2012 (3) TMI 210 - AT - Income Tax

Disallowance of interest u/s 36(1)(iii) - the assessee gave interest free advances to its sister-concerns - AO observed that the assessee had not charged any interest on such advances whereas substantial amount of interest was paid on the funds borrowed - Held that - it is manifest that if the assessee has interest free funds as well as interest bearing funds at its disposal, then the presumption would be that investments were made from interest free funds available with the assessee (East India Pharmaceutical Works Ltd. v. CIT 1997 -TMI - 5570 - SUPREME Court . - it is observed that the interest free funds available at the disposal of the assessee are far in excess of the interest free loans advanced to the sister-concerns. Respectfully following the mandate of the Hon ble jurisdictional High Court in the case of Reliance Utilities & Power Ltd. (2009 - TMI - 32150 - HIGH COURT BOMBAY), we order for the deletion of the addition. Disallowance of interest u/s 40(a)(ia) for non deduction of TDS u/s 194A - held that - As per Section 145 income under the head Profits and gains of business or profession is to be computed in accordance with either cash or mercantile system of accounting regularly employed by the assessee considering a person to become entitled to deduction when liability in respect of any expenditure is incurred - in the mercantile system of accounting, deduction is allowed on accrual of liability - when the assessee is admittedly following mercantile system of accounting it cannot be disputed that the impugned interest expenditure has accrued within the year, it is to be allowed irrespective of the fact that assessee has passed necessary entries in the books of account or not - the assessee did not credit such interest in the books of account under any account - rather the deduction has been claimed on the basis of mercantile system of accounting straightway in the computation of income, without routing it through books of account, which has been held by us to be allowable. - Once there is no liability to deduct tax at source u/s 194A, the provisions of section 40(a)(ia) cannot be attracted.

Issues Involved:
1. Disallowance of interest under Section 36(1)(iii).
2. Disallowance of accrued interest payable under Section 40(a)(ia).

Issue-wise Detailed Analysis:

1. Disallowance of Interest under Section 36(1)(iii):

The first issue concerns the confirmation of disallowance of interest amounting to Rs. 7,54,350 under Section 36(1)(iii). The facts reveal that the assessee provided interest-free advances to its sister concerns totaling Rs. 50.29 lakh. The Assessing Officer (AO) observed that the assessee did not charge any interest on these advances while paying substantial interest on borrowed funds. The AO disallowed the interest by applying a 15% rate due to the lack of a nexus between the interest-free loans and the interest-free funds available.

The Commissioner of Income-tax (Appeals) [CIT(A)] upheld the AO's decision, noting that despite the assessee having share capital and reserves amounting to Rs. 35.73 crore, there was a debit balance in the Profit and Loss account and a liability of Rs. 24.43 crore towards interest payable to M/s. Sahara India Financial Corporation Limited.

Upon review, it was found that the assessee had sufficient interest-free funds (Rs. 35.73 crore) to cover the interest-free advances (Rs. 50.29 lakh). Citing the jurisdictional High Court's decision in CIT v. Reliance Utilities & Power Ltd., it was held that if interest-free funds are sufficient to meet investments, it can be presumed that the investments were made from such funds. Therefore, the Tribunal ordered the deletion of the addition, allowing this ground.

2. Disallowance of Accrued Interest Payable under Section 40(a)(ia):

The second issue pertains to the disallowance of Rs. 3,36,49,307 towards accrued interest payable to M/s. Sahara India Financial Corporation Limited under Section 40(a)(ia). The AO disallowed the interest on two grounds: the non-deductibility of interest and the application of Section 40(a)(ia) for non-deduction of tax at source.

The Tribunal noted that the assessee, a limited company, is required to maintain accounts on a mercantile basis. Under the mercantile system, deduction is allowed on the accrual of liability, not its actual discharge. The Tribunal found that the liability to pay interest had accrued, and the claim was genuine, even though it was not recorded in the books of account.

In previous years, similar interest deductions were allowed, and the CIT dropped proceedings under Section 263 for the assessment year 2004-2005. Thus, the deduction of interest payable to M/s. Sahara India Financial Corporation Limited was deemed allowable.

Regarding the application of Section 40(a)(ia), the Tribunal clarified that this section disallows deductions for interest payable to a resident if tax is not deducted at source under Chapter XVII-B. Section 194A requires tax deduction at the time of credit or payment of interest. Since the assessee did not credit the interest in the books or pay it during the year, Section 194A was not applicable, and consequently, Section 40(a)(ia) could not be invoked.

The Tribunal acknowledged that this loophole might not have been contemplated by the Legislature, but it could not remedy the situation. The deduction was allowed for this year, with the AO free to consider the actual payment or non-payment of interest in subsequent years.

Conclusion:

The appeal was allowed, with the Tribunal ruling in favor of the assessee on both issues. The disallowance of interest under Section 36(1)(iii) was deleted, and the disallowance of accrued interest under Section 40(a)(ia) was also overturned.

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