B.P Jeevan Reddy, J.:— R.C No. 315 of 1982.— Two questions are referred under section 256(1) of the Income-tax Act, 1961, in this case. They are:

“(1) Whether, on the facts and in the circumstances of the case, the Tribunal was justified in holding that the amount of Rs. 15,092 should not be considered for being taxed as revenue but had to be set off against interest payment of Rs. 7,79,297 and the balance alone had to be capitalised?

(2) Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the amount of Rs. 4,900 could not be considered as a separate revenue receipt but had to be set off against larger amounts of expenditure of a capital nature and the reduced amount alone should be considered for the purpose of determining the actual cost of assets?”

2. The assessment year concerned is 1977-78. The assessee-company was incorporated on July 19, 1974. The main objects of the company were to own and acquire ferrous and non-ferrous metal melting furnaces, rolling mills and to carry on business as traders and manufacturers of ferrous and non-ferrous metal ingots, etc., and to do business of traders or manufacturers of steel products and hardware of all kinds, and also to act as stockists, commission agents, etc., for engineering and industrial requirements. In the return filed by the assessee for the assessment year 1977-78, it showed its total income as “nil” and gave the following computation of its income:

“I. Income from business:

Rs. Rs The company is still under construction stage and has yet to commence production. The expenses incurred during construction period, pending allocation to capital account, are detailed in the notes attached to the balance-sheet as at 30-6-1976. The interest income received by the company is being treated as part of the business income, pursuant to one of the objects for which the company is established. Since it is being treated as business income, a portion of the expenditure incurred has to be deducted from this income. Therefore, “Nil” income is being returned under this head. (a) Interest received as detailed in Schedule “E” of the balance-sheet 15,092 (b) Other miscellaneous receipts … 4,900 … 19,992 Expenses apportionable … 30,13,628 Balance to be capitalised … 29,93,636 … Nil Total income … Nil”

3. A few facts need to be stated to understand the above computation. In the words of the Tribunal, the following is the factual position:

“In the present case, on facts, the assessee had borrowed funds. Some of the borrowed funds which were not immediately required were kept by the assessee in deposits and some interest was earned. There was a direct nexus between the borrowed funds and the deposited funds, since the deposited funds came out of the borrowed funds…”

4. It was further found:

“On the facts, admittedly, in the present case, the interest receipt of Rs. 15,092 is on deposits made from borrowed funds, on which interest was paid by the assessee, which funds were kept in such deposits till they were used in the construction work. We find from schedule ‘E’ to the balance-sheet as at June 30, 1976, that there were interest payments in all to the extent of Rs. 7,94,389 which remained unadjusted…”

5. From the above statement of facts, it is clear that the assessee, after having been incorporated, was engaged in setting up the-plant. During the accounting year relevant to the assessment year concerned herein, it was still at the stage of construction. It had borrowed certain funds for setting up the plant. A part of the funds which was not immediately required was kept in deposit upon which some interest was earned. On the amounts borrowed by it, it was paying interest at a much larger figure. It, therefore, sought to deduct the interest earned by it from out of the interest paid by it and capitalise the balance interest paid. The Income-tax Officer, however, did not agree with this method. He treated the interest earned in a sum of Rs. 15,092 as “income from other sources” and held that no amount is deductible therefrom as none was expended wholly and exclusively for earning the said interest amount. In short, he treated the said amount as income of the said year, refusing to allow it to be deducted from the interest paid by the assessee during the relevant assessment year. On appeal, the Commissioner (Appeals) affirmed the order of the Income-tax Officer. On further appeal, however, the Tribunal took a different view. Relying upon the notes prepared by the Institute of Chartered Accountants of India on “A study on expenditure during construction period”, the Tribunal held that the proper method to be adopted in such cases is not to treat the said interest amount of Rs. 15,092 as income from other sources, but to treat the same, as also the interest paid by the assessee on the loans obtained by it, as one single account. This is what the Tribunal said:

“It is, therefore, clear that on the facts of the present case, receipts and payments of interest have to be considered as in a single account. Therefore, the receipts of interest would go to reduce the payment of interest. As we have already pointed out, interest payments were to the extent of Rs. 7,94,389 and interest receipts were to the extent of Rs. 15,092. Thus the amount of interest to be considered for capitalisation purposes would, on the facts of this case, be only the net figure, i.e, Rs. 7,79,297 (Rs. 7,94,389 less Rs. 15,092), because this is the net interest outgoing…”

6. Questioning the correctness of the said finding, the, Revenue asked for and obtained reference of the above two questions. Sri M. Suryanarayana Murthy, learned standing counsel for Revenue, contended that the Tribunal was in error in treating the receipts and payments of interest as a single account. He submitted that the interest received on deposits is income from other sources, chargeable under section 56 of the Act, and that it cannot also be said that the interest paid by the assessee was an expenditure incurred wholly and exclusively for earning this interest amount. For that reason, there is no question of setting off these two amounts against one another, he argued.

7. On the facts found in this case, we are of the opinion that the reasoning adopted by the Tribunal is the correct one and is a realistic assessment of the situation. The company was incorporated for setting up a plant and to manufacture certain products and to deal in them. During the relevant accounting year, it was in the course of setting up the plant. For that purpose, it had borrowed certain amounts upon which it was paying interest. All the amount borrowed was not needed at once. A portion of the said amount was kept in deposit, until needed. Those deposits earned some interest. Would it be realistic to say that that is income from other sources, or would it be more appropriate to adopt the approach indicated by the Institute of Chartered Accountants of India in their “A Study on Expenditure during construction period”; relied upon by the Tribunal? The following portions of the said study are relevant for the present purpose:

“Paras 8 to 8.3:

8. Income during the construction or pre-production period:

8.1: It is possible that a new project may earn some income from miscellaneous sources during its construction or pre-production period. Such income may be earned by way of share transfer fees or by way of interest from the temporary investment of surplus funds prior to their utilisation for capital or other expenditure.

8.2: Where a particular item of miscellaneous income can be directly related to a particular item of expenditure, it is suggested that it should be set off against the expenditure, and the net amount of the expenditure should be treated in the appropriate manner depending upon its nature, in accordance with the various principles suggested above. For example, income from share transfer fees may be set off against the various corporate expenses incurred during the construction or pre-production period and income, if any, from lending transport vehicles to outsiders may be set off against the expenditure incurred in operating and maintaining those vehicles. Similarly, interest income earned during the construction period may be off-set against interest expenses incurred during this period…”.

8. In our opinion, the course indicated by the Institute of Chartered Accountants of India is the proper one to be adopted in such circumstances. Indeed, a somewhat similar case had arisen before us in R.C No. 134 of 1982, disposed of on April 2, 1987 (CIT v. Andhra Farm Chemicals Corporation, [1988] 171 ITR 660). There, a subsidiary company had borrowed certain funds from its parent company. The subsidiary company, the assessee, was in its formative period. With a view not to keep the borrowed money idle, it deposited a part of the same with the holding company, which was to mature only by December 31, 1974. Meanwhile, the assessee required some amount and, accordingly, it borrowed a small amount from the parent company on which it was made to pay interest. The interest, earned by the assessee-company on deposits made by it was Rs. 34,865 and the interest paid by it on the loan taken from the parent company was Rs. 13,464. Accordingly, the assessee returned an income of Rs. 21,401 representing the difference between both the figures. An identical contention was urged by the Revenue that the interest earned is “income from other sources” and since the interest paid by the assessee was not an expenditure incurred for earning the said interest amount, the said amount cannot be set off under section 57 of the Act. We noted the finding of the Tribunal recorded in that case, viz., that though for the purpose of accountancy, there appeared to be two independent transactions, i.e, one of deposit by the assessee with the parent company, and the other the transaction of borrowing of the money by the assessee from the parent company, they, in truth and reality, constituted one single transaction. On the basis of the said finding, we upheld the assessee's contention that the income received by the assessee in that case is only Rs. 21,401, and nothing more. We observed that having regard to the finding of the Tribunal, section 57(iii) has no application, nor can the said interest income be treated as “income from other sources”. Of course, we did not think it necessary to go into the concept of “real income” which concept too was employed by the Tribunal in that case to sustain its finding.

9. We are of the opinion that though the particular situation of a subsidiary company and parent company does not obtain in this case, the same principle must be applied.

10. Learned standing counsel for the Revenue relied upon a few decisons which we may refer now. In CIT v. New Central Jute Mills Co. Ltd., [1979] 118 ITR 1005 (Cal), the assessee-company was setting up a heavy chemical plant, and during the accounting year relevant to the assessment year 1958-59, the plant was under erection. Earlier in 1955, the assessee had obtained from the Government of Uttar Pradesh a loan of Rs. 1.45 crores for the purpose of setting up the said plant. The amounts received towards loan were kept in deposit with a bank till their transfer or utilisation for the stipulated purpose. During the relevant assessment year, the assessee earned a sum of Rs. 1,75,471 as interest on such deposits, while during the same period it paid to the Government U.P a sum of Rs. 9,54,588 as interest. The assessee, since it was an existing company and already engaged in another business, claimed the difference between the interest earned and interest paid, i.e, Rs. 7,79,117, as revenue expenditure, which was disallowed by the Income-tax Officer on the ground that the expenditure had nothing to do with the existing business of the assessee, but related to a separate unit altogether which was still under erection. The Appellate Assistant Commissioner affirmed the said view. On further appeal, the Tribunal held that the amount paid by way of interest should be allowed as a deduction as against interest earned from the bank in terms of the loan; that as the assessee had to keep the money in deposit with the bank segregated from its other business assets, the interest earned from the deposits would be “income from other sources”, and that by adopting a different method of assessment, the Income-tax Officer could not defeat the assessee's claim. It held that the interest paid by the assessee towards loan to the Government should be set off against the interest earned by the assessee on its deposits. This view was questioned by the Revenue before the Calcutta High Court. The High Court held that though the assessee had succeeded in establishing that there was some connection or nexus between the interest paid to the Government and the interest earned from the bank, it was not established that it was one of the terms of the agreement of loan that the amounts borrowed shall be kept in a deposit account which would earn interest in the interim period. Accordingly, it held that the interest so earned had to be treated as “income from other sources” and since the interest paid by the assessee cannot be said to be an expenditure incurred solely and wholly for the purpose of earning the said interest, it cannot be set off against the interest earned. It held further that the interest paid to the Government had to be capitalised and added to the cost of the plant which was being set up, and that the interest amount has to be taxed as income from other sources. In our opinion, the High Court has taken too narrow a view of the situation. Just because it was not proved that the loan agreement stipulated that the amounts borrowed should be kept in deposit earning interest, treating the said interest as an independent income may not be a proper course. After all, the assessee is not expected to keep the amounts in its own till. It kept them in a bank. Whether the amounts are kept in an account which earns interest or in an account which does not earn interest should not make any difference to the principle, because it was only an interim arrangement. Instead of keeping the amounts with itself, the assessee deposited the same with a bank to be drawn and utilized as and when necessary.

11. The next decision cited is of the Bombay High Court in Commissioner Of Income-Tax, Bombay City-Ii v. United Wire Ropes Ltd., [1980] 121 ITR 762. Here too, the facts were similar; it was found as a fact that the interest paid on foreign exchange loan and the interest earned on bank deposits were not inter-connected or inter-dependent. Accordingly, it was held that under section 57(iii), the interest paid cannot be set off against the interest received. In our opinion, the finding that there was no connection or nexus between the transactions is the distinguishing factor.

12. Learned standing counsel for the Revenue, then relied upon the decision of the Madras High Court in Addl. CIT v. Madras Fertilisers Ltd., [1980] 122 ITR 139. The facts of this case too are again somewhat similar. But here too, a finding was recorded that there was no direct connection between the interest paid and the interest received. This finding again, in our opinion, is a distinguishing factor.

13. On the other hand, learned counsel for the assessee relied upon a decision of the Delhi High Court in Snam Progetti S.P.A v. Addl. CIT, [1981] 132 ITR 70. In this case, Snam Progetti, an Italian company carrying on business as engineers and contractors in the field of petroleum and petro-chemical plants, was engaged in India having huge contracts, each running into millions of dollars, which necessitated the assessee having large liquid funds. The excess business funds were placed in short-term deposits with the bank and interest income was earned thereon. For the assessment year 1970-71, the assessee incurred a net business loss of Rs. 122 lakhs, but in the next assessment year 1971-72, it earned a profit of Rs. 30 lakhs and interest income of about Rs. 5 lakhs. The assessee sought to carry forward the business loss incurred in the assessment year 1970-71 and set it off against the interest income as well earned in the succeeding assessment year. This was rejected by the Department, whereupon the matter was taken to the High Court by way of a writ petition. The court-held that, in the circumstances of the case, even the interest earned on short-term deposits should be deemed as “business income” and not as “income from other sources”. It observed that the assessee had not come from Italy to make bank deposits in India but had come to carry on business here and that the said short-term deposits were made in that connection. It, therefore, held that the interest earned is really business income and the losses of the previous assessment year carried forward can be set off against the said interest income as well. In our opinion, the approach adopted by the Delhi High Court in the facts of the case before it can also be adopted in the facts of the case before us. In this case too, the object of the assessee was not to earn interest on deposits. The object was to do business. It was in the course of setting up a plant and since all the borrowed money was not needed at once, it put certain moneys in deposits which earned interest. In our opinion, the said interest earned on deposits should be set off against the interest paid by the assessee on the loans obtained by it and the balance of the interest amount capitalised.

14. For the above reasons, we answer both the questions in the affirmative, i.e, in favour of the assessee and against the Revenue. There shall be no order as to costs.

15. R.C No. 8 of 1985—The question referred in this case is:

“Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was correct in directing that the interest payable to M/s. Andhra Pradesh Industrial Development Corporation is wholly and exclusively incurred for the purpose for earning the interest from short-term deposits within the meaning of section 57(iii)?”

16. The facts of this case are similar to the facts in R.C No. 315 of 1982. Though the question referred is squarely based upon section 57(iii), the finding of the Tribunal is that during the relevant assessment years, the assessee was engaged in setting up its plant and unit and that part of the amount borrowed by it from Andhra Pradesh Industrial Development Corporation was kept in short-term deposits with banks, whereon it earned some interest. The Tribunal disagreed with the departmental authorities that the said interest income should be treated as “income from other sources”. It was of the opinion that the payment of interest on the loans obtained by the assessee and earning of interest on short-term deposits made by it out of the amounts borrowed must be treated as a single transaction. On the above finding, we are of the opinion that the question referred does not really arise, because the interest income earned cannot be treated as income from other sources. As held by us in R.C No. 315 of 1982, the said interest income has to be set off against the interest paid by the assessee during the relevant assessment years and the balance of interest capitalised.

17. Accordingly, we decline to answer the question referred while affirming the correctness of the decision of the Tribunal. No costs.

18. R.C No. 12 of 1985.—The assessee in this case is the A.P Forest Development Corporation, Hyderabad, and the question referred is:

“Whether, on the facts and in the circumstances of the case, the Income-tax Appellate Tribunal is justified in holding that interest received on short-term deposits is not assessable under the head ‘Other sources’ but would have to be set off against the payment of interest?”

19. The facts of this case are again practically similar to the facts in R.C No. 315 of 1982. For the same reasons as are given hereinbefore, the question referred is answered in the following terms: the interest received by the assessee on short-term deposits is not assessable under the head “Other sources”, but would have to be set off against the interest paid by it, and the balance interest capitalised. No costs. R.C No. 79 of 1985.—The question referred in this case is:

“Whether, on the facts and in the circumstances of the case, the Appellate Tribunal is justified in holding that the bank interest received on the deposits during the stage of construction of the factory should be treated as capital receipt and this would go to reduce the actual cost of capital assets?”

20. Though the question is framed differently, the facts found by the Tribunal are again practically the same as the facts in R.C No. 315 of 1982. Accordingly, for the reasons given in our judgment in R.C No. 315 of 1982, we hold that the proper course to be adopted in such cases is to set off the interest earned against the interest paid by the assessee and capitalize the balance interest paid.

21. Accordingly, while we do not wish to express any opinion on the question whether the said interest amount received represents a capital receipt or not, we are of the opinion that it cannot be taxed as income from other sources, and that the proper course to be adopted is the one indicated by us hereinbefore. Accordingly, we re-frame the question in the following terms:

“Whether, on the facts and in the circumstances of the case, the Appellate Tribunal is justified in holding that the bank interest received during the stage of construction of the factory cannot be treated as income from other sources and should go towards reducing the actual cost of capital assets?”

and answer the question in the affirmative. No costs.