also save tax. However, a new proviso was been inserted w.e.f.  01.04.2004 to provide that interest on capital borrowed for extension of business by way of acquiring assets shall not be allowed for the period up to putting to use the assets

The proviso is a case of bias and  power show. It is to overrule well settled legal position by way of several judicial pronouncements. This tendency of bureaucracy ( unfortunately exercised through parliament) is not proper as it renders, to a great extent, inoperative the valuable judicial system of our country. 

Liberal provisions and approach- a peek in past:

Liberal provision were found in section 36(1)(iii) which was further liberalized by judicial pronouncements. As per the provision, and its interpretation up to assessment year  2003-04 requirements to be eligible for deduction of interest paid were:

(a)  capital should have been borrowed,

(b)  the borrowing should be for the purpose of business or profession.

The purpose of business may be to meet revenue costs or to meet capital costs - there was no difference. Thus interest on capital borrowed  for acquisition of new plant and machinery or construction of buildings for the purpose of an existing business as well as for its expansion  was allowed. 

Amendment from assessment year 2004-05:

By the Finance Act, 2003  a proviso has been added to the section 36(1)(iii).  The purpose of the proviso to disallow interest on capital borrowed for acquiring assets for the purpose of extension of business or profession. After this insertion the effective part of whole of the relevant section reads as follows:

Other deduction.

                    36.(1) The deductions provided for in the following clauses shall be allowed in respect of the matters dealt with therein, in computing the income referred to in section 28—

                      (iii) the amount of the interest paid in respect of capital borrowed for the purpose of the business or profession.

           Provided that any amount of the interest paid, in respect of capital borrowed for acquisition of an asset for extension of existing business of profession ( whether capitalized in the books of account or not); for any period beginning from the date on which the capital was borrowed for acquisition of the asset till the date on which such asset was first put to use, shall not be allowed as deduction.  

{Explanation. -  xxx - relevant in case of societies only hence not discussed}

The conditions, as applicable prior to amendment shall have to be satisfied even from assessment year 2004-05. However, from 01.04.2004 certain amount of interest expenses will be disqualified for deduction in view of the proviso. An analysis of  disabling provision is given below:

( a ) capital should be borrowed for acquisition of an asset,

(c)   acquisition should be for extension of  existing business or profession,

(d)   accounting treatment - capitalization or not, will make no difference,

(e)   interest for the period from the day  on which capital  was  borrowed to the date on which the asset is put to use will not be allowed as deduction.       

The word used are  'for acquisition of an asset', thus the asset can be capital asset or other asset. However, later on the words used are 'such asset was first put to use'. The harmonious construction would therefore lead to the conclusion that the asset in question should be a capital asset and not a stock-in-trade or inventory item. However, one should not be surprised even if  revenue authorities take view that an item of stores or consumable spare parts are also assets and if they are acquired in connection with extension or expansion of business then interest shall not be allowed till such asset is put to use.,

Extension of existing business:

In an existing business some extension or expansion is a  normal feature. Substantial expansion or new set up is different thing but normal growth in existing business should be considered as a normal phenomenon. Therefore, capital borrowed for normal extension or expansion should not be hit by the proviso. In the context of additional depreciation we find that  earlier expansion of capacity by 25% was  earlier considered as substantial expansion as per Section 32 (1) (iia) The Finance (no.2) Act  2004  reduced this requirement to  10%. To promote purpose of incentive}

For the purpose of the proviso under discussion there is no definition of extension or expansion. However, as per normal understanding in commercial world, an expansion at a time which leads to increase in capacity by 25% or more is considered as substantial expansion .Therefore, one can say that  unless the capacity is increased by 25% , it cannot be said that there is extension of business in an existing business.

As noted above the disabling provision will apply only if there is an extension of existing business.

Extent of expansion:

The term extension has not been defined, therefore, it will cover normal circumstances which in business circles are regarded as extension of business. The term 'extension', has its synonymous like additional room, addition, annex, wing, expansion etc. Therefore, creation of additional rooms, additional facilities, additional machines, expansion of business etc. shall be covered by the term extension of business. A clarity in this regard is desirable.

Expansion versus replacement:

Replacement of facilities will not be equal to extension. Suppose in a paper mill one boiler is to be replaced. Capital is borrowed for placing order and execution of the project for new boiler. This will take about 10-12 months period. Once the new boiler becomes operational the old one will be discarded. This is a case of replacement of an existing machine and not a case of expansion. Therefore, capital borrowed for placing orders, doing civil work and all other matters till installation of new boiler will be for the purpose of existing business and will not be for extension of the business. According the interest will be fully allowable and the proviso will not apply.

Let us take another case, A Cost  Accountant is in practice for ten years. He want to do the following:

A.    He want to replace his tenanted office premises and staff quarters with own premises. He borrows capital for house building, construct building, and then shift his office and staff quarters to own building and surrenders his tenancy. This is not a case of extension of profession but a case of making alternative arrangements for office and staff quarters.

B.    After shifting to new building, he wants to employ additional Cost Accountants and other staff. And for that purpose he constructs more chambers and quarters - this will be a case of extension or expansion of business. Therefore, capital borrowed for this purpose will be subject to the said proviso.  

Efficiency improvement is not extension:

Mere increase in efficiency and productivity is not for extension of business or profession , some increase in capacity being incidental to increase of productivity will not amount to extension. For example by installing automatic machines in lieu of semi automatic machines, or by installing new generation equipments in place of old ones one will get better productivity and efficiency and reduced cost. However, this will not be a case of extension. Example:

A Cost Accountant make replacement of equipments, telephone systems, computers with new technology to improve his efficiency and productivity. There is no case of extension or expansion of profession. The same number of people are working. This is not a case of extension of profession but making the professional activities more convenient and effective. Hence interest on capital borrowed for these purpose will be fully allowable.

A Sugar Mill replaces 50 year old power generation equipments with new equipments with a view to improve thermal efficiency, reduce labor cost, reduce break downs, and also to align the power generation equipments more conveniently with other machinery. This is not a case of extension but improvement by replacement. Therefore, capital borrowed and used during the period of making new equipments operational (say about two years) will be fully allowable.

A textile mill replaces some machines with improved new machines to keep up with the requirement of the market. Entire replacement cost can be considered as revenue costs. However, as per practice the assessee show additions of machines as new addition and discarding of old machines as deductions from fixed assets schedule. This case will also be increasing efficiency by replacement and therefore full amount of interest on capital borrowed for the purpose shall be allowable as there is no case of extension.

In several cases it has been held that replacement of machines for improvement in efficiency and to carry business more effectively is on revenue account and not  on capital account.

Capital borrowed for expansion of existing business but not for acquisition of assets shall not be affected:

 Some times capital may be borrowed for the purpose of expansion but not necessarily for  acquiring any asset. In that case the proviso shall not be applicable. Some examples of such expenses are as follows:

(1)  traveling expenses in connection with new products, higher production,

(2)  advertisement expenses in connection to expanded production, or new products,

(3)  advertisement expenses for new branches,

(4)   consultations in connection with expansion,

(5)  Taking tenanted premises for new branches, The tenanted property is not an asset.

If the payments for such expenses are made out of borrowed capital, the proviso shall not be applicable and interest shall be fully allowable.

Creation of assets without extension:

In practical life we find that business is carried with inadequate resources. For example due to inadequacy of equipments some work is out sourced. Some times equipments are taken on rent. In some cased we find that housing for labor, staff and executives is not sufficient- many are taken on rent. In such cases if capital is borrowed to acquire new assets to meet deficiencies or to have own assets instead of rented assets, the case will not be for extension of business. This will be case of creation of required assets for the existing business. Therefore, the proviso shall not be applicable.

Same unit:

It seems that expansion of business within the existing unit will not be hard hit. In case of existing unit the capital assets purchased are usually issued to the shop floor immediately because the new assets are to be aligned with old ones. The process and steps involved in designing foundations, aligning with existing assets etc amount to put to use. In any case in such cases gestation period shall be very nominal. 

New units or new place of business:

Adding new manufacturing units or offices may attract the disability of the proviso. Suppose an assessee is manufacturing sugar at unit A and now set up new unit B. Capital borrowed for the purpose of new unit shall be hit by the proviso and interest for the period up to commencement of production may be disallowed.

All carrying costs of assets even if for expansion should also be allowed:

As discussed earlier holding and carrying assets in the course of business does not add to the value of assets. Holding and carrying of such assets are normal features and steps required in the course of business. Merely carrying a capital asset does not amount to acquiring or improving the asset. Therefore all carrying costs like charges for storage, warehousing, safety and security, insurance, and interest on capital borrowed should be allowed as normal business and revenue expenses.

Earlier interest paid on capital borrowed for expansion of business or profession was allowed. That represented computation of real income of the assessee. Interest on capital borrowed for new unit which is extension of existing business was also allowed. The allowance is totally justified and there is nothing wrong in it. In fact by adding interest in the value of assets any new asset is not created. For example suppose an assessee agreed to purchased a set of machines of Rs. five crores and paid Rs. two crores, as advance, out of  borrowed  capital. The machines were in the process of installation after   erection and transportation from the factory of vendors. Due to certain reasons the project has to be abandoned. The machines are returned. The assessee will not get any credit for the interest which he paid on capital borrowed for making advances. In fact he may loose out of the agreed price also , because the vendor shall deduct his overhead costs and profit element on return of the machines.

Similarly if the machines are installed in short duration the interest to be capitalized will be less where as if the process prolongs, the interest burden will be higher. But it is true that the interest element will not add to the price or market value of the asset. If one wants to sell such assets, he will not get back the element of interest burden.

 This shows that increasing the value of assets by the amount of interest will un-necessarily inflate the cost of the assets.

 The capitalization of interest in new projects can only be justified and not in case of normal expansion of existing business. 

It is likely that the new proviso shall create lot of  un-necessary litigation.

 Amendment is prospective:

In CIT V Hindustan Zinc Ltd (2004) 269 ITR 369 (Raj.) it has been held that the amendment of section 36 (1)(iii) is w.e.f. 01.04.2004 and therefore it will not apply to earlier years. Prior to amendment  if capital is borrowed for the purpose of the business or profession, interest shall be allowed, even if the assets have not been put to use (  off course in an existing business).

Power show by bureaucracy through parliament:  

The legal position was well settled by several judgments of the supreme court and high courts. The disallowance of interest goes against spirit of the Income Tax Act, which has all along been liberal towards capital expenditure. For that purpose accelerated depreciation allowance, initial depreciation, additional depreciation, investment allowance , development rebates were allowed from time to time. Thus , disallowance of interest as per the proviso is exactly not in tune with the fiscal policy. It appears  to be a case of power show  to overcome judicial pronouncements in favor of assessees.  As in our country, hardly any discussion is made by members of parliament on such issues and implications are not understood properly, it can be said that such amendments are just show of power by bureaucracy particularly because the legislative intention has already been gathered by judiciary while interpreting law and there are no change in circumstances to incorporate such amendments. When the business and commercial situations remain the same, there is no justification of such amendments.

This can be illustrated by two examples as follows:

Fast project Ltd.	Normal Project Ltd	Remarks
01.01.2005 Orders placed and advance made Rs.20 Cr. Consideration fixed Rs.50 Cr. For quick delivery.	01.01.2005 Orders placed and advance made Rs.20 Cr. Consideration fixed at Rs.49 Cr.	Same
01.03.2005 Assets received	01.12.2005 Assets received.	Delay in receiving assets by nine months
01.03.2005 assets installed and put to use	01.06.2006 assets installed and put to use.	Delayed by eight months.

Fast projects adopted policy of fast implementation at crash cost. They incurred extra costs for the same but completed project just  in three months to avail opportunities. This is as per the theory of great Dhirubhai Ambani.

 The Normal Projects wanted to save some costs but were delayed in implementation of project. They took seventeen months in implementation of project though orders were placed at the same time.

In above cases, the Normal Projects have not added to the value of assets due to delay in implementation of project. But as per proviso the interest during the period of delay will  also be added in value of assets. This will unnecessarily increase the cost of assets and the balance sheet will reflect untrue results.