Facts of the Case

The assessee, a corporate entity engaged in the sugar manufacturing business, had obtained borrowed funds on which interest expenditure was incurred. During the relevant assessment year, the assessee advanced certain amounts to related parties/sister concerns. The Assessing Officer observed that such advances were either interest-free or not demonstrably linked to business purposes and, therefore, concluded that borrowed funds had been diverted for non-business use. Consequently, a proportionate disallowance of interest expenditure was made under Section 36(1)(iii).

The assessee contended that the advances were made out of commercial considerations and that sufficient own funds were available, negating any presumption of diversion of borrowed funds.

Issues Involved

  1. Whether interest on borrowed capital is allowable when funds are advanced to sister concerns without charging interest.
  2. Whether the Assessing Officer can presume diversion of borrowed funds in the absence of direct nexus.
  3. Whether availability of own funds protects the assessee from disallowance under Section 36(1)(iii).
  4. Whether advances were made out of commercial expediency.

Petitioner’s Arguments (Revenue)

  • The assessee had advanced substantial funds to related entities without charging interest.
  • Borrowed funds were utilized for non-business purposes, leading to diversion of capital.
  • Interest expenditure attributable to such advances was not allowable under Section 36(1)(iii).
  • The assessee failed to establish a direct business nexus or commercial necessity for the advances.

Respondent’s Arguments (Assessee)

  • Adequate own funds and reserves were available to cover the advances.
  • No direct linkage was established between borrowed funds and the advances made.
  • Advances were given for business considerations and commercial expediency.
  • Interest expenditure on borrowings used for business purposes remains allowable even if surplus funds are deployed elsewhere.

Court Order / Findings (ITAT)

  • Disallowance under Section 36(1)(iii) requires a clear nexus between borrowed funds and non-business advances.
  • Where sufficient interest-free funds are available, a presumption arises that advances were made from such funds.
  • In the absence of evidence demonstrating diversion of borrowed capital, interest cannot be disallowed merely on suspicion.
  • Commercial expediency must be assessed from the viewpoint of the business, not the Revenue.

Important Clarification

  • Mere existence of interest-free advances does not automatically justify disallowance.
  • The burden lies on the Revenue to prove utilization of borrowed funds for non-business purposes.
  • Availability of substantial own funds is a critical factor.
  • Commercial expediency includes indirect business benefits and strategic considerations.

Link to download the order –

https://itat.gov.in/public/files/upload/1640332122-ITA%20No.%20227%20Alld%202016%20Shervani%20Sugar%20Syndicate%20Ltd.pdf

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