B.P Jeevan Reedy, C.J:— Common questions are referred in these three references made under section 256 of the Income-tax Act, 1961. The assessee is common in all these cases. The assessment years concerned are 1963-64 to 1967-68.

2. The two questions referred in Income-tax Reference Case No. 895 of 1978 are:

“(i) Whether, on the facts and in the circumstances of the case, was the assessee-company entitled to allowance of Rs. 32,994 and Rs. 1,40,805 by way of interest in the assessment years 1963-64 and 1964-65, respectively?

(ii) Whether, on the facts and in the circumstances of the case, was the Tribunal justified in treating the loss on the sale of U.P Development Loan as business loss?”

3. In Income-tax Reference No. 896 of 1978, only one question is referred, which reads:

“Whether, on the facts and in the circumstances of the case, was the assessee-company entitled to allowance of Rs. 1,39,330 by way of interest in the assessment year 1965-66?”

4. In Income-tax Reference No. 912 of 1978 too, only the following question is referred:

“Whether, on the facts and in the circumstances of the case, the assessee-company was entitled to allowance of interest of Rs. 1,85,858 and Rs. 2,14,522 for the assessment years 1967-68 and 1968-69?”

5. It may be stated that the judgments of the Tribunal in all the three matters are different. Though in Income-tax Reference No. 895 of 1978, two questions ape referred, no arguments have been advanced with respect to the second question. The answer to question No. (ii), therefore, shall be in the affirmative, that is, in favour of the assessee and against the Revenue.

6. The discussion in this judgment shall be confined only to question No. (i), which is common to all the three cases except for the fact that the amounts vary from year to year.

7. The broad facts as they appear from the orders of the Tribunal are as follows: The assessee, H.R Sugar Factory (P.) Ltd., Bareilly, is a private limited company, in which the directors/shareholders are substantially interested Three persons, Murli Manohar Sahu, Ram Swarup and Ram Avtar hold shares in the proportion of 50%, 25% and 25%, respectively, in their own names or in the names of their respective family members. The assessee is engaged in manufacture of sugar. For purposes of its business, it raises loans from banks on the security of its assets. It has also got a cash credit account with banks. Over the last several years, it has been advancing loans to its directors and since there was practically no repayment, the loan amounts went on mounting. Up to the previous year relevant to the assessment year 1963-64, the assessee was charging interest at the rate of 5% per annum on the loans advanced to the directors, whereas it was paying interest at the rate of 8% per annum on the moneys borrowed by it from banks. In the previous year relevant to the assessment year 1963-64, however, the interest payable by the directors on the amounts borrowed by them from the assessee was reduced to 2.5%, whereas the banks continued to charge interest at the rate of 8% on the loans advanced to the assessee. The “previous year” adopted by the assessee over all these years was the year ending with September 30. The total amount of debit balances outstanding against the directors/shareholders as on September 30, 1957 (relevant for the assessment year 1958-59) onwards up to September 30, 1963 (for the assessment year 1964-65) and other particulars relevant in that behalf are shown in the Table at page 367. Such figures are not available for the “previous years” relating to the assessment years 1965-66, 1966-67, 1967-68 and 1968-69. The fact, however, remains that loans advanced to the directors have been rising steadily.

8. For the assessment year 1963-64, the Income-tax Officer disallowed interest to the extent of Rs. 1,32,994 representing the difference of interest between 8% (paid by the assessee to the banks) and 2.5% (collected by the assessee from its directors on the amount lent to the directors) on the ground that the said amount of interest cannot be said to have been paid in respect of capital borrowed for the purposes of the assessee's business or profession. Similar disallowance was made for the other assessment years concerned in these references. The Income-tax Officer referred to the following circumstances in support of his action. The assessee is a private limited company in which the directors/shareholders are substantially interested. The assessee is engaged in the manufacture of sugar. A dispute had arisen among the directors with respect to the amount of advances made to each of them as a result of which the assessee issued notices to all the directors/borrowers to deposit back the loans drawn by them. The said notices were questioned in writ petitions filed in this court which were dismissed, whereafter civil suits were filed. As a result of a compromise in the civil suits, the rate of interest chargeable to the directors was reduced from 5% to 2.5% with effect from “the previous year” relevant to the assessment year 1963-64. The compromise decree in the civil suits embodies the minutes of the extraordinary general meeting of the shareholders of the company held on April 6, 1961. According to this resolution, the total amount of loans outstanding against the directors as on August 21, 1960 was Rs. 14,09,624. This amount was made repayable up to March 31, 2000 A.D Moreover, it was resolved that some of the directors shall be entitled to draw further advances from the assessee-company. In short, Murli Manohar Sahu (holding 50% shares) was permitted to draw loans up to eleven and a half lakhs of rupees and, similarly, the other two groups were also permitted to draw loans up to the same extent. Thus, instead of taking steps for recovery of the loans already advanced, the directors were permitted to draw more loans, and that too at a very low interest of 2.5%. On these facts, the Income-tax Officer held that the

Table:

As on 30-9-1957 30-9-1958 30-9-1959 30-9-1960 30-9-1961 30-9-1962 30-9-1963 Rs. Rs. Rs. Rs. Rs. Rs. Rs. Total debit balance outstanding against directors and shareholders 15,37,560 16,71,648 18,92,601 14,50,609 23,85,868 24,92,274 25,37,860 Less : Total debits for interest debited to their accounts. 2,42,199 3,20,467 4,04,810 4,88,401 5,36,966 5,97,420 6,59,537 Net amount of advances given and remaining outstanding 12,95,361 13,51,181 14,87,791 9,62,208 18,48,902 18,94,854 18,78,323 Total paid up capital and reserves 15,72,000 16,95,000. 17,08,000 18,71,851 19,17,123 19,21,902 18,86,302 Total bank borrowings (Cash Credit Account) 38,95,001 26,19,447 15,49,181 28,41,518 54,92,866 35,33,629 13,49,740 Stocks of sugar and stores against which bank loan taken 47,93,448 31,68,121 18,17,482 39,67,131 71,70,895 52,09,293 20,46,701

difference of interest amount on the loans advanced to the directors cannot be said to have been incurred on the capital borrowed for the purposes of the business of the assessee and, accordingly, disallowed a sum of Rs. 1,32,994 for the assessment year 1963-64. Similar orders were passed in respect of the other assessment years concerned herein. The assessee carried the matter in appeal to the Appellate Assistant Commissioner. So far as the assessment year 1963-64 is concerned, the Appellate Assistant Commissioner affirmed the finding of the Income-tax Officer; but so far as the appeal relating to the assessment year 1964-65 is concerned, it was allowed by the Appellate Assistant Commissioner, with the result that both the assessee and the Department filed appeals before the Income-tax Appellate Tribunal in respect of the afore said assessment years. So far as the remaining assessment years concerned herein are concerned, the Appellate Assistant Commissioner agreed with the Income-tax Officer and the appeals were preferred by the assessee before the Tribunal. The Tribunal, in its separate judgments in these three matters, agreed with the assessee and allowed the appeals filed by it. The appeal preferred by the Department was dismissed.

9. The reasoning of the Tribunal is to the following effect: The assessee has been raising loans from banks on the security of its debentures and loan bonds; it was also having a cash credit account with the banks against the pledge of its finished products and stc res. Interest is payable by it on each of these types of borrowings at the rate of 8% per annum. Indisputably, these amounts were borrowed for the purpose of the business of the assessee. It is not the Revenue's case that the amounts borrowed were not utilised for the purposes of the business of the assessee but for advancing the same to the directors for some unproductive purpose unrelated to the business of the assessee. The mere fact that there is a difference in the rate of interest paid by the assessee and that charged by it from the directors is not sufficient by itself to disallow the interest paid by the assessee. Further, there is no connection between the capital borrowed and the advances made. The amount advanced in “the previous year” relating to the assessment years concerned herein is not very large as compared to the borrowings of the assessee during each of those years. The Tribunal, however, observed:

“We generally agree that the large block of advances to the directors and shareholders of the assessee-company, which are continuing year after year, had relatively little annual addition and that neither the block of advances nor the additions can be linked with the borrowers of the assessee-company. However, since it was not possible to identify in the working funds of the company how much it consisted of old borrowings, current borrowings and cash funds, it might have been worth considering whether a portion of the interest paid by the assessee which was proportionate to the funds utilised in the loans to the directors and shareholders of the company to its total funds should not have been disallowed. However, the Revenue did not explore this possibility.”

(See the last portion of paragraph 17 of the judgment of the Tribunal relating to the assessment year 1963-64) Practically, the same reasoning was followed by the Tribunal in its subsequent judgments relating to the later assessment years.

10. Shri Bharatji Agrawal, learned counsel for the Revenue, submitted that under section 36(1)(iii) of the Act, “the amount of the interest paid in respect of capital borrowed for the purposes of the business or profession” alone is deductible, and not any other amount. The amount of advances to the directors by the assessee, which are very large, compared to its total volume of business and its borrowings, cannot be said to be for the purpose of the business of the assessee. The advances were made to the directors at such a low interest for their private benefit and profits. The assessee is not a finance company. It is engaged in the business of manufacture of sugar. It had no business to lend such huge amounts to its directors. The said lending becomes significant when it is noticed that the assessee is a private limited company closely held by three persons/families. Actually, the assessee is made to pay a large amount of interest on the amounts borrowed by its directors; in short, the burden of interest has been shifted from the directors to the assessee as part of a deliberate plan to take unfair advantage of their control over the assessee-company. On the other hand, Sri S.N Verma, learned senior advocate appearing for the assessee, submitted that the court should not look to the previous borrowings, but must confine its attention to what happened during the previous year relating to each assessment year under consideration. If this approach is adopted, learned counsel says, the amount advanced during each of the previous years relating to the assessment years (concerned herein) is not large. For example, during the previous year relevant to the assessment year 1963-64, it would be less than fifty thousand rupees. In the next year, it would be nothing. Even in the subsequent years, the advances to the directors would not be substantial, compared to the total borrowings of the assessee-company during each year for the purposes of its business. There is no connection or nexus between the borrowings of the assessee and the amounts advanced by it to its directors. So long as the amounts borrowed by the assessee cannot be said to be unrelated to its business, the interest paid by the assessee thereon has to be allowed. The fact that some amounts were advanced to the directors at a lower rate of interest is not relevant to the question of allowing of interest under section 36(1)(iii). Learned counsel also submitted that the Department has not put forward the plea of the device which is now sought to be raised by learned counsel for the Revenue. The approach adopted by Sri S.N Verma, learned counsel for the assessee, namely, that you must look only to the particular assessment year, and not beyond, looks attractive at first flush, but does not stand scrutiny in depth. It is true that, for the purposes of income-tax, each assessment year is a separate unit. It may be equally true that the amounts of loans to the directors are not substantial in each of the years. But, this, approach would have been valid if the assessee had been paying interest only on the amounts lent during a particular assessment year. As a matter of fact, the difference of interest, which the assessee is made to bear on account of loans to the directors, is more than rupees two lakhs in the assessment year 1968-69. With respect to;he assessment year 1967-68, it is Rs. 1,85,858. The court cannot shut its eyes to realities. What has actually happened is visible to the naked eye. The assessee, a private limited company closely held by three family groups, is made to lend huge amounts (up to 23 lakhs of rupees as per the compromise arrived at between the assessee and the directors/shareholders in the civil suits referred to above) at a very low rate of interest and the entire difference of interest is being charged to the assessee. The assesses is not a finance company. It is engaged in the manufacture of sugar. No business purpose of the assessee-company is served by such lendings to its directors/shareholders. It cannot be said that it is expedient in the interest of business or is laid out for the purpose of the business of the assessee. It is not even a case where employees of the company are being lent some small amounts at a lower rate of interest with a view to keep them happy and satisfied. The amount of interest paid each year payable on account of the loans to directors is very substantial and this fact cannot be glossed over by saying that the amount is not substantial in each of the years. It must be remembered that, in pursuance of the compromise referred to above, the limit of amounts to be lent to the directors/shareholders was substantially raised while, at the same time, drastically reducing the rat; of interest to be charged to them. It is clear that the directors/shareholders are taking unfair advantage of their control over the assessee and that they are exploiting it for their private ends. We are not saying that it is a device; we need not go that far. What has happened in this case is self-evident, viz., the assessee is made to pay huge amounts by way of interest on account of heavy amounts advanced to its directors, bearing no relation whatsoever with the business purpose of the assessee. A look at the figures mentioned in the questions referred clearly shows that huge amounts are being paid by the assessee on account of interest. May be that the company borrows large amounts for the purpose of its business every year, but that does not explain the huge advances to the directors/shareholders. Had this money been not advanced to the directors, it would have been available to the assessee for its business purposes and to that extent it may not have been necessary to borrow from the banks. We are, therefore, of the opinion that the Income-tax Officer was right in disallowing the difference of interest under section 36(1)(iii) of the Income-tax Act and that the Tribunal's approach is not only superficial but too naive.

11. For the above reasons, our answer to question No. (i) in Income-tax Reference No. 895 of 1978 and the only question referred in Income-tax Reference No. 896 of 1978 and Income-tax Reference No. 912 of 1978 is in the negative, that is, in favour of the Revenue and against the assessee. No order as to costs.