Allowability of Interest on Borrowings advanced on Interest Free Basis Allowability of Interest on Borrowings advanced on Interest Free Basis S. 36(1)(iii): Law on when interest expenditure on loans diverted to sister concerns and directors can be allowed as business expenditure explained Citation :- Hero Cycles (P) Ltd vs. CIT (Supreme Court) | CIVIL APPEAL NO. 514 OF 2008 Facts of the Case and Why Revenue Disallowed the Claim of Interest The present appeal preferred by the assessee pertains to the Assessment Year 1988-1989. In the income tax return filed by the assessee for the aforesaid Assessment year, the assessee, inter alia, claimed deduction of interest paid on borrowed sums from Bank under the provisions of Section 36(1)(iii) of the Income Tax Act (hereinafter referred to as ‘Act’). The aforesaid deduction was disallowed by the Assessing Officer vide his Assesssment Order dated 26.03.1991 on the following two points: – (1) The assessee had advanced a sum of Rs.1,16,26,128/- to its subsidiary company known as M/s. Hero Fibers Limited and this advance did not carry any interest. According to the Assessing Officer, the assessee had borrowed the money from the banks and paid interest thereupon. Deduction was claimed as business expenditure but substantial money out of the loans taken from the Bank was diverted by giving advance to M/s. Hero Fibres Limited on which no interest was charged by the assessee. Therefore, he concluded that money borrowed on which interest was paid was not for business purposes and no deduction could be allowed. (2) In addition, the assessee had also given advances to its own directors in the sum of Rs. 34 lakhs on which the assessee charged from those directors interest at the rate of 10 per cent, whereas interest payable on the money taken by way of loans by the assessee from the Banks carried interest at the rate of 18 per cent. On that basis, the Assessing Officer held that charging of interest at the rate of 10 per cent from the above mentioned persons and paying interest at much more rate,i.e., at the rate of 18 per cent on the money borrowed by the assessee cannot be treated for the purposes of business of the assessee. CIT (Appeals) & ITAT Set Aside the Demand The CIT (Appeals) set aside the order of the Assessing Officer holding that the interest paid by the assessee of which deduction was claimed, on the facts of this case, was for business purposes and, therefore, the entire interest paid by the assessee should have been allowed as business expenditure. Hon’ble Supreme Court Ruled in Assessee’s Favour i) Insofar as loans to the sister concern / subsidiary company are concerned, law in this behalf is recapitulated by this Court in the case of ‘S.A. Builders Ltd. v. Commissioner of Income Tax (Appeals) and Another’ [2007 (288) ITR 1 (SC)]. Once it is established that there is nexus between the expenditure and the purpose of business (which need not necessarily be the business of the assessee itself), the Revenue cannot justifiably claim to put itself in the arm-chair 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. It further held that no businessman can be compelled to maximize his profit and that the income tax authorities must put themselves in the shoes of the assessee and see how a prudent businessman would act. The authorities must not look at the matter from their own view point but that of a prudent businessman. (ii) Applying the aforesaid ratio to the facts of this case as already noted above, it is manifest that the advance to M/s. Hero Fibres Limited became imperative as a business expediency in view of the undertaking given to the financial institutions by the assessee to the effect that it would provide additional margin to M/s. Hero Fibres Limited to meet the working capital for meeting any cash loses. It would also be significant to mention at this stage that, subsequently, the assessee company had off-loaded its share holding in the said M/s. Hero Fibres Limited to various companies of Oswal Group and at that time, the assessee company not only refunded back the entire loan given to M/s. Hero Fibres Limited by the assessee but this was refunded with interest. In the year in which the aforesaid interest was received, same was shown as income and offered for tax. (iii) Insofar as the loans to Directors are concerned, it could not be disputed by the Revenue that the assessee had a credit balance in the Bank account when the said advance of Rs. 34 lakhs was given. Remarkably, as observed by the CIT (Appeal) in his order, the company had reserve/surplus to the tune of almost 15 crores and, therefore, the assessee company could in any case, utilise those funds for giving advance to its Directors. 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S. 36(1)(iii): Law on when interest expenditure on loans diverted to sister concerns and directors can be allowed as business expenditure explained 

Citation :-  Hero Cycles (P) Ltd vs. CIT (Supreme Court)  | CIVIL APPEAL NO. 514 OF 2008

Facts of the Case and Why Revenue Disallowed the Claim of Interest

The present appeal preferred by the assessee pertains to the Assessment Year 1988-1989. In the income tax return filed by the assessee for the aforesaid Assessment year, the assessee, inter alia, claimed deduction of interest paid on borrowed   sums   from   Bank   under   the   provisions   of   Section 36(1)(iii) of the Income Tax Act (hereinafter referred to as ‘Act’).     The   aforesaid   deduction   was   disallowed   by   the
Assessing   Officer   vide   his   Assesssment   Order   dated 26.03.1991 on the following two points: –

(1) The   assessee   had   advanced   a   sum   of Rs.1,16,26,128/- to its subsidiary company known as M/s.
Hero Fibers Limited and this advance did not carry any interest.     According   to   the   Assessing   Officer,   the assessee had borrowed the money from the banks and paid interest thereupon.   Deduction was claimed as business expenditure but substantial money out of the loans taken from the Bank was diverted by giving advance to M/s. Hero Fibres Limited on which no interest was charged by the assessee.  Therefore, he concluded that money borrowed on which interest was paid was not for business purposes and
no deduction could be allowed.

(2) In addition, the assessee had also given advances to its own directors in the sum of Rs. 34 lakhs on which the assessee   charged   from   those   directors   interest   at   the rate   of   10   per   cent,   whereas   interest   payable   on   the money  taken  by  way  of  loans  by  the  assessee  from  the Banks carried interest at the rate of 18 per cent.   On that basis, the Assessing Officer held that charging of interest   at   the   rate   of   10   per   cent   from   the   above mentioned persons and paying interest at much more rate,i.e., at the rate of 18 per cent on the money borrowed by the   assessee   cannot   be   treated   for   the   purposes   of business of the assessee.

CIT (Appeals) & ITAT Set Aside the Demand

The CIT (Appeals) set aside the order of the Assessing Officer holding that the interest   paid   by   the   assessee   of   which   deduction   was claimed,   on   the   facts   of   this   case,   was   for   business
purposes   and,   therefore,   the   entire   interest   paid   by   the assessee should have been allowed as business expenditure.

Hon’ble Supreme Court Ruled in Assessee’s Favour 

i) Insofar as loans to the sister concern / subsidiary company are concerned, law in this behalf is recapitulated by this Court in the case of ‘S.A. Builders Ltd. v. Commissioner of Income Tax (Appeals) and Another’ [2007 (288) ITR 1 (SC)]. Once it is established that there is nexus between the expenditure and the purpose of business (which need not necessarily be the business of the assessee itself), the Revenue cannot justifiably claim to put itself in the arm-chair 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.

It further held that no businessman can be compelled to maximize his profit and that the income tax authorities must put themselves in the shoes of the assessee and see how a prudent businessman would act. The authorities must not look at the matter from their own view point but that of a prudent businessman.

(ii) Applying the aforesaid ratio to the facts of this case as already noted above, it is manifest that the advance to M/s. Hero Fibres Limited became imperative as a business expediency in view of the undertaking given to the financial institutions by the assessee to the effect that it would provide additional margin to M/s. Hero Fibres Limited to meet the working capital for meeting any cash loses. It would also be significant to mention at this stage that, subsequently, the assessee company had off-loaded its share holding in the said M/s. Hero Fibres Limited to various companies of Oswal Group and at that time, the assessee company not only refunded back the entire loan given to M/s. Hero Fibres Limited by the assessee but this was refunded with interest. In the year in which the aforesaid interest was received, same was shown as income and offered for tax.

(iii) Insofar as the loans to Directors are concerned, it could not be disputed by the Revenue that the assessee had a credit balance in the Bank account when the said advance of Rs. 34 lakhs was given. Remarkably, as observed by the CIT (Appeal) in his order, the company had reserve/surplus to the tune of almost 15 crores and, therefore, the assessee company could in any case, utilise those funds for giving advance to its Directors.

Complete Text of the Judgement is as under:-