NO INTEREST DISALLOWANCE U/S 36(1)(iii) IF PARTNERS’ DRAWINGS ARE COVERED BY INTEREST-FREE FUNDS
ISSUE
Whether the Assessing Officer is justified in disallowing interest expenditure under Section 36(1)(iii) on the ground that interest-bearing overdraft funds were diverted for partners’ drawings (resulting in negative capital balances), even when the assessee-LLP possessed ample interest-free funds to cover such withdrawals.
FACTS
Assessee: An LLP engaged in the business of ship recycling.
Assessment Year: 2016-17.
The Disallowance: The Assessing Officer (AO) disallowed Rs. 2.88 Crores out of the total interest claimed.
AO’s Logic: The AO observed that withdrawals made by two partners from the Overdraft (OD) account resulted in negative balances in their capital accounts. He concluded that interest-bearing funds were diverted for personal purposes (non-business), and thus, the proportionate interest paid to the bank was disallowed.
CIT(A)’s Stand: The Commissioner (Appeals) upheld the disallowance, noting that the drawings were made directly from the OD account without any demonstrated “commercial expediency.”
Assessee’s Defense:
The assessee had incurred a total interest expenditure of Rs. 10.63 Crores but also earned interest income of Rs. 7.97 Crores (Net Outgo: Rs. 2.66 Crores).
Crucially, the assessee demonstrated through balance sheets and day-wise workings that it possessed ample interest-free funds (reserves, profits, etc.) at all material times which exceeded the partners’ withdrawals.
DECISION
Presumption of Own Funds: The Tribunal relied on the settled legal principle (akin to the Reliance Industries judgment) that if an assessee possesses sufficient interest-free funds (own funds) to cover the non-business advances/withdrawals, it must be presumed that such withdrawals were made from the interest-free funds, not the borrowed interest-bearing funds.
Source of Drawings Irrelevant: Even if the specific withdrawal check was cut from the OD account, the existence of a common pool of funds and sufficient “own funds” protects the interest claim.
Business Purpose Intact: Since the AO did not doubt the genuineness of the borrowings for business operations otherwise, and the “own funds” covered the drawings, the disallowance was unjustified.
Verdict: The disallowance of Rs. 2.88 Crores was deleted. [In Favour of Assessee]
KEY TAKEAWAYS
The “Mixed Pot” Theory: Money is fungible. If you have Rs. 100 in Share Capital (Interest-Free) and Rs. 100 in Bank Loan (Interest-Bearing), and you withdraw Rs. 50 for personal use, the Tax Department cannot force you to say you used the Loan money. You can claim you used the Share Capital.
Negative Capital Warning: While this judgment favors the assessee, partners having “Negative Capital” balances while the firm pays heavy interest is a red flag that always invites scrutiny. It is best to maintain positive capital balances or document that reserves exceed the drawings.
Netting Off: The fact that the assessee had substantial interest income (netting off the expense) also helped strengthen the argument that the net burden on the P&L was for business.
IN THE ITAT AHMEDABAD BENCH ‘A’
R.K. Industries Unit- II LLP
v.
Assistant Commissioner of Income-tax
Sanjay Garg, Judicial Member
and MAKARAND V. MAHADEOKAR, Accountant Member
and MAKARAND V. MAHADEOKAR, Accountant Member
IT APPEAL No. 1318 (Ahd) OF 2024
[Assessment year 2016-17]
[Assessment year 2016-17]
DECEMBER 5, 2025
Hiren Trivedi, AR for the Appellant. Santosh Kumar, Sr. DR for the Respondent.
ORDER
Makarand V. Mahadeokar, Accountant Member.- This appeal by the assessee arises from the order dated 14.05.2024 passed by the Commissioner of Income Tax (Appeals), National Faceless Appeal Centre, Delhi [hereinafter referred to as “CIT(A)”], under section 250 of the Income Tax Act, 1961[hereinafter referred to as “the Act”], for the assessment year 2016-17. The assessment in the present case was originally completed under section 143(3) by the Assistant Commissioner of Income Tax, Circle 1, Bhavnagar [hereinafter referred to as “Assessing Officer or AO”], vide order dated 21.12.2019.
2. Facts of the Case:
2.1 The assessee, a Limited Liability Partnership engaged in the business of ship recycling, had filed its return of income on 30.11.2016 declaring total income of Rs. 7,69,25,170/-. The case was selected for scrutiny and statutory notices were issued from time to time. After considering the material placed on record and after examining the withdrawals made by two of the partners from the overdraft account of the firm, the Assessing Officer determined the total income at Rs. 10,57,38,760/-, making a principal addition of Rs. 2,88,13,592/- under section 36(1)(iii) of the Act on account of alleged diversion of borrowed funds for non-business purposes. The Assessing Officer also initiated penalty proceedings under section 270A and computed interest chargeable under sections 234A, 234B, 234C and 234D.
2.2 The Assessing Officer noted in the assessment order that substantial withdrawals during the year were made by two partners, namely Smt. Ranjanben M. Patel and Shri Bhavya M. Patel, from the overdraft account maintained by the assessee with the bank. According to the Assessing Officer, these withdrawals were not supported by any business purpose, and the firm had not charged any interest on such drawings. The Assessing Officer traced the date wise utilisation of overdraft limits and concluded that the impugned drawings resulted in a corresponding increase in interest liability payable to the bank. It was observed that the assessee had incurred total interest expenditure of Rs. 10.63 crore and earned interest income of Rs. 7.97 crore during the year, implying a net interest expense of Rs. 2.66 crore. The Assessing Officer concluded that the assessee had failed to demonstrate that borrowed funds were utilised wholly and exclusively for the purpose of business. The Assessing Officer further noted that the assessee had negative or reduced capital balances in respect of two partners as a result of distribution of book loss incurred in the preceding year. The Assessing Officer rejected the assessee’s explanation that sufficient interest free funds in the form of partner’s capital, accumulated profits and non-interest bearing liabilities were available and held that withdrawals from the overdraft account had a direct nexus with borrowed funds. On this reasoning, proportionate interest of Rs. 2,88,13,592 was disallowed under section 36(1)(iii).
2.3 The assessee preferred an appeal before the CIT(A) and raised various factual and legal submissions. The assessee contended that although two partners had debit balances at certain points of time, the firm had neither paid interest on the credit balance of the third partner nor charged interest on the debit balances of the partners. It was contended that the disallowance under section 36(1)(iii) could not be made by viewing debit balances in isolation and that the cumulative capital position of all partners had to be considered. The assessee demonstrated through detailed tables that the negative balances appearing at the beginning of the year were entirely attributable to the allocation of exceptional book loss relating to permanent diminution in value of investments in the preceding year. The assessee contended that once the impact of such noncash loss was removed, the partners’ opening and closing capital balances were substantially positive. It was further submitted that the assessee had, at all material times, sufficient interest free funds far in excess of the withdrawals of the partners. The assessee furnished computations showing availability of interest free funds of Rs. 238.43 crore on 01.04.2015 and Rs. 240.95 crore on 31.03.2016. Reliance was placed on several judicial precedents, including the decisions of Coordinate Benches in case of Xebec Exports v. Asstt. CIT [2009] 126 TTJ 190 (Delhi) and in case of Torrent Financiers v. Asstt. CIT [2001] 73 TTJ 624 (Ahmedabad – ITAT)] – Ahmedabad ITAT, to emphasise that no disallowance can be made if interest free funds available with the assessee exceed the interest free advances.
2.4 The assessee also argued before the CIT(A) that on a net basis, after adjusting interest receivable from one partner and interest notionally chargeable to others at 7.95 percent, the firm was required to pay net interest of only Rs. 56.58 lakh to partners, which demonstrated that interest bearing funds were not diverted. The assessee explained that the Assessing Officer had chosen to consider only the debit balances of two partners without appreciating that the firm had not paid interest to the partner who maintained a credit balance throughout the year. It was submitted that principles of equity required netting of interest receivable and interest payable. The assessee also relied upon the principle that when interest free funds and interest-bearing funds are mixed, a presumption arises that interest free funds are utilised first, as held in various judgments including the judgement of Hon’ble Supreme Court in CIT v. Reliance Utilities and Power Ltd. (SC)(Civil appeal No. 35 of 2019 and others).
2.5 The CIT(A), however, rejected these submissions. After examining the date wise withdrawals and the working of interest, the CIT(A) endorsed the reasoning of the Assessing Officer that partners’ withdrawals were directly from the overdraft account and resulted in a tangible escalation of interest cost to the firm. The CIT(A) held that the assessee had not demonstrated any commercial expediency in permitting interest free drawings to partners and relied extensively upon various judicial precedents to emphasise that commercial expediency must be proved by facts. The CIT(A) observed that the assessee’s reliance on availability of interest free funds was misplaced because the firm continued to maintain an overdraft balance and had not utilised interest free funds for reduction of overdraft. It was held that the assessee’s explanation that interest free funds existed on paper but were not utilised for settlement of overdraft was insufficient. The CIT(A) also recorded that the assessee had attempted to divert attention from the primary issue by clubbing interest receivable with interest payable. Ultimately, the CIT(A) confirmed the disallowance of Rs. 2,88,13,592/- under section 36(1)(iii). The levy of interest under sections 234A, 234B, 234C and 234D and initiation of penalty under section 270A were also upheld. The assessee’s appeal was dismissed.
3. Aggrieved by the order of the CIT(A), the assessee is now in appeal before us and has raised following grounds of appeal:
| 1. | “In law and in the facts and in the circumstances of the case, the ld. CIT (Appeal) NFAC has passed the appellate order without providing video hearing as provided in Faceless Appeals Scheme more particularly when Appellant has stated that proper opportunity of being heard should be provided before disposing of its appeal. |
| 2. | In law and in the facts and circumstances of the case of the Appellant, the order u/s 250 of the Income Tax Act,1961 without considering the submissions made by appellant is bad in law and deserves to be quashed and set aside. |
| 3. | In law and in the facts and circumstances of the case of the Appellant, the Ld. CIT(Appeal) NFAC erred in not appreciating the fact that the order of learned AO is passed in breach of natural justice and thus deserved to be quashed and set-aside. |
| 4. | In law and in the facts and circumstances of the case of the Appellant, the Ld. CIT(A)- NFAC has erred in confirming addition of Rs. 2,88,13,592/-under section 36(1)(iii) of the Act without considering the availability of interest free funds available with the appellant. |
| 5. | Without prejudice to above, in law and in the facts and circumstances the Ld. CIT(A)- NFAC erred in confirming the levy of interest under section 234A/B/C/D. |
| 6. | Without prejudice to above, in law and in the facts and circumstances the Ld. CIT(A)- NFAC erred in initiating proceedings under section 270A of the Act. |
| 7. | The appellant craves leave to add to alter, amend and/or withdraw any ground or grounds of appeal either before or during the course of hearing of the appeal.” |
4. During the course of the appellate proceedings before us, the learned Authorised Representative (AR) invited our attention to the detailed financial workings and explanatory statements placed in the paper book, including Tables A, B and C as reproduced in the submissions before the lower authorities. It was submitted that these workings were already before the Assessing Officer during scrutiny and again before the CIT(A) and demonstrate beyond any factual doubt that the assessee possessed substantial interest free funds at all points of time during the relevant accounting period.
4.1 The learned AR submitted that the Assessing Officer had erroneously proceeded on the assumption that merely because two of the partners had debit balances on the first day of the year, the assessee did not have interest free funds and had diverted interest bearing funds for non-business purposes, whereas such an inference ignores the complete financial matrix.
4.2 The learned AR drew our attention to Table A placed at page 4 of the paper book, wherein the cumulative partners’ capital, current liabilities and trade payables have been tabulated as on 01.04.2015 and 31.03.2016. It was pointed out that as on 01.04.2015, the assessee had total interest free funds of Rs. 2,06,80,01,543/- and as on 31.03.2016, such funds stood at Rs. 2,09,31,86,439/-. These figures, it was submitted, conclusively demonstrate that the assessee had more than adequate interest free funds to meet any withdrawals made by the partners. The learned AR emphasised that both CIT(A) and the Assessing Officer had overlooked the basic nature of the assessee’s business, wherein ships are purchased against usance letters of credit with 360 days’ credit period, resulting in continuous free float of funds from ship breaking activities. It was submitted that the assessee ordinarily beaches three to four ships at a time and even a conservative floating margin of 40 percent of sale value generates significant liquidity that constitutes interest free funds. These factual aspects, though part of the record, were not appreciated by the Assessing Officer.
4.3 The learned AR then referred to Table B at page 5 of the paper book, wherein the distribution of the permanent diminution loss of Rs. 31,63,41,024/- relating to financial year 2014-15 has been shown. It was explained that the debit balances of two partners on 01.04.2015 were solely the outcome of the distribution of the aforesaid diminution loss among partners in their profit-sharing ratio. The assessee had already disallowed the said provision in its computation of income for assessment year 2015-16 and no tax benefit had been derived therefrom. It was submitted that the Assessing Officer himself noted this fact in the assessment order but nevertheless treated the debit balances as an adverse factor for making the impugned disallowance, ignoring the non-cash nature of the diminution entry and the assessee’s suo motu disallowance of the provision.
4.4 Proceeding further, the learned AR invited our attention to Table C reproduced at page 6 of the paper book, wherein the revised partners’ capital balances have been tabulated after neutralising the diminution loss entry. It was pointed out that upon removing the non-cash diminution adjustment, the cumulative partners’ capital as on 01.04.2015 stood at Rs. 97,46,33,899 and this figure increased to Rs. 1,22,07,59,057 as on 31.03.2016. It was therefore submitted that the assessee had substantial positive partners’ capital both at the beginning and at the end of the year, and there was no factual basis for the conclusion reached by the Assessing Officer that interest bearing funds were diverted.
4.5 The learned AR then drew our attention to Annexure 2 placed at page 63 of the paper book, containing day-wise computation of interest free funds vis-a-vis withdrawals made by partner Smt. Ranjanben M. Patel. The learned AR explained that the assessee had furnished before the lower authorities detailed date-wise availability of interest free funds comprising cumulative partners’ capital, proportionate profit and current liabilities, which clearly established that on each date of withdrawal the assessee had sufficient interest free funds available. It was argued that both CIT(A) and Assessing Officer erred in law and on facts in proceeding on a presumption of utilisation of borrowed funds despite the presence of substantial interest free funds, which is contrary to the settled principle that where mixed funds exist, a presumption arises that interest free funds are utilised first.
4.6 Continuing his submissions, the learned AR placed particular emphasis on paragraph 2.8.1 of the submissions before the CIT(A), wherein it was pointed out that the assessee had neither paid interest to any partner nor charged interest from any partner during the year. There were three partners in the assessee LLP, namely Shri Mukeshbhai B. Patel, Smt. Ranjanben M. Patel and Shri Bhavya M. Patel. While two partners had debit balances as a result of diminution loss allocation, the third partner, Shri Mukeshbhai Patel, consistently maintained a substantial credit balance throughout the year and no interest was paid to him by the firm. The learned AR submitted that the Assessing Officer committed a fundamental error by examining the debit balances of two partners in isolation without netting the credit balance of the third partner and without recognising that the assessee had not claimed any interest expenditure relatable to partners’ balances.
4.7 It was accordingly submitted that the impugned disallowance of Rs. 2,88,13,592/- is wholly unsustainable.
5. The learned Departmental Representative supported the orders of the Assessing Officer and the CIT(A).
6. We have carefully considered the rival submissions, the orders of the Assessing Officer and the learned CIT(A) and the material placed in the paper book, including the detailed workings in Tables A, B and C, Annexure 2 and the partners’ capital accounts. The sole substantive issue is whether the disallowance of interest expenditure of Rs. 2,88,13,592/- under section 36(1)(iii) is justified on the allegation that interest bearing overdraft funds were diverted for interest free drawings by two partners.
6.1 It is not in dispute that the assessee is engaged in the business of ship recycling and that it has earned net profit of Rs. 5,43,19,491/- during the relevant previous year. It is also an admitted position emerging from the assessment order as well as the submissions recorded by the learned CIT(A) that the assessee incurred total interest expenditure of Rs. 10.63 crores and simultaneously earned interest income of Rs. 7.97 crores, leaving a net interest outgo of about Rs. 2.66 crores only. The Assessing Officer has not doubted the genuineness of the borrowings or their utilisation for business operations. The disallowance has been made solely on the footing that withdrawals by two partners, namely Smt. Ranjanben M. Patel and Shri Bhavya M. Patel, from the overdraft account resulted in negative balances in their capital accounts and that the interest paid to the bank on the overdraft to that extent was not for the purpose of business.
6.2 From the assessment order it is evident that the Assessing Officer has primarily proceeded on a comparison between the overdraft balance and the debit balances in the capital accounts of the two partners. The focus of the Assessing Officer is only on withdrawals during the year. While computing the notional disallowance he has not examined the overall availability of interest free funds in the assessee’s business, the composition of partners’ capital on a cumulative basis, or the additions made to partners’ capital accounts during the year by way of profits and fresh capital contributions. The working in paragraph 18 of the assessment order also shows that the Assessing Officer has taken the debit balances of two partners in isolation, granted a limited relief on closing balance of one partner, and then straightway linked the resultant figure to the interest paid on the overdraft.
6.3 The learned CIT(A), though he has reproduced at length the submissions of the assessee and the working furnished in Tables A, B and C, has, in substance, endorsed the approach of the Assessing Officer. The learned CIT(A) has proceeded to examine the matter on the footing that if the assessee had surplus interest free funds it ought to have first repaid or reduced the overdraft and that permitting partners’ drawings in the presence of an overdraft lacks commercial expediency. In doing so he has treated every withdrawal by the partners from the overdraft account as diversion of borrowed funds for non-business purposes. He has heavily relied on judicial precedents dealing with cases of interest free advances to sister concerns or diversion of borrowed funds for non-business purposes, and on the wider doctrine of lifting the corporate veil, without first recording any clear finding that, on facts, the assessee did not have sufficient interest free funds of its own at the relevant points of time. At the same time, the judicial precedents specifically cited by the assessee on the presumption arising where mixed funds are available and interest free funds exceed the advances, such as the decisions in Reliance Utilities and Power Ltd. (supra), Torrent Financiers (supra) and Xebec Exports (supra), have not been dealt with or distinguished by the learned CIT(A) in a reasoned manner.
6.4 Turning to the factual matrix, we find that the assessee has placed on record a detailed working of availability of interest free funds. Table A, compiled from the audited financial statements, shows that as on 01.04.2015 the cumulative partners’ capital balance stood at Rs. 65,82,92,874/-, current liabilities at Rs. 1,00,65,000/- and trade payables at Rs. 1,39,96,43,669/-. The total interest free funds available on that date, being the aggregate of these three components, are thus Rs. 2,06,80,01,543/-. As on 31.03.2016 the corresponding figures are Rs. 90,44,18,032/-, Rs. 90,04,162/- and Rs. 1,17,97,64,245/- respectively, aggregating to Rs. 2,09,31,86,439/-. These figures are not in dispute and are drawn from the very balance sheet which has been relied upon by the Assessing Officer for making the disallowance. The impugned withdrawals by the two partners, even taking the peak debit balances, are only a fraction of the aforesaid interest free funds.
6.5 The Assessing Officer as well as the learned CIT(A) have, however, treated the opening negative capital balances of two partners as an indicator that partners’ capital as a whole was not available as interest free funds. In this regard the assessee has brought on record an important piece of factual explanation which, in our view, has considerable bearing on the controversy. Table B explains that the negative capital balance at the beginning of the year is on account of the book entry passed in financial year 2014-15 for permanent diminution in the value of investments amounting to Rs. 31,63,41,024/-. This diminution loss was apportioned to the partners strictly in their profit-sharing ratio and debited to their capital accounts, resulting in substantial reduction or negative figures in the capital accounts of Smt. Ranjanben M. Patel and Shri Bhavya M. Patel. It is further not in dispute that the assessee had itself disallowed this provision while computing taxable income for that year and no deduction has been allowed in assessment. In other words, the diminution in value is a noncash, exceptional book entry which has already been neutralised for tax purposes and has not involved any outflow of funds.
6.6 Once this non-cash diminution entry is neutralised, the picture of partners’ capital undergoes a material change. Table C demonstrates that upon adding back the share of each partner in the permanent diminution to the opening capital balance as on 01.04.2015, the revised capital balances of the partners become positive. On this basis, the cumulative partners’ capital balance, which was Rs. 65,82,92,874/- as per the balance sheet, works out to Rs. 97,46,33,899/- when the non-cash diminution is ignored. When to this figure are added current liabilities of Rs. 1,00,65,000/- and trade payables of Rs. 1,39,96,43,669/-, the total interest free funds available as on 01.04.2015 come to Rs. 2,38,43,42,568/-. A similar exercise for 31.03.2016 shows revised cumulative capital of Rs. 1,22,07,59,057/- and, together with current liabilities and trade payables, total interest free funds of Rs. 2,40,95,27,464/. Thus, even leaving aside the question of day wise availability, the very opening and closing position in the year clearly shows that partners’ capital, together with other interest free liabilities, was substantially positive and far exceeded the alleged interest free drawings.
6.7 In our considered view, the approach of the lower authorities in treating the book entry for diminution in value of investments as if it represented actual depletion of interest free funds is not in consonance with commercial reality. The capital accounts of partners in a running partnership represent a residual interest in the net assets of the firm. A mere accounting provision for diminution in value of an investment does not, in itself, result in withdrawal of funds from the business. When such provision is itself disallowed for tax purposes, as in the assessee’s own case, it cannot be used again as a basis to infer that partners’ capital stood eroded so as to deny deduction of interest on borrowings which are otherwise for the purposes of business. For the limited purpose of examining the availability of interest free funds in the context of section 36(1)(iii), what is relevant is the real pool of own funds and noninterest-bearing liabilities and not a notional reduction arising from a noncash book entry.
6.8 We also find force in the submission of the learned authorised representative that both the Assessing Officer and the learned CIT(A) have unduly emphasised only the withdrawals from the capital accounts without giving due regard to the credits and additions therein during the year. The partners’ capital accounts placed on record, including the summary extracted in the audited financial statements, show that besides the brought forward balances, substantial credits have arisen during the year on account of share of profit and, in the case of at least one partner, additional capital introduced. These credits have remained in the business and have not been treated as interest bearing loans. When partners’ capital is seen on a holistic basis, comprising opening balances adjusted for the non-cash diminution entry, current year profits and capital introductions, the resultant net position is of substantial positive capital employed in the firm throughout the year. The lower authorities have not recorded any finding that these capital credits were fictitious or that they were not available for use in the business. In our view, it is not permissible to dissect only the debit side of the capital account and ignore the credit side while deciding whether interest free funds were available.
6.9 The assessee has further fortified its factual case by furnishing Annexure 2, a day wise working of interest free funds vis-a-vis the withdrawals of Smt. Ranjanben M. Patel. This working, which has not been controverted by the Revenue with any specific defect, demonstrates that on each of the dates of withdrawal the assessee had sufficient interest free funds in the form of cumulative credit balance of other partners, proportionate profits earned till that date and current liabilities. The learned CIT(A) has summarily brushed aside this working by holding that the assessee ought to have utilised such funds for reducing the overdraft. In our view, such an approach ignores the well settled legal position that when an assessee has a common pool of funds and it is shown that interest free funds available are more than the investments or advances in question, a presumption arises that such advances have been made out of interest free funds. The assessee is not required to establish, on a source to application basis, that every rupee advanced has come only from a particular fund. The contrary presumption drawn by the lower authorities, merely because the withdrawals have passed through the overdraft account, is not sustainable when the balance sheet and the day wise working demonstrate that the assessee’s own funds were more than adequate.
6.10 We also note that the assessee had relied upon a line of judicial precedents which lay down that where total interest free funds, including partners’ capital and accumulated profits, exceed the interest free advances, no disallowance of interest is warranted, and that in such circumstances the presumption would be that interest free funds are first utilised for noninterest bearing advances. The learned CIT(A) has noticed the citations but has not dealt with them by giving cogent reasons. Instead, he has relied heavily on decisions, which primarily dealt with different factual situations such as tax avoidance through complex restructuring or advances to sister concerns without proof of commercial expediency. In all those cases the fundamental factual finding was that borrowed funds had indeed been diverted for non-business purposes and that the assessee had failed to demonstrate any nexus with business requirements. In the present case, the foundational fact itself is different. Here the assessee has demonstrated, through uncontroverted balance sheet figures and day wise workings, that it possessed ample interest free funds at all material times. The question of lifting the corporate veil or of examining commercial expediency in the context of advances to third parties does not arise in the same manner where the issue is simply whether partners’ drawings can, by themselves, result in disallowance of interest even when the firm’s own funds are adequate.
7. On the other hand, the principle emerging from the judicial precedents relied upon by the assessee, including the decisions of the jurisdictional High Court which have been cited before the learned CIT(A), is that where an assessee has mixed funds and the interest free funds are more than the investments or advances, the Revenue cannot make a proportionate disallowance of interest merely on the basis of a hypothetical nexus. The lower authorities were required to first address these binding precedents and record why the presumption laid down therein would not apply on the facts of the present case. The absence of such an analysis, coupled with the reliance on decisions which are materially distinguishable on facts, renders the impugned conclusion vulnerable.
8. Viewed from the perspective of commercial expediency as well, we find it difficult to uphold the disallowance. The assessee is a partnership firm carrying on a highly capital-intensive ship recycling business. Partners’ drawings from their capital accounts are a normal incident of such a structure. The material on record does not show that the overdraft borrowings were raised with the primary object of financing partners’ personal requirements. On the contrary, the assessee has demonstrated that its overall interest free funds, comprising partners’ capital and trade liabilities, were of a magnitude more than sufficient to cover the partners’ drawings. In such circumstances, merely because the partners have chosen to route their drawings through the overdraft account cannot lead to a conclusion that interest burden to that extent has ceased to be for the purposes of business. What is relevant under section 36(1)(iii) is whether the borrowing itself is for the purposes of business and whether there is a direct nexus between borrowed funds and non-business advances. On the facts before us, such nexus has not been established by the Revenue.
9. Having regard to the totality of these facts, namely, that the negative capital balance at the beginning of the year is only on account of a non cash diminution entry which has already been disallowed in the earlier year, that on neutralising this entry the partners’ capital and other interest free funds are found to be substantially positive and in excess of the impugned withdrawals, that the lower authorities have failed to consider the additions and credits to partners’ capital during the year and have examined only the withdrawals, that the day wise working of availability of interest free funds has not been rebutted, and that the judicial precedents relied upon by the assessee have not been properly considered while those relied upon by the learned CIT(A) are distinguishable on facts, we are of the considered opinion that the disallowance of interest expenditure of Rs. 2,88,13,592/- under section 36(1)(iii) is not sustainable.
10. We, therefore, direct that the impugned disallowance be deleted. Since we have adjudicated the substantive ground concerning the disallowance under section 36(1)(iii) in favour of the assessee and have deleted the impugned addition, the remaining grounds which are merely consequential in nature, including the grounds relating to levy of interest under sections 234A, 234B, 234C and 234D and initiation of penalty proceedings under section 270A, do not require separate adjudication at this stage. These grounds are accordingly treated as consequential and not independently adjudicated.
11. In the result, the appeal of the assessee is allowed.