DEDUCTION OF INTEREST ON BORROWED CAPITAL

[Mr. M. GOVINDARAJAN]

Section 36(1) (iii) provides that the amount of the interest paid in respect of capital borrowed for the purposes of business or profession. Any amount of the interest paid in respect of capital borrowed for acquisition of an asset for extension of existing business or profession (whether capitalized in the books of account or not) for any period beginning from the date on which the capital was borrowed for acquisition of the asset till the date on which such asset was first put to use shall not allowed as deduction.

Thus if the borrowed fund is utilized for the capital expenditure then the interest on the borrowed funds will not be allowed.   There shall be nexus between the expenditure and the business.   The border line between a capital expenditure and revenue expenditure is a blurred line. In ‘Atherton V. British insulated and Helsby Cables Limited’ – (1925) 10 TC 155, it was held that if the expenditure is incurred for starting a new business which was not carried out by the assessee earlier, then such expenditure is held to be of capital nature.   In that event it would be irrelevant as incurred is in respect of the same business which is already carried on by the assessee, even if it is for the expansion of the business, namely, to start a new unit which is the same as earlier business and there is unity of control and a common fund, then such an expense is to be treated as business expenditure.   In such a case whether the new business/asset comes into existence or not would become a relevant factor.   If there is no creation of new asset, then the expenditure incurred would be of revenue nature.

In ‘K. Somasundaram and brothers V. Commissioner of Income Tax’ – 1998 (8) TMI 59 - MADRAS High Court the court held that the capital amount so borrowed should not only be invested on the business but that the amount borrowed should continue to remain in the business and so long as the amount borrowed is used in the business, the interest paid on such borrowing is an expenditure which is required to be deducted in the computation of income from the business.

In ‘Commissioner of Income Tax V. Tarai Development Corporation Limited’ – 1993 (8) TMI 64 - ALLAHABAD High Court it was observed by the High Court that when the assessee was setting up a new factory in the previous year and it was an extension of its existing business and money borrowed was for the purpose of carrying on the business and which could be spent by the assessee on any account, either capital or revenue.   Section 36(1)(iii) provides that the amount paid in respect of capital borrowed for the purpose of the business could be covered under Section 36 for deduction.

In ‘Indo Rama Synthetics India Limited V. Commissioner of Income Tax’ – 2009 (9) TMI 635 - Delhi High Court it was held that the interest borrowed on capital as business expenditure is allowable when the amount was borrowed for setting up a new plant.   In that case, the assessee was already in the business of ferro alloys plant and it had set up sugar plant.   Still, the interest paid on borrowed capital was treated as allowable expenditure by applying the test of common management and common funds inasmuch as there was a common board of directors controlling the two plants, which operated from the head office located at New Delhi and funds of the two plants were common.   On this basis, it was opined that there intermingling and interlacing of funds.   The fact that the two divisions are located at different sites did not affect the outcome since marketing of the final products of both divisions was carried out under the supervision and control of the same set of executives at the head office.

In ‘A. Murali and Co. P. Limited V. Assistant Commissioner of Income Tax’ –2013 (6) TMI 337 - MADRAS HIGH COURT the assessee is engaged in the business of export of beedi leaves and food grains. The assessee is also engaged in transport contracts. For the assessment year under consideration, the assessee declared a loss of Rs.3,71,680/-. When the assessment was taken up for scrutiny, it was found that the assessee had advanced loan to the directors of a sum of Rs.3.91 crores as against what was given earlier at Rs.3.23 crores.   The Assessing officer viewed that the assessee had not utilized the borrowed funds for business purpose, but diverted the same for advancing loans to the directors.   Hence the claim of interest payment is disallowed.  

Against the order the assessee filed appeal before the Commissioner of Income Tax (Appeals). Before the Commissioner (Appeals), the assessee contended that the borrowed funds were used only for the purpose of business particularly for the purchase of masoor dhall from Shri Saravana Agency. The borrowed funds related to the earlier year and there was no borrowal during the relevant assessment year. The money advanced to the directors during the year were only out of the assessee’s own funds and there was no nexus between the borrowed funds and the advance made to the directors. The Commissioner (Appeals) rejected the appeal of the assessee.

The assessee approached the Tribunal. The Tribunal pointed out that the assessee had not proved before the Assessing Officer that the interest bearing borrowed funds were exclusively used for the business purpose and they have not diverted as by way of loan to the directors. The fund flow position, whereby the advances made to the directors during the immediate previous year showed the increase compared to the earlier balance and also the advances made by the directors of the company had come down.   Thus on analysis of facts the Tribunal rejected the assessee’s appeal.

The assessee filed appeal before the High Court against the rejection of Tribunal. Before the High Court the assessee argued that they had borrowed a sum of Rs.1.10 crores and odd on May 8, 2000 and the same was utilized for the purpose of masood dhall. The High Court held that except for stating that the assessee had made borrowal in the immediate preceding accounting year, no materials were placed before the Court or before any authority to show that the borrowed funds were not diverted for any purpose other than business.   The mere contention that the borrowed funds were utilized for the purchase of masoor dhall from Sri Saravana Agency, per se, cannot be taken as a good ground to accept the plea of the assessee, considering the fact that consistently the advances given to the directors had increased from Rs.3.23 crores to Rs.3.9 crores without corresponding return thereof and with no better performance in the business of the assessee. The High Court also rejected the appeal.

In ‘Commissioner of Income Tax V. U.P. Asbestos Limited’ –2013 (7) TMI 336 - ALLAHABAD HIGH COURT the assessee is a public limited company engaged in the business of manufacturing of asbestos sheets and allied products. During the year 1999-2000 the assessee has completed expansion of its manufacturing plant and existing capacity was increased. For this purpose the assessee had borrowed loans from IDBI Bank and paid interest on the borrowings. The interest was disallowed by the Adjudicating Authority and the Tribunal allowed the interest. Against this order the Revenue filed appeal before the High Court. The Revenue submitted the following before High Court:

• This was a new unit and new business, so interest is not allowable under Section 36(1)(iii) of the Act;
• The assessee did not furnish bifurcation of the amount of the loans utilized in the building, plant and machinery ;
• The Assessing Officer worked out an investment in building, plant and machinery and calculated the loan in the ration 1:3:5. Accordingly a part of the investment was capitalized by the Assessing officer and interest paid there upon was disallowed;
• The assessee has wrongly claimed the expansion as a revenue expenditure as the same was capitalized expenditure;
• The assessee is entitled only for depreciation.

The assessee contended that there was an expansion of the existing business.   There was common management, finance and production of the existing business.   There was complete unity, control and management, interlacing of funds were unrebutted.   The capital was purchased for the purpose of business and the same was used.   Hence the interest paid on the borrowed funds is to be allowed.

The High Court found that various loans were borrowed for the expansion of the business and the same were fully utilized for that purpose.   It is not a case of the Revenue that the funds were utilized anywhere else.   The new unit was established in the existing premises of the factory under the same management and finance control. The unit which the appellant has set up had inextricable linkage with the existing business of the appellant.   The proposed business was not an individual business but vertical expansion of the present business.   Thus, the test of the existing business with common administration and common fund is clearly made out. It is not a case of subsidy.   It is a case of interest paid on the borrowed funds, which were exclusively utilized for the purpose of expansion of the business, which resulted the enhancement of the production. The Tribunal held that the interest paid on the loan borrowed from IDBI Bank will have to be treated as revenue in nature and borrowed from the IDBI will have to be treated as revenue in nature and, accordingly the same is allowed under the said provision.