2016 (7) TMI 1716 - HC - Income Tax

Interest expenditure incurred by the appellant on the funds borrowed for the purpose of business of making share application - Allowable business expenditure or not? - HELD THAT - The questions posed for our consideration are required to be answered in favour of the assessee and against the department. The judgments relied upon by the learned counsel for the respondent are not applicable in the facts of the present case. We are of the opinion that for the business urgency loan was taken. Therefore the expenses are required to be allowed under Section 36(1) (iii) of the Act and in view of the decision in 2016 (8) TMI 739 - GUJARAT HIGH COURT the same is accepted by deciding the issue in favour of the assessee

Summary

The core legal questions considered by the Court revolve around the allowability of interest expenditure incurred on borrowed funds used for share application money and the applicability of relevant provisions of the Income Tax Act. Specifically, the issues include:

(i) Whether the interest expenditure incurred on funds borrowed for the purpose of making share application money qualifies as business expenditure deductible under section 36(1)(iii) of the Income Tax Act.

(ii) Whether the borrowed funds, ultimately used for business purposes, entitle the assessee to claim interest deduction, even if shares were not allotted.

(iii) Whether interest expenditure can be disallowed under section 57(iii) of the Act when the shares were not allotted and no income was earned therefrom.

(iv) Additional questions relating to the disallowance of interest on delayed payment of allotment money and the applicability of principles such as res judicata and penalty provisions under section 271(1)(c) of the Act.

Regarding the first and second issues, the Court examined the legal framework under section 36(1)(iii), which allows deduction of interest on capital borrowed for the purpose of business. The Court considered precedents including the Supreme Court decisions in S.A. Builders Ltd. and Deputy Commissioner of Income Tax v. Core Health Care Ltd., which establish that the phrase "for the purpose of business" encompasses expenditure incurred out of commercial expediency, even if the borrowed funds were advanced to sister concerns or used indirectly for business expansion.

The Tribunal had relied on a decision where interest on share application money was disallowed because shares were never allotted and the funds were rotated among related entities without genuine business purpose. The Tribunal held that the interest expenditure was not incurred wholly and exclusively for business purposes and thus not deductible. However, this Court noted that such a view was inconsistent with a subsequent decision of the same High Court in Tax Appeal No. 474 of 2006 and allied matters, which clarified that the absence of actual allotment of shares does not negate the business purpose behind borrowing funds for share acquisition. The Court emphasized that the test is whether the borrowing was for the purpose of business, not whether the intended business outcome materialized.

The Court further reasoned that the borrowed funds were used as a measure of commercial expediency to acquire controlling interest in an associate concern, aiming to expand business operations. This intention satisfies the requirement under section 36(1)(iii), entitling the assessee to claim deduction of interest paid, notwithstanding the failure to obtain shares due to market conditions. The Court rejected the revenue's contention that income from dividends being exempt negates the allowability of interest, citing decisions that distinguish the nature of interest expenditure from the income head under which dividends are assessed.

Regarding the third issue, the Court referred to earlier judgments interpreting section 57(iii), which permits deduction of expenditure incurred solely for the purpose of making or earning income from other sources. The Court highlighted the principle that the purpose for incurring expenditure must be the sole purpose and not a mixed or dominant purpose unrelated to income earning. In the present case, since shares were not allotted, and no income was derived, interest expenditure could not be allowed under this provision.

In addressing competing arguments, the Court gave weight to the commercial reality and the intention behind the borrowing, rather than the ultimate outcome. It distinguished cases where transactions were found to be colorable or illusory, such as loans disguised as gifts to related parties, which fail the test of genuine borrowing for business purposes and are rightly disallowed under section 36(1)(iii). The Court also considered the principle that the revenue cannot substitute its commercial judgment for that of a prudent businessman in determining the reasonableness of expenditure if a nexus with business purpose is established.

On the issue of penalty under section 271(1)(c), the Court did not extensively analyze the principles but allowed the appeal to the extent of quantum, leaving other aspects governed by the Tribunal's order. It also refrained from deciding on the applicability of res judicata in income tax proceedings, noting that the Tribunal may take a different view if material facts were overlooked previously.

Significant holdings include the following verbatim legal reasoning:

"All that is germane is: whether the borrowing was, or was not, for the purpose of business. It was held that the expression for the purpose of business occurring in section 36(1)(iii) indicates that once the test of for the purpose of business is satisfied in respect of borrowed capital, the assessee would be entitled to deduction under section 36(1)(iii) of the 1961 Act."

"When funds are invested for business purposes, there can be no guarantee that the purpose would be achieved. What has to be looked into is whether the funds were expended as a measure of commercial expediency, which includes such expenditure which a prudent businessman incurs for the purposes of business."

"The interest payment with relation to the amount attributable to share application money without the allotment of shares would not entitle the assessee to claim any deduction for the interest paid on such borrowings and could not be said to be an expenditure incurred wholly and exclusively for the purpose of making and earning income from other sources."

"Business exigency and prudency are the two basic parameters to determine the allowability of any expenditure. Therefore no prudent businessman will gift his money when there is certain exigency of money."

Core principles established include:

• The allowability of interest deduction under section 36(1)(iii) hinges on whether the borrowing was for the purpose of business, which includes commercial expediency, not merely the actual success of the business purpose.
• Interest expenditure on borrowed funds used for share application money is deductible even if shares are not allotted, provided the borrowing was genuinely for business purposes.
• Expenditure incurred for mixed or dominant purposes other than earning income from other sources is not deductible under section 57(iii).
• Transactions that are colorable or illusory, such as loans disguised as gifts to related parties without genuine borrowing, do not qualify for interest deduction.
• The revenue cannot substitute its commercial judgment for that of a prudent businessman once a nexus with business purpose is established.

Final determinations on each issue are:

The Tribunal erred in disallowing interest expenditure under section 36(1)(iii) merely because shares were not allotted. The appeals on this point are allowed, and the orders of the Commissioner of Income Tax (Appeals) are restored. The interest expenditure incurred on borrowed funds for share application money is deductible as business expenditure.

The issue regarding disallowance under section 57(iii) is left unanswered due to the Court's findings under section 36(1)(iii).

The penalty under section 271(1)(c) is allowed to the extent of quantum in favor of the assessee, with other issues governed by the Tribunal's order.

The principles of res judicata in income tax proceedings were not decided but the appeal was allowed on merits.