K. SOMASUNDARAM & BROTHERS VS COMMISSIONER OF INCOME-TAX
2001 P T D 101
[238 I T R 939]
[Madras High Court (India)]
Before R. Jayasimha.Babu and Mrs. A. Subbulakshmy, JJ
K. SOMASUNDARAM & BROTHERS
versus
COMMISSIONER OF INCOME‑TAX
Tax Cases Nos. 125 and 126 of 1986 (Reference No.55 of 1986), decided on 03/08/1998.
Income‑tax‑‑
‑‑‑‑Business expenditure‑‑‑Interest on borrowed capital‑‑‑Condition precedent for deduction‑‑‑Capital must be used in business‑‑‑Borrowed capital invested in executing contracts‑‑‑From contract receipts, sums advanced interest free to relatives of partners‑‑‑Interest paid on borrowed capital to extent relatable to sums advanced to relatives not deductible‑‑‑Indian Income Tax Act, 1961, S.36(1)(iii).
Section 36(1)(iii) of the Income Tax Act, 1961, refers to "the amount of the interest paid in respect of capital borrowed for the purposes of the business or profession". It is implicit in this provision that the capital so borrowed should not only be invested in the business, but that the amount borrowed should continue to remain in the business. So long as the amount borrowed is used in the business, the interest paid on such borrowing is an expenditure which is required to be deducted in the computation of the income from the business. The interest payable on the capital borrowed is a liability which continues till such time as the amount borrowed is repaid. Such interest is allowable under the provision only for the reason that the amount on which interest is paid continues to be used in the business and the payment of such interest is, therefore, necessary for the purpose of running the business. This provision cannot be construed as enabling an assessee to burden the business with interest even while taking the amount initially borrowed for the business, but subsequently taken out of the business by diverting it as interest‑free loans to relatives of the partners.
The assessee‑firm was engaged in the business of construction. It had borrowed certain amounts for the purpose of its business and claimed deduction of interest paid on the borrowing for the assessment years 1978‑79 and 1979‑80. The Assessing Officer found that the assessee had been advancing monies to close relatives of the partners without charging any interest. The assessee claimed that the amounts so lent had not been lent out of the borrowed funds, but only at a time when the firm had sufficient funds at its disposal. According to the assessee, the advance was made when it received substantial contract receipts. The Assessing Officer held that there was diversion of borrowed funds and, therefore, the interest claimed to the extent relatable to the amount diverted was to be disallowed. On appeal, the Appellate Assistant Commissioner reduced the extent of the disallowance, but upheld the finding that there had been a diversion. On further appeals, the Tribunal affirmed the orders under appeal. On a reference:
Held, that the amount lent, according to the assessee, came out of the contract earnings. The amount borrowed, according to the assessee, was invested in the execution of the contracts. It was clear, therefore, that the assessee had invested the borrowed funds in the execution of the contracts, had recouped the money so invested presumably with profits as well on executing the contract. The amount realised on the execution thus, included the amount which the assessee had borrowed and invested. When the assessee decided to lend a substantial part of those funds interest‑free to the relatives of the partners, it was clearly not a business purpose. The assessee clearly diverted the funds which had been borrowed. After such diversion, the interest paid on the capital borrowing to the extent of the amounts diverted could no longer be an item of expenditure which could be claimed for deduction as an item of business expenditure.
CIT v. Coimpatore Salem Transport (Private) Ltd. (1966) 61 ITR CIT v. Malayalam Plantations Ltd. (1964) 53 ITR 140 (SC) ref.
P.P.S Jarthana Raja for the Assessee.
Mrs. Chitra Venkatraman for the Commissioner
JUDGMENT
R. JAYASIMHA BABU, J.‑‑‑At the instance of the assessee, the following question has been referred to us for our consideration by the Tribunal:
"Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the interest of Rs.13,122 and Rs.37,146 were not allowable as deduction under section 36(1)(iii) of the Income Tax Act, 1961, for the assessment years 1978‑79 and 1979‑80, respectively?"
The true scope of section 36(1)(iii) of the Income‑tax Act is required to be determined in this tax case. The assessment years with which we are concerned are 1978‑79 and 1979‑80. The assessee's grievance is that the interest paid by the assessee during these assessment years have been wrongly held to be not allowable as deduction under that provision.
The assessee is a partnership firm engaged in the business of construction. It has borrowed heavily, or the purpose of its business and claimed deduction in respect of a sum of Rs.1,58,354 as interest during the assessment year 1978‑79. For the assessment year 1979‑80, the amount sought to be deducted as interest payment was Rs.2,26,180, the Assessing Officer found in the course of examination of accounts that the assessee had been advancing monies to close relatives of the partners without charging any interest. The advance made during the previous year relevant to the assessment year 1978‑79 was to the extent of Rs.6,08,408. The bulk of the advance had been made in October, 1979. The assessee claimed that the amounts so lent had not been lent out of the borrowed funds, but only at a time when the firm had sufficient funds at its disposal. According to the assesssee, the advance was made when it received substantial contract receipts. The Assessing Officer on these facts held that there was diversion of borrowed funds and, therefore, the interest claimed to the extent relatable to the amount diverted was to be disallowed.
On appeal, the Appellate Assistant Commissioner reduced the extent of disallowance, but upheld the finding that there had been a diversion. The Commissioner held that the extent of diversion was Rs.362 lakhs entitled adjusting the amount standing in the business as credit balance of the partners in the capital accounts in the sum of Rs.2,46,252. He worked out the average rate of interest of borrowing effected by the assessee at 8.7 per cent. and disallowed the interest at that rate on the sum of Rs.362 lakhs for a period of five months, for the assessment year 1978‑79. For the assessment year 1979‑80, the Commissioner determined the average rate of interest at 12.3 per cent. and held that the amount diverted was Rs.3.2 lakhs. Interest on that sum at that rate was disallowed for the whole year and the amount disallowed was Rs. 37,146. The amount disallowed for the assessment year 1978‑79 was Rs. 13,122.
The Tribunal, to whom the assessee appealed affirmed the orders in appeal by its common order, dated December 29, 1983. The assessee being aggrieved by that order, is now before us. The principal submission of learned counsel for the assessee is that the record does not show that the amount advanced to the close relatives of the partners without charging any interest has come out .of the amount borrowed and on which borrowed ‑amounts interest had been paid and claimed as a deduction in the computation of the income of the firm. Counsel submitted that in the absence of any direct link between the funds borrowed and the amounts advance though for non?-business purpose, the utilisation of the funds belonging to the firm for a non-?business purpose would not amount to diversion of borrowed funds. The funds which had been borrowed, counsel submitted, had been indisputably used in the business and it was only out of the realisations from the performance of the contracts, that the advances had been made. The monies realised from the performance of the contract could not be characterise as borrowed funds. Once the borrowed funds were invested in the business, the utilisation of other monies at a later point of time for non‑business purposes cannot be characterised as the diversion of borrowed funds. Counsel in this context relied on the decision of this Court in the case of CIT v. Coimbatore? Salem Transport (Pvt.) Ltd. (1966) 61 ITR 480, wherein it was held, inter alia, that the Tribunal, on the figures before it of borrowings by the assessee in each accounting year, of the advances made to the directors without interest as well as the figures of amounts due from the assesses to certain other concerns in which some of the directors had interest and on which no interest was paid, found that the diversion of the borrowed money for advancing to the directors should have taken place in the years earlier to September 30, 1955. There was no question of the Tribunal misplacing the onus of proof, that its finding was justified on the materials on record.
For the Revenue it was submitted that the Tribunal, as also the Commissioner and Assessing Officer had found as a question of fact that there was diversion of funds and that finding has not been shown to be without any basis. The finding so arrived at was binding. Counsel submitted that even, according to the assessee, the advance was paid only from the contract realisation though the assessee had later sought to rely on the fact that as the amounts due to sundry debtors was well over Rs.5 lakhs and that also could have been the source for making the advance. On the assessee's own showing the amount advanced to the relatives of the partners interest free came out of the funds of the business and the advance was not for the purpose relate to the business. The advance made was out of the contract of realisation which certainly would include the amount borrowed as that amount had been invested in the contract and the amounts realised from the performance would include the borrowed funds besides‑the profits, if any, realise. The deduction permitted under section 36(1)(iii) of the Income‑tax Act is the amount of the interest paid in respect of capital borrowed "for the purposes of the business or profession" and, therefore, capital borrowed if diverted though after the amount had 'been invested in the business or contract and the diversion was from out of the funds realised from the performance of the contract, it could not be said that the capital borrowed was for the purpose of the business in the relevant assessment year. Counsel in this context relied on the decision of the Supreme Court in the case of CIT v. Malayalam Plantations Ltd. (1964) 53 ITR 140, wherein the apex Court explained the scope of expression "for the purpose of business". It was held by the apex Court in that decision that (headnote): "The expression 'for the purpose of the business' is wider in scope than the expression 'for the purpose of earning profits'. Its range is wide: it may take in not only the day‑to‑day running of a business but also the rationalisation of its administration and modernisation of its machinery: it may include measures for the preservation of the business and for the protection of its assets and property from expropriation coercive process or assertion of hostile title; it may also comprehend payment of statutory dues and taxes imposed as a pre‑condition to commence or for the carrying on of a business; it may comprehend many other acts incidental to the carrying on of the business".
Section 36 of the Act occurs in Chapter IV which deals with the computation of total income and it is a provision which relates to the computation of income earned under the head "Profits and gains of business or profession". The deduction contemplate by the section is in relation to the expenditure which could properly be regarded as legitimate for the purpose of the business or profession. Expenditure incurred on account of commercial expediency for the purpose of business would be allowable under this provision. The expenditure to be allowed must have a nexus with the business. If the expenditure incurred is ostensibly for the business, but in reality is not for the business such expenditure is not allowable.
Section 36(1)(iii) of the Act refers to "the amount of the interest paid in respect of capital borrowed for the purposes of the business or profession". The capital borrowed should be for the purposes of the business or profession. It is implicit in this provision that the capital so borrowed should not only tie invested in the business, but that the amount borrowed continues to remain in the business. So long as the amount borrowed is used in the business, the interest paid on such borrowing is an expenditure which is required to be deducted in the computation of the income from the business. The interest payable on the capital borrowed is a liability which continues till such time as the amount borrowed is repaid. Such interest is allowable under the provision only for the reason that the amount on which interest is paid continues to be used in the business and the payment of such interest is, therefore, necessary for the purpose of running the business.
The object of the provision is not to enable an assessee to make a large borrowing and create a liability for payment of interest thereon not only in the year in which the borrowing was made, but the subsequent years as well, keep the loan outstanding and thereafter divert the amount borrowed by taking it out of the business by giving it interest‑free to relatives of partners, but continue to pay interest out of the income of the business and claim the amount of interest paid as a business expenditure. The payment of interest on the amount not used in the business cannot be regarded as a business expenditure as the business does not derive any benefit by the outgoing by way of interest on an amount which is no longer in the business, but had been diverted from the business. This provision, therefore, cannot be construed as enabling an assessee to burden the business with interest even while taking the amount initially borrowed for the business, but subsequently taken out of the business by diverting it as interest‑free loans to relatives of the partners.
The amount borrowed for the business remains a liability for the business till its discharge. The fact that the amount borrowed may have been invested in the purchase of machinery or utilised as working capital or used in any other way does not in any way affect the liability for repayment of the amount borrowed. So long as the money borrowed is used in the business, interest paid on such borrowing is a proper charge on the business and is allowable as an expenditure. Under section 36(1)(iii) of the Act amounts diverted not being used for the purpose of the business. Interest relating to the operation diverted cannot be treated as an item of permissible deduction in the computation of income.
The submission of counsel for the assessee is that once the amount borrowed is found to have been used for some time in the business, the subsequent diversion is of no consequence cannot be accepted. The words used in the statutory provision are borrowed for the purpose of the business. The amount borrowed must continue to be used for the purposes of the business and the fact that it was used for some point of time, but later diverted would not entitle the assessee to claim the interest paid on the borrowing as a deduction even after such diversion.
In cases where diversion occurs immediately after the borrowing and the borrowed amounts are not invested in the business at all, but diverted for other purposes, there can be no doubt that interest paid on such borrowed amounts are not allowable. The postponement of diversion, in cases where such, diversion is found to be clearly established from the facts on record, does dot entitle the assessee to claim the benefit of deduction on interest paid on the amounts borrowed but not presently used in its business diverted for other purposes. The time at which the diversion takes place is not the only relevant criterion. It is the fact of the diversion which is material and once it has been shown that there has been diversion of interest on the amount borrowed, but subsequently diverted would not qualify for deduction.
Any view to the contrary would not in the least subserve the object of the provisions, but it would only open the gates for the assessees to borrow merrily and after ostensibly using it in the business for a short period at a subsequent point of time divert the funds in whole or part, for non-?business purposes and continue to claim the interest on the borrowing as a deductible item of expenditure. The objects of the section would not in any way be advanced by the adoption of such a view. If a business for which the interest paid is claimed as a deduction has not benefited during the year from the capital borrowed by such borrowed amount being used in the business, such interest cannot be regarded as an expenditure for the purposes of the business. The assessee may not even while using borrowed funds for its personal purposes and not business purposes claim deduction of the interest paid on the borrowing.
In cases, where the diversion takes place after the borrowed monies had been initially invested in the business, such diversion must be clearly established and should not be a matter of mere speculation. In this case, the facts are sufficiently clear to warrant the finding that there has been a diversion, it is the assessee's own case that the amounts lent as advances without interest are nearly three times the amount of capital lying to the credit of the partners in the firm. The amount so lent, according to the assessee, came out of the contract earnings. The amount borrowed, according to the assessee was invested in the execution of the contracts. It is clear, therefore, that the assessee had invested the borrowed funds in the execution of the contracts, had recouped the money so invested presumably with profits as well on executing the contract. The amount realised on the execution thus, included the amount which the assessee had borrowed and invested. When the assessee decided to lend a substantial part of those funds interest free to the relatives of the partners, it was clearly not a business purpose. The assessee clearly diverted the fund which had been borrowed, has been invested in the contract work, after the investment was recovered and was available either for the purposes of the business or by way of repayment of the loan. The assessee did neither, but chose to divert the money for non?-business purposes. After such diversion, the interest paid on the capital borrowing to the extent of the amounts diverted can no longer be an item of expenditure which can be claimed for deduction as an item of business expenditure. If the amounts diverted was subsequently brought back into the business and utilised in the business, the assessee could thereafter claim the interest paid as a deduction. But so long as the diversion continues the assessee would be disentitled.
The arguments which had been advanced for the assessee before the Commissioner and the Tribunal that the amount in the advance from out of the amounts shown as amounts payable to the sundry creditors had not been advanced before the Assessing Officer. The version placed before the Assessing Officer is the more credible one. The amount diverted could only have come out of the contract realisations, as it is not the assessee's case that it had sold goods obtained from the sundry creditors and lent the amount realised from such sale to the relatives of the partners to whom monies had been advanced without interest.
Our answer to the question referred to us, therefore, is in the affirmative, in favour of the Revenue and against the assessee. Parties shall bear their respective costs.
M.B.A./174/FC
Reference answered.