Section 36(1)(iii): Interest Deduction Allowed Where Borrowed Funds Are Routed Through a Group Entity on Grounds of Commercial Expediency

1. Introduction

The appeal arose from an assessment year 1989–90 dispute on the allowability of interest as a deduction under Section 36(1)(iii) of the Income Tax Act, 1961 (“the Act”). The assessee (L.K. Trust) borrowed Rs. 3.80 crores from Corporation Bank, paid Rs. 21,74,234 as interest, and claimed the interest as a business deduction.

The Assessing Officer disallowed the deduction on the footing that the borrowed money was routed to a group company (M/s Gayatri Holdings Private Limited), which in turn transferred the amount to Shri G Venkateshwaran for the purchase of shares of M/s Shaw Wallace and Company Limited. The Commissioner (Appeals) affirmed the disallowance, but the ITAT allowed the claim. The Karnataka High Court partly accepted the Revenue’s case, effectively restricting the interest allowance to the extent the shares were purchased “for” the assessee and disallowing the remainder as funds “lying with” the group entity.

2. Summary of the Judgment

The Supreme Court allowed the assessee’s appeal, set aside the High Court’s judgment, and declared that the assessee is entitled to deduction of the interest paid on the borrowed sum of Rs. 3.80 crores under Section 36(1)(iii).

The Court held that the High Court erred in rejecting the ITAT’s approach based on commercial expediency and in treating the downstream utilisation through the group entity as fatal to the deduction.

3. Analysis

3.1 Precedents Cited (and their influence)

• Madhav Prasad Jatia v. CIT (SC) 118 ITR 200
  The ITAT relied on this decision to articulate the classic prerequisites for interest deduction: (i) the loan is borrowed by the assessee; (ii) it is borrowed for the purpose of the assessee’s business; and (iii) interest is paid. The Supreme Court also used it to reiterate that “for the purpose of business” under Section 36(1)(iii) is broader than the “for the purpose of making or earning income” formulation in Section 57(iii).
• Bombay Steam Navigation Co. Pr. Ltd. v. CIT, 56 ITR 52 (SC)
  Cited by the Supreme Court to stress the doctrinal boundary of Section 36(1)(iii): it concerns capital borrowed (money) and not every form of debt or liability. This frames the inquiry around borrowed funds and their business-purpose nexus, rather than accounting labels or downstream structures.
• CIT v. Associated Fibre and Rubber Industries (P) Ltd. (1999) 236 ITR 471
  The ITAT used this to support the proposition that where assets acquired from borrowings are treated as business assets, the interest outgo is ordinarily allowable—reinforcing a business-asset/business-purpose linkage.
• Vecumsees (supra) (220 ITR 185) (as quoted by the ITAT)
  The ITAT treated this authority as establishing that if loans were obtained for business purposes, later transfer/closure of the particular business line does not by itself defeat the interest deduction, especially where the business is composite and management is common. This supported the ITAT’s “composite business” framing.
• Sharp Business System v. CIT 2025 SCC OnLine SC 2892
  This was the Supreme Court’s central modern anchor. The Court noted that the key question is whether the transfer/advance of borrowed funds is justified by commercial expediency; the inquiry is not confined to whether the advance directly earned profits for the assessee.
• S.A. Builders v. CIT 288 ITR(1)
  Referenced through Sharp Business System v. CIT, it supplies the established test that advances to sister concerns can be covered by commercial expediency and still qualify under Section 36(1)(iii).

3.2 Legal Reasoning

The Court’s reasoning proceeds in three linked steps:

1. Statutory construction of Section 36(1)(iii): The Court highlighted the three central statutory elements—interest, borrowed, and for the purpose of business/profession. It also clarified that while “interest” is defined widely in Section 2(28A), for Section 36(1)(iii) the focus remains on interest on money borrowed (not every species of debt).
2. Business-purpose test is wide and not profit-contingent: By contrasting Section 36(1)(iii) with Section 57(iii) (via Madhav Prasad Jatia v. CIT), the Court reaffirmed that “for the purpose of business” is broader than “for earning income.” Accordingly, the assessee need not prove that the specific deployment of funds immediately generated taxable income.
3. Commercial expediency governs intra-group routing/advances: The High Court had effectively treated the subsidiary/group entity’s involvement as breaking the nexus with the assessee’s business. The Supreme Court rejected this, holding that such a narrow view ignores the correct test—commercial expediency—recently analysed in Sharp Business System v. CIT (with reliance on S.A. Builders v. CIT). The question is whether, from a businessperson’s perspective, the borrowing and its deployment (even through a group vehicle) served the assessee’s business purposes. If yes, the interest is deductible.

3.3 Impact

• Stronger protection for genuine group-structure financing: Interest deductions under Section 36(1)(iii) cannot be denied merely because borrowed funds are routed through a subsidiary/sister concern, provided the assessee demonstrates commercial expediency/business purpose.
• Limits on “look-through disallowance” based on end-use alone: The High Court’s approach—allowing interest only to the extent shares were in the assessee’s name and disallowing the rest as “lying with” the group entity—stands disapproved. Revenue authorities must engage with the business rationale rather than mechanically tracking the immediate recipient.
• Litigation posture in “colourable device” allegations: Where Revenue alleges a “colourable devise,” this judgment indicates that mere intra-group movement is insufficient; the adjudication must still apply the commercial expediency framework and the statutory “purpose of business” test.

4. Complex Concepts Simplified

• “Interest on capital borrowed” (Section 36(1)(iii)): A deduction for interest paid on money borrowed, so long as the borrowing is for business purposes (broadly understood).
• “For the purpose of business”: Wider than “to earn income.” It includes steps taken on business considerations—such as funding arrangements, strategic acquisitions, or maintaining/control of business interests—if commercially justified.
• Commercial expediency: A practical business test: would a reasonable businessperson see the expenditure/advance as serving business interests? It is not necessary that the step yields immediate profit.
• Capital borrowed vs. debt incurred: Every loan creates a debt, but not every debt arises from a loan. Section 36(1)(iii) specifically targets loans/borrowings (money borrowed).
• Colourable device: An arrangement alleged to be a sham designed only for tax benefit. This decision signals that such allegations must be tested against the substantive business-purpose/commercial-expediency inquiry, not inferred solely from group routing.

5. Conclusion

L.K. TRUST v. COMMISSIONER OF INCOME TAX reaffirms and applies the modern Supreme Court approach that Section 36(1)(iii) is governed by a broad business-purpose standard anchored in commercial expediency. The Court rejects a narrow, formalistic denial of interest deduction merely because borrowed funds are routed through a group entity or ultimately benefit another group participant. The governing question remains whether the borrowing and its deployment were for the assessee’s business purposes; if so, the interest is deductible.