AO Cannot Disallow Interest Under Section 36(1)(iii) Once TPO Accepts the Rate as Arm’s Length.

The Dispute: The 15% vs. 5% Conflict

The Scenario:

Borrowing: The Assessee (a Reliance Power subsidiary) borrowed funds from its Indian parent company at an interest rate of 15% (in INR).
Lending: The Assessee then lent these funds to its subsidiary in the Netherlands at an interest rate of 5% (in Foreign Currency).

The Assessing Officer’s (AO) Stand:

The AO alleged that the Assessee was acting as a “conduit” to siphon off funds at lower rates. He claimed there was no “Commercial Expediency” and disallowed the difference of ₹47.76 Crores under Section 36(1)(iii), arguing that the company should have charged 15% to its subsidiary to avoid loss.

The Judicial Verdict: Three Pillars of Defense

The Tribunal upheld the deletion of the disallowance based on three critical legal and commercial principles:

1. LIBOR vs. Domestic Rates

The Tribunal reiterated a well-settled principle of international taxation: the interest rate must be benchmarked against the currency of the loan and the geography of the borrower.

Since the loan was in foreign currency to a Netherlands entity, the LIBOR (London Inter-Bank Offered Rate) applied.
At the time, LIBOR was 3–4%. The Assessee charged 5%, which was technically higher than the prevailing market rate in the borrower’s country.

2. Binding Nature of the TPO’s Order

A pivotal point in this case was that the Transfer Pricing Officer (TPO) had already examined the 5% interest rate and issued a “clean order,” accepting it as being at Arm’s Length Price (ALP).

The Ruling: Once the TPO (a specialized wing of the Department) accepts the interest rate as “Arm’s Length,” the AO cannot later claim the same rate lacks “commercial expediency” or is “unreasonable” to make a disallowance under Section 36(1)(iii).

3. The “Exchange Gain” Factor

The AO focused solely on the interest percentage, ignoring the Foreign Exchange reality.

Because the loan was in foreign currency, the devaluation of the Indian Rupee resulted in a Foreign Exchange Gain of ₹31.61 Crores for the Assessee.
When you combine the 5% interest income with the Forex gain, the effective return to the company was much higher, negating the AO’s “huge loss” theory.

Strategic Takeaways for Multi-National Groups in 2026

Currency Matching: Always ensure that cross-border loans are benchmarked against the currency in which they are issued. An INR interest rate of 15% cannot be compared to a USD/Euro rate of 5%.
TPO Order as a Shield: If your Transfer Pricing audit results in a “no adjustment” order regarding interest, use that order as your primary defense against any “Commercial Expediency” challenges by the regular Assessing Officer.
Total Return Documentation: When documenting such transactions, include Forex gain projections. Showing that the company expects to gain from a strengthening foreign currency helps justify a lower nominal interest rate.
Commercial Objective: Ensure the “purpose” of the loan is documented (in this case, it was coal procurement for power generation). This establishes the “Commercial Expediency” required to satisfy Section 36(1)(iii).

IN THE ITAT MUMBAI BENCH ‘D’

ACIT

Reliance Coal Resoures (P.) Ltd.^*

SAKTIJIT DEY, Vice President
and MAKARAND VASANT MAHADEOKAR, Accountant Member

IT Appeal No. 3620 (Mum) of 2025
[Assessment year 2020-21]

MARCH 25, 2026

Niraj Sheth, Adv. for the Appellant. Umashankar Prasad, CIT-DR for the Respondent.

ORDER

Saktijit Dey, Vice President.-Captioned appeal by the Department arises of order dated 10.02.2025 passed by National Faceless Appeal Centre (NFAC), Delhi pertaining to Assessment Year (AY) 2020-21.

2. Before adverting to the issue arising for consideration in the appeal, it is necessary to observe, the appeal is delayed by 22 days. After considering the submissions of learned Departmental Representative (DR), we are satisfied that the delay in filing the appeal was due to reasonable cause. Accordingly, we condone the delay and admit the appeal for re-adjudication on merits. Though, the Department has raised four grounds, however, they are on the solitary issue of deletion of disallowance interest expenses amounting to Rs.47,76,75,486/-.

3. Relevant facts deciding these issues are, the assessee is a resident corporate entity stated to be engaged in the business of trading, producing and mining etc. of coal in India as well as abroad. It is a wholly owned subsidiary of Reliance Power Ltd. a listed company. For the assessment year under dispute, assessee filed its return of income on 11.02.2021 declaring loss of Rs.30,65,50,828/-. The return of income filed by the assessee was selected for scrutiny. In course of assessment proceeding, the Assessing Officer having noticed that the assessee had entered into international transaction with its overseas subsidiary made a reference to the Transfer Pricing Officer (‘TPO’) to determine the Arm’s Length Price (‘ALP’) of such transaction. One of the issues picked up by the Assessing Officer in course of scrutiny assessment proceeding is the interest charged on the loan/fund advanced to its overseas subsidiary at Netherlands, namely, Reliance Power, Netherlands B.V. From the materials available on record, the Assessing Officer noticed that in addition to the outstanding opening balance of advances of Rs.401,21,80,441/- as on 01.04.2019, the assessee had advanced loan of Rs.5,15,81,780/- to the subsidiary in the current year charging interest at the rate of 5%. Whereas, he observed, the assessee had taken loans from M/s Reliance Power Ltd. in the year under consideration as well as in earlier years on applicable interest rate of 15% per annum.

4. Thus, he found that while the assessee has paid interest at the rate of 15% on its borrowings, it had charged interest at the rate of 5% on the loans advanced to the overseas subsidiary. He observed, such lopsided interest rate charged by the assessee has resulted in huge loss to the company. Therefore, he called upon the assessee to explain why a part of the interest expenditure incurred by the assessee should not be disallowed under section (u/s.) 36(1)(iii) of the Act. In response to the show cause notice, the assessee submitted that the applicable rate of interest on bank loan at Netherland is 4%. Therefore, interest charged at the rate of 5% is in terms with the interest rate prevailing in the country of residence of borrower. He further found that in the year under consideration, the assessee had not carried out any business activity in terms with its object. Rather, the assessee is acting as a conduit siphon off the funds at a lower rate of interest to other companies in the group. Thus, based on the aforesaid analysis of facts, the Assessing Officer was of the view that charging of interest at the rate of 5% to the overseas subsidiary as against payment of interest by the assessee at 15% on borrowings is unacceptable. Thus, he was of the view that the assessee had understated interest income to the extent of Rs.47,76,75,486/- by applying the rate of interest of 5%. Accordingly, he disallowed an amount of Rs.47,76,75,486/- out of the interest expenses invoking the provisions of Section 36(1)(iii) of the Act.

5. Assessee contested the aforesaid addition by filing an appeal before learned First Appellate Authority. After considering the submissions of the assessee’s in the context of facts and materials on record, learned First Appellate Authority noted that the assessee’s holding company is primarily engaged in the business of generating electricity not only by itself but through other subsidiaries. The generation of power is cola based and to meet the procurement of coal from Indonesia the holding company through the assessee had advanced money from time to time. For providing loan to the subsidiary at Netherland which in turn made investment in companies set up in Indonesia for procurement of coal. He further found that while the loan transaction between the assessee and its holding company in India were in Indian rupee, the transactions between the assessee and the Netherland based subsidiary was in foreign currency. Even, the repayment of loan by Netherland based subsidiary to assessee is in foreign currency. Learned First Appellate Authority found that assessee is not only deriving interest income but was also deriving gain from fluctuation of foreign exchange as the rupee was rapidly devaluing against Euro. From the details available on record, he found that during the year under consideration the gain on account of foreign exchange fluctuation was Rs.31,61,27,378/-, which was offered to tax. He also found that the assessee had reported similar foreign exchange gain in earlier years also. He further noted that while examining the arm’s length nature of loan transactions between the assessee and its Netherland based subsidiary, the TPO has found the interest rate of 5% charged by the assessee to be within arm’s length requiring no further adjustment. He further noted that the facts and materials on record also established commercial expediency in advancement of loan. Thus, based on the aforesaid analysis of facts learned First Appellate Authority deleted the disallowance of Rs.47,76,75,456/-.

6. Before us, learned Departmental Representative (DR) submitted the assessee is merely a pass through entity without having any business activity. He submitted, while the assessee availed loan from its holding company paying higher rate of interest of 15%, it has charged interest at the lower rate of 5% to its overseas subsidiary on loans advanced. Therefore, there is no commercial expediency in advancement of the loan as the assessee is acting merely as a conduit. He submitted, acceptance of the interest charged by the assessee to be at arm’s length by TPO has no relevance for determining the reasonableness of the expenditure u/s. 36(1)(iii) of the Act. He submitted, whether a particular amount is deductible u/s. 36(1)(iii) of the Act. is to be independently examined by the Assessing Officer keeping in view the commercial expediency, which is absent in the case of the assessee. Thus, he submitted, the addition made by the Assessing Officer should be restored.

7. Per contra, learned counsel appearing for the assessee strongly relied upon the observations of the First Appellate Authority. He submitted, assessee was setup to procure coal from abroad. To facilitate such activity, the assessee had setup a subsidiary in Netherlands which had in turn made investments in Indonesian company for procurement of Coal. He submitted, the assessee had availed loans from its holding company in India currency, whereas, loans advanced to the overseas subsidiary was in foreign currency. He submitted, the prevailing ‘London Inter-Bank Offered’ (LIBOR) rate for foreign currency loan in the country of residence of borrower was between 3% to 4%, whereas the assessee had charged interest at the rate of 5%. He submitted, considering these facts, the TPO has passed a clean order being satisfied with the arm’s length nature of such transaction between the assessee and Netherland based subsidiary. In this context, he drew our attention to order dated 05.01.2021 passed u/s. 92CA(3) of the Act, copy of which is placed at Page 124 of the paper book. Thus, he submitted, once the rate of interest charged by the assessee to the foreign subsidiary was found to be at arm’s length by the TPO, the Assessing Officer cannot disallow a part of the interest expenditure on such loan u/s. 36(1)(iii) of the Act.

8. Without prejudice, he submitted, while disallowing the interest expenditure, the Assessing Officer has completely lost sight of the fact that the assessee had offered substantial income on account of foreign exchange gain arising out of the foreign currency loan advanced to the overseas subsidiary. He further submitted, since the borrowings and advancement of loans are directly linked, the assessee would be entitled to claim the interest expenditure against the interest income. Thus, he submitted, the First Appellate Authority was justified in deleting the disallowance.

9. We have considered rival submissions and perused the materials on record. The dispute between the parties lie within a narrow compass. There is no dispute regarding the fact that the assessee had borrowed funds from its holding company in Indian rupee and advanced loan to its Netherland based subsidiary in foreign currency. While the holding company has charged interest at the rate of 15% on loans advanced to the assessee, the assessee in turn has charged interest at the rate of 5% on the foreign currency loan advanced to its overseas subsidiary. The Assessing Officer was not satisfied with the rate of interest charged by the assessee on the loan advanced to the foreign subsidiary and accordingly had made disallowance u/s. 36(1)(iii) of the Act by charging the interest at par with the rate of interest at which the assessee had availed loan from the holding company i.e. 15%. Undoubtedly, while the assessee has received loan from its holding company in Indian currency, it had advanced loan to the overseas subsidiary in foreign currency. Therefore, the rate of interest as per the judicially accepted principle has to be the rate of interest at which loan is available in the country of residence of the borrower. As per the facts brought on record, the LIBOR rate of interest of loan advanced by banks in the country of residence of overseas subsidiary is between 3 to 4%. Whereas, the assessee had charged interest at the rate of 5%, which is higher than the LIBOR rate. It is a fact on record that the loan transaction between the assessee and overseas subsidiary as also the arm’s length nature interest charged on such loan was examined by the TPO on a reference made by the Assessing Officer. After examining the issue in detail, the TPO, in the order referred to above, has held as under:

“5.1 Interest received on loan given:

After going through assessee’s submissions and facts of the case, the value of assessen’s international transactions with respect to interest received on the loan given is accepted to be arm’s length price, and therefore no adjustment is being proposed on this issue during this year.”

10. Thus, once the TPO being a part of the Income Tax Department has accepted the arm’s length nature of loan transaction, the Assessing Officer cannot doubt the reasonableness of rate of interest as also the commercial expediency. The observations of the Assessing Officer itself reveal that the assessee had entered such loan transaction with the overseas subsidiary in earlier assessment years. Whereas, there is no history of such disallowance being made by the Assessing Officer in any earlier year. One more crucial factor which cannot be lost sight of is, since the loan was advanced in foreign currency, due to fluctuation in exchange rate on account of devaluation of rupee, the assessee had earned substantial foreign exchange gain, which has been offered as income. Learned First Appellate Authority has given a categorical finding that such gain had also accrued in earlier assessment years and offered to tax. Thus, keeping in view the fact that in addition to the interest income of Rs.23,88,37,743/-, the assessee had earned exchange gain of Rs.31,61,21,378/-, the Assessing Officer’s allegation that charging of interest at the rate of 5% has resulted in huge loss to the assessee cannot be accepted. Even otherwise also, apart from making general observations, the Assessing Officer has failed to establish on record that the loan transaction between the assessee and its overseas subsidiary lacks commercial expediency. More so, when the AO expect making disallowance u/s. 36(1)(iii) of the Act and a small addition of Rs.4,70,368/- on account of provident fund has not tinkered with any other part of return of income. In any case of the matter, when there is a direct link between the borrowings made by the assessee and the loans advanced by the assessee to the foreign subsidiary, the interest expenditure has to be set off against interest income. In view of the aforesaid, we are inclined to uphold the decision of learned First Appellate Authority in deleting the disallowance. Grounds are dismissed.

11. In the result, appeal is dismissed.