Interest on borrowed capital

HELD Prior to the Finance Act 1992, payment of interest to the partner was an item of business disallowance. However, after the Finance Act 1992, the said section 40(b) puts limitations on the deductions under sections 30 to 38 from which it follows that Section 40 is not a stand-alone section. Section 40, before and after the Finance Act 1992, has remained the same in the sense that it begins with a non-obstante clause. It starts with the words ‘Notwithstanding anything to the contrary in sections 30 to 38’ which shows that even if an expenditure or allowance comes within the purview of sections 30 to 38, the assessee could lose the benefit of deduction if the case falls under section 40. In other words, every assessee, including a firm, has to establish, in the first instance, its right to claim deduction under one of the sections between sections 30 to 38 and in the case of the firm, if it claims special deduction, it has also to prove that it is not disentitled to claim deduction by reason of applicability of section 40(b)(iv). Therefore, in the instant case, the assessee was required to establish in the first instance that it was entitled to claim deduction under section 36(l)(iii) and that it was not disentitled to claim such deduction on account of applicability of section 40(b)(iv). It is important to note that section 36(1) refers to other deductions whereas section 40 comes under the heading ‘amounts not deductible’. Therefore, sections 30 to 38 are other deductions, whereas section 40 is a limitation on that deduction. Therefore, even if an assessee is entitled to deduction under section 36(l)(iii), the assessee(firm) will not be entitled to claim deduction for interest payment exceeding 18/12 per cent per se. This is because section 40(b)(iv) puts a limitation on the amount of deduction under section 36(1)(iii). [ Para 14] It was vehemently urged on behalf of the assessee that the partner's capital is not a loan or borrowing in the hands of a firm. According to the assessee, section 40(b)(iv) applies to partner's capital, whereas section 36(l)(iii) applies to loan/borrowing. Conceptually, the position may be correct, but in the instant case, the scheme of Chapter IV-D is in question. After the enactment of the Finance Act, 1992, section 40(b)(iv) was brought to the statute book not only to avoid double taxation, but also to bring on par different assessess in the matter of assessment. Therefore, the assessee-firm, in the instant case, was required to prove that it was entitled to claim deduction for payment of interest on capital borrowed under section 36(l)(iii), and that it was not disentitled under section 40(b)(iv). There was one more way of answering the above contention. Section 36(l)(iii) and section 40(b)(iv) both deal with payment of interest by the firm for which deduction could be claimed. Therefore, keeping in mind the scheme of Chapter IV-D, every assessee, who claims deduction under sections 30 to 38, is also required to establish that it is not disentitled under section 40. The object of section 40 is to put limitation on the amount of deduction which the assessee is entitled to under sections 30 to 38. Section 40 is a corollary to sections 30 to 38 and, therefore, section 40 is not a stand-alone section. [Para 15] In the instant case, the Tribunal, for the assessment year 1992-93, held that loans were given for business purposes. Similarly, for the assessment year 1993-94, the Tribunal had taken the view that the said loans given to the firm's sister concerns were for business purposes. Accordingly, the Tribunal had deleted the disallowances during the assessment years 1992-93 and 1993-94. However, for the assessment year 1994-95, the Tribunal took a contrary view in view of change in law brought about by the Finance Act 1992. Prior to 1-4-1993, payment of interest to the partner had to be added back to the assessable income of the firm whereas after the Finance Act, 1992, such payment became an item of deduction for computing the assessable income of the firm and it became part of the business income of the partner. In view of this change of law, the Tribunal disallowed payment of the interest in the instant case for the assessment years 1994-95 to 1997-98. However, the point, which had been left out from consideration, was that the loans, which were given in August/September 1991 to the sister concerns, got wiped out only in the assessment year 1997-98. Once, it was found that the loans granted in August/September 1991 continued up to the assessment years 1997-98, that the said loans were advanced for business purposes, and that the interest paid thereon did not exceed 18/12 per cent per annum, the assessee was entitled to deductions under section 36(l)(iii) read with section 40(b)(iv). Further during the assessment year 1995-96, apart from the loan given in August/September 1991, the assessee advanced interest free loan to its sister concern amounting to Rs.5 lakhs. According to the Tribunal, there was nothing on record to show that the loans were given to the sister concerns by the assessee-firm out of its own funds and, therefore, it was not entitled to claim deduction under section 36(l)(iii). That finding was erroneous. The opening balance as on 1-4-1994 was Rs. 1.91 crores, whereas the loan given to the sister concerns was a small amount of Rs.5 lakhs. Thus, the profits earned by the assessee during the relevant year were sufficient to cover the impugned loan of Rs.5 lakhs. [para 17] Accordingly, the impugned judgment of the High Court was set aside. The appeal was allowed. [para 19]