“36(1) The deductions provided for in the following clauses shall be allowed in respect of the matters dealt with therein,in computing the income referred to in Section 28 –( i ) and ( ii )******(iii) the amount of the interest paid in respect of capital borrowed for the purposes of the business or profession :-Provided that any amount of the interest paid, in respect of capital borrowed for acquisition of an asset for extension of existing business or profession (whether capitalized in the books of account or not); for any period beginning from the date on which the capital was borrowed for acquisition of the asset till the date on which such asset was first put touse, shall not be allowed as deduction.Explanation. - Recurring subscriptions paid periodically by shareholders, or subscribers in Mutual Benefit Societies which fulfill such conditions as may be prescribed, shall be deemed to be capital borrowed within the meaning of this clause.”
- (i) Interest,
- (ii) Borrowed and,
- (iii) For the purpose of business or profession.
- Importance of loan settlement. For the loan there must be a settlement / agreement between the parties that particular amount would be given by one party to other party. The terms would be that it would be refunded or returned either on demand or on the directions of the creditors and particular interest / no interest would be paid on the said amount. Thus, for the purpose of loan there must be interaction between the parties and there must be a concluded contract. Thus for Section 36(1)(iii) the necessary precondition is the existence of a loan transaction or a loan agreement between two parties with an established role of creditor and debtor. There is a Gujarat High Court judgment in the case of Arun Family Trust Vs. CIT 298 ITR 437 (Guj.) which brings out this fact clearly.
- Element of refund is a must. An element of refund or repayment is a must in the concept of borrowing. If there is no obligation to refund the capital provided, interest on such capital is not deductible under Section 36(1)(iii) –Pepsu Road Transport Corpn. V. CIT 130 ITR 18 (P&H).
“an expression of wide import and includes such expenditure as a prudent businessman incurs for the purpose of business. The expenditure may not have been incurred under any legal obligation, but yet it is allowable as a business expenditure, if it was incurred on grounds of commercial expediency”.
“The commercial expediency would include such purpose as is expected by the assessee to advance its business interest and may include measures taken for preservation, protection or advancement of its business interests, which has to be distinguished from the personal interest of its directors or partners, as the case may be. In other words, there has to be a nexus between the advancing of funds and business interest of the assessee-firm. The appropriate test in such a case would be as to whether a reasonable person stepping into the shoes of the directors/partners of the assessee-firm and working solely in the interest of the assessee-firm/ company, would have extended such interest free advances.Some business objective should be sought to have been achieved by extending such interest free advances when the assessee-firm/company itself is borrowing funds for running its business”.
- (i) The money, that is capital, must have been borrowed by the assessee
- (ii) It must have been borrowed for the purpose of business.
- (iii) The assessee must have paid interest on the borrowed amount i.e. he has shown the same as an item of expenditure.
- This proviso is to operate prospectively as held by Hon’ble Supreme Court in the case of Deputy Commissioner of Income Tax. Vs. Core Health Care Ltd. (SC) 298 ITR 194.
- In this proviso, the word “extension” has been used which is to be taken as synonymous to the word “expansion” which is used for Sections 80IC(8)(ix) and 80IE(7)(iii)[as held in case of Nahar Poly Films Ltd. Vs. CIT, Ludhiana 201 Taxmann 304 (P&H)]. The word expansion is not different from extension of business and therefore the interest expenditure, on the utilization of borrowed funds for the acquisition of new assets, from the date of its acquisition till the date when the asset is put to use, is to be disallowed.
- An expenditure may either relate to a new units on expansion of existing business or it may relate to a totally new business apart from existing business. In the latter case, pre-commencement expenditure of new business would be required to be capitalized. They cannot be charged to the preexisting business. It is only for the former case, that relates to expansion of existing business, that can be allowed under Section 36(1)(iii). This was analyzed in the case of CIT Vs.Vadilal Dairy International Ltd.  328 ITR 544 by Gujarat High Court.
- Interest paid on capital borrowed for setting up of a new unit in the same line of business – capital expenditure – Interest on capital borrowed for the purpose of acquisition of the assets of the new unit is to be allowed as a revenue expenditure only when such assets start yielding income and not for any period prior thereto – Section 36(1)(iii) to be read alongwith Explanation 8 to Section 43(1) – Proviso to Section 36(1)(iii) added by Finance Act, 2003 is merely clarificatory as it has made explicit what was already implicit. [CIT Vs. Vardhman Polytex Ltd. (P&H) 299 ITR 152.]
- Such purpose as is expected by the assessee to advance its business interest.
- May include measures taken for preservation, protection or advancement of its business interests.
- To be distinguished from the personal interest of its directors or partners, as the case may be.
- There has to be a nexus between the advancing of funds and business interest of the assessee. Some business objective should be sought to have been achieved by extending such interest free advances when the assessee firm/company itself is borrowing funds for running its business.
- (a) Section 36(1)(iii) vis-à-vis Section 57(iii)
- (b) Whether dividend on preference shares can be equated with interest on borrowed capital.
- (c) The case of Circular Trading
- 1. It is entitled to claim deduction under Section 36(1)(iii), and
- 2. It is not disentitled to claim such deduction on account of applicability of Section 40(b)(iv).
It must be interest on capital (moneys) borrowed.
It may be interest even on any debt incurred.
The borrowings must be for the “purpose of the business”.
The debt incurred must be and exclusively for the purposes of the business.
The borrowed amount may be utilized for even procuring a capital asset related to the business
The debt incurred must not utilized for procuring a capital asset so as to fall within the gamut of “capital expenditure”
“Where the interest paid concerns the borrowed money for business as well as non business purposes, the claim may be disallowed in its entirety if no adequate material is adduced by the assessee to determine that portion of interest which pertains to business purposes”.
- Where there is only borrowed fund and no composite or mixed fund. In such cases, the disallowance is to be made at the full rate of interest payable on such borrowed money. The amount of interest, if any, realized from such utilization is not to be taken into account for ascertaining the extent of the disallowance [CIT Vs. India Silk House, 152 ITR 79 (Mad)].
- Where there is composite or mixed fund, in such a case, the Assessing Officer is required to co-relate between the nature of feeding fund with utilization of such fund. After this co-relation the Assessing Officer may devise methods based on factual analysis of the source of fund with the utilization of fund to arrive at the figure of part disallowance of interest expenditure.
- In this case, there cannot be full disallowance of interest payable by the assessee. Where the funds are mixed up, so that it is not possible to identify the extent of borrowings utilized for such loans, proportionate amount could be disallowed as held in K. Somasundaram and Brothers Vs. CIT 238 ITR 939 (MAD).
“…………any body corporate, unless the making of such loan, the giving of such guarantee or the provision of such security has been previously authorized by a special resolution of the lending company………”.
- (i) Bombay Steam Navigation Co. P. Ltd. V. CIT 56 ITR 52 (SC).Payment of interest by a company on unpaid price of the assets taken over is not an affordable expense.
- (ii) Lachhiram Puranmal Vs. CIT 119 Taxman 1 (MP) Interest paid on borrowed capital was held not deductible where such capital was utilized for the purpose of agricultural land which was admittedly not a business investment.
- (iii) Malwa Mills Karmchari Paraspur Sahkari Sanstha Ltd. Vs. CIT 140 ITR 379 (MP). Assessee having two units, A and B, made advances from unit A and unit B. Interest debited in unit B held not allowable because the entity was the same.
- (iv) CIT Vs. Ahmedabad Mfg. & Calico Printing Co. Ltd. (Guj.) 215 ITR 735 Payment of betterment charges is capital expenditure. Therefore, payment of interest on annual installments of the betterment charges will have to be regarded as capital expenditure, because it has no direct nexus with the day-to-day running of the business of the assessee.
- (v) East India Pharmaceutical Works Ltd. Vs. CIT (SC) 224 ITR 627 The interest that is paid by the assessee on any sum borrowed by him for payment of income tax is not deductible from his net income since it is only application of profits and not expenditure incurred to earn profits.
- (vi) Saraspur Mills Ltd. Vs. CIT (Guj.) 226 ITR 533 Interest paid for late payment of Income Tax is not deductible as it is not incurred for the purpose of carrying on of the business. The interest takes colour from the nature of the principal.
- (vii) Auto Sales Vs. CIT 227 ITR 790 (All) Interest on gifted amount remaining with the assessee firm in the name of the donee to whom gift was made by book entries and the donor partner not having sufficient credit balance to his account, held not allowable because such a transaction of gift could not be treated as a genuine one.
- (viii) Bharat Commerce and Industries Ltd. Vs. CIT (SC) 230 ITR 733 For VDIS Tax paid in installments with interest, the interest is not deductible as business expenditure or as interest on borrowed capital.
- (ix) Saswad Mali Sugar Factory Ltd. Vs. CIT 236 ITR 706 (Bom) Interest on capital for purchase of machinery, which was leased out and income therefrom was assessed under the head “Income from other sources”, was held not deductible under Section 36(1)(iii) in view of the finding recorded by the Tribunal that the assessee’s intention was not to carry on business, but to let out the business assets as income yielding properties.
- (ix) CIT Vs. Indian Express Newspaper (Madurai) P. Ltd. 238 ITR 70 (Mad). Interest paid on amount borrowed by the assessee company and transferred to the investment company floated by it which in turn transferred to same to an associate company of the assessee company which was engaged in the construction of a building was held not deductible because the borrowed amount was not used for the purposes of the assessee’s business.
- (xi) CIT Vs. Ramkant Mishra 252 ITR 210 (Cal.) Interest on cash credit, which have not been explained, has been held not allowable in spite of the fact that no addition was made on account of unexplained cash credit.
- (xii) JCT Ltd. Vs. DCIT (Calcutta) 276 ITR 115 Section 36(1)(iii), read with Sections 43(1) and 37(1), of the Income-tax Act, 1961 - Interest on borrowed capital - Assessment years 1987-88 and 1988-89- Whether interest paid on borrowed capital under deferred payment scheme for acquisition of plant and machinery for period relevant till asset was first put to use would not be eligible for deduction under Section 36(1)(iii) or Section 37(1) since it is includible in actual cost of acquisition of asset till asset was first put to use, in view of Explanation 8 to Section 43(1) - Held, yes.
- (xiii) CIT Vs. Swapna Roy (All) 331 ITR 367 Borrowed funds were invested in financially fragile sister concerns. The court held that there was no intention to earn income but merely to assist sister concerns. Deductions of interest paid on such borrowings is not allowable.