Per P.N. Parashar, J.M. - This appeal has been filed by the assessee against the order of the CIT(A) dated 17-11-1994, for the assessment year 1991- 92.

2. Shri Rakesh Garg, Adv., appeared on behalf of the assessee, whereas Shri D.K. Shrivastava and Shri B.K. Bharadwaj, Sr. Drs. represented the Department.

3. Ground Nos. 1, 2 & 3 are directed against the sustenance of disallowance of Rs. 1,31,701 on account of claim of deduction towards payment of interest.

4. The facts concerning this disallowance are as under :

The assessee-company had paid interest of Rs. 3,61,034 on the loans and advances taken by it and claimed deduction of this amount. On examination of the records of assessee, the Assessing Officer found that as per Schedule VIII annexed to the Balance Sheet, the opening debit balances under the head "Loans and Advances" was of Rs. 10,09,583 and the closing debit balance was at Rs. 8,78,012. The assessee had not charged any interest on the debit balance, whereas it was paying interest on the credit balance of the loans and advances taken by it. The Assessing Officer required the assessee to explain as to why no interest was being charged on the debit balances. Vide reply dated 29-3-1994, it was stated on behalf of the assessee that the interest has not been accounted for on accrual basis for the reasons that the advances made were not interest bearing. It was also submitted that the principal amount of Rs. 8,78,012 was itself doubtful of its recovery and was, therefore, likely to be written off and, thus, no purpose would be served if the interest is charged on it and, thereafter it is written off.

5. The Assessing Officer did not accept this plea of the assessee and observed that if one has paid interest on the borrowed money, he is supposed to charge the interest. The Assessing Officer after making reference to the decision of Karnataka High Court in the case of CIT v. Salgaoncar & Bros (P.) Ltd. [1992] 198 ITR 738 and to the decision in the case of CIT v. C. Kulandaivelu Konar [1975] 100 ITR 629 (Mad.) and the decision in the case of Addl. CIT v. A.K. Laxmi [1975] 113 ITR 368 (Mad.) disallowed the claim of the assessee relating to interest chargeable by the assessee on the debit balances of Rs. 8,78,012 at the rate of 15 per cent per annum on which the rate of interest the assessee was paying interest to the bank. On this basis, the Assessing Officer disallowed the claim of the assessee to the extent of Rs. 1,31,701 out of interest paid by it on the borrowed money.

6. In appeal, it was contended before the CIT(A) that the assessee-company had two divisions - i.e. Rubber Division and Warehousing Division. It was demonstrated that the loans were taken in the rubber division for the business of retreading of tyres. It was also shown that the loans taken from Shri Vishwanath Gupta and Kashinath Gupta, HUF were utilized for payment to Indag Rubbers Limited, whose franchisee, the assessee held. Thus, it was pointed out that the loans taken were utilized for business purposes only and, therefore, no disallowance ought to have been made.

7. The ld.CIT(A), however, did not accept the plea and confirmed the disallowance by observing as under :—

"The argument placed on behalf of the appellant appears to be acceptable and convincing prima facie. But I do not agree with the same for the reason that no prudent businessman would borrow interest bearing funds for one division while it advanced interest free loans and advances to others. There is no commercial expediency involved in such an act either. Therefore, I fully agree with the action of Assessing Officer on his issue. I also rely upon the Allahabad High Court decision in the case of CIT v. H.R. Sugar Factory Pvt. Ltd. 187 ITR 363 . The disallowance made in hereby upheld. No interference is called for."

8. Before us, the ld. Counsel for the assessee, Shri Rakesh Garg pointed out that during this assessment year, no fresh advance was made. He also pointed out that in the earlier year also no disallowance was made as is evident on perusal from the order of ld.CIT(A) dated 27-5-1994 for assessment year 1990-91, which is available at pages 34 to 38 of the paper book. The ld.Counsel also invited our attention to the details of interest account for the year ending on 31-3-1991 available at page 5 of the paper book, according to which a sum of Rs. 3,51,351 was paid to the bank on term loan and vehicle loan and a sum of Rs. 10,115 was also paid. Thus, total interest paid during this year was at Rs. 3,61,496. Referring to para 6 of the paper book, it was submitted by him that total amount of other loan taken by the assessee was at Rs. 6,44,154-38, on which no interest was paid.

9. On the basis of balance sheet as on 31st March, 1991, it was shown by him that the entire loan related to, earlier years. This was illustrated by him by pointing out that in assessment year 1989-90, the secured loan was at Rs. 18,23,795-99 and unsecured loan was at Rs. 5,83,414-31, total Rs. 37,46,910-30 whereas in assessment year 1990-91 the secured loans were at Rs. 14,85,464-24 and unsecured loans at Rs. 7,45,126-90, the total Rs. 35,70,29-14. He also pointed out that there was similar decrease in the current liability as compared to earlier year, which was reduced from Rs. 17,26,796-51 in assessment year 1989-90 to Rs. 9,31,277-45 in assessment year 1990-91. In view of these figures, the ld.Counsel submitted that no loans were advanced during this year, rather the liability on account of loans was reduced by paying of some bad debts and further pleaded that the assessee had, on the other hand, taken interest free advances/loans from others. According to the ld.Counsel, therefore, the ld.CIT(A) was not justified in confirming the disallowance.

10. In support of his arguments, he placed reliance on the following decisions :—

(1)ITO v. Naresh Fabrics [2002] 75 TTJ (Jodh.) 386

(2)CIT v. Dalmia Cement (B) Ltd. [2002] 254 ITR 377¹ (Delhi)

(3)Torrent Financiers v. Asstt. CIT [2001] 73 TTJ (Ahd.) 624

(4)Netherlands Steam Navigation Co. Ltd. v. CIT [1969] 74 ITR 72 (SC)

(5)Commissioner Of Income-Tax v. Sahni Silk Mills P. Ltd. [2002] 253 ITR 294² (Delhi)

(6)G.R. Agencies v. ITO [IT Appeal No. 625 (All.) of 1998]

11. On the other hand ld. Sr. DR, submitted that if in earlier year, the disallowance was not made against the claim of deduction on account of interest, this by itself cannot bind the Assessing Officer as each assessment year is a separate and independent assessment year.

12. In support of this contention, the ld. Sr. DR placed reliance on the following decisions :—

(a) CIT v. H.R. Sugar Factory (P.) Ltd. [1991] 187 ITR 363 ³ (All)

(b) CIT v. Saraya Sugar Mills (P.) Ltd. [1992] 193 ITR 575 ⁴ (All)

(c) CIT v. Saraya Sugar Mills (P.) Ltd. [1993] 201 ITR 181 (All)

(d) Saraya Sugar Mills (P.) Ltd. v. CIT [1993] 201 ITR 711 ⁵ (All)

13. According to the ld. Sr. DR, in view of the decision of Allahabad High Court in the case of H.R. Sugar Factory (P.) Ltd. (supra), the claim of the assessee for deduction on account of interest is not allowable.

14. We have carefully considered the facts and circumstances relating to this matter, the material to which our attention was invited and the rival submissions. The claim of the assessee as put in the written submission dated 10-10-1994 before the ld.CIT(A), (page Nos. 1 to 4 of the paper book), was that the funds borrowed on which interest were paid have all been utilized by the Rubber Division and have nothing to do with the loans and advances made by the assessee. It was further explained that the Rubber Division was mainly having loans and advances from the Bank and outside parties, whereas the loans and advances made amounting to Rs. 8,78,012 pertained to mostly warehousing division, where no borrowed funds were utilized. It was also informed that even if the funds have been borrowed in the warehousing division, the same were interest free and it is out of the interest free funds that interest free loans and advances have been made. It was also stated that there is no controversy or dispute that the loans borrowed have not been borrowed for the purpose of business and interest has not been paid on the same.

15. The ld.CIT(A) has rejected this plea by saying that no prudent men would borrow interest bearing funds for one division, while it advanced interest free loans on advances to other. According to him, there was no commercial expediency involved such an Act either. The ld.CIT(A), however, has not recorded any finding on the following issues :

(i)Whether any part of borrowed funds was diverted for non-business purposes by making advances to some persons without charging interest.

(ii)Whether the assessee had borrowed funds for business purposes and whether any part of such borrowed funds was diverted or utilized for non-business purposes or for making interest free advances.

(iii)Whether the assessee had non-interest bearing funds available with it and whether such non-interest bearing funds were more than the advances made free of interest or not.

Since the averments of the assessee on the above-mentioned issues were very specific and further since these averments have not been found to be incorrect, it can safely be inferred that the assessee was in possession of deposits/credits or funds, which were non-interest bearing. Neither the Assessing Officer nor the ld.CIT(A) have given finding that interest bearing funds were diverted for non-business purposes or that there was a nexus between the borrowed interest bearing funds and advance of interest free loans.

16. In the light of the above facts, we have to decide the issue relating to disallowance of a sum of Rs. 1,31,701 out of interest of Rs. 3,61,034 claimed by the assessee.

17. The issue relating to allowability of claim of deduction on account of interest paid by the assessee under section 36(1)(iii) of the Act has been considered by various Courts. Under the old Act of 1922, similar provisions existed under section 10(2)(iii) of the old Act. This issue arose in the case of Calico Dyeing & Printing Works v. CIT [1958] 34 ITR 265 (Bom.). In that case, it was held by the Hon’ble Bombay High Court that where the assessee claims deduction of interest paid on capital borrowed, under section 10(2)(iii) of Income-tax Act, all that the assessee had to show is that the capital, which was borrowed was used for the purposes of the business of the assessee in the relevant year of accounts.

18. In the case of Amna Bai Hajee Issa v. Commissioner Of Income-Tax, Madras. [1964] 51 ITR 835 , it was held by the Hon’ble Madras High Court that in deciding the claim for interest on borrowing. The fact that the assessee had ample resources at its disposal and need not have borrowed, is not a relevant matter for consideration. According to the Hon’ble Court, the matter to be decided is whether the amount of interest was paid, in fact, in respect of capital borrowed for business.

19. In the case of Ram Kishan Oil Mills v. Commissioner Of Income-Tax, U.P [1965] 56 ITR 186 , the Hon’ble Madhya Pradesh High Court held that the only conditions required to be satisfied in order to enable the assessee to claim a deduction in respect of interest under section 10(2)(iii) are, firstly, that money must have been borrowed by the assessee; secondly, it must have been borrowed for the purpose of business and thirdly, the assessee must have paid interest on the said amount and claimed it as a deduction.

A relevant part of the observation of the Hon’ble High Court is being reproduced below :—

"Under section 10(2)(iii ) for a claim for deduction of interest under that provision all that is necessary is that, first, the money, that is capital, must have been borrowed by the assessee; secondly, it must have been borrowed for the purposes of the business, profession or vocation of the assessee; and, thirdly, the assessee should have paid this amount as an allowance under that clause. This clause makes no distinction between the capital borrowed in order to acquire a revenue asset and the amount borrowed to acquire a capital asset, and it does not provide that for the purposes of business the borrowing of capital should have been necessary, so that if at the time of borrowing the assessee had sufficient money of his own to invest in the business then the deduction cannot be allowed. Again, the interest paid is also not subject to the test of reasonableness. When the Income-tax Officer finds that the borrowing transaction was not illusory or colourable and that the capital was borrowed by the assessee for the purposes of the business and the amount of interest was paid, then the claim made by the assessee for deduction on account of the interest paid on borrowed capital has to be allowed.

20. The above-mentioned three decisions were considered by Hon’ble Bombay High Court in the case of CIT v. Bombay Samachar [1969] 74 ITR 723. In that case, the assessee-company which was carrying on business as a publisher of Gujarati Newspaper called "Bombay Samachar" had borrowed certain funds and paid interest on the same. The assessee claimed deduction on account of payment of interest. It was found that there was amount due to the assessee from M/s. Cama Norton and Company. Likewise, the assessee made advances to another company, namely, Bombay Chronicle Pvt. Ltd. The ITO disallowed the claim of deduction on the grounds that the assessee should not have advanced money to Bombay Chronicle without charging interest and should have collected the amount from the other company, namely, M/s. Cama Norton and Company to reduce its liability of interest. The ld.CIT(A) justified the disallowance of interest. The contention of the assessee, before the Tribunal was that no specific item of borrowal was relatable to the advances to Bombay Chronicle Pvt. Ltd. As regards, Cama Norton & Company, it was claimed that the balances to the credit of the assessee arose on account of business transaction in paper. The department’s case was that the borrowings on which interest was paid would have been partly or wholly unnecessary, if these large amounts were not due from or had been repaid by Bombay Chronicle Pvt. Ltd. or Cama Norton & Company as the case may be. The I.T.A.T. after considering the facts and conditions of the case, held that when loans have been outstanding for several years and when the interest was paid only on the same and when there is no proof of any borrowed amount having been diverted for any non-business purposes, the assessee is held to be eligible for the claim for deduction of interest. The Hon’ble Bombay High Court upheld the review taken by the Tribunal. A part of the relevant observation of the Hon’ble Court is being reproduced below :—

"In our opinion the view taken by the Tribunal is correct and must be upheld. For the facts which have been already stated, it will be clear that the balance due from the Bombay Chronicle Pvt. Ltd. was not in respect of any loans advanced by the assessee to it, as considered by the Income-tax Officer and the Appellate Assistant Commissioner. The said balance was in respect of the common account between the parties in connection with the expenditure in relation to the business agreed to be incurred in common and allocated in shares at the end of the year. Similarly the amount due from Messrs. Cama Norton & Co., in the calendar year 1954, did not constitute any loan advanced by the assessee to Messrs Cama Norton and Co., but constituted the outstandings in connection with certain business transactions. The capital borrowed by the assessee from outsides on the other hand was admittedly used by the assessee for the purpose of its business and it was also undisputed that no part of the borrowed capital had been utilized for the purpose of advancing loans either to Messrs. Bombay Chronicle Pvt. Ltd. or to Messrs. Cama Norton & Co. In these circumstances, it is difficult to see how the assessee’s claim for the interest actually paid by it could be disallowed."

21. The issue relating to necessary conditions for allowing the claim of deduction under section 10(2)(iii) and 10(2)(xv) of Income-tax Act also came for consideration before the Hon’ble Supreme Court of India in the case of Madhav Prasad Jatia v. Commissioner Of Income Tax, U.P Lucknow [1979] 118 ITR 200 ¹. In that the case, the assessee had donated a sum of Rs. 10,00,000 to an Engineering College and she paid a sum of Rs. 5,00,000 after borrowing the same from Bank. The remaining amount of Rs. 4.5 lakhs was shown as loan of the institution. The Hon’ble Supreme Court of India affirmed the view of Hon’ble Allahabad High Court and held that the borrowing of Rs. 5.5 lakhs was made by the assessee to meet her obligation and not the obligation of her business and as such the expenditure incurred by the assessee by way of interest thereon was not for carrying on the business or in her capacity as a person carrying on that business. Regarding the necessary conditions for allowability of deduction, the Hon’ble Court observed as under :—

"Proceedings to consider the claim for deduction made by the assessee under section 10(2)(iii) or section 10(2)(xv), we may point out that under section 10(2)(iii) three conditions are required to be satisfied in order to enable the assessee to claim deduction in respect of interest on borrowed capital, namely, (a) that money (capital) must have been borrowed by the assessee, (b) that it must have been borrowed for the purpose of business, and (c) that the assessee must have paid interest on the said amount and claimed it as a deduction."

22. The scope of term "the purposes of business" appearing in section 10 of Old Act, 1922, was considered by the Hon’ble Calcutta High Court in the case of CIT v. Tingri Tea Co. Ltd. [1971] 79 ITR 294 . In that case, the assessee. A sterling company, which owned tea garden in India and was a non-resident company remitted profits from time to time to the United Kingdom for the purposes of declaration of dividend to its shareholders and the surplus balance, after paying dividends was kept with the Bank in the United Kingdom deposit. During the relevant accounting years, the assessee-company paid interest accuring on its overdrafts to the Banks in India and claimed deduction of the amounts paid, as interest paid on money borrowed for the purpose of its business. This claim was rejected on the ground that overdrafts from the Bank were not incurred wholly and exclusively for the assessee’s business. The AAC also found that the company had made remittances to U.K. by taking overdrafts from the banks in India and the borrowings from the Banks in India were partly invested in earning interest income in United Kingdom. The Tribunal was of the opinion that correct way to interpret the transaction would be that the remittances to the United Kingdom came out of profits in India and the Bank overdrafts in India had, in fact, been utilized in carrying on the overseas business and, thus, Income-tax Authorities were not justified in disallowing any part of Bank interest paid by the assessee in India on its bank overdrafts. It was held by the Hon’ble Calcutta High Court that the inference of the Tribunal that remittances to the U.K. came out of profits earned in India and the Bank overdrafts in India, had in fact, been utilized in carrying on assessee’s business was sustainable in law and on such inference of findings of fact, the Tribunal was right in holding that the Income-tax Authorities was not justified in disallowing any part of Bank’s interest on the overdrafts.

23. The Hon’ble Allahabad High Court also considered the issue relating to interest on advances and foregoing of interest in the case of Triveni Engg. Works Ltd. v. CIT [1987] 167 ITR 742¹ . In that case, the assessee had claimed deduction on account of interest on the amounts borrowed from the bank and also on the interest of arrears of Cane Purchase Tax and Interest on advances foregone by the assessee. The I.T.A.T. in that case held that the interest on advances foregone by the assessee was not deductible and a part of the interest on borrowed capital was also disallowed, because it was found that it represented a loan given by the assessee to another concern. The Hon’ble High Court observed that the assessee had not been able to prove that the disputed part of the amount taken as loan from the Bank was used for business purposes or that the advance to the other concerns, had been made for business purpose. In view of this finding, the disallowance of part of interest was found to be justifiable. So far as the interest, which was claimed to have been foregone for reasons of commercial expediency, the matter was remanded to the Tribunal on the ground that the Tribunal had not brought all the necessary facts on record showing what commercial expediency the assessee had in mind.

24. The other important case in which the issue was considered by the Hon’ble Allahabad High Court was that of H.R. Sugar Factory (P.) Ltd. (supra). In that case, the assessee, a private limited company, which carried business of manufacturing of sugar had advanced huge amounts of loan to its Directors at the rate of 5 per cent per annum whereas it was paying interest at the rate of 8 per cent per annum on the moneys borrowed by it from Banks. In the previous year relevant to assessment year 1963-64, the interest payable by the Directors on the amounts borrowed by them from the assessee was reduced to 2.5 per cent in pursuance of a compromise decree of Civil Court. The Bank continued to charge interest at the rate of 8 per cent on the loans advanced to the assessee. The ITO as well as the First Appellate Authority held that the difference between the interest paid to the Bank and interest recovered from the Directors on the loans advances to them could not be said have been incurred on the capital borrowed for purposes of business and disallowed the difference between the interest paid to the Bank and interest recovered from the Directors. The Tribunal, however, deleted the disallowance. On reference, the disallowance of interest was upheld by the Hon’ble High Court by observing as under :—

"Held, that the assessee was not a finance company. It was engaged in the manufacture of sugar. No business purpose was served by the advances to its directors. The amount of interest payable in each year on account of the loans to the directors was very large and this fact could not be glossed over by saying that the amount was not substantial in each of the relevant years. The company might have borrowed large amounts for the purpose of its business every year, but that did 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 might no have been necessary to borrow from the bank. Therefore, the Income-tax Officer was right in disallowing the difference between interest paid to the banks and interest recovered from the directors under section 36(1)(iii) of the Income-tax Act, 1961."

25. It may be pointed out that in the case H.R. Sugar Factory (P.) Ltd. (supra), there was a direct nexus between the borrowed funds and the funds advanced at a very low rate to its directors. After examining the scheme and device adopted by the assessee and also the volume of advances made by it and rate of interest charged from directors, it was found that the amount of interest paid each year payable on account of the loans to Directors, was substantial and by the compromise decree, the limit of amounts to be lent to the Directors was further raised and at the same time the rate of interest was also drastically reduced. The Hon’ble High Court also observed that in view of these facts, it is clear that the Director/shareholders were taking unfair advantage of their control over the assessee and they were exploiting it for their private ends. It was also held that what has happened in this case was self-evident i.e. the assessee was 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.

26. It may also be pointed out that in the case of H.R. Sugar Factory (P.) Ltd. (supra) it was not the case of the assessee that it had other funds with it, which were interest free or it had advanced loans to the Directors, which were not out of the borrowed funds. Thus, there was clear-cut nexus between the borrowed funds and funds advanced to the Directors on which lesser rate of interest was charged. The present case is, therefore, distinguishable on facts, inasmuch as in this case the specific plea of the assessee was that interest bearing funds were utilized for business purposes and advances without charging interest were made out of interest free amount available with it.

27. The decision in the case of H.R. Sugar Factory (P.) Ltd. (supra) was considered by the Hon’ble Allahabad High Court in the case of Saraya Sugar Mills (P.) Ltd. (supra). In that case, the assessee had claimed deduction of amount paid by it towards interest on borrowed funds. The ITO found that out of the money so borrowed from the Bank, a substan- tial portion was lent to the directors free of interest. Similar loans were also extended to a firm in which the Directors of the assessee were interested. The ITO was of the opinion that interest relatable to the amount lent to the firm cannot be granted deduction, because it cannot be said that money to that extent was borrowed for the purpose of the said company. The Tribunal reduced the disallowance of interest. The Hon’ble Allahabad High Court held that since the amount advanced were quite substantial and it was a continuing course of conduct and was not isolated transaction, under these circumstances, the principle laid down in the decision of H.R. Sugar Factory clearly applies. The matter again came for consideration before the Hon’ble Allahabad High Court in the case Saraya Sugar Mills (P.) Ltd. (supra). The matter again came for consideration of the Hon’ble Allahabad High Court in the case of Saraya Sugar Mills (P.) Ltd. (supra). On the facts of the case, it was found that there was a company, which had taken overdraft from the Bank, part of which was diverted to the Directors and other firms, in which the Directors of the company were substantially interested. On such advances, no interest was charged from the Directors. The Assessing Authority held that the amount was advanced to the Directors and the firms by the assessee-company from the overdraft for non-business purposes and, therefore, the interest paid by the company to the Bank was disallowed to that extent. Following its earlier decision, in the case of Saraya Sugar Mills (P.) Ltd. (supra), the issue was decided in favour of the Revenue and against the assessee by the Hon’ble High Court. It may be pointed out that as in the case of H.R. Sugar Factory (P.) Ltd. (supra) in the two cases of Saraya Sugar Mills (P.) Ltd. (supra) referred to above a direct nexus was found to have been established between the borrowed funds and the advances made free of interest by the assessee and there was a categoric and clear finding by the Income-tax Authorities that a part of the borrowed money was diverted towards interest free advances or for non-business purposes. To iterate, it was not the claim of the assessee in these cases that it had its own funds or deposits or free of interest capital, which was advanced to the Directors or the firms without charging interest. Thus, the above-mentioned cases are distinguishable on facts from the cases where it is positive assertion of the assessee that interest free advances are given out of interest free capital available with the assessee.

28. The issue relating to interest on borrowed capital was also considered by the Hon’ble Madhya Pradesh High Court (Indore Bench) in the case of D & H Secheron Electrodes (P.) Ltd. v. CIT [1983] 142 ITR 528 ¹. In that case, part of interest was disallowed by the Tribunal on the ground that no interest was charged by the assessee on the advances made to the sister concern. The Tribunal had not recorded any finding that capital borrowed was not for the purposes of business. The Hon’ble Madhya Pradesh High Court held that this ground alone cannot justify disallowance of interest if other conditions required under section 36(1)(iii) are satisfied.

29. In the case of Commissioner Of Income-Tax v. Hotel Savera [1999] 239 ITR 795² , the Hon’ble Madras High Court also considered the issue. In that case, the Tribunal found that the total amount in the Partners’ capital and current account was greater than the amount advanced to the private Company. It was also found that the amount borrowed by the firm was mixed up with its own funds. Under these circumstances, the Tribunal raised a presumption that the amount had been advanced by the firm from its own fund. On this presumption, the Tribunal allowed the entire amount of interest on borrowed capital. The finding of the Tribunal that no part of interest should be disallowed, specially in absence of any finding that the borrowed money was advanced to the Private Limited Company free of interest was upheld by the Hon’ble Madras High Court. In taking this view, the Hon’ble Madras High Court also followed the decision of Hon’ble Gujarat High Court in the case of Shree Digvijay Cement Co. Ltd. v. (supra), [1982] 138 ITR 45 ¹.

30. In that case, reference has also been made to the observation of Sampath Iyengar’s Law of Income-tax, 9th Edition, page 2349, which is as under :—

"For the same reason a presumption appears to be permissible that where the assessee has his own capital as also the borrowed funds, the former rather than latter to have been utilized for the non-business or personal expenses."

31. The issue also came before the Hon’ble Delhi High Court in the case of Regal Theatre v. CIT [1997] 225 ITR 205 ²0. In that case, the assessee-firm, which was carrying on cinema theatre business and was also running a Restaurant, claimed deduction under section 36(1)(iii) of the Income-tax Act, 1961, of a sum of Rs. 26,108 being interest paid on capital borrowed for the purpose of business. The Income-tax Act disallowed deduction to the extent of Rs. 23,166 on the ground that partners’ account showed debit balances and no interest was charged on these debit balances. The explanation of the assessee-firm was that originally a loan was taken in order to purchase machinery etc. and that there were debit balances, because of depreciation allowed in earlier years on the fixed assets and that according to the terms of agreement, amongst partners, no interest was to be charged on these debit balances. The contention of the assessee was rejected by the ITO, who held that the assessee should have returned loans to the creditors instead of permitting the partners to draw excess money in their account and that since the assessee had been paying interest at the rate of 12 per cent on borrowed money, interest at this rate of average debit balances in the capital account could not be deducted. The ld. CIT(A) modified the figures by working out the figure of diversion of loans for non-business purposes. The ITAT, however, agreed with the ITO and held that since a major part of borrowings had been diverted by the assessee to its non-business purposes, the deduction was justifiable. Hon’ble Delhi High Court, however reversed the view taken by the ITAT by observing as under :—

"Held, that the finding arrived at by the Tribunal that a part of the borrowings had been diverted by the assessee to its non-business purposes was not a finding of fact, but was an inference drawn by the Tribunal on the basis, that the interest paid on the capital borrowed was not in law an allowable deduction from the profit, in case the profit minus depreciation was not in excess of the withdrawals made by the partners and in such a case, the withdrawals should be deemed to be in part from the capital account and would mean that the original borrowings were utilized for other purposes and not for business purposes. The Tribunal ignored the law laid down by the Supreme Court in Madhav Prasad Jatia v. Commissioner Of Income Tax, U.P Lucknow [1979] 118 ITR 200 and the Bombay High Court in CIT v. Bombay Samachar Limited [1969] 74 ITR 723 that once the three conditions laid down in section 36(1)(iii) were satisfied, the deduction under the section must be given. Again the contention that the correct amount of debit balance to the account of the partners should be taken on Rs. 1,73,643 instead of Rs. 1,93,049 as calculated by the Income-tax Officer was again a figure arrived at as a matter of law. Therefore, the Tribunal was not correct in holding that a part of the borrowings had been diverted by the assessee for its non-business purposes and that the assessee was not entitled to claim deduction of the interest on those borrowings under section 36(1)(iii) of the Act."

32. In the case of Sahni Silk Mills (P.) Ltd. (supra), the assessee had charged interest at 12 per cent from 3 parties to whom advanced were made. It was found that the assessee had paid interest at 16 per cent on its borrowed funds. The ITO disallowed Rs. 51,528 being the difference between the interest on advance at 12 per cent and interest on borrowings at 16 per cent. The ld. CIT(A) upheld the disallowance. On further appeal, the Tribunal held that the interest paid cannot be subject-matter of the test of reasonableness and hence the ITO was in error to determine as to what rate of interest should have been charged. The Tribunal also held that the borrowing transactions were not unreal and that the capital was borrowed by the assessee for the purpose of business and the amount of interest was paid as claimed and, therefore, there was no scope for determining the rate of interest, which would be reasonable. The Hon’ble Delhi High Court upheld the view taken by the Tribunal and declined to answer the question referred to it.

33. In the case of Dalmia Cement (B) Ltd. (supra), the assessee had borrowed moneys from financial institutions and paid interest of Rs. 14,59,816 thereon. The Assessing Officer made a reduction in the allowance of interest on the basis that the deposits had been collected by the sole selling agent towards disputed sales-tax and the deposits had been allowed by the assessee to be retained by the sole selling agent. The CIT allowed the claim for deduction of interest in full on the admitted position that the sole selling agent was handling sales-tax returns when were filed by it and sales-tax assessments were made on it and the deposits collected were either to be refunded to the customer or paid to the Government. The ITAT affirmed the decision of the Commissioner (Appeals). On a reference, the Hon’ble High Court affirmed the decision of ITAT and held that if all the requisite conditions in section 36(1)(iii) for allowance of interest were fulfilled, it was not possible and open for the Revenue to make a part of disallowance, unless there was a positive finding recorded that a part of the amount borrowed was not used for the purpose of the assessee’s business.

34. It may be pointed out that in this case, the Hon’ble Delhi High Court has considered various decisions including the decision in the case of Bombay Samachar (supra), and the decision in the case of Madhav Prasad Jatia (supra), the reference to which have been made out above and view the ratio of the decision of Hon’ble Supreme Court in the case of Madhav Prasad Jatia (supra), observed that the scope for allowing a deduction under section 36(1)(iii) is much wider than the one available under section 57(3) of the Act.

35. In the case of the Commissioner Of Income-Tax v. Sridev Enterprises. [1991] 59 Taxman 439 , the Hon’ble Karnataka High Court has held that if on the balance from a person no interest was charged against that advance and even if the person to whom the advance was made was having close relationship with the assessee, then also the deduction cannot be disallowed to the extent of interest free advances standing in the name of person in whose name advance was made on the ground that the amount borrowed was not utilized by the assessee for its own business. It was also held that if no addition has been made in earlier year, the opening balance could not be considered in the year in question and the inquiry had to be limited only to the increase in the year in question.

36. The ITAT Ahmedabad "A" Bench also considered this issue in the case of Torrent Financiers ( supra). The Bench after considering the various cases including the decisions of Hon’ble Allahabad High Court in the case of Triveni Engg. Works ( supra) and H.R. Sugar Factory (P.) Ltd. (supra) has observed as under :—

"10. We have heard the representatives of both the parties. Perused the records and gone through the cases referred/cited by both the parties. Under the facts and circumstances, the ld.CIT(A) has found that borrowed funds have been diverted partly for non-business purposes, therefore, the Assessing Officer was justified in making disallowance. It has been further found by CIT(A) that in view of the fact that the assessee was also having interest free loans, the disallowance made by the Assessing Officer cannot be sustained in totality. Therefore, it was concluded by ld.CIT(A) that interest has to be disallowed only in respect of amount representing the difference between the interest free advances made by assessee and interest free funds available to the assessee and accordingly amount was calculated and the disallowance was restricted to Rs. 1,38,492. We uphold the above view of CIT(A) with an exception about the interest free loans available with the assessee is to be considered, with this modification, the finding of ld.CIT(A) is confirmed. The entire interest-free funds include owner’s own capital, accumulated profits and other interest free creditors and loans, if total interest free advances including debit balances of partners do not exceed the total interest free funds available with the assessee, no interest is disallowable on account of utilization of fund for non-business purposes and if it exceeds, the proportionate disallowance can be made."

The Ahmedabad Bench of ITAT in the above-mentioned case placed reliance on the judgment of Hon’ble Calcutta High Court in the case of Tingri Tea Co. Ltd. ( supra) and held that profits earned, own capital and interest free loans received, can be given advances as interest free advances and to that extent question of disallowance of interest on borrowed funds does not arise.

37. The ITAT, Lucknow Bench has also considered the issue in the case of G.R. Agencies (supra ) and after considering the facts of that case, the claim of the assessee was allowed on the ground that advances made to various parties were prior to the borrowings and the department was not able to prove that the borrowed funds were not utilized for business purposes and no nexus could be established by the Department between the borrowed funds and the advances made by the assessee free of interest.

38. On the basis of ratio of decisions referred to above, it can be said that non-charging of interest on loans given by the assessee can not by itself, be a sufficient ground for disallowing the interest paid by the assessee on the loans taken by it in absence of any nexus having been brought on record between the borrowed capital and interest free advances or in absence of any finding that borrowed funds or part thereof, was diverted towards interest free advances made by the assessee.

The above view is also supported by the orders of the Hon’ble Benches of ITAT in the following cases :—

a. Oswal Industries v. Asstt. CIT [2000] 109 Taxman 279 (Mum.) (SMC-IV)

b. Dy. CIT v. Shivalik Agro Poly Products Ltd. [2000] 108 Taxman 219 (Chd.)

c. Smt. Tara Devi v. ITO [2000] 68 TTJ (Jod.) 361.

d. Dy. CIT v. Ganesh Chhababhai Valabhai Patel Family Trust, [2000] 108 Taxman 78 (Ahd.)

39. On the basis of analytical study and examination of proposition laid down in the above-mentioned decision and relevant material including the provision contained under section 36(1)(iii) of IT Act. 1961, the following guiding postulates may be logically deduced and laid down :—

(i)The requisite condition for allowability of the claim under section 36(1)(iii) of the Act are that—

(a)That the capital must have been borrowed by the assessee.

(b)It must have been borrowed for the purpose of business, and

(c)The assessee must be paid interest on the borrowed amount and must have claimed it as a deduction.

(ii)If the assessee makes a claim of deduction in terms of section 36 of the Act for the purpose of computation of income, referred to in section 28 of the Act, he has to place material in support of his claim of entitlement to the deduction. It, therefore, follows that the assessee has a legal obligation to satisfy the assessing authority that he is entitled to obtain deduction in accordance with the taxing statute. In other words, the burden to establish that the borrowed fund was utilized exclusively for the business purpose is on the assessee. This proposition is supported by the decision on Hon’ble Orissa High Court in the case of Indian Metals and Ferro Alloys Ltd. v. CIT [1992] 193 ITR 344.

(iii)The ITO concerned has to examine the issue relating to the utilization of the borrowed funds by taking into account the time of borrowing, the purpose of borrowing and purpose for which borrowed funds were utilized.

(iv)If it is found that the entire borrowed funds were utilized for business purposes alone and no part of such fund was diverted for non-business purpose, the deduction claimed by the assessee should not be disallowed.

(v)If it is found that the assessee while paying interest on borrowed funds also advanced loans to family members, friends, relations, partners of the firm, directors or sister concerns or others, then it is to be seen as to whether these non-interest bearing funds were advanced out of interest bearing loans or out of interest free deposits, loans or profits available with the assessee. In case the assessee succeeds in showing that at the time of making interest free advances, it/he had more interest free deposits or funds than advanced by it, then no deduction on the claim of interest should be made merely because the assessee had any past borrowed funds and by not advancing interest free loan, it could have reduced interest liability, unless it is found that the motive of the assessee was to take undue advantage by diverting its funds for non-business purposes.

(vi)So far as charging of interest or the rate of interest on advance funds is concerned, each case should be examined in the factual background and the context of business expediency. Since the rate of interest is based on various conditions generally, there should be no scope to determine the reasonableness of the rate of interest. This view was also taken by Hon’ble Delhi High Court in the case of Sahni Silk Mills (P.) Ltd. (supra).

(vii)So far as old interest bearing borrowing or old interest free advances are concerned, the justification for continuing the same can be given by the assessee by explaining circumstances and business expediency.

(viii)If the interest free advances were made prior to the interest bearing borrowing, then the mere fact that the interest free advances were not recovered by the assessee should, by itself, not be a sufficient ground to disallow the claim of deduction of interest on subsequent borrowings. For disallowing the claim on this basis, the version of the assessee should be considered properly. This view is supported by the decision of ITAT, Lucknow Bench in the case of G.R. Agencies (supra).

(ix)No disallowance should be made, when money had been advanced in earlier years and no addition was made in the earlier years on such advances on account of interest free advances in earlier years. As held in the case of Sridev Enterprises (supra), if no addition has been made in earlier years, then the opening balance should not be considered in the year in question and the inquiry is to be limited only to the increase in the year in question. This approach will also be in consonance with the rule of consistency and definiteness, because the Revenue cannot be allowed to re-examine the nature of accounts maintained by the assessee and concluded assessments should not be ignored without actually reopening the assessment.

(x)The test to be applied for considering part of borrowed advances used for interest free advances is as to whether or any part of the advances made free of interest, is out of borrowed funds and if it is so, then the disallowance can be made only in relation to the advance made out of or from the borrowed funds.

(xi)The entire interest free funds include owner’s own capital, accumulated profits and other interest free credits and loans. If total interest free advances including debit balances of partners do not exceed the total interest free funds available with the assessee, no interest is disallowable on account of utilization of funds for non-business purposes and if it exceeds, the proportionate disallowance can be made. This view is supported by the decision of Hon’ble Calcutta High Court in the case of the Tingri Tea Co. Ltd. (supra) and also by the decision of ITAT Ahmedabad, ‘A’ Bench in the case of Torrent Financiers (supra).

(xii)It may be clarified that while applying the above propositions, the facts and circumstances of each case including entire relevant position of account books of the assessee should be thoroughly examined to find out the nexus between the borrowed funds and the interest free advances. After the assessee claims and proves that borrowed funds were utilized only for business purposes, the burden will shift to the department to disprove such claim and for doing so the department has to establish clear nexus between the borrowed funds and the interest free advances. In this regard, the department may also bring on record the collusive conduct of the assessee and design of tax evasion on his or its part by bringing on record the true nature of transactions, the colourable device, if any, and for that purpose, positive findings based on cogent material should be recorded.

40. Viewed in the context of the above propositions, it has to be seen as to whether the interest free advances made by the assessee during the current year are out of the borrowed funds or out of the other interest funds available with the assessee. Since the assessee has placed the photocopies of the account books before us, to justify the claim that the interest free advances were made out of the interest free funds available with it, we have to allow the claim of the assessee subject to the condition that the facts and figures placed before us, are verified by the Assessing Officer. In case, it is found that at the time of making interest free advances, the assessee had more interest free funds available with it than the interest free advances made by it and it is also found that no part of borrowed capital were diverted towards interest free advances, then the claim of assessee for deduction of interest is to be allowed. In view of the above, the claim of the assessee is to be considered subject to verification and in the light of the propositions. This ground is, therefore, decided accordingly.

41 to 58. [These paras are not reproduced here as they involve minor issues.]

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