2025 (6) TMI 1831 - AT - Income Tax

Addition u/s 36(1)(iii) - interest free advances given by assessee to its sister concern - commercial expediency or not? - HELD THAT - Perusal of the order of the CIT(A) reveals that the assessee company has advanced an interest free loan to its sister concern and it has debited its profit loss account of interest as paid to the banks and financial institution on secured loan raised for construction etc. CIT(A) called the remand report during the appeal proceedings and found that there is nothing on record to prove that the interest free advance to the sister concern was made for non-business purposes. From the order of the Ld. CIT(A) it is evident that the investee company has been regularly paying the advance tax and effective tax rate in the hands of investee is more than the assessee CIT(A) has examined the issue in correct prospective and rightly deleted the additions towards disallowances u/s 36(1) (iii) made by the A.O. Appeal of the revenue is dismissed.

Summary

The core legal issues considered by the Tribunal in this appeal arising from the assessment under section 153A read with section 143(3) of the Income Tax Act, 1961, relate primarily to the validity of disallowance under section 36(1)(iii) of the Act. The issues can be summarized as follows:

1. Whether the Commissioner of Income Tax (Appeals) was correct in deleting the addition made under section 36(1)(iii) on account of interest-free advances given by the assessee to its sister concern, considering whether such advances were for business purposes and whether the Assessing Officer (AO) had made any findings to prove that the advances were interest-bearing funds diverted for non-business purposes and without commercial expediency.

2. Whether the CIT(A) erred in concluding that there was no tax evasion plan, particularly in light of the fact that the tax rates of the two companies were different and the assessee had not incorporated surcharge and cess in its tax figures.

3. Whether the CIT(A) was justified in ignoring the absence of documentary evidence from the assessee to prove receipt of services from the sister concern in lieu of interest-free funds, such as marketing trade name, technical know-how, office space, skilled staff, or bank guarantees.

4. Whether the AO was correct in making the disallowance despite providing the assessee opportunity to submit documentary evidence regarding utilization of interest-bearing funds by the sister concern, which the assessee failed to produce.

5. Whether the CIT(A) erred in ignoring the lack of documentary evidence from the assessee regarding loans given to the sister concern out of interest-free funds received from advances from customers or other group entities, to demonstrate business utilization of such funds.

Issue-Wise Detailed Analysis

Issue 1: Validity of Disallowance Under Section 36(1)(iii) on Interest-Free Advances

Legal Framework and Precedents: Section 36(1)(iii) disallows interest expenditure where borrowed funds are not utilized for business purposes. The Supreme Court in S.A. Builders Ltd. vs CIT established that interest paid on borrowed funds is deductible only if the funds are used for business or commercial expediency, including use by sister concerns or subsidiaries, provided there is a nexus with business purpose. The Delhi High Court in Punjab Stainless Steel Industries held that the test of commercial expediency is critical, and mere availability of interest-free funds does not justify disallowance if the loan is extended for commercial expediency.

Court's Interpretation and Reasoning: The AO disallowed Rs. 2,80,10,435/- as interest on the basis that the assessee had diverted borrowed funds (secured loans) to its sister concern as interest-free advances, which were not used for business purposes. The AO calculated the disallowance by applying 12% interest on the difference between secured loans and the amount invested in work-in-progress (WIP), presuming the balance was advanced interest-free to the sister concern.

The CIT(A) noted that the assessee had advanced Rs. 87 crore interest-free to the sister concern from its own interest-free funds (share capital, reserves, advances from customers), while the borrowed funds were utilized in business. The CIT(A) found no material on record indicating that the interest-free advances were for non-business purposes or lacked commercial expediency. The CIT(A) relied on judicial precedents emphasizing commercial expediency and held that since both companies were paying tax at maximum marginal rates and there was no tax evasion, the disallowance was not justified.

Key Evidence and Findings: The assessee submitted an agreement dated 01.07.2014 evidencing business support services between the companies. Copies of income tax returns showed that both entities paid advance tax regularly, with the investee company having an effective tax rate higher than the assessee. The AO admitted that tax revenue was received periodically, negating any tax avoidance intent.

Application of Law to Facts: The Tribunal concurred with the CIT(A) that the interest-free advances were out of own funds and for commercial expediency. The absence of any finding by the AO on non-business use or tax evasion was significant. The arrangement was held to be genuine and bonafide, with no justification for disallowance under section 36(1)(iii).

Treatment of Competing Arguments: The revenue argued that the advances were diverted borrowed funds and thus disallowance was warranted. The assessee countered that borrowed funds were used for business, advances were from own funds, and both companies paid taxes at similar rates. The CIT(A) and Tribunal favored the assessee's position based on commercial expediency and absence of tax evasion.

Conclusion: The disallowance under section 36(1)(iii) was rightly deleted as the advances were for commercial expediency and no tax evasion was established.

Issue 2: Alleged Tax Evasion and Different Tax Rates

Legal Framework and Precedents: The principle from Glaxo Smithkline Asia Pvt. Ltd. is that related party transactions must be scrutinized for revenue loss or tax evasion. If the arrangement is revenue neutral, no disallowance should be made. The Supreme Court in Excel Industries Ltd. emphasized pragmatic rather than pedantic approaches, discouraging litigation when revenue is not deprived.

Court's Interpretation and Reasoning: The CIT(A) examined the tax returns and found that both the assessee and sister concern paid taxes at comparable or higher effective rates. The AO's claim that tax evasion was planned was not supported by evidence. The CIT(A) held that since tax was paid regularly and no tax evasion was apparent, the disallowance was unwarranted.

Key Evidence and Findings: Tax returns showed the assessee's taxable income at Rs. 2.33 crore and tax paid Rs. 77 lakh (33.06%), while the sister concern declared Rs. 12.39 crore income and Rs. 4.28 crore tax (34.60%). The AO admitted advance tax was paid periodically by both entities.

Application of Law to Facts: The Tribunal upheld the CIT(A)'s view that the arrangement was revenue neutral and no tax evasion existed. Different tax rates claimed by the revenue were not substantiated with surcharge and cess, and thus not determinative.

Treatment of Competing Arguments: Revenue's assertion of different tax rates and tax evasion was rejected due to lack of evidence and contradictory tax payment records.

Conclusion: The CIT(A) correctly dismissed the tax evasion allegation and the appeal on this ground was dismissed.

Issue 3: Lack of Documentary Evidence Regarding Services Received in Lieu of Interest-Free Advances

Legal Framework and Precedents: The law does not mandate that interest-free advances must be supported by documented services to qualify as business expenditure or for commercial expediency. The focus is on the commercial purpose and nexus with business.

Court's Interpretation and Reasoning: The CIT(A) noted the existence of a business support agreement and the similar business activities of both companies. The AO did not dispute the agreement. The absence of specific documentary proof of services such as trade name use or technical know-how was not held fatal, given the overall commercial context.

Key Evidence and Findings: The agreement between the companies and the similar nature of their businesses supported the commercial expediency of the advances.

Application of Law to Facts: The Tribunal agreed that the advances were part of a business plan and commercial expediency, and lack of detailed documentary proof of services did not negate this.

Treatment of Competing Arguments: Revenue's insistence on documentary proof of services was not accepted as a prerequisite for allowing the deduction.

Conclusion: Absence of documentary evidence of services did not justify disallowance.

Issue 4 and 5: Opportunity to Submit Evidence and Loans from Interest-Free Funds

Legal Framework and Precedents: The burden of proof lies on the assessee to establish business use of funds. However, the AO must consider the evidence submitted and cannot disallow on mere presumption.

Court's Interpretation and Reasoning: The CIT(A) found that the assessee had provided explanations and documentary evidence such as agreements and tax returns. The AO's claim that no documentary evidence was submitted was contradicted by the record. The CIT(A) held that the AO failed to prove non-business use or tax evasion.

Key Evidence and Findings: The assessee's submissions and remand report clarified the source and use of funds, and the AO did not demonstrate any misuse.

Application of Law to Facts: The Tribunal upheld the CIT(A)'s conclusion that the disallowance was not justified due to lack of adverse findings on documentary evidence.

Treatment of Competing Arguments: Revenue's argument on lack of evidence was rejected as the record showed sufficient explanation and no contrary finding.

Conclusion: The CIT(A) rightly ignored the AO's claim of non-submission of evidence and deleted the disallowance.

Significant Holdings

"In view of the above judgments particularly in the case of S A Builders Ltd. vs CIT [2007] 288 ITR 1 (SC) and provisions contained in Section 36(1)(iii) of Income Tax Act, the interest paid by the assessee in respect of capital borrowed for the purpose of business or profession is to be allowed as a deduction. Hence, the question to be considered in a case such as in the case of the Appellant is as to whether the interest free advance was made by the assessee for commercial expediency or not."

"Therefore, under these facts and circumstances of the case, in my view, the case does not indicate any tax evasion plan. Both the companies are taxpaying entities at the same rate of tax. Therefore, so long as the arrangement is genuine and bonafide and the intention is not to evade taxes, it cannot be disregarded for the purpose of determination of tax liability of the appellant."

"The Hon'ble Supreme Court in the case of S A Builders Ltd. vs CIT held that 'once it is established that there was nexus between the expenditure and the purpose of the business (which need not necessarily be the business of the assessee itself), the Revenue cannot justifiably claim to put itself in the armchair of the businessman or in the position of the board of directors and assume the role to decide how much is reasonable expenditure having regard to the circumstances of the case.'"

"In the case of Glaxo Smithkline Asia Pvt. Ltd. the Hon'ble Supreme Court has held that in the case of related party transactions the authorities must examine whether there is any loss of revenue. And if exercise is revenue neutral, then the matter may be decided accordingly."

"The AO has correctly invoked the provisions of section 153A and the ground taken by the appellant is hereby dismissed."

"The appeal filed by the revenue is liable to be dismissed."

The Tribunal ultimately dismissed the revenue's appeal, affirming the CIT(A)'s deletion of the disallowance under section 36(1)(iii). The core principle established is that interest paid on borrowed funds is deductible if the funds are used for business purposes or commercial expediency, including advances to sister concerns, provided there is no tax evasion or misuse. The absence of adverse findings on non-business use and the presence of genuine business arrangements and tax payments by both entities negate the basis for disallowance. The Tribunal emphasized a pragmatic and realistic approach consistent with judicial precedents, discouraging unnecessary litigation where revenue is not deprived.