2025 (6) TMI 1624 - AT - Income Tax

Disallowing the interest expenses incurred u/s 36(1)(iii) - deployment of the funds in mutual funds and fixed deposits - As contended on behalf of the Assessee that the funds were borrowed for the purpose of business the requirement of Section 36(1)(iii) of the Act stood fulfilled and therefore the deduction was correctly claimed under Section 36(1)(iii) - HELD THAT - We note that the AO did not dispute the fact that funds were borrowed for the purpose of business. The reason for disallowance made by the AO was that the funds were utilized for the purpose other than business (i.e. for making investment in shares and securities). On perusal of records following facts emerges that the Assessee had raised debt capital by way of issuance of debentures for the stated purpose of purchasing plot of land on 21/04/2014 and the payment for the acquisition of the said plot of land of was to be made on 28/04/2014. Thus the Assessee had an interim period of 7 days for which the funds were idle. Assessee was aware that the investment made by utilizing the aforesaid funds would be liquidated on or before 28/04/2014 and funds received would be utilized for the purchase of plot of land. In our view the Assessee had carried out the aforesaid activity in a systematic manner and the same would qualify as adventure in the nature of business as defined in Section 2(13) of the Act. The Assessee was not seeking to earn gains on appreciation of the value of the investment. To the contrary the intention of the Assessee was to earn income by way of purchase/sale of mutual funds and interest income from fixed deposits to offset the corresponding interest cost incurred in the aforesaid period of 7 days. Thus the action of the Assessee to utilized funds for making investments/deposits was necessitated on account of commercial expediency. Therefore we are of the considered view that the Assessee was correct in claiming deduction u/s 36(1)(iii) of the Act. Benefit of lower rate of tax in respect of the Short Term Capital Gains - Assessee had claimed income as exempt dividend income - Computation of Income furnished by the Assessee supports the aforesaid submissions advanced on behalf of the Assessee. Therefore even if the income from purchase/sale of investments was characterized as business income there would have been no change in the final outcome. Instead of inter-head set off of business loss with Capital Gains u/s 71(2) of the Act the income from purchase/sale of investment would offset the interest expenses debited to Profit Loss Account. Accordingly we accept Assessee s claim for deduction of interest expenses u/s 36(1)(iii) of the Act. However we note that the Assessee had claimed income as exempt dividend income. Section 14A of the Act provides for disallowance of expenses incurred for earning exemption income. Accordingly interest expenses pertaining to funds deployed in investments yielding exempt dividend income during the interim period of 7 days would be hit by the provisions of Section 14A of the Act. We note that the CIT(A) had also referred to the provisions contained in Section 14A of the impugned order. Accordingly the Assessing Officer is directed to make disallowance of party of interest expense of INR.1, 56, 06, 164/-, if any attributable to investments yielding exempt income of INR.4, 54, 581/- under Section 14A of the Act. For the aforesaid we direct the Assessee to furnish to the Assessing Officer the details of investments made during the interim period of 7 days in investments yielding exempt income along with the date of purchase and sale of such investments and the source of such investments. It is clarified that the Assessee would be granted a reasonable opportunity of being heard. Accordingly the Assessing Officer is directed to allow deduction claimed by the Assessee for interest expenses of INR.1, 56, 06, 164/- under Section 36(1)(iii)after making disallowance under Section 14A of the Act if any as per the aforesaid directions. In view of the aforesaid the deduction granted by the Assessing Officer while computing Income from Other Sources shall stand reversed/disallowed. Alternative contention raised on behalf of the Assessee - As contented on behalf of the Assessee that interest cost debited to the Profit and Loss Account should be treated as cost of acquisition of investments and the same should be taken into account while computing the capital gains earned during the relevant previous year - contention of the Assessee that the fund were admittedly borrowed for the purchase of plot of land for the Project - HELD THAT - As we have already concluded that the Assessee had entered into an adventure in the nature of trade by utilization of funds raised which were idle for an interim period of 7 days. It was on account of utilization of funds that the cost was attributed to the business activity carried out by the Assessee. Therefore the alternative submissions made on behalf of the Assessee cannot be accepted.

Summary

1. ISSUES PRESENTED and CONSIDERED

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

(a) Whether the interest expenses of INR 1,53,55,135/- debited to the Profit & Loss Account and claimed as deduction under Section 36(1)(iii) of the Income Tax Act, 1961 (the Act) are allowable when the borrowed funds were temporarily invested in mutual funds and fixed deposits prior to acquisition of land for a real estate project.

(b) Whether, if such interest expenses are not allowable as business expenditure under Section 36(1)(iii), the interest expenses can be treated as part of the cost of acquisition of investments (mutual funds) and allowed as deduction against short-term capital gains arising from their sale.

(c) The applicability of Section 14A of the Act regarding disallowance of expenses incurred in relation to income exempt from tax, specifically in respect of interest expenses attributable to investments yielding tax-free dividend income during the interim period.

2. ISSUE-WISE DETAILED ANALYSIS

Issue (a): Allowability of Interest Expenses under Section 36(1)(iii) of the Act

Relevant legal framework and precedents: Section 36(1)(iii) allows deduction of interest on capital borrowed for the purpose of business or profession. The three essential ingredients are: (i) interest must have been paid, (ii) capital must have been borrowed, and (iii) the interest must have been incurred for the purpose of business. Judicial precedents emphasize that expenditure not incurred for earning business income cannot be allowed as business expenditure.

Court's interpretation and reasoning: The Assessing Officer (AO) disallowed the interest expense on the ground that the borrowed funds were temporarily invested in mutual funds and fixed deposits, which was not the business of the Assessee (real estate development). The AO held that interest on funds used for investment cannot be allowed as business expenditure under Section 36(1)(iii). The CIT(A) upheld this disallowance, relying on judicial precedents including decisions of the Bombay High Court and the Supreme Court which held that interest paid on borrowings used for investment in shares is not deductible as business expenditure.

The Tribunal observed that the Assessee had borrowed funds specifically for the purpose of acquiring a plot of land for its real estate project, with payment due after seven days. During this interim period, the funds were invested in mutual funds and fixed deposits. The Tribunal held that this short-term deployment of funds was a commercial expediency and constituted an adventure in the nature of business as defined under Section 2(13) of the Act. The Assessee's intention was not to earn gains from appreciation of investments but to earn income to offset the interest cost. Therefore, the Tribunal concluded that the interest expenses were incurred for the purpose of business and were deductible under Section 36(1)(iii).

Key evidence and findings: The Assessee raised INR 750 Crores by debentures on 21/04/2014, payment for land was due on 28/04/2014, and the interim period investment was liquidated before the payment. The income from mutual fund sale was offered as short-term capital gains, dividend income was claimed as exempt, and interest income was offered under other sources. The AO accepted the characterization of income but disallowed interest expenses.

Application of law to facts: The Tribunal applied the legal principle that interest on borrowed capital used for business purposes is deductible, and the temporary investment of funds did not change the fundamental purpose of borrowing. The commercial expediency of utilizing idle funds was recognized as incidental to the business purpose.

Treatment of competing arguments: The AO and CIT(A) relied on the principle that interest on funds used for investments is not deductible as business expenditure. The Assessee argued that the funds were borrowed for business and temporary investment was incidental. The Tribunal sided with the Assessee, distinguishing the facts from cases where borrowings were directly for investment purposes.

Conclusion: Deduction of interest expenses under Section 36(1)(iii) is allowable subject to disallowance under Section 14A for interest attributable to exempt income.

Issue (b): Treatment of Interest Expenses as Part of Cost of Acquisition for Capital Gains Computation

Relevant legal framework and precedents: Section 48 of the Act allows deduction of expenditure wholly and exclusively incurred in connection with the transfer of a capital asset and the cost of acquisition or improvement of the asset. Interest expenses are generally not allowed as part of cost of acquisition unless directly linked. Judicial precedents cited by the AO and CIT(A) hold that interest on loans taken for acquisition of shares or other capital assets does not form part of cost of acquisition for capital gains computation.

Court's interpretation and reasoning: The Assessee contended that if deduction under Section 36(1)(iii) is disallowed, interest expenses should be allowed as part of cost of acquisition of mutual fund units to be set off against capital gains. The Tribunal rejected this alternative plea, observing that in the present case, the funds were borrowed for acquisition of land, not mutual funds. The interest cost related to the land acquisition was allocated to Work-in-Progress. The mutual fund investments were a temporary deployment of funds and did not create a direct nexus between borrowing and acquisition of mutual fund units.

Key evidence and findings: The Assessee's own books allocated interest after acquisition date to Work-in-Progress. The mutual fund investments were held briefly and liquidated before land acquisition. Judicial precedents relied upon by the Assessee involved facts where borrowings were directly for purchase of shares, which is distinguishable.

Application of law to facts: The Tribunal applied the principle that interest forms part of cost of acquisition only when there is a direct nexus between borrowing and acquisition of the asset. Here, no such nexus existed for mutual funds.

Treatment of competing arguments: The Assessee's reliance on judicial precedents was considered but found factually distinguishable. The AO and CIT(A) submissions were accepted on the basis of statutory provisions and precedents.

Conclusion: Interest expenses cannot be treated as part of cost of acquisition of mutual fund units and thus are not allowable against short-term capital gains.

Issue (c): Applicability of Section 14A Disallowance on Interest Expenses Attributable to Exempt Income

Relevant legal framework: Section 14A of the Act disallows expenditure incurred in relation to income which does not form part of total income (exempt income). Interest expenses attributable to earning exempt dividend income are subject to disallowance under this provision.

Court's interpretation and reasoning: The Tribunal noted that the Assessee had claimed exempt dividend income of INR 4,54,581/- during the interim period. Therefore, interest expenses attributable to such exempt income are liable to be disallowed under Section 14A. The Tribunal directed the AO to quantify and disallow such portion of interest expenses after giving the Assessee an opportunity of being heard.

Key evidence and findings: The Assessee was directed to furnish details of investments yielding exempt income, including dates and sources, to enable proper disallowance.

Application of law to facts: The Tribunal applied the statutory provision of Section 14A to the facts of exempt dividend income earned during the interim period.

Treatment of competing arguments: The Assessee did not dispute the applicability of Section 14A but sought clarity on the quantum. The Tribunal upheld the statutory provision and procedural fairness.

Conclusion: Interest expenses attributable to exempt income are to be disallowed under Section 14A.

3. SIGNIFICANT HOLDINGS

The Tribunal's crucial legal reasoning includes:

"The Assessee had carried out the aforesaid activity in a systematic manner and the same would qualify as adventure in the nature of 'business' as defined in Section 2(13) of the Act. The Assessee was not seeking to earn gains on appreciation of the value of the investment. To the contrary, the intention of the Assessee was to earn income by way of purchase/sale of mutual funds and interest income from fixed deposits to offset the corresponding interest cost incurred in the aforesaid period of 7 days. Thus, the action of the Assessee to utilize funds for making investments/deposits was necessitated on account of commercial expediency. Therefore, we are of the considered view that the Assessee was correct in claiming deduction under Section 36(1)(iii) of the Act."

"In view of the aforesaid, the Assessing Officer is directed to allow deduction claimed by the Assessee for interest expenses of INR.1,56,06,164/- under Section 36(1)(iii) of the Act after making disallowance under Section 14A of the Act, if any, as per the aforesaid directions."

"The alternative submissions made on behalf of the Assessee cannot be accepted" regarding treatment of interest expenses as part of cost of acquisition for capital gains computation.

Core principles established:

• Interest expenses on borrowed funds are deductible under Section 36(1)(iii) if incurred for the purpose of business, even if funds are temporarily invested pending their application to business use.
• Temporary deployment of borrowed funds in investments incidental to business does not negate the business purpose of borrowing.
• Interest expenses cannot be treated as part of cost of acquisition of investments for capital gains computation unless there is a direct nexus between borrowing and acquisition of those investments.
• Section 14A disallows expenses attributable to exempt income, and such disallowance must be quantified separately.
• Tax statutes must be strictly construed, and concessional capital gains provisions do not allow interest expenses as deductions unless explicitly provided.

Final determinations on each issue:

(a) Deduction of interest expenses of INR 1,53,55,135/- under Section 36(1)(iii) is allowed, subject to disallowance under Section 14A for interest attributable to exempt dividend income.

(b) Deduction of interest expenses as part of cost of acquisition of mutual fund units for capital gains computation is not allowed.

(c) The Assessing Officer is directed to disallow interest expenses attributable to exempt income under Section 14A after giving the Assessee an opportunity to present details.

Accordingly, the appeal is partly allowed on these terms.