Supreme Court approves deduction of interest paid via debentures for tax calculation under Sec 43B of Income Tax Act

Facts of the case

• MM Aqua Technologies was in default of the payment of principal and interest on loan from ICICI Bank. So, the two parties agreed that the interest be paid through issue of ‘debentures’ by the assessee to the lender. The assessee, after the conversion of interest into debentures, claimed the interest under Section 43B of the IT Act as paid.
• The deduction of interest claimed by the company was disallowed by the assessing officer. However, it was allowed by the Commissioner of Income Tax (Appeals) as well as the Income Tax Appellate Tribunal. The matter went to the Delhi High Court, which relied on the Explanation 3C to the section 43B (d) of the IT Act to disallow the deduction.

Legal provisions as per Income Tax Act

• Section 43B provides a list of expenses allowed as deduction under the head ‘Income from business and profession’. It states that some expenses can be claimed as deduction from business income only in the year of actual payment and not in the year when the liability to pay such expenses is incurred.
• Sec 43B(d): Any sum payable by the assessee as interest on any loan or borrowing from any public financial institution or a State financial corporation or a State industrial investment corporation, in accordance with the terms and conditions of the agreement governing such loan or borrowing,
• Explanation 3C – For the removal of doubts, it is hereby declared that a deduction of any sum, being interest payable under clause (d) of this section, shall be allowed if such interest has been actually paid and any interest referred to in that clause which has been converted into a loan or borrowing shall not be deemed to have been actually paid.”

Why was Section 43B inserted?

Section 43B was originally inserted by the Finance Act, 1983 w.e.f. 1st April, 1984 after taking note of the fact that in several cases taxpayers were not discharging their statutory liability such as in respect of excise duty, employer’s contribution to provident fund, Employees State Insurance Scheme, etc., for long periods of time, extending sometimes to several years.

To curb this practice, the Finance Act inserted a new section 43B to provide that deduction for any sum payable by the assessee by way of tax or duty under any law for the time being in force or any sum payable by the assessee as an employer by way of contribution to any provident fund or superannuation fund or gratuity fund or any other fund for the welfare of employees shall irrespective of the previous year in which the liability to pay such sum was incurred, be allowed only in computing the income of that previous year in which such sum is actually paid by the assessee.

Why was Explanation 3C inserted?

The Finance Act, 2006 inserted Explanation 3C w.e.f. 1st April, 1989 after it was brought to the notice of Income tax authorities that certain assessees were claiming deduction under section 43B on account of conversion of interest payable on an existing loan into a fresh loan on the ground that such conversion was a constructive discharge of interest liability and, therefore, amounted to actual payment. Claim of deduction against conversion of interest into a fresh loan is a case of misuse of the provisions of section 43B.

A new Explanation 3C was, therefore, inserted to clarify that if any sum payable by the assessee as interest on any loan or borrowing, referred to in clause (d) of section 43B, is converted into a loan or borrowing, the interest so converted, shall not be deemed to be actual payment.

Supreme Court Ruling

• Supreme Court (SC) has allowed MM Aqua Technologies to deduct interest paid via issue of debentures from its income for the purpose of income tax calculation.
• The court held that the interest was “actually paid” by the assessee through issuance of debentures, which has extinguished its liability to pay interest. To reach this conclusion, the court relied on the fact that the accounts of the bank reflected the amount received by way of debentures as its business income for the assessment year in question.
• At the heart of the introduction of Explanation 3C to Sec 43B(d) is misuse of the provisions of Sec 43B by not actually paying but converting such interest into a fresh loan. Bona fide/ genuine transactions of actual payments are not meant to be affected.
• Explanation 3C is “clarificatory” in nature, it explains Sec 43B (d) as it originally stood and does not purport to add a new condition retrospectively.
• A retrospective provision in a tax act which is “for the removal of doubts” cannot be presumed to be retrospective, even where such language is used, if it alters or changes the law as it earlier stood.

Impact of Supreme Court ruling

• The judgment could pave the way for corporates under stress in the current environment to restructure their interest payment as debentures or other instruments, and deduct the same for income tax purposes. This is provided the lender recognises such interest payment in its books and pays tax on it.

Sources of information:

• Supreme Court Judgement: M.M. Aqua Technologies Ltd. vs Commissioner Of Income Tax, Delhi dt 11 August, 2021
• https://www.business-standard.com