2016 (11) TMI 963 - AT - Income Tax

Disallowance of interest expenses - whether interest expense was incurred to earn interest income on capital balance in the firm which is taxable as business income? - Income from other sources OR Business Loss - Held that - No doubt, the interest due to or received by partner on capital contributed by partners in partnership firm is assessed to tax as business income u/s 28(v) of the Act in the hands of the partner but the assessee could not show that the partners have in-fact agreed to pay interest on their capital contributed in the partnership firm M/s Systematic Exports during the impugned assessment year and a valid and legal binding obligation is cast on the partnership firm M/s Systematic Exports to pay interest on capital specifically to the partners in presenti during the impugned assessment year . The assessee s had taken a contention that had there been any profits in Systematic Export, the assessee would have received interest from the partnership firm need verification from the actual conduct of Systematic Exports over the years to prove that the firm Systematic Exports in fact paid interest on capital contributed by the partners when there were profits in the said firm . The share of profits on the capital contributed by the assessee with the partnership firm M/s Systematic Exports , are exempt from tax u/s. 10(2A) of the Act. Thus, necessarily the expenses incurred in relation to earning of the income which does not form part of total income, has to be disallowed as per provisions and mandate of Section 14A of the Act unless it is shown that the interest is paid / payable on the capital contributed by the partner in the firm Systematic Exports which interest is chargeable to tax u/s 28(v) of the Act . Interest of justice will be best served if the matter is set aside and restored to the file of the AO for fresh determination of the issue on merits

Issues Involved:

1. Disallowance of interest expense of ?10,27,507/-.

Issue-wise Detailed Analysis:

1. Disallowance of Interest Expense:

The primary issue in this case revolves around the disallowance of an interest expense amounting to ?10,27,507/-. The assessee had filed a return of income declaring a total income of ?19,63,290/-, which was initially processed under section 143(1) of the Income-tax Act, 1961. The case was subsequently reopened under section 148 for reassessment. The Assessing Officer (AO) disallowed the interest expense claimed by the assessee against salary income and interest income, asserting that such deductions are not permissible under the Income-tax Act.

The assessee contended that the interest expense was incurred on a loan taken from LIC, which was invested in a partnership firm, Systematic Exports, with the intention to earn interest. The assessee argued that the interest should be considered a business expenditure under sections 36 and 37 of the Act and claimed that the interest expense was mistakenly filed under "Income from other sources" instead of "Business Loss."

The AO observed that the share of profit from the partnership firm is exempt under section 10(2A) of the Act and disallowed the interest expense, stating that the loan was not taken for the purpose of earning taxable income. The AO also noted that the assessee did not receive any interest from the partnership firm and thus, the interest expense could not be justified as a business expenditure.

Upon appeal, the Commissioner of Income Tax (Appeals) [CIT(A)] upheld the AO's decision, noting that the assessee's capital account in the partnership firm was negative and there was no binding stipulation in the partnership deed for the payment of interest on the capital contributed by the partners. The CIT(A) concluded that the assessee failed to demonstrate a clear nexus between the loan taken and the business purpose, suggesting that the claim was an afterthought to avoid tax liability.

The assessee further appealed to the Tribunal, reiterating the arguments made before the AO and CIT(A). The Tribunal examined the submissions and observed that only ?10,00,000/- out of the total LIC loan of ?1.19 crores was invested in the partnership firm. The Tribunal noted discrepancies in the assessee's claims and found that the entire loan amount was not invested in the firm as claimed.

The Tribunal highlighted that losses under the head "Profit and gain from business or profession" cannot be set off against salary income as per section 71(2A) of the Act. The Tribunal also pointed out that the partnership deed did not mandate the payment of interest on capital contributed by the partners, and the assessee could not prove that the firm had a binding obligation to pay such interest.

Considering these observations, the Tribunal decided to set aside the matter and remand it back to the AO for fresh determination. The AO was directed to re-examine the issue, allowing the assessee to present relevant evidence and explanations. The Tribunal emphasized the need for the AO to consider the provisions of section 14A, which disallows expenses incurred in relation to income that does not form part of the total income, unless the interest is chargeable to tax under section 28(v) of the Act.

Conclusion:

The appeal filed by the assessee was allowed for statistical purposes, with the matter being remanded back to the AO for fresh consideration. The Tribunal instructed that the assessee be given an opportunity to present additional evidence and explanations, and the AO was to re-evaluate the issue in accordance with the law and principles of natural justice. The order was pronounced in the open court on 11th November 2016.

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