(a) Income‑tax‑‑‑

Interest on borrowed capital‑‑‑Meaning of "interest"‑‑Assessing Officer extra amount paid as interest for non‑commercial reasons‑‑‑ Amount of rupees two lakhs borrowed from charitable trust founded by Director of assessee‑company‑‑‑Amounts of more than rupees one and a half lakhs a year paid as finance charges in two years‑‑‑Loan continuing beyond agreed date of re‑payment‑‑‑Assessing Officer was justified in disallowing interest in excess of fifteen per cent. per annum on borrowed money‑‑‑Indian Income Tax Act, 1961, S.36(1)(iii).

"Interest" is the return or compensation for the retention by one person of a sum of money belonging 'to or owed to another. The essence of interest is that it is a payment which becomes due because the creditor has not had his money at the due date. It may be regarded either as representing the profit he might have made if he had the use of the money, or conversely, the loss he suffered because he had not that use. The general idea is that he is entitled to compensation for the deprivation. It is only interest in the above sense which is deductible under section 36(1)(iii) of the Income Tax Act, 1961 If in the garb of interest something more is paid over and above "interest", that something cannot be allowed as deduction under this section. What is allowable as a deduction under section 36(1)(iii) of the Act is any sum paid by way of interest in the commercial sense. There can be no straitjacket formula. The Income‑tax Officer cannot refuse to allow the deduction of interest on the ground that the rate of interest is high or that the assessee could have borrowed money at lower rate .of interest. But if the Income‑tax Officer comes to a finding that what is claimed as deduction by way of interest is, in fact, not wholly payment by way of interest but partly interest and partly payment of non‑commercial considerations, he may allow the deduction of the amount which is interest and disallow the balance which is for extra commercial considerations.

Dharamvir Dhir v. CIT (1961) 42 ITR 7 (SC) applied.

The assessee was a private limited company. The shares of the assessee‑company were held by the members of a single family. The assessee‑company took a loan of Rs.2 lakhs from a trust F. The assessee was liable to pay finance charges to the trust for the amount of loan. During the previous year relevant to the assessment years 1969‑70. 1970‑7? and 1971‑72, the assessee credited Rs. 1,54,884, Rs. 1,70,848 and Rs.82,120, respectively, to the account of the trust as finance charges for a loan of Rs.2 lakhs and claimed the same as deduction in the computation of its income of the respective years. The claim was allowed by the Income‑tax Officer. However, while completing the assessment of the assessee for the assessment year 1975‑76, the Income‑tax Officer found that the trust was founded by one D, who was a senior member of the group of shareholders, known as. "Apar Group" and the affairs of the trust, which was a charitable trust, were controlled by "T" the founder of the assessee‑company, through his kith and kin. The Income‑tax Officer was oaf the opinion that payment of finance charges at exorbitant rates was not by way of interest but for extraneous considerations. The Income‑tax Officer held that the payment of finance charges at the rate of 15 per cent. per annum on the amount borrowed could be considered reasonable. He, therefore, allowed finance charges calculated at the rate of 15 per cent. per annum as interest under section 36(1)(iii) and disallowed the amount credited as finance charges in excess thereof. On the basis of the above information, the assessments for the assessment years 1969‑70, 1970‑71 and 1971‑72 were reopened under section 147(4,'1 of the Act and finance charges at the rate of 15 per cent. per annum as interest was allowed and the amount credited to the account of the trust by way of finance charges in excess thereof was disallowed. The Commissioner (Appeals) allowed the appeal of the assessee which was upheld by .the Tribunal. On a reference:

Held, that the admitted position was that there had been no re payment of the loan on or before the due date, viz., March 31; 1972. It remained with the assessee for years. It appeared in the accounts of the assessee for the assessment year 1979‑80. There was also no dispute about the fact that the trust was founded by one of the directors of the assessee company. Admittedly, all the shares of the assessee-company were held by the members of one family of which the said director was a senior member. There was nothing on record to show that the assessee's financial condition justified borrowing a sum of Rs.2 lakhs on the terms set out in the agreement as a result of which, it was required to pay for borrowing a sum of Rs.2 lakhs, Rs.1,54,884 as finance charges in one year, Rs.1,70,848 in the second year and Rs.82,120 in the third year and to keep the amount for years even after the due date of re‑payment, vii., March 31, 1972, on such stringent terms of payment of finance charges. It was obvious that the object was to pay certain amount to the trust for considerations other than commercial. In the circumstances, the Income‑tax Officer was justified in holding that part of the amount credited to the account of the trust by way of finance charges could be regarded as interest on borrowings and to disallow the balance as payment on account of extra commercial considerations.

(b) Words and phrases‑‑

‑‑‑‑‑ Interest"‑‑‑Meanings.

Riches v. Westminster Bank Ltd. (1947) SC 390 (HL) ref.

R. V. Desai with P. S. Jetleyfor the Commissioner.

S.J. Mehra with I.A. Munium and Ms. A. Visinji for the Assessee.

JUDGMENT

DR. B.P. SARAF, J.‑‑‑By this reference under section 256(1) of the Income Tax Act, 1961, the Income‑tax Appellate Tribunal has referred the following question of law to this Court for opinion:

"Whether, on the facts and in the circumstances of the case and in law, the Tribunal was justified in holding that the payment of Rs.1,54,884, Rs.1,70,848 and Rs.82,120 representing finance charges on the loan taken from a closely connected trust, is allowable in full as a deduction for the assessment years 1969‑70, 1970‑71 and 1971‑72, respectively?"

The material facts giving rise to this reference are as follows:

The assessee is a private limited company. The shares of the assessee‑company are held by the members of a single family. The assessee company took a loan of Rs.2 lakhs from one D.R. Foundation Trust under a memorandum of agreement, dated March 5, 1967. Under that agreement, the assessee was liable to pay finance charges to the trust for the amount ofloan. During the previous years relevant to the assessment years 1969‑70, 1970‑71 and 1971‑72, the assessee credited Rs.1,54,884, Rs.1,70,848 and Rs.82,120, respectively, to the account of the trust as finance charges for a loan of Rs.2 lakhs and claimed the same as deduction in the computation of its income of the respective years. The claim was allowed by the Income‑tax Officer. However, while completing the assessment of the assessee for the assessment year 1975‑76, the Income‑tax Officer found that the trust was founded by one Shir D.D. Desai, who was a senior member of the group of shareholders known ac "Apar Group" and the affairs of the said trust, which was a charitable trust, were controlled by the founder of the assessee company Shri D.D. Thakur through his kith and kin. The Income‑tax Officer was of the opinion that payment of finance charges at exorbitant rates was not by way of interest but for extraneous consideration. The Income‑tax officer held that the payment of finance charges at the rate of 15 per cent. per annum on the amount borrowed can only be considered reasonable. He, therefore, allowed finance charges calculated at the rate of 15 per cent. per annum as interest under section 36(1)(iii) and disallowed the amount credited as finance charges in excess thereof. On the basis of the above information, the assessments for the assessment years under reference were reopened under section 147(a) of the Act. As in the: assessment for thee assessment year 1975‑76, in re‑assessment orders made for these three assessment years, the income‑tax Officer allowed deduction of finance charges calculated at the rate of 15 per cent. per annum as interest uncle; section 36(1)(iii) and disallowed the claim for deduction of the amount credited to the account of the trust by way of finance charges in excess thereof. The assessee appealed to the Commissioner of Income‑‑tax (Appeals). The Commissioner (Appeals) allowed the appeal of the assessee. The appeal of the Revenue against the above order of the Commissioner (Appeals) was rejected by the Income‑tax Appellate Tribunal ("the Tribunal"). Hence, this reference at the instance of the Revenue.

Mr. R.V. Desai, learned counsel for the Revenue, submits that the Income‑tax Officer was justified in disallowing deduction of finance charges in excess of 15 per cent. per annum of the loan amount under section 36(1)(iii) of the Act. It was pointed out by the learned counsel that on the facts and circumstances of the case, the Income‑tax Officer had found that the payment of Rs.I,54,884, Rs.1,70,848 and Rs.80,120 to the trust founded by one of the directors of the assessee‑company by way of finance charges or interest on borrowing of Rs.2 lakhs in the three assessment years was for extra‑commercial consideration. This finding of the Income‑tax Officer., according to Mr. Desai, is evident from his observation that the trust was founded by one of the directors of the assessee‑company. The Income‑tax Officer was of the opinion that the amount credited to the account of the said trust to the extent of 15 per cent. per annum of the borrow amount can only be regarded as‑ interest. He, therefore, allowed the deduction under section 36(1)(iii) of finance charges calculated at that rate as "interest" and disallowed the balance. The disallowance of the balance amount, according to learned counsel for the Revenue, is on the ground that it was not interest but payment for extra‑commercial consideration. It was contended that the Commissioner (Appeals) went wrong in reversing the above finding of the Income‑tax Officer without taking note of this aspect of the matter and the Tribunal perpetuated that wrong by upholding the same.

Mr. S. J. Metha, learned counsel for the assessee, on the other hand, submits that, having found that the amount of Rs.2 lakhs had in fact been borrowed by the assessee from the trust and the amount claimed as finance charges had been credited to the account of the trust in terms of the memorandum of agreement between the assessee and the trust, the Income tax Officer had no power or authority to disallow any portion of the amount payable to the trust under the said agreement by way of finance charges. Learned counsel contended that in such circumstances this Court cannot go behind the finding of fact arrived at by the authorities below and take a different view in the matter. According to him, section 36(1)(iii) of the Act which provides for deduction of interest in respect of the capital borrowed for the purpose of the business or profession does not authorise or empower the Income‑tax Officer to examine the reasonableness of the rate of interest. Learned counsel submitted that the amount credited by the assessee to the trust account as finance charges under the agreement was nothing but interest on the borrowings and in such cases, unless the factum of borrowing was challenged, it was not open to the Income‑tax Officer to disallow any part of the amount payable by way of finance charges, even, if he was of the opinion that the interest paid was excessive or. unreasonable. Reliance was placed in support of this contention on the decision of the Supreme Court in Dharamvir Dhir v. CIT (1961) 42 ITR 7.

We have carefully considered the rival submissions. There is no dispute about the fact that any amount of interest paid on amount (sic) by way of capital on borrowing for the purpose of business or profession is allowable as a deduction under section 36(1)(iii) of the Act. In the instant case, a sum of Rs.2 lakhs had been borrowed by the assessee from the trust for the purpose of its business That being so, interest on such borrowing, is allowable as a deduction under section 36(1)(iii) of the Act The controversy is, whether the full amount paid in this case by way of finance charges on the amount of Rs.2 lakhs which, in the opinion of the Income‑tax Officer, is not merely by way of interest, but also for extra commercial considerate ins can be allowed as a deduction. The Income‑tax Officer was of the opinion that part of the finance charges, which can be regarded as interest on borrowing can only be allowed as a deduction and the amount in excess thereof being for non‑commercial consideration should be disallowed. He, accordingly, allowed finance charges calculated at the rate of 15 per cent. of the amount borrowed and disallowed the balance. We have perused the order of the Income‑tax Officer. We have also perused the memorandum of agreement, (Dr. B. P. Saraf, J) dated May 9, 1967, under which the amount of Rs.2 lakhs had been borrowed by the assessee from the trust. In the preamble of the said agreement, it is stated that the assessee was in urgent need of finance and the trust agreed to advance a sum of Rs.2 lakhs on the terms and conditions set out therein. One of the terms of the agreement was that the amount should be utilised by the assessee for the purpose of business only and not for any other purpose. It reads:

"In consideration of the, finance of the said amount of Rs.2,00,000 the financiers are entitled to 196 (one per cent.) of the net sale proceeds of the company every year by way of return provided that in no case the amount payable by way of dues to the financiers by the company shall be less than Rs.30,000 for a year."

Under the said agreement, the assessee‑company was obliged to repay the amount with interest thereon on or before March 31, 1972, unless the parties consented to extend the time for repayment.

The admitted position is that no repayment was made on or before that date. 'It remained with the assessee for years. It appears ever in the accounts of the assessee for the assessment year 1979‑80. There is also no dispute about the fact that the trust was founded by one of the directors of the assessee‑company. Admittedly, all the shares of the assessee‑company are held by the members of one family of which the said director was a senior member. There is nothing on record to show that the assessee's financial condition justified borrowing a sum of Rs.2 lakhs on the terms set out in the agreement, as a result of which, it was required to pay for borrowing a sum of Rs.2 lakhs, Rs.1,54,884 as finance charges in one year, Rs.1,70,848 in the second year and Rs.82,120 in the third year and to‑keep the amount for years and years even after the due date of repayment, viz., March 31, 1972, on such stringent terms of payment of finance charges. it is obvious that the object was to pay certain amounts to the trust. for considerations other than commercial. Mr. Mehta, learned counsel for the assessee, was fair enough to draw our attention to the amendment of clause 3 of the agreement by another agreement, dated May 1, 1976, by which the finance charges on the borrowing were restricted to 15 per cent. per annum on the amount borrowed. This was done by incorporating the following proviso to clause 3 of the original agreement:

"Provided further that with effect from May 1, 1976, the amount payable by way of dues to the financiers by the company for jury year ending April 30, shall not exceed 15 per cent. calculated on the total of the amount outstanding as loan and unpaid amount of finance charges." .

By the above amendment, the rate of finance charges was restricted to an amount calculated at tire rate of 15 per cent. of the amount of the outstanding loan. Undoubtedly, finance charges so calculated can be regarded as "interest".

From the facts and circumstances of the case set out above, it is clear that the so‑called finance charges credited during the years under reference did not represent Interest but interest plus something which was not for commercial consideration. There is nothing on record to show that the assessee‑company was in such financial hardship and continued to be in that situation throughout to justify retention of the borrowing of Rs.2 lakhs on such stringent terms, as a result of which it was required to pay finance charges of Rs.1,54,884, Rs.1,70,848 and Rs.82,120 during the three assessment years for borrowing a paltry sum of Rs. 2 lakhs. Obviously, the intention was to benefit the trust, which was founded by one of the directors of the assessee‑company. In such a situation, the Income‑tax Officer was justified in allowing that part of the amount credited to the account of the trust by way of finance charges which, according to him, could be regarded as interest on borrowings and to disallow the balance as payment on account of extra commercial considerations. Though the Income‑tax Officer ' in his order, has not said so‑ in that language, it is implicit from his following

"Normally in respect of such advance, only interest is payable. There is no other reason put forth for paying one per cent. of thesales towards such interest, whether it is called interest or financial

In view of the above, in our view, in the facts and circumstances of the case, the action of the Income‑tax Officer was fully justified and the Commissioner of Income‑tax (Appeals) and the Income‑tax Appellate Tribunal were not correct in reversing the same.

We have also given our careful consideration to the submission of Mr. Mehta that the Income‑tax Officer has no power under section 36(1)(iii) of the Act to examine the reasonableness of the rate of interest paid by the assessee on borrowings and to disallow any part of the amount which is paid by the assessee as interest on borrowings. We find it difficult to accept the above contention because, in our opinion, the income‑tax Officer is undoubtedly entitled, while considering the claim for deduction under section 36(1)(iii) of the Act to examine whether the amount paid as interest is really "interest" and if he finds that it is not wholly interest but partly interest and partly payment for extra‑commercial consideration, to allow only that part of the so‑called interest which in his opinion is "interest" and disallow the balance which is for extra‑commercial considerations. It is true that in the normal course, the income‑tax Officer cannot disallow any part of the interest on the ground that the rate of interest is high but that does not mean that he has to allow anything and everything claimed by the assessee, as interest on the amounts borrowed, even if he finds that in fact all that has been paid is not "interest".

"Interest" is the return or compensation for the retention by one person of a sum of money belonging to or owed to another. The essence of interest is that it is a payment which becomes due because the creditor has not had his money at the due slate. It may be regarded either as representing the profit he might have made if he had had the use of the money, or, conversely, the loss he suffered because he had not that use. The general idea is that he is entitled to compensation for the deprivation. (Per Lord Wright in Riches v. Westminster Bank Ltd. (1947) AC 390 at page 400 (HL)). It is only interest in the above sense which is deductible under section 36(1)(iii) of the Act. If in the garb of interest, something more is paid over and above "interest", that something cannot be allowed as deduction under this section. It will not be correct to say that once a claim is made for deduction of any amount by, way of interest on the amount borrowed for the purpose of business, the Income‑tax Officer has no power even to examine whether the amount claimed as "interest" is really an interest, wholly or in part, and if he finds that it is not wholly interest, to ascertain that part of it which is interest and restrict the allowance of deduction under section 36(1)(iii) only to that part which represents interest and to disallow the balance. In our opinion, under section 36(I)(iii)‑of the Act, the assessee is entitled to deduction only of that part of the amount paid by him for money borrowed which can, genuinely be regarded as interest. Any and every payment in the garb of interest in excess of what can really be termed as "interest" cannot be allowed as a deduction under that section.

We have perused the decision of the Supreme Court in Dhnrarnvir Dhir v. CIT (1961) 42 ITR 7, on which reliance has been placed by learned counsel for the assessee. We fail to understand how that decision support die case of the assessee. On the other hand, in our opinion, that judgment la the facts and circumstances of the present case, goes against the assessee. In that case, the assessee was an employee of a firm earning a salary of Rs.10,572 and Rs.500 from shares annually. He entered into a coal raising contract with a coal company, but as he did not have the requisite funds for his business, he entered into an agreement with a public charitable trust for the advance to him of sums up to rupees one and a half lakhs on payment of interest at the rate of six per cent. per annum and 11/16ths of the profits of the business. The assessee agreed that the coal raising contract would be carried on in accordance with the policy settled between him and the trust. The trust could withdraw its money at any time and stop further advances. It was not liable for any losses. The assessee was also to send monthly returns to the trust. In pursuance of this agreement, the assessee paid during the accounting years relevant to the assessment years 1947‑48 and 1948‑49 besides interest, the sum of Rs.72,963 and Rs.75,526 and claimed these amounts as allowable deductions. The Appellate Tribunal found that the average amount of loan advanced by the trust to the assessee in 1946 was Rs.18,100 and the High Court, on a reference,,, held that this was a case of joint adventure between the assessee and the trust on the arrangement that they shall divide the profits in specified proportions and that, therefore, the amounts paid by the assessee to the trust were not allowable expenditure. The assessee appealed to the Supreme Court. The Supreme Court found that the records showed that the advances were very considerable in the first year ranging from Rs.12,000 in January, 1946 to Rs.1,86,000 in July of that year and in the following months of that year they ranged from Rs.59,000 to Rs.7,000. In the following years beginning from the end of the 1946 to 1953 considerable sums of money had been advanced which ranged on an average from Rs.1,97,000 in 194: to Rs.3,17,000 in 1953. It was on these facts that the Supreme Court held that in a commercial sense, the payments were an expenditure wholly and exclusively laid out for the purpose of the assessee's business and they were, therefore, deductible revenue expenditure. The Supreme Court, observed that in cases‑like this in order to justify the deduction the sum given up must be for reasons of commercial expediency. It may be voluntary but so long as it was incurred for the assessee's benefit, i.e., for the carrying on of his business, the deduction would be allowable.

It is clear from the above decision, that the Supreme Court allowed the deduction in view of the peculiar facts and circumstances of that case and the finding that the payments were for the purpose of the assessee's business in a commercial sense, We fail to understand how this judgment of the Supreme Court supports the case of the assessee. In fact, in our opinion, the ratio of this decision squarely supports the view we have taken in this case that what is allowable as a deduction under section 36(l)(iii) of the Act is any sum paid by way of interest in the commercial sense. This determination has to be done by the Income‑tax Officer having regard to the facts and circumstances of each case: There can be no straitjacket formula. The Income‑tax Officer cannot refuse to allow the deduction of interest on the ground that the rate of interest is high or that the assessee could have borrowed money at a lower rate of interest. But if the Income‑tax Officer comes to a finding that what is claimed as deduction by way of interest is, in fact not wholly payment by way of interest but partly interest and partly payment for non‑commercial consideration, he may allow the deduction of the amount which is interest and disallow the balance which is for extra commercial considerations. In view of the above discussion, we ‑answer the question referred us in the negative, i.e., in favour of the Revenue and against the assessee.

M.B.A./374/FCReference answered.