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Smt. Chanchal Katyal v. Commissioner Of Income-Tax
Factual and Procedural Background
The Income-tax Appellate Tribunal, Allahabad, referred five questions of law under section 256(1) of the Income-tax Act, 1961, to this Court. The reference concerns assessment years 1978-79, 1979-80 and 1980-81.
Briefly, the assessee (a woman who had obtained an import licence to import machines for running a tannery) planned to run the tannery in family residential premises in Civil Lines, Kanpur but was prevented by the Municipality. Initial financing from the U.P. State Financial Corporation fell through. The machines were already en route, and in the accounting period ending 30 April 1975 the assessee raised loans totaling Rs. 8,43,446.91 from close relatives and acquired machines costing Rs. 8,41,978.
The assessee had entered into an agreement with M/s Mohan General Trading Co., Calcutta (dated 15 May 1973) under which that firm was to construct a building for the tannery on leased land and the machines would be installed nearby during construction. A fresh agreement was entered with Malik & Co. (a Hindu undivided family) on 2 April 1975. Subsequently the assessee advanced funds to both firms.
The Income-tax Officer (ITO) disallowed, under section 36(1)(iii), portions of interest claimed by the assessee on the ground that borrowings (on which the assessee paid interest) had not been utilised for her business but had been given interest-free to the two firms. The respective disallowances for the assessment years were recorded in the ITO’s orders (the ITO disallowed amounts on the basis that interest should have been charged on advances made to these firms).
The Commissioner of Income-tax (Appeals) allowed the assessee’s appeals (holding that the disallowance was not justified and describing the arrangements as devices to avoid or evade tax was not established). The Tribunal considered the matter, made findings about the nature of the advances, and dealt with whether interest had accrued under the agreements; the Tribunal confirmed the disallowance for assessment year 1980-81 but deleted the disallowance for the earlier two years. The Tribunal refused the assessee’s request to remit the matter back to the ITO for further opportunity to explain.
Legal Issues Presented
- Whether the Tribunal was justified in law in concluding that the assessee got reasonable opportunity to meet the case in respect of accrual of interest on advances made to M/s. Mohan General Trading Co., Calcutta and M/s. Malik & Co., Kanpur?
- Whether the Tribunal was justified in law in concluding that interest at the rate of 18% per annum accrued to the assessee on the advances made to M/s. Mohan General Trading Co., Calcutta and M/s. Malik & Co., Kanpur?
- Whether the Tribunal was justified in law in holding that the advance made to M/s. Malik & Co. was not a business advance?
- Whether the Tribunal was justified in law in upholding the disallowance of Rs. 1,98,607 made by the income-tax authorities under section 36(1)(iii) of the Income-tax Act, 1961, on the ground that interest should have been charged on advances made to M/s. Mohan General Trading Co., Calcutta and M/s. Malik & Co., Kanpur?
- Whether the Tribunal was justified in law in confirming the disallowance of Rs. 1,98,607 under section 36(1)(iii) of the Income-tax Act for the assessment year 1980-81?
Arguments of the Parties
Assessee's Arguments (as presented)
- The Tribunal had deleted the proportionate amounts of interest added by the assessing authorities for assessment years 1978-79 and 1979-80 on the ground that the advances were made for business purposes.
- The assessing authority's remand report expressly stated that the photocopy of the agreements, accounts of creditors and debtors, and the replies to notices under section 143(3) did not reveal that borrowings (on which interest was paid) were utilised as interest-free loans to the debtors.
- Given the remand report finding, the disallowance of proportionate interest on the interest-free advances to the two firms did not arise for the assessment year 1980-81 either.
- The assessee relied on authorities (Orissa Cement Ltd., Tin Box Co., Radico Khaitan Ltd.) in support of her position that the disallowance was not warranted where borrowed funds were not shown to have been diverted to interest-free advances.
Revenue's Arguments (as presented)
- The agreements with the two firms contained clauses that, if the projects were not completed within specified periods, the firms would be liable to pay interest at an accrued rate. On that basis the Tribunal was justified in treating interest as having accrued and in upholding the disallowance under section 36(1)(iii).
- The Revenue relied on the decision in CIT v. H.R. Sugar Factory P. Ltd. (1991) to support its contention that the contractual clause justified treating interest as accrued and thus supported the disallowance of proportionate interest paid on borrowed capital.
Table of Precedents Cited
| Precedent | Rule or Principle Cited For | Application by the Court |
|---|---|---|
| Commissioner of Income-Tax v. Orissa Cement Ltd., [2001] 252 ITR 878 (Delhi) | Recognised authority (Delhi High Court) cited for the proposition that where an assessee has sufficient funds other than the borrowed money used to make loans, the conditions of section 36(1)(iii) are complied with and interest paid on borrowed capital may be allowable. | The Court treated this decision as supporting the view that disallowance under section 36(1)(iii) is not warranted if borrowed funds were not the source of interest-free advances; it forms part of the line of authority the Court relied on to set aside the disallowance. |
| Commissioner of Income-Tax v. Tin Box Co., [2003] 260 ITR 637 (Delhi) | Similar Delhi High Court view aligning with the proposition that availability of non-borrowed funds for making loans satisfies the conditions of section 36(1)(iii) so that interest on borrowed capital is allowable. | The Court cited this authority as corroborative of the approach favouring the assessee where borrowed money was not shown to have been diverted to interest-free loans. |
| CIT v. Radico Khaitan Ltd., [2005] 274 ITR 354 (All) | After discussing H.R. Sugar, this Court held that if the assessee has sufficient funds other than borrowed money for giving loans to another concern, the conditions of section 36(1)(iii) are complied with and the assessee is entitled to full allowance of interest paid on borrowed capital. | The Court relied on Radico Khaitan as a directly applicable authority supporting the assessee's position and used it to conclude that the Tribunal was not justified in confirming the disallowance for assessment year 1980-81. |
| Commissioner of Income-Tax v. Prem Heavy Engineering Works P. Ltd., [2006] 285 ITR 554 | Reinforced the view (as stated in Radico Khaitan) that where loans made by an assessee are not sourced from borrowed funds on which interest is paid, section 36(1)(iii) is satisfied and interest on borrowed capital should be allowable. | The Court cited this decision as consistent with the line of authorities favouring the assessee and relied upon it in reaching its conclusion on the reference. |
| CIT v. H.R. Sugar Factory P. Ltd., [1991] 187 ITR 363 | Relied upon by the Revenue (as presented) to support the proposition that contractual provisions and accrual can justify treating interest as having accrued and therefore support disallowance under certain circumstances. | The Court noted that the Revenue heavily relied on H.R. Sugar, but observed that Radico Khaitan (and subsequent decisions) had discussed H.R. Sugar and reached conclusions that favoured the assessee's position in the circumstances of the present case. The Court did not accept H.R. Sugar as dispositive in favour of the Revenue on the present facts. |
Court's Reasoning and Analysis
The Court examined the factual findings recorded in the remand report called for by the Tribunal. The remand report expressly stated that examination of the photocopies of agreements, accounts of creditors and debtors, and the reply to notice under section 143(3) did not reveal that borrowings (on which the assessee had paid interest) had been utilised as interest-free loans to the two firms (M/s Mohan General Trading Co. and M/s Malik & Co.).
The Court noted the parties' opposing legal positions: the Revenue urged that the contractual clause made interest accrue (and that therefore the Tribunal was justified in upholding the disallowance under section 36(1)(iii)), whereas the assessee pointed to the remand report and to authorities holding that where the assessee has sufficient funds other than borrowed capital the conditions of section 36(1)(iii) are satisfied and interest on borrowed capital remains allowable.
The Court placed emphasis on the factual finding in the remand report — that the borrowed money on which the assessee paid interest had not been shown to have been diverted to interest-free advances. The Court also observed that the Revenue did not argue that, under the mercantile system of accounting, interest had in fact accrued to the assessee despite not having been charged.
Having reviewed precedent, the Court relied on a line of decisions (including Radico Khaitan Ltd., Prem Heavy Engineering Works, Orissa Cement Ltd. and Tin Box Co.) for the principle that if an assessee has sufficient funds other than borrowed money for making loans to another concern, the requirements of section 36(1)(iii) are met and the interest paid on borrowed capital is allowable. The Court treated those authorities as directly applicable and persuasive.
Applying that principle to the present facts (and noting the remand report finding that the borrowed funds were not shown to be used for the interest-free advances), the Court concluded that the Tribunal was not justified in confirming the disallowance for assessment year 1980-81.
The Court also recorded that the Tribunal had already reversed the disallowance for assessment years 1978-79 and 1979-80; consequently, consideration of the other questions became academic once question No. 5 was decided in the assessee's favour.
Holding and Implications
Holding: The Court answered question No. 5 referred to it in the negative — that is, it held in favour of the assessee and against the Revenue. The Court specifically concluded that the Tribunal was not justified in confirming the disallowance (as applied to the assessment year 1980-81).
Core Ruling: The Court found that the Tribunal was not justified in confirming the disallowance under section 36(1)(iii) for the assessment year 1980-81 (the Court referred to the disallowance figure recorded in the order concerning that year).
Direct implications:
- The disallowance that the Tribunal had confirmed for assessment year 1980-81 is not sustained by this Court (the Court held in favour of the assessee on question No. 5).
- The other four questions that formed part of the reference were rendered academic by the answer to question No. 5 and were accordingly returned unanswered.
Broader implications: The Court's decision applied and relied on existing authorities (Radico Khaitan, Prem Heavy Engineering Works, Orissa Cement Ltd., Tin Box Co.) emphasising that where borrowed funds are not shown to have been utilised for making interest-free advances, and where non-borrowed funds were available, section 36(1)(iii) will not operate to disallow interest paid on borrowed capital. The opinion does not purport to set a new principle beyond application of those precedents to the facts before it.
1. The Income-tax Appellate Tribunal, Allahabad, has referred the following questions of law under section 256(1) of the Income-tax Act, 1961, (hereinafter referred to as the Act), for opinion to this court:
“Whether, on the facts and in the circumstances of the case, the Tribunal was justified in law in coming to the conclusion that the assessee got reasonable opportunity to meet the case in respect of accrual of interest on advances made to M/s. Mohan General Trading Co., Calcutta and M/s. Malik & Co. Kanpur?
Whether, on the facts and in the circumstances of the case, the Tribunal was justified in law in coming to the conclusion that interest at the rate of 18 per cent, per annum accrued to the assessee on the advances made to M/s. Mohan General Trading Co., Calcutta and M/s. Malik & Co., Kanpur?
Whether, on the facts and in the circumstances of the case, the Tribunal was justified in law in holding that the advance made to M/s. Malik & Co. was not a business advance?
Whether, on the facts and in the circumstances of the case, the Tribunal was justified in law in upholding the disallowance of Rs. 1,98,607 made by the income-tax authorities under section 36(1)(iii) of the Income-tax Act, 1961, on the ground that the interest should have been charged on advances made to M/s. Mohan General Trading Co., Calcutta and M/s. Malik & Co., Kanpur?
Whether, on the facts and in the circumstances of the case, the Tribunal was justified in law in confirming the disallowance of Rs. 1,98,607 under section 36(1)(iii) of the Income-tax Act, 1961, for the assessment year 1980-81 ?”
2. The reference relates to the years 1978-79, 1979-80 and 1980-81. Briefly stated the facts giving rise to the present reference are as follows:
3. The brief facts of the case are that the assessee lady had obtained import licence for importing certain machines for running a tannery. To finance the aforesaid imports, she had made arrangements with the U.P Financial Corporation. Originally, it was intended that the tannery would be run in the part of residential premises of the family situated in Civil Lines, Kanpur. The Municipality of Kanpur, however, did not permit her to do the said business there. The financial arrangement with the U.P State Financial Corporation accordingly fell through. The machines were, however, already on their way and were about to land at Calcutta port. The assessee, therefore, felt obliged to make alternative financial arrangement and accordingly she raised loans of Rs. 8,43,446.91 from her close relatives. The said loans were raised in the accounting period ended on April 30, 1975. The cost of machines was Rs. 8,41,978, thus, the entire borrowings were more or less utilised for the purchase of the aforesaid machine in the accounting period ending on April 30, 1975.
4. The assessee entered into an agreement with M/s. Mohan General Trading Co., Calcutta on May 15, 1973. As per the terms of the agreement, the Calcutta firm was to construct a new building to be used as the tannery of the assessee on a plot of land which was with the said firm on lease and during the construction period, the machines would be installed in the nearby plot.
5. On April 2, 1975, a fresh agreement was entered into between the asses-see and the Hindu undivided family known as Malik & Co. In terms of these agreements, the assessee started advancing funds to M/s. Mohan General Trading Co., Calcutta. In respect of the advances to M/s. Mohan General Trading Co., Calcutta and M/s. Malik & Co., Kanpur, the findings of the Income-tax Officer for, the three years were as under:
Assessment year 1978-79:
“As regards non charging interest from parties mentioned above, the assessee has furnished details in his letter dated March 5, 1982, from perusal from this above letter, it appears that the assessee mainly accommodated the above parties' for certain services to be rendered by them and accordingly did not charge any interest. The assessee had paid huge interest amounting to Rs. 2,04,837 to the parties from whom the loans were raised. Since the amount of borrowings had not been utilised for business purposes of the asses see and had been given to other parties without interest, I disallow the interest at 12 per cent per annum chargeable on the amount advanced to various parties from the interest paid by the assessee as under:
Rs. “1. M/s. Mohan General Trading Co. Rs. 3,31,343 at 12% 39,761 2. M/s. Malik & Co. Rs. 4,76,785 at 12% per annum 57,214 96,975”
Assessment year 1979-80
“Scrutiny of balance-sheet showed that the assessee had advanced Rs. 3,88,057 to M/s. Mohan General Trading Co. and Rs. 7,02,464 to M/s. Malik & Co. for known business purposes and interest income over it has not been shown whereas interest on debt balance of M/s. Ideal Glass Co. has been shown by the assessee. The assessee paid Rs. 2,38,772 interest to her creditors. The assessee has not been able to establish as to how interest has not been charged from two debtors while same was charged from others. Considering the facts and circumstances of the case interest amounting to Rs. 1,09,685 is disallowed under section 36(1)(iii) of the Income-tax Act.”
Assessment year 1980-81
“The assessee has paid interest of Rs.,2,33,434 to the various creditors and has shown interest of Rs. 17,500 having been received from M/s. Ideal Glass Co. The assessee has not charged interest from other debtors. Therefore, the interest amounting to Rs. 1,98,607 is disallowed under section 36(1)(iii) of the Income-tax Act.”
6. The Commissioner of Income-tax (Appeals) disposed of the appeals by a common order dated February 10, 1987, and his findings in paragraph 8 of his order are reproduced below:
“In the instant case, it is more than clear that while on the one hand, the appellant is having borrowing of money from various parties and for which in the assessment year 1978-79, as per profit and loss account it has claimed deduction for payment of interest amounting to Rs. 2,04,837, she has diverted funds to the tune of more than Rs. 8 lakhs without charging interest, to its closely related concerns and, thus, it is clear these are very crude and obvious devices by the appellant to evade or at least avoid tax. The very fact that the agreement with M/s. Mohan General Trading Co. dates back to May 15, 1973, and with M/s. Malik & Co. on April 2, 1975, and still none of the projects has been completed till date, at least so far as its benefits being taken by the appellant is concerned, would clearly show, that those agreements were merely an eyewash. In these circumstances, I hold that the disallowance of interest by the Income-tax Officer in respect of interest-free advances given to M/s. Mohan General Trading Co. and M/s. Malik & Co. for all these three years are dismissed.”
7. The Tribunal has dealt with the disallowance under section 36(1)(iii) of the Income-tax Act, 1961, in paragraphs 3 to 15 of the order dated April 30, 1990. In paragraph 12, the Tribunal has held as follows:
“We have carefully examined the facts of the case and the rival submissions and have also perused the two contracts. So far as the advance to M/s. Mohan General Trading Co. is concerned, it was, in our opinion, a trade advance given with a view to acquire the place for carrying on business.”
8. In paragraph 14, the Tribunal has held as under:
“So far as loan given to M/s. Malik & Co. is concerned, it is undoubtedly true that the loans to M/s. Malik & Co. has not been given out of the borrowings on which assessee was paying interest. Therefore, no part of the interest paid on the aforesaid borrowings could be disallowed that interest bearing loans was diverted to give the interest-free loan to M/s. Malik & Co. Therefore, the contention of the assessee against invoking the provisions of section 36(1)(iii) in respect of M/s. Malik & Co. is also correct.”
9. The Income-tax Officer categorically mentioned in his order as “therefore, interest amounting to Rs. 1,98,607 is disallowed under section 36(1)(iii) of the Income-tax Act, 1961, like last year”. As has been mentioned by the Tribunal in paragraph 11 of the order, the Departmental Representative on behalf of the respondent only relied upon the orders of the authorities below and read in extenso the order of the Commissioner of Income-tax (Appeals). None of the lower authorities had considered the aspect of the approval of income in terms of the agreement even there was no submission on behalf of the Department that any opportunity was allowed to the assessee to explain her viewpoint on the question of accrual of income in terms of the aforesaid two agreements. On behalf of the assessee, specific argument was made that no opportunity was allowed to explain her case before the authorities below but this was rejected by the Tribunal and the relevant findings of the Tribunal contained in paragraph 13 of the order are reproduced below:
“The request of the assessee that she should be provided an opportunity to explain this point before the authorities below and for this purpose the matter should be restored to the Income-tax Officer is not acceptable to us. After all, the viewpoint of the Income-tax Officer and the disallowance in question was all along the bone of contention and the assessee's defence was the agreement with M/s. Mohan General Trading Co. that the very agreement provided for charging of interest by the assessee. Had there been any variation in the aforesaid clause, the assessee should have brought it on record and in any case would point it out to us at the time of hearing. There has been no such attempt. We, therefore, refuse to accept the asses see's plea and to restore back the matter to the files of the Income-tax Officer.”
10. The Tribunal as per the discussion in paragraphs 13, 14 and 15 of its order, held that the interest accrued to the assessee in respect of the assessment year 1980-81 in terms of the two agreements.
11. We have heard Shri Shakil Ahmad, learned counsel appearing for the assessee and Shri A.N Mahajan, learned standing counsel for the Revenue.
12. Shri Shakil Ahmad, learned counsel submitted that in respect of the two assessment years, namely, 1978-79 and 1979-80, the Tribunal itself has held that the proportionate amount of interest relatable to the advances made by the applicant to M/s. Malik & Co. Kanpur and M/s. Mohan General Trading Co. Calcutta, which were added by the assessing authorities had been deleted on the ground that the advances were made for business purposes. He further submitted that for the remand report submitted by the assessing authorities, it has been specifically mentioned that the photocopy of the agreement obtained from the assessee, copy of the accounts of the creditors and debtors and copy of reply of notice under section 143(3) do not reveal that the borrowings from the creditors, whose interest has been paid were utilized as interest-free loans to the debtors, and, therefore, in view of the categorical finding having been returned by the assessing authority in his remand report the question of disallowing proportionate amount of interest on interest-free advances to the two firms, did not arise. In support of his various pleas, he has relied upon the following decisions:
(1) Commissioner Of Income-Tax v. Orissa Cement Ltd., [2001] 252 ITR 878 (Delhi);
(2) Commissioner Of Income-Tax v. Tin Box Co., [2003] 260 ITR 637 (Delhi); and
(3) CIT v. Radico Khaitan Ltd., [2005] 274 ITR 354 (All).
13. Shri A.N Mahajan, learned standing counsel, on the other hand, submitted that under the agreements entered into by the applicant with the two firms has clearly established that if the project is not completed within a specified period, the firms would be liable to pay interest on the accrued rate and, therefore, the Tribunal was justified in relying upon the said clause of the agreement and upholding the disallowance of the proportionate amount of interest under section 36(1)(iii) of the Act, which the applicant had paid on borrowed capital. He has relied upon a decision of this court in the case of CIT v. H.R Sugar Factory P. Ltd., [1991] 187 ITR 363.
14. We have given our anxious consideration to the various pleas raised by learned counsel for the parties.
15. It is not in dispute that for the assessment years 1978-79 and 1979-80, the Tribunal has reversed the disallowance of the proportionate amount of interest. In respect of the assessment year 1980-81, the Tribunal has confirmed the disallowance relying upon the clause of the agreement, which provided charging of interest. However, we find that in the remand report, which was called for by the Tribunal, the assessing authorities had mentioned the following facts:
“As desired I have examined the issue as to whether borrowings from the creditors have been utilized as interest-free loan to M/s. Mohan General Trading Co. and M/s. Malik & Co. by the assessee, copy of the accounts of creditors and debtors, copy of the reply of notice under section 143(3), photocopy of the agreement obtained from the assessee does not reveal that the borrowing from the creditors whom interest has been paid were utilized as interest-free loans to the debtors.”
16. The factual position, thus, is that the borrowed money on which the applicant was liable to pay the interest to its creditors had not been diverted towards interest-free loans by her to the aforesaid two firms on which interest has not been charged. It is not the case of the Revenue that as the applicant is following the mercantile system of accounting and under the agreement, the interest even though not actually charged had accrued as income and, therefore, liable to pay tax. On the other hand, the specific stand taken by the Revenue is that as the applicant had not taken any interest on the advances made by her to M/s. Malik & Co., Kanpur and M/s. Mohan General Trading Co., Calcutta proportionate interest which the applicant could have realized from these two firms and which had not been realized should be disallowed under section 36(1)(iii) of the Act. This court in the case of Radico Khaitan Ltd., [2005] 274 ITR 354 after discussing its decision in the case of H.R Sugar, [1991] 187 ITR 363, which has been heavily relied upon by Shri A.N Mahajan has held that if the assessee has sufficient funds other than the borrowed money for giving the amount as loan to any other concern, the conditions of section 36(1)(iii) of the Act had been complied with and the assessee is entitled to full allowance of the amount of interest paid by her on borrowed capital. Similar view has been taken by this court in the case of Commissioner Of Income-Tax v. Prem Heavy Engineering Works P. Ltd., [2006] 285 ITR 554. Similar view has been taken by the Delhi High Court in the cases of Orissa Cement Ltd., [2001] 252 ITR 878 and Tin Box Co., [2003] 260 ITR 637. In view of the foregoing discussions, we are of the considered opinion that the Tribunal was not justified in confirming the disallowance of Rs. 1,96,607 for the assessment year 1980-81.
17. In view of our answer to question No. 5, the other four questions have been rendered academic. We, accordingly, answer question No. 5 referred to us in the negative, that is, in favour of the assessee and against the Revenue while the remaining four questions are returned unanswered.
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