Understanding disallowance under section 36 of the act with latest case laws: Part – II.

The concept of disallowance in details has been earlier discussed in part – I. Please refer the link below for your kind reference.

http://taxbymanish.blogspot.in/2011/12/understanding-section-36-deductions.html

Over the period of time, there has been number of development in respect of disallowance under section 36 of the act and hence there is necessity to be updated with the changes. In this respect, given below the recent case laws judgments which enable yourself with better   understanding of section 36 disallowance.

SN	Issue	Summary of case laws.
1	Interest free loan	The assessee gave interest-free loans to sister concerns. Held, there was no fresh borrowing in year under appeal and there was reduction of borrowed funds. Held, it could not be assumed that borrowed funds were used for non-business purpose. Also, there was availability of interest-free funds. Hence, disallowance of interest was to be restricted only for the remaining sum. Refer, CIT .v. Kajal Exports, 362 ITR 328. In the case of CIT v. Suraj Dev Dada (P&H), 367 ITR 78 it was held that Notional interest could not be disallowed under section 36(1)(iii) . In the case of Reliance Industries .v. Addl. ACIT, 159 TTJ 349 held that Tribunal held that in the absence of any nexus establishing that the interest bearing borrowed funds were given as interest free to its subsidiaries, the disallowance of interest is not justified. Assessee made interest-free advances to related concerns out of its own capital and interest-free trade credits/advances from customers apart from the fact that he was having substantial trade dealings with two such concerns. Therefore, the Tribunal correctly came to the conclusion that the interest paid by the assessee on borrowings was allowable as deduction and no disallowance was justified. Refer, CIT .v. Jugal Kishore Dangayach, 98 DTR 95. The Assessing Officer having noticed that assessee had given loan to family members without charging interest disallowed interest claim of assessee under section 36(1)(iii).The assessee was having sufficient own capital as against interest free loan given to family members. Therefore, no disallowance of interest paid by assessee could be made under section 36(1)(iii). Refer, Krishan Murari Lal Agarwal .v. DCIT, 59 SOT 136. Tribunal held that revenue has not proved that borrowed funds were diverted in making interest free advance, therefore, no part of interest on borrowings can be disallowed. Refer, Marudhar Hotel (P) Ltd. v. ACIT, 156 TTJ 697. The tribunal held that ,if loans relatable to specific purpose and not part of general pool of funds available to assessee, no disallowance of any part of interest relatable to such secured loans to be disallowed. Assessee advancing interest-free loans. Matter remanded for finding on nature of secured loans raised by assessee. Refer, Gurudas Mann v. Dy. CIT, 21 ITR 57 (Chandigarh)(Trib.) Where assessee had utilised its own surplus funds to give interest free loans to its sister concerns, disallowance of interest payment made by AO under section 36(1)(iii) was to be deleted. Refer, ACIT v. Apollo Hospital Enterprise Ltd, 139 ITD 594 (Chennai)(Trib.).
2	Interest to creditors	Assessee paid interest to creditors as well as trade partiesupto 30 days at the rate of 18 per cent and beyond 30 days at the rate of 21 per cent and claimed deduction of the same. A.O. disallowed interest exceeding that where payment was made within 30 days, interest was paid at the rate of 18 per cent and in other cases interest was paid at the rate of 21 per cent. CIT(A) deleted the addition. Affirming the view of CIT(A) Tribunal held thatthe rate of interest chargeable for delayed payments are mentioned in the invoices itself. This clearly establishes payment policy of the assessee-company. Refer, ITO .v. Axon Global (P.) Ltd, 146 ITD 473.
3	Provident Fund	In the case of CIT v. Hemla Embroidery Mills (P.) Ltd, 366 ITR 167 it was held that when amount of PF paid on or before filing of return of income, same should allowed.  Same also confirmed in the case of (i)            CIT v. Udaipur Dugdh Utpadak Sahakari Sangh Ltd., 366 ITR 163. (ii)          Essae Teraoka P. Ltd. v. Deputy CIT, 366 ITR 408 (iii)         CIT v. Gujarat State Road Transport Corporation, 366 ITR 170. (iv)         Euro Pratik Ispat P. Ltd. .v. ACIT, 27 ITR 432 (v)          Deputy CIT v. Worldwide Media P. Ltd, VOL 30 PG 181 (vi)         CIT .v. Mark Auto Industries Ltd, 358 ITR 43 (vii)        CIT v. Kichha Sugar Co. Ltd, 216 Taxman 90 (viii)      CIT v. Nipso Polyfabriks Ltd, 350 ITR 327.
4	Investment from borrowed fund	Interest on borrowed capital-There is no requirement that an assessee should have a separate account in respect of non-interest bearing funds from that of interest bearing funds to establish that investments have been made out of its own funds. Refer, CIT .v. Mahanagar Gas Ltd., 221 Taxman 80. Assessee claimed interest and finance charges paid by it as allowable business expenditure. AO disallowed proportionate interest on interest free advances and investment made by assessee to its associate concern. Tribunal held that assessee's available capital and reserves was more than borrowed fund, it can be presumed that loan and investment in associate concern were made from interest free funds available with assessee and thus, proportionate interest cannot be disallowed as it had no nexus to other finance charges claimed by assessee. Refer, Gujarat Reclaim & Rubber Products Ltd. .v. Ad.CIT, 60 SOT 22. The assessee paid interest on borrowed capital from which it made investment in shares for strategic business purposes. The companies promoted as special purpose companies strengthened an promoted assessee's existing business by combining different business segments. Hence, the interest was held allowable. Refer, CIT .v. Spencers and Co. Ltd, 359 ITR 644. Since assessee had invested in companies suffering heavy losses and was aware about financial health of all companies of group, there was no possibility to receive any pecuniary benefit and thus, investment made by assessee could not be considered as “for the purpose of business”. Held, interest paid by assessee on borrowed funds was not exclusively and wholly for purpose of business but was a colourable device for tax evasion. Refer, CIT .v. Subrata Roy, 219 Taxman 133. The tribunal held that where assessee had sufficient funds in shape of share capital and share application money out of which it could advance loan to its sister concern, interest paid on borrowed capital would be allowed under section 36(1)(iii). Refer, Venus Records & Tapes (P) Ltd v. Addl. CIT, 82 DTR 35 (Mum.)(Trib.). The assessee's claim for deduction of interest on borrowed capital was disallowed because the Assessing Officer found that the borrowed capital had been utilized for advancing loans to directors of the assessee and this was upheld by the Tribunal. On appeal to the High Court also confirmed the order of Tribunal. Refer, A. Murali and Co. P. Ltd. v. ACIT, 357 ITR 580 (Mad.)(HC) The assessee claimed that the entire borrowed funds to the extent of Rs.76.06 crores was invested as stock-in-trade, and hence, debited an amount of Rs.7,14,80,735 towards interest and bank charges andinterest on advance. The Assessing Officer disallowed proportionate interest on the borrowed funds on the ground that interest-free advances were not given from the capital or current account of the proprietor but from interest bearing business funds. Held, if the assessee demonstrated that sufficient capital funds were available, there may not be any diversion of funds. However, it was for the  assessee to demonstrate  that sufficient capital funds were available in the books of account. The Assessing Officer was directed to examine the matter with regard to the available funds in the capital and current accounts of the proprietor and the nature of deposit. Refer, P. A. Jose v. ACIT, 25 ITR 1 (Cochin)(Trib). Where the assessee was not engaged in business of investment in shares, interest bearing funds invested in shares of related company could not be said to have been utilized for purposes of business, and therefore, proportionate interest was liable to be disallowed under s. 36(1)(iii).Refer, CIT v. Deepak Agarwal, 216 Taxman 153.
5	Other Interest	Interest paid by assessee on loan utilized for setting up a V-SAT facility held to be allowable. High Court relied on the decision of the Apex Court in the case of Dy. CIT .v. Core Health Care [2008] 298 ITR 194 and allowed the interest expense u/s. 36(1)(iii). Refer, CIT .v. Kirloskar Computer Services Ltd., 221 Taxman 391. In the case of CIT v. Peninsular Investment Ltd, 265 CTR 601, If the main business of the assessee is to trade in shares as per its Memorandum of Association, the interest paid on the borrowed funds to its sister concern is allowable as business expenditure. In the case of JayeshRaichand Shah .v. ACIT, 360 ITR 387 it was held that Loans were made from funds provided by assessee him self-Colourable transaction-Interest was held to be not deductible. Assessee claimed interest on loans taken from subsidiaries. AO observed that assessee had also given loans to its subsidiaries. he disallowed proportionate interest .Tribunal held that that the assessee had more than sufficient funds of its own. Commercial interest of assessee was effectuated by business purpose of subsidiaries ,hence interest on loans taken by assessee from subsidiary companies was allowable. Refer, Dy. CIT .v. Vistas Wind Technology India (P.) Ltd, 60 SOT 10. As the assessee failed to show that the amount was advanced out of interest free funds and in course of business, disallowance of interest to be upheld. Refer, Hareshbhai Jagmohandas Mehta (HUF) .v. ACIT, 28 ITR 561. Interest on loan taken for setting up new plant upon specific finding that new glass factory nothing but expansion of existing business was allowable. Also, since entire investment in tax-free bonds was made by assessee out of its own funds and not by  utilisation of borrowed funds, interest was allowable u/s 36(1)(iii). Refer, Addl. CIT .v. Nicholas Piramal India Ltd, 27 ITR 182. Assessee company was incorporated in the period relevant to AY 2006-07. In May 2006, it entered into MoUs with third parties and subsequently, JV agreement was entered into in July 2006. Loan was taken by the assessee in May 2006. On the issue of whether the assessee was entitled to deduction in respect of the interest expenditures, held: It is well-settled that there may be a distinction in the dates of setting up and commencement of business. Date of setting up business depends on the facts and the nature of business. A pragmatic and practical view has to be taken and interest has been allowed as an expenditure in AY. 2007-08. Refer, CIT .v. Arcane Developers, 95 DTR 49. The Tribunal, finding possibility of factual error, remanded issue of interest on advance to sister concern to Assessing Officer, to decide same after verification. Held on facts, the Tribunal had taken correct decision. Refer, CIT .v. Rajesh J. Desai. 218 Taxman 113 Assessee having not produced any evidence to indicate apportionment of OTS amount of Rs. 91 Lakhs, i.e. Rs 72 lakhs against principal and Rs 19 lakhs against interest. Court held that the revenue authorities had taken a possible view and no question of law did arise there from. Refer, Akay Organics Ltd. .v. ITO, 218 Taxman 154. Where assessee had sufficient funds available, interest could not be disallowed holding advances made to concerns, for purchase of raw material and plant-machinery, as diversion of interest bearing funds. Refer, CIT .v. Shree Rama Multi Tech Ltd, 219 Taxman 162. Interest on borrowed capital-Interest on borrowed capital in his individual capacity for the purpose of money lendingis allowable deduction. Refer, ACIT .v. Arun Thomas, 157 TTJ 781. Interest payable due to instalment payment for purchase of land without any borrowing was not deductible u/s 36(1)(iii). Also, the same was not deductible u/s 37(1) as the same was capital expenditure. Refer, CIT .v. Career Launcher India Ltd, 358 ITR 179 Tribunal held that the CIT(A) has given a factual finding according to which assessee trust had own funds amounting to Rs. 54.34 crores where as the account advanced to Dr. D. Y. Patil Education Society was Rs. 11.85 crores and there is no nexus of the funds advanced with the loan funds of the assessee. Therefore, the assessee is entitled to the deduction of interest. Refer, Dr. D. Y. Patil Pratisthan v. Dy. CIT, 154 TTJ 320. Tribunal held that the Assessing Officer was justified in disallowing interest worked out on the monthly balances of capital work in progress by applying the proviso to section 36(1)(iii) on the basis that the assessee had utilized various loan funds in the creation of capital work-in-progress. Refer, Amartex Industries Ltd. v. Addl. CIT, 155 TTJ 43. It was held that where borrowed funds were exclusively utilized for purpose of expansion of existing business having common administration and common fund, which resulted enhancement of production by thrice, interest paid on loan borrowed was to be treated as revenue in nature and accordingly, same was allowable under section. Refer, CIT v. U.P. Asbestos Ltd, 357 ITR 509. In light of a finding that loan to subsidiary was not from borrowed capital, interest was deductible u/s 36(1)(iii). Refer, CIT v. Vijayawada Bottling Co. Ltd, 356 ITR 625(AP) (HC). Having not accepted the condition regarding payment of interest on borrowings, assessee did not make any provision of interest on aforesaid loan in earlier years. However, in the previous year relevant to assessment year in question, it claimed deduction of entire amount of interest payable on loan amount. Since assessee had been following mercantile system of accounting, liability for payment of interest for all previous assessment years could not be claimed or allowed in relevant assessment year. Refer, U.P.S.I.C Ltd. v. CIT, 216 Taxman 147. Where it was not examined that directors who had advanced interest free loans to assessee were same as directors who were beneficiaries of interest free loans from assessee, issue of allowability of interest on loan taken from bank was to be remitted back for re-examination. Refer, CIT v. Southern Bottlers (P.) Ltd, 216 Taxman 145. Where the assessee had merely submitted details of income of borrowers same would not entitle assessee to claim interest paid on borrowed capital. Refer, Vipin Gupta v. CIT, 216 Taxman 101
6	Bad Debts	The AO, on a perusal of the return of income filed by the assessee, observed that it would not be possible for the assessee to establish that the outstanding debts had become bad and doubtful and hence disallowed  the deduction of bad and doubtful debts to a certain extent. However, the Tribunal allowed the deduction for the same. The High Court dismissing the departmental appeal observed that the fact that the assessee could establish  before the AO that a debt had become bad was a matter of appreciation. The High Court held that the relevant books of accounts were placed before the AO and hence the Tribunal was correct in allowing the deduction of bad and doubtful debts written off on the basis of materials placed on record. Refer, CIT .v. Wipro Ltd, 222 Taxman 181. In the case of CIT .v. Accord Communication Ltd, 220 Taxman 120, it was held that  No requirement to prove by documents / evidences that sufficient efforts to recover the debts were made. In the Canara Bank, 363 ITR 156, it was held that Bad debts disallowed by Assessing Officer. Revision order passed without considering the bad debts issue. Consequential order passed by the Assessing Officer. Assessee filed appeal before the CIT(A) raising the issue of bad debts. Disallowance set aside by the CIT(A) and confirmed by the Tribunal. Matter remanded to CIT(A). In the case of Angel Commodities Broking (P.) Ltd. .v. Dy.CIT, 146 ITD 754, it was held that Write off of debt owed by client was allowed. The Tribunal held that the assessee is entitled to deduction in respect of the amount becoming unrecoverable from its clients. However the deduction has to be restricted to the amount determined after reducing the sum recoverable from sale proceeds of shares with assessee. The Tribunal set aside the matter and restored back to file of the Assessing Officer to decide afresh after allowing a reasonable opportunity of being heard to the assessee. Refer, ACIT .v. Rishiti Stock & Shares (P) Ltd, 159 TTJ 300. Usance interest (6.79 per cent) and interest on the buyers line of credit availed from bank (6.9 per cent) was agreed to be paid at international Libor which was much lower than the rate of interest of 13.50 per cent charged for CC limit availed from bank in Indian rupee. AO’s objection regarding higher level of stock of imported items was satisfactorily met by the assesee. Relevant international transactions of assessee company with its foreign holding company were accepted by TPO in his transfer pricing analysis. AO was not justified in disallowing expenditure towards usance interest and BLC interest. Refer, ITO .v. Ricoh India Ltd., 98 DTR 435.  Advances were written off in profit and loss account. The required details like name of parties, purpose for which advance was granted, were not furnished. Amounts were mostly in the nature of liquidated damages and not bad debts. Details of liquidated damages were not furnished by assessee and no finding was given by AO. Hence, matter was remanded. Refer, GE India Industrial P. Ltd. .v. DCIT, 27 ITR 543. The deduction claimed by the assessee on account of bad and doubtful debts was disallowed by the AO on the ground that creation of mere provision was not enough. Assessee’s contention that specific amounts were identified as bad and doubtful debts and relevant entries made in the books of account was held sufficient to show that the bad debts were written off as required by the provisions of s. 36(1)(vii) subject to verification. Refer, Addl. CIT .v. Nicholas Piramal India Ltd, 27 ITR 182. Tribunal held that when assessee had admitted that claim of purchases from a distributor were all bogus, advance for such purchases could be written off as bad debt. Refer, Dy. CIT .v. Vistas Wind Technology India (P.) Ltd, 60 SOT 10. Once assessee records debt as a bad debt in his books of account, that would prima facie establish that it was a bad debt unless Assessing Officer for good reasons holds otherwise. Refer, CIT .v. Sushila Mallick (Smt.), 218 Taxman 118. When the Tribunal allowed the claim of bad debt on the ground that there was no hope of recovery, it was held that it did not commit any error in doing so, and no question of law arose. Refer, CIT .v. Gujarat Narmada Valley Fertilizers Co. Ltd, 218 Taxman 122. The assessee gave advance to labours and suppliers of material during the course of its business. Subsequently, the said amount became non-recoverable and was written off in books of account. Held, in view of the amended provisions of section 36(1)(vii), assessee was entitled to claim deduction in respect of amount in question written off unilaterally in its books of account. Refer, TRG Industries (P.) Ltd. v. DCIT, 59 SOT 64. Assessee filed his Return of Income u/s 139(1) wherein no claim for bad debts was raised. Subsequently, a search was conducted in assessee’s premises in course of which certain documents were seized. In response to notice issued u/s 153A, assesee filed a revised return disclosing interest from income from debtors. Assessee also made a claim for bad debts in said return. On appeal in Tribunal, Tribunal held that it could not be concluded that assessee had written off bad debt as irrecoverable in accounts maintained for previous year in ordinary course of business. Further essential feature for claiming deduction on account of bad debt was that such bad debt is to written off as irrecoverable in accounts in ordinary course of business .Since condition of section 36(1)(vi) had not been satisfied in instant case, assessee’s claim was rejected by authorities. Refer, Gendmal Kothari v. DCIT, 139 ITD 397. For allowability of deduction on account of bad debt, it was not necessary for assessee to close individual account of each debtor in its books and it would suffice if amount had been reduced from debtors balance shown on asset side of balance-sheet at close of year. Refer, KEC International Ltd. v. DCIT, 58 SOT 18. In the case of CIT v. U.P. Rajkiya Nirman Nigam Ltd., 217 Taxman 367, it was held that Bad debts could be written off even after closure of the accounting period. Since the assessee had written off the amount in its books of account since it was not recoverable. The addition made by the AO on the ground that assessee failed to justify its claim, was to be deleted. Refer, Indian Research Manifestation Labs P. Ltd. v. ACIT, 24 ITR 30. The assessee having written off bad debts in books of account, it was not necessary any further to establish that bad debt had in fact become bad. Windmills, treated as stock in trade, were seized by bank under the order of the High Court. Finding title of machines in doubt, the assessee was held to be justified in deciding to write off investment in the same. Refer, CIT v. Sambhav Media Ltd, 216 Taxman 115. For an assessee to claim deduction in relation to bad debts it is now no longer necessary for assessee to establish that debt had become irrecoverable; and it is sufficient if assessee forms such an opinion and writes off debt as irrecoverable in its accounts. Refer, CIT v. Samara India (P.) Ltd, 216 Taxman 93. Assesee with a view to maintain customer relationship and not to loose valuable customers assessee-advertising company accepted short payments against bills raised and short payments were written off by assessee as bad debts .The Tribunal held that write off of the amount was a reversal of income which was booked in excess and was borne out of a commercial consideration and therefore could not be termed as arbitrary or irrational, therefore, assessee’s claim of bad debts was to be allowed. Refer, Hindustan Thompson Associates (P.) Ltd. v. ACIT, 53 SOT 389(Mum.)(Trib.). The assessee was not recognised as a moneylender under any law or as a financial institution, it cannot be said that assessee is carrying on money lending activity as part of its business. Therefore, amount advance by the assessee becoming irrecoverable cannot be allowed as bad debt under section 36 (1) (vii) of the Act. Refer, CIT v. Epsilon Advisers (P) Ltd, 80 DTR 366 (Karn.)(High Court)
7	Provision for Bad debt.	Amount credited by a bank to reserve for bad and doubtful debts towards standard assets is not deductible under section 36(1)(viia), as it is not akin to provision for bad and doubtful debts, which is a liability, whereas reserve is assessee's own fund. Refer, Bharuch Dist. Central Co-op. Bank Ltd. .v. ITO, 59 SOT 150 Assessee claimed deduction towards provisions for bad & doubtful advances u/s 36(1)(viia) at 7.5% of gross total income . Assessing Officer rejected assesee’s claim because no provision was made as required u/s 36(1)(viia). CIT(A) upheld the order of the Assessing Officer. On appeal in Tribunal, the Tribunal dismissed the appeal of the assesee and held that deduction u/s.36(1)(viia) is to be allowed in respect of any provision for bad& doubtful debts made by the assessee . Hence, the condition for allowing deduction is the creation of any provision for bad & doubtful debts which can only be created in the books of account maintained by the assesee. Since the assesee has claimed the deduction without making any provision as stated in s/36(1)(viia), the tax authorities were justified in not allowing the same. Refer, Kottakkal Co-op. Urban Bank Ltd V. ITO, 142 ITD 123 (Coch.) (Trib.). In the case of State Bank of Hyderabad v. Dy.CIT, 58 SOT 278, the  ITAT held that  Allowance cannot be in excess of provision for bad debts actually made in accounts.
8	Others	Processing charges, foreclosure charges and penalty for late payments incurred by a financial corporation had direct nexus with business of providing finance, and hence, were deductible. Refer, CIT v. Weizmann Homes Ltd, 357 ITR 74 (Karn.)(HC).

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