Learning from reported cases: Interest paid to close relatives, though similar to bank loan interest but more than paid to third parties- excess disallowed. – Lacking in preparation and presentation of the case.

[DEV KUMAR KOTHARI]

Interest paid to close relatives, though similar to bank loan interest but more than paid to third parties- excess disallowed. – Lacking in preparation and presentation of the case.

Case discussed:

Shri Rashmikant Venilal Mehta Versus The Deputy Commissioner of Income Tax, Chennai And Vice-Versa- 2018 (2) TMI 1364 - ITAT CHENNAI

General discussions:

Capital is borrowed for business purposes from banks, close relatives, friends, associates and outsiders also.

In each case of money lender there can be different terms and conditions as to rate of interest, periodicity of payment, security, post-dated cheques, promissory notes issued and re-payment etc.

Flexibility in payment of interest and re-payment of loan is also an important factor.

In case of bank, interest is charged by bank every month. Generally loans taken for business, from banks are secured loan.

In case of third parties, the terms and conditions are more stringent than in case of loan taken from close relatives.

In case of loans taken from close relatives also the terms and conditions are negotiated. However, in relation to payment of interest and re-payment of loan borrower can expect much more flexibility and sympathetic considerations from lender, in case need arises.

Comparison of all terms and conditions and privileges is desired:

When we need to compare relative terms and conditions, we need to compare all terms and conditions and aspect of flexibility. A loan taken from close relative can be considered as a safer loan in comparison to loan from others. This is because, in case of difficult times in business, one can expect more co-operation and more flexibility about payments to be made.

The level of comfort is also, therefore, higher in case of loan taken from close relatives.

Loans from close relatives are for long period:

Generally loans taken from close relatives is for  open term or tenure which is considered flexible term.

Close relatives, while granting loan, also act in a team manner.

Therefore, a higher rate of interest can be justified.

  Case of  Shri Rashmikant Venilal Mehta (supra.)

As noted by the Tribunal in this case assesse had taken loans from bank on interest @ 17.25% was charged, however, on  taking into account all direct and indirect costs cost of borrowing was about 21% per annum.

Loan from third parties were availed at interest rate of 12% PA.

Loan from close relatives were availed at interest rate of 18% PA.

On reading of the order we do not find other terms and conditions.

Comparison has been made only on the basis of rate of interest. Even fact about when loans were taken is not known. If a loan was taken in past, and rates were negotiated earlier, then that factor also need to be considered.

Comparison has also not been made about amount of loans taken from close relatives vis a vis loans taken from third parties.

It seems that the assesse did not provide all relevant details to counsel and counsel also did not made an in-depth study and both were  over confident that in view of finance cost for loan taken from bank, rate of interest of 18% paid to close relatives was reasonable.

Order of Tribunal:

Tribunal confirmed assessment order and order of CIT(A) and thus disallowance of interest paid , in excess of 12% to close relatives has been upheld.

The reasons for such decision are as follows:  

• There was no reason for paying higher rate of interest to the close relatives.
• That the interest charged by the bank at the relevant point of time is not relevant.
• The rate of interest charged by bank may be relevant in case the assessee has not borrowed loan from third parties.
• When the loan was availed from third parties at the rate of 12%, there is no reason why the assessee preferred to borrow loan from close relatives and paid interest at the rate of 18%.
• Therefore The Tribunal expressed opinion that the CIT(Appeals) has rightly found that the excess payment has to be disallowed.

Lesson:More in-depth analysis was required:

Author feels that the assesse must have made in-depth analysis of all terms and conditions, past history, qualitative comparison of loans taken from close relatives vis a vis other loans.

Average rate of finance was also not brought to the notice of Tribunal. Average rate is likely to be higher because loan from bank and interest paid to bank is likely to be major component.

Even if we take simple average, the rate of interest (including other costs) to bank is 21% and others is 12 %. Simple average workout 16.5%. Therefore, rate of 18% paid to close relatives cannot be called excessive because of qualitative advantages in case of loans from close relative in comparison to bank and others.    

Past history about interest paid and allowed was also an important aspect which seems to have been missed by counsel.

Tribunal has not taken a reasonable view in light of ground realities:

With due respect to counsels for assesse author feels that more information and evidences should have been brought to the notice of honourable Tribunal.

With due respect to the members, author also feel that ground realities must have been considered and mere comparison of rate of interest paid to third parties vis a vis close relatives is a bit unreasonable. Tribunal could have at least allowed interest which work out as average cost of funding from banks and other third parties.