Interest on loan borrowed for capital assets - deduction u/s 36(1)(iii) - A never ending battle

Interest on loan borrowed for capital assets - deduction u/s 36(1)(iii) - A never ending battle "

Whether interest paid on loan borrowed for purchase of capital assets is deductible as revenue expenditure or to be capitalized with the cost of such asset.

This issue arises generally when the assets have been acquired but could not be put to use in the concerned year.

Cases in Favor of Assessee - Apex Court

In a series of judgments dated 8-2-2008, honorable Supreme Court has held that interest can be allowed under section 36(1)(iii).

1 2008 -TMI - 3024 - SUPREME COURT OF INDIA

2 2008 -TMI - 3026 - SUPREME COURT OF INDIA

3 2008 -TMI - 3020 - SUPREME COURT OF INDIA

In these cases, the stand of department was:

According to the Department, the assessee was not entitled to treat the interest on borrowings as revenue expenditure.  According to the Department, in view of Explanation 8 to Section 43(1) of the Income-tax Act, 1961 (for short, ""1961 Act') the assessee was not entitled to claim deduction for interest on borrowings, particularly, when the machines were not put to use during the assessment year under consideration.  According to the Department, provisions of Section 36(1)(iii) of the 1961 Act were required to be harmoniously construed along with the provisions of Explanation 8 to Section 43(1) regarding actual cost.  According to the Department provisions of Section 36(1)(iii) being general in nature had to give way to the special provisions contained in Explanation 8 of Section 43(1) of the 1961 Act.

Apex Court observed that:

At the outset, we may clarify that before the High Court it was not the case of the Department that a new business was set up or commenced during the assessment year under consideration.  It was undisputed before the High Court that three additional machines were installed by the assessee during the assessment year under consideration for the production of intravenous injectibles.  It was not in dispute that the assessee had borrowed moneys during the accounting year commencing from 1.4.91 to 31.3.92.

For considering whether payment of interest on borrowing is revenue expenditure or not, the purpose for which the borrowing is made is irrelevant.  In our view, Section 36(1)(iii) of the 1961 Act has to be read on its own terms.  It is a Code by itself.  Section 36(1)(iii) is attracted when the assessee borrows the capital for the purpose of his business.  It does not matter whether the capital is borrowed in order to acquire a revenue asset or a capital asset, because of that the section requires is that the assessee must borrow the capital for the purpose of his business.  This dichotomy between the borrowing of a loan and actual application thereof in the purchase of a capital asset, seems to proceed on the basis that a mere transaction of borrowing does not, by itself bring any new asset of enduring nature into existence, and that it is the transaction of investment of the borrowed capital in the purchase of a new asset which brings that asset into existence.  The transaction of borrowing is not the same as the transaction of investment.

After observing the above, Apex Court has allowed deduction of interest u/s 36(1)(iii). 

Case against the Assessee - P & H High Court

On other side just few days back (dated 21-1-2008) honorable High Court of Punjab & Haryana has given a ruling against the assessee and disallowed the deduction of interest u/s 36(1)(iii)

2008 -TMI - 3017 - HIGH COURT, PUNJAB AND HARYANA

In this ITAT has allowed the deduction u/s 36(1)(iii) on account of interest.

The facts of the case were

The assessee, who is engaged in the business of yarn, filed its return of income for the year in question on 30.12.1992, declaring its taxable income at Rs. 3,59,86,351/.  The return was processed under Section 143 (1)(a) of the Income Tax Act, 1961 (for short 'the Act') on 6.1.1992 at a total income of Rs. 3,60,04,130/-. The assessee thereafter filed revised return on 6.8.1993 declaring a taxable income of Rs. 3,48,09,071/-. In the computation of income filed along with revised return, the assessee claimed additional deduction on account of Rs. 1,97,290/- and Rs. 9,80,000/-on account of interest under Section 36(1) (iii) of the Act and upfront fees, respectively. This claim was made on account of loans raised for set up of a new unit at Baddi (HP). In the revised return a detail note was given at Serial No. 9 that the assessee has set up a new unit, for the purpose of which, the assessee incurred expenses on interest of loans and upfront fees of loan raised from financial institutions for establishing a new unit. It was admitted in the return that the new unit had not yet come into commercial production.  However, the claim of the assessee was that the same is nothing but expansion of its earlier business under the same management and administration.

Observation of HC

Even a conjoint reading of Section 36(1)(iii) as existing prior to the proviso thereto and Section 43(1) explanation 8 clearly shows that any interest paid on the capital borrowed for the acquisition of an asset cannot be allowed as a revenue expenditure. The capital might have been borrowed by an assessee for the purpose of business. However, once it is admitted that a part thereof was used by the assessee for the purpose of acquisition of an asset, which is not in the form of replacement or modernization the interest component thereon upto the date it is first put to use has to be dealt with in terms of provisions of Section 43 (1) Explanation 8 as otherwise cost of the asset shown in the balance sheet will not depict its true picture. This is in conformity with law and the accounting principles.

A perusal of explanation 8 to Section 43(1) of the Act, no such distinction is carved out as it merely talks about payment of interest in connection with the acquisition of an asset. The business of the assess in the present case admittedly is to manufacture yarn and not setting up of plant and machinery to manufacture yarn.

After considering all the facts and circumstances, HC has ruled that interest can not be allowed to be deducted u/s 36(1)(iii).

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For full text of judgments - visit - Income Tax 

1  2008 -TMI - 3024 - SUPREME COURT OF INDIA

2 2008 -TMI - 3026 - SUPREME COURT OF INDIA

3 2008 -TMI - 3020 - SUPREME COURT OF INDIA

4 2008 -TMI - 3017 - HIGH COURT, PUNJAB AND HARYANA