2025 (4) TMI 1453 - AT - Income Tax

Disallowance of interest expenses u/s 36(1)(iii) - CIT(A) observed that it is not the business of assessee company to give share application money to sister concern from borrowed funds and further the assessee-company do not have any surplus to invest in shares of sister concern and entire investment has been funded through interest bearing borrowings - HELD THAT - From the details filed by the assessee it is undisputedly proved that the impugned sum considered by the AO as loan for the purpose of sec.36(1)(iii) of the Act is in fact an investment in another group company but not a loan. Therefore AO is erred in invoking the provisions of sec.36(1)(iii) of the Act for the amount invested in M/s. Kamineni Health Care Pvt. Ltd. Assuming for a moment it is a loan and advance for the purpose of sec.36(1)(iii) but the fact remains that the assessee has given said loan and advance out of it s own interest free funds available in the form of fresh investment received from two of it s Directors. No interest bearing funds have been used for the purpose of giving amount to M/s. Kamineni Health Care Pvt. Ltd. and therefore on this count also the addition made by the AO towards disallowance of interest u/sec.36(1)(iii) cannot be sustained. We therefore delete the addition made by the AO towards interest on amount given to M/s. Kamineni Health Care Pvt. Ltd. Coming back to loan and advances given. There is no dispute with regard to the fact that the appellant-company had given loan to above company on 31.03.2016. AO has computed interest for the whole year. Although CIT(A) has restricted the disallowance of interest for the actual period of loan i.e. for one day but uphold the reasons given by the AO to treat the said transaction as loans and advances for the purpose of sec.36(1)(iii) of the Act. Before us Assessee claims that it is not a loan or advance but a current account between the two group companies in the ordinary course of business. We find that although Assessee brings in the theory of business exigency or commercial exigency but failed to prove the theory of commercial exigency by bringing on record any evidence to prove that there is a business connection between the two companies. Although the appellant-company claims that it is a holding company of appellant-company but in our considered view except making a oral statement no evidence has been placed on record to prove the claim that the transaction is between the holding company and subsidiary company in the ordinary course of business and such transactions are carried-out under commercial expediency. Since the appellant-company fails to prove commercial/business exigency in advances given to the other company in our considered view there is no error in the reasons given by the learned CIT(A) to treat the said advances as loans and advances within the meaning of sec.36(1)(iii). We therefore direct the AO to levy interest for the actual period of loan. Thus we uphold the reasons given by the learned CIT(A) on this issue. We direct the AO to delete addition made towards disallowance of interest on investment with M/s. Kamineni Health Care Pvt. Ltd. and sustain the addition made toward interest on loan given to M/s. United Steel Allied Ind Private Limited but restrict the interest disallowance as per the directions of the learned CIT(A). Appeal of the Assessee is partly allowed.

Summary

1. ISSUES PRESENTED and CONSIDERED

The core legal questions considered by the Tribunal in this appeal are:

(a) Whether the sum of Rs. 4.43 crores given by the assessee-company to M/s. Kamineni Health Care Pvt. Ltd. constitutes a loan/advance attracting disallowance under section 36(1)(iii) of the Income Tax Act, or whether it is an investment in shares of the group company, thereby exempting it from such disallowance.

(b) Whether the advances given to M/s. United Steel Allied Industries Pvt. Ltd. (USAIPL) on 31.03.2016 can be treated as loans/advances for the purpose of disallowance of interest under section 36(1)(iii) of the Act, or whether they represent normal current account transactions in the ordinary course of business with no business exigency or commercial expediency issues.

(c) The correctness of the Assessing Officer's and the CIT(A)'s treatment regarding the disallowance of interest expenses incurred by the assessee on borrowed funds which were allegedly used to provide interest-free loans/advances to group companies.

(d) The applicability of judicial precedents, including the ratio in S.A. Builders v. CIT and ACIT vs. Tulip Star Hotels Ltd., in the context of disallowance of interest expenses under section 36(1)(iii).

2. ISSUE-WISE DETAILED ANALYSIS

Issue (a): Nature of Rs. 4.43 crores given to M/s. Kamineni Health Care Pvt. Ltd. - Loan/Advance or Investment?

Relevant legal framework and precedents: Section 36(1)(iii) of the Income Tax Act disallows deduction of interest expenses on borrowed funds to the extent they are used for providing loans or advances which do not carry interest. The principle is that interest on borrowed funds used for non-business purposes or interest-free loans to others cannot be allowed as a business expense.

Precedents such as CIT, Patiala vs. M/s Punjab Tractors have established that when borrowed funds are used to provide interest-free loans to sister concerns, interest deduction must be disallowed proportionately.

Court's interpretation and reasoning: The Tribunal carefully examined documentary evidence including share allotment returns, board resolutions, and ledger accounts. It was undisputed that the Rs. 4.43 crores was initially shown as share application money under "Loans and Advances" as per the Companies Act disclosure requirements but was subsequently converted into share capital by allotment of shares within the same financial year.

The Tribunal found that the assessee-company received fresh investments from two directors amounting to Rs. 4.03 crores, which were then invested in the group company via share application money. This established that the funds were not interest-bearing borrowed funds but fresh equity capital from directors. Therefore, the amount cannot be treated as a loan or advance under section 36(1)(iii).

Key evidence and findings: The share allotment was completed in the same financial year; board resolutions and ledger accounts corroborated the investment nature. The Tribunal held that the Assessing Officer erred in treating the amount as a loan attracting disallowance.

Application of law to facts: Since the funds were not borrowed but fresh equity investment, section 36(1)(iii) disallowance provisions did not apply. Even if treated as a loan, the funds came from interest-free sources (directors' fresh investment), so no interest-bearing funds were used to provide the amount, negating the basis for disallowance.

Treatment of competing arguments: The Revenue contended the transaction was a loan disguised as share application money to circumvent disallowance. The Tribunal rejected this, relying on documentary evidence proving genuine share allotment and fresh investment.

Conclusion: The Tribunal deleted the disallowance of interest expenses on Rs. 4.43 crores given to M/s. Kamineni Health Care Pvt. Ltd., holding it to be a bona fide investment and not a loan or advance.

Issue (b): Treatment of Advances to M/s. United Steel Allied Industries Pvt. Ltd. (USAIPL)

Relevant legal framework and precedents: Section 36(1)(iii) disallows interest expense deduction to the extent borrowed funds are used to provide interest-free loans or advances. The burden is on the assessee to prove commercial expediency or business exigency for such advances to related parties.

Court's interpretation and reasoning: The Tribunal noted that the assessee had given advances to USAIPL on 31.03.2016. The Assessing Officer initially computed interest disallowance for the whole year, which the CIT(A) modified to restrict disallowance to the actual period of one day (the date of advance).

The assessee claimed these advances were normal current account transactions in the ordinary course of business and not loans or advances for the purpose of section 36(1)(iii). However, the assessee failed to provide evidence proving business exigency or commercial expediency, or that the transaction was between holding and subsidiary company in the ordinary course of business.

Key evidence and findings: No documentary proof was produced to establish the nature of the transaction as a current account or business necessity. The Tribunal found the oral assertions insufficient.

Application of law to facts: Since the assessee failed to establish commercial or business purpose, the advances were rightly treated as loans/advances attracting disallowance of interest under section 36(1)(iii). However, the Tribunal upheld the CIT(A)'s direction that interest disallowance should be limited to the actual period of loan (one day), not the whole year.

Treatment of competing arguments: The assessee's contention of business exigency was rejected due to lack of evidence. The Revenue's view that the advances were interest-free loans without business purpose was accepted.

Conclusion: The Tribunal upheld the disallowance of interest expenses on advances to USAIPL but restricted the disallowance to the actual period of loan as directed by the CIT(A).

Issue (c): Disallowance of Interest Expenses under Section 36(1)(iii) on Borrowed Funds Used for Interest-Free Loans/Advances

Relevant legal framework and precedents: Section 36(1)(iii) disallows deduction of interest expenses on borrowed funds used for providing interest-free loans or advances. The principle is that interest on borrowed funds used for non-business purposes or interest-free advances should not be allowed as business expenses.

Precedents such as S.A. Builders v. CIT and ACIT vs. Tulip Star Hotels Ltd. clarify the scope of disallowance and the necessity to prove the source and use of funds.

Court's interpretation and reasoning: The Assessing Officer relied on the Punjab and Haryana High Court ruling in Punjab Tractors case, which held that interest on borrowed funds used to provide interest-free loans to sister concerns is not deductible. The CIT(A) partially allowed the assessee's claim by restricting the disallowance period for advances given on the last day of the year.

The Tribunal concurred with the principle but applied it differently based on the nature of the transactions. For the Kamineni Health Care Pvt. Ltd. investment, the Tribunal held no disallowance was warranted as funds were not borrowed but fresh equity. For the USAIPL advances, disallowance was appropriate but limited to the actual period.

Key evidence and findings: The Tribunal relied on documentary evidence and the timing of transactions to determine the correct application of section 36(1)(iii).

Application of law to facts: The Tribunal applied the legal principles to facts, distinguishing between genuine investments and interest-free loans, and ensuring interest disallowance was proportionate and justified.

Treatment of competing arguments: The Tribunal balanced the assessee's evidence and submissions against the Revenue's contentions and applied the law accordingly.

Conclusion: The Tribunal upheld the principle of disallowance under section 36(1)(iii) but tailored its application to the facts, deleting disallowance on genuine investments and restricting it on short-term advances.

3. SIGNIFICANT HOLDINGS

"From the details filed by the assessee, it is undisputedly proved that, the impugned sum considered by the Assessing Officer as loan for the purpose of sec.36(1)(iii) of the Act is in fact, an investment in another group company, but, not a loan."

"Assuming for a moment it is a loan and advance for the purpose of sec.36(1)(iii) of the Act, but, the fact remains that the assessee has given said loan and advance out of it's own interest free funds available in the form of fresh investment received from two of it's Directors. Further, no interest bearing funds have been used for the purpose of giving amount to M/s. Kamineni Health Care Pvt. Ltd. and, therefore, on this count also, the addition made by the Assessing Officer towards disallowance of interest u/sec.36(1)(iii) of the Act cannot be sustained."

"Since the appellant-company fails to prove commercial/business exigency in advances given to the other company, in our considered view, there is no error in the reasons given by the learned CIT(A) to treat the said advances as loans and advances within the meaning of sec.36(1)(iii) of the Act."

"We direct the Assessing Officer to delete addition made towards disallowance of interest on investment with M/s. Kamineni Health Care Pvt. Ltd. and sustain the addition made toward interest on loan given to M/s. United Steel Allied Ind Private Limited, but, restrict the interest disallowance as per the directions of the learned CIT(A)."

Core principles established include:

- The nature of funds (borrowed vs. fresh equity) and the actual use of funds are critical in determining applicability of section 36(1)(iii) disallowance.

- Mere classification of share application money under "Loans and Advances" as per Companies Act disclosures does not override the true nature of the transaction.

- The assessee bears the burden to prove commercial expediency or business exigency for advances to related parties to avoid disallowance.

- Interest disallowance under section 36(1)(iii) must be proportionate to the actual period and extent of interest-free loans or advances funded by borrowed funds.

Final determinations:

- The disallowance of interest expenses on Rs. 4.43 crores given to M/s. Kamineni Health Care Pvt. Ltd. was deleted as it was a genuine investment funded by fresh equity.

- The disallowance of interest expenses on advances to M/s. United Steel Allied Ind Pvt. Ltd. was upheld but restricted to the actual period of loan (one day).