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December 4, 2020

Is deduction under Section 36(1)(iii) available when interest free loan is given to subsidiary?

by CA Shivam Jaiswal in Income Tax

Is deduction under Section 36(1)(iii) available when interest free loan is given to subsidiary?

While computing the profit and gains from business or profession, there are certain expenditures which are disallowed. This means that the income tax department does not allow the benefit of such expenditures and the assesses are required to pay taxes on such expenditures by adding it back to the net profits. Section 36(1)(iii) allows deduction of the amount of interest paid in respect of capital borrowed for the purposes of business. The deduction is granted under the section, once it is established that the borrowing is for the purposes of business and that the interest is paid on such borrowings.

Section 36(1)(iii) has to be read on its own terms. It is a code by itself. Section 36(1)(iii) is attracted when the assessee borrows the capital for the purpose of his business. It does not matter whether the capital is borrowed in order to acquire a revenue asset or a capital asset, because all that the section requires is that the assessee must borrow the capital for the purpose of his business. There by meaning that the transaction of borrowing is not the same as the transaction of investment. However, can such deduction be available when the funds are provided to subsidiaries?

Let us refer to the case of CIT (LTU) v. Reliance Industries Ltd. (2019), where the issue under consideration whether interest referable to funds given to subsidiaries is allowable as deduction under section 36(1)(iii) or not?

Facts of the Case:

  • The assessee had given interest free loans to its subsidiaries aggregating to Rs. 3,727.14 crores during the year under consideration.
  • The Assessing Officer (AO) disallowed proportionate interest on such loans by treating the same as not being incurred for the purpose of business.
  • The Tribunal held that assessee had sufficient interest-free funds and in fact, the net profit after tax and before depreciation for the year under consideration exceeded not only the differential/ incremental loan given to subsidiaries during the year but also exceeded the total interest free loans given to the subsidiaries.
  • Accordingly, the Tribunal held that it could be presumed that the investments were made from the interest free funds available with the assessee and no disallowance was required under section 36(1)(iii) of the Act.
  • The Bombay High Court agreed with the view of the Tribunal

The following questions were raised to the Supreme Court (SC)

  • Whether interest referable to funds given to subsidiaries was allowable as deduction under section 36(1)(iii) when the interest would not have been payable to banks, if funds were not provided to subsidiaries?
  • Whether, the interest paid and referable to funds given to subsidiaries could be said to be incurred for the purpose of business so as to be allowable under section 36(1)(iii)?
  • Where an assessee was having sufficient interest free funds at its disposal, could it be presumed that the funds advanced to the subsidiary is out of the interest free funds?

Observations of the Supreme Court (SC)

  • Section 36(1)(iii) provides for deduction of interest expenditure which was incurred for the purpose of business, meaning thereby the funds bearing interest were utilised for the purpose of business.
  • If an assessee was paying interest on any loan, the funds of which were advanced to a group company, then unless the business of both the companies were linked and connected and the advancing of loan to the group company was proved to be for the purpose of business, interest on loan taken by the assessee was prone to disallowance for not satisfying the conditions of section 36(1)(iii).
  • However, when the assessee was having sufficient interest free funds to take care of such advance to the subsidiary, then the Courts had laid down that a presumption could be made that such advance was out of the interest free funds available with the assessee, thereby requiring no disallowance under section 36(1)(iii).
  • Sometimes, the interest free funds and the interest-bearing funds of the assessee were mixed in a common account, which was then utilised to make various payments, in which case, such presumption became inevitable.
  • Such presumption was accepted by SC in case of East India Pharmaceutical Works Ltd. v. CIT though in the facts of that case, no relief was granted to the assessee as no such argument was raised before the lower courts.
  • Further, similar view was taken in an earlier judgment of the Calcutta High Court in Woolcombers of India Ltd. v. CIT.
  • Following the above judgments, the Bombay High Court in case of CIT v. Reliance Utilities & Power Ltd. (2009), approved the theory of presumption, which was then followed in number of other judgments.
  • Even otherwise, it could be argued that the interest-bearing funds were employed in the business so as to interest free funds to be utilised for any non-business purpose.

SC dismissed the appeal of the Revenue held that, when interest free funds available with assessee was sufficient to meet investment, presumption was that investments in subsidiaries were out of interest free funds. Accordingly, no disallowance could be made u/s. 36(1)(iii)

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