Disallowance of Interest and Cash Credit Addition on Partners’ Capital Held Unsustainable Due to Sufficient Interest-Free Funds and Accounting Misconception

ORDER

Prakash, Accountant Member. – This appeal by the Assessee is directed against the order of the learned Commissioner of Income Tax (Appeals) [hereinafter referred to as “the learned CIT(A)”] dated 29.01.2026 arising out of the assessment order dated 23.12.2019 passed by the Assessing Officer (hereinafter referred to as “the AO”) under section 143(3) of the Income Tax Act, 1961 (hereinafter referred to as “the Act”) for the assessment year 2017-18.

2. The grounds of appeal raised by the Assessee before us in the memorandum of appeal in Form No. 36 read as under:

“1. That the Ld. CIT (A), NFAC, has erred seriously in dismissing the appeal by not considering the reply of the assessee.

2. That on the facts and in the circumstances of the case, the Ld. CIT (Appeals) has erred in law and on facts in sustaining the action of the Ld. Assessing Officer in making disallowance of Rs. 12,92,111 out of interest expenses claimed u/s 36(1)(iii) of the Income Tax Act 1961.

3. That on the facts and in the circumstances of the case, the Ld. CIT (Appeals) has erred in law and on facts in sustaining the action of the Ld. Assessing Officer in making addition of Rs. 66,26,524/- being Net Profit as declared in the Profit and Loss Account on the allegation that the appellant was mandatorily required to charge depreciation in its books,

4. That the appellant craves leave to add, amend, alter, withdraw any of the grounds of appeal before hearing.”

3. Briefly stated, the facts of the case are that the assessee is a partnership firm engaged in the business of working as a contractor for excavating chrome ore from the mines of Ferro Alloys Corp. Ltd., Bhadrak, Orissa. For the year under consideration, the assessee filed its return of income on 24.10.2017 declaring a loss of Rs. 43,04,518. The case was selected for scrutiny and the AO completed the assessment under section 143(3) of the Act on 23.12.2019 at a total income of Rs. 40,05,650 after making three additions, namely, (i) Rs. 3,91,534 on account of delayed deposit of the employees’ contribution to provident fund and employees’ state insurance under section 36(1)(va) of the Act, (ii) Rs. 12,92,111 by way of proportionate disallowance of interest under section 36(1)(iii) of the Act and (iii) Rs. 66,26,524 under section 68 of the Act in respect of the book profit credited to the capital accounts of the partners. The CIT(A) confirmed all the three additions and dismissed the appeal. Before us, the assessee has assailed only the disallowance of Rs. 12,92,111 and the addition of Rs. 66,26,524, the disallowance made under section 36(1)(va) of the Act having not been agitated.

4. Ground No. 1 and Ground No. 4 are general in nature and do not call for any separate adjudication. We, therefore, proceed to decide Ground No. 2 and Ground No. 3.

5. Ground No. 2 relates to the disallowance of Rs. 12,92,111 out of interest expenditure under section 36(1)(iii) of the Act. The AO noticed from the balance sheet as on 31.03.2017 that the assessee had shown loans and advances of Rs. 1,12,03,428 on the assets side while it had claimed interest expenditure of Rs. 54,99,632 on secured and unsecured loans. On examination, the AO found that the assessee had extended interest free advances aggregating to Rs. 1,07,67,596, the particulars whereof are that a sum of Rs. 85,00,000 was advanced to Aditya PropconPvt. Ltd., Rs. 12,65,000 to Shri Ashish Kumar Pati, Rs. 1,00,000 to Shri Mruthunjay Mohanty and Rs. 9,02,596 to Shri Sibananda Pradhan. Holding that the assessee had not established the business purpose or the commercial expediency of these advances, the AO worked out interest at the rate of 12 percent on the said sum and disallowed the same. The relevant finding of the AO in paragraph 4.7 of the assessment order reads as under:

“Based on the above discussed facts, interest expenses to the extent of Rs. 12,92,111/-(i.e 12% on total 1,07,67,596/-) are not allowable expenses and accordingly added to the total income of the assessee and taxed in its hands accordingly.”

6. Before the CIT(A), the assessee submitted that it had substantial interest free funds in the form of partners’ capital which stood at Rs. 8,57,50,609 as per the balance sheet and that no interest was paid on such capital, and therefore the advances in question were made out of interest free funds. The CIT(A) was not persuaded and confirmed the disallowance by holding as under:

“In view of the above facts and circumstances, it is held that the appellant has failed to substantiate the allowability of interest expenditure relatable to such advances. Accordingly, the disallowance of Rs. 12,92,111/- made by the Ld. AO is found to be justified and is confirmed, and Ground No. 2 is dismissed.”

7. Before us, the learned Authorised Representative (hereinafter referred to as “the learned AR”) reiterated the submissions made before the lower authorities. He submitted that the interest free funds available with the assessee in the form of partners’ capital were many times the interest free advances and that the AO had not brought on record any material to show that the borrowed funds had been diverted towards these advances. The learned Departmental Representative (hereinafter referred to as “the learned DR”), on the other hand, supported the orders of the authorities below highlighting that the amount is lent to a related party.

8. We have heard both the parties and perused the material available on record. The facts are not in dispute. The audited balance sheet of the assessee as on 31.03.2017 shows the capital account of the partners at Rs. 8,57,50,609 as against secured loans of Rs. 28,74,818 and unsecured loans of Rs. 4,71,08,413. The interest free advances on which the AO has computed notional interest aggregate to Rs. 1,07,67,596. The interest free funds available with the assessee are thus nearly eight times the interest free advances and they also exceed the entire quantum of the borrowed funds. Nothing has been brought on record by the AO to demonstrate that any part of the borrowed funds was diverted towards these advances.

9. The law on the subject is well settled. Where an assessee has mixed funds and the interest free funds available with it are larger than the interest free advances made by it, a presumption arises that the advances were made out of the interest free funds and not out of the borrowed funds. In Hero Cycles (P.) Ltd. v. CIT (Central) 379 ITR 347 (SC), the Hon’ble Supreme Court, while dealing with a similar disallowance, held in paragraph 16 as under:

“16. Insofar as the loans to Directors are concerned, it could not be disputed by the Revenue that the assessee had a credit balance in the Bank account when the said advance of Rs. 34 lakhs was given. Remarkably, as observed by the CIT (Appeal) in his order, the company had reserve/surplus to the tune of almost 15 crores and, therefore, the assessee company could in any case, utilise those funds for giving advance to its Directors.”

10. The same principle has been applied by the Coordinate Bench of this Tribunal in Allen Career Institute v. Jt. CIT [2023] 147  (Jaipur – Trib.), wherein it has been observed in paragraph 3.6 as under:

“At the outset, it is observed that the law is well settled that where assessee is having mixed i.e. interest free/interest bearing funds both, but the interest free funds are larger than the interest free advances than there will be a presumption that the interest free advances were given out of the interest free funds (but not out of interest bearing fund/OD) and hence, no interest can be disallowed.”

11. In the present case, the presumption that flows from the above judicial pronouncements operates squarely in favour of the assessee. Once the assessee demonstrated the availability of interest free funds far in excess of the interest free advances, the onus shifted to the AO to establish a nexus between the interest bearing borrowings and the interest free advances. The AO has not discharged that onus. He has neither identified any particular borrowing out of which the advances are said to have been made nor traced the movement of any borrowed fund into these advances. In the absence of such a nexus, the disallowance rests only on the coexistence of borrowings and interest free advances in the balance sheet, which by itself is not a permissible basis for a disallowance under section 36(1)(iii) of the Act. The CIT(A) has confirmed the disallowance by casting the entire onus on the assessee, which approach runs contrary to the ratio of Hero Cycles (P.) Ltd. (supra) and Allen Career Institute (supra).

12. In view of the above discussion, we hold that the disallowance of Rs. 12,92,111 made under section 36(1)(iii) of the Act is not sustainable in law. The same is directed to be deleted. Ground No. 2 is accordingly allowed.

13. Ground No. 3 relates to the addition of Rs. 66,26,524 made under section 68 of the Act. The assessee had disclosed a net profit of Rs. 66,26,524 in its Profit and Loss Account and had credited the same to the capital accounts of the partners in their profit sharing ratio. In the computation of income, the assessee claimed depreciation of Rs. 1,26,52,410 under section 32 of the Act and, after other adjustments, returned a loss of Rs. 43,04,518. The AO took the view that depreciation ought to have been charged in the books of account itself and that, on charging depreciation, the firm had in fact incurred a loss, with the result that the profit credited to the capital accounts of the partners was not explained. The AO recorded his finding in paragraph 5.5 of the assessment order as under:

“Since, the firm has incurred loss therefore, the profit credited in the partner’s capital account to the extent of Rs. 66,26,524/- are not allowable. The assessee has wrongly credited the profit in partner’s capital account despite having sustained loss in the year under consideration. The assessee has not debited the depreciation in its profit & loss account contravening the provisions of IT Act just to credit the profit in the hands of partners to increase their capital which was resulted in increase of capital of the assessee firm. This entire exercise was made by the assessee firm to generate exempt income in the hands of the partners and increase their capital in the firm. Thus, the share increase in the capital of the partners to the extent of Rs. 66,26,524/- is hereby treated as unexplained cash credit and added to the total income of the firm u/s 68 of the IT Act and taxed in its hands in accordance with the provisions of section 115BBE of the IT Act.”

14. The CIT(A) confirmed the addition. In his findings on Ground No. 3 he held as under:

“Further, the appellant has also not furnished any reconciliation or working to demonstrate how the amount of Rs. 66,26,524/- credited to the partners’ capital accounts correlates with the profits computed under the Act after considering allowable depreciation. Thus, the nature and correctness of the credits appearing in the partners’ capital accounts remain unexplained on record.

Moreover, the profit required for computing remuneration must be as per books, which includes allocation of wear and tear of fixed assets as well, which is nothing but in form of depreciation as per applicable accounting principles. Therefore, the contention of appellant are not found to be acceptable. It very well leads to artificially increase in book profit considered in computation of partner remuneration.”

15. Before us, the learned AR submitted that the sum of Rs. 66,26,524 is nothing but the book profit of the firm disclosed in its audited Profit and Loss Account, which stood appropriated to the partners in their profit sharing ratio. He submitted that such an appropriation of the firm’s own disclosed profit is not a credit of which the nature and source require to be explained, that depreciation under section 32 of the Act is an allowance claimed in the computation of total income and not an entry which the Act obliges an assessee to make in its books, and that the entire figure stands reflected in the return of income filed by the assessee. The learned DR relied upon the orders of the authorities below and submitted that in the absence of depreciation being charged in the books of account the credits appearing in the capital accounts of the partners remained unexplained.

16. We have heard both the parties and perused the material available on record. Section 68 of the Act, in so far as it is material for the present purpose, reads as under:

“68. Where any sum is found credited in the books of an assessee maintained for any previous year, and the assessee offers no explanation about the nature and source thereof or the explanation offered by him is not, in the opinion of the Assessing Officer, satisfactory, the sum so credited may be charged to income-tax as the income of the assessee of that previous year:”

17. The provisos to the section deal with share application money, share capital and share premium credited in the books of a closely held company and with sums credited by way of loan or borrowing, and they have no application to the facts before us. Shorn of the provisos, the section requires the concurrent presence of three elements before it can be invoked.

18. If any one of these elements is missing, the section is not attracted at all. The section is essentially intended to enable an unexplained receipt appearing in the books to be assessed as the income of the assessee. It does not create a charge on an amount which is already the disclosed income of the assessee, nor does it clothe the AO with authority to recast the accounting treatment adopted by an assessee.

19. Judged by that test, the very first requirement is not satisfied in the present case. The sum of Rs. 66,26,524 is not a sum received by the assessee from any person or credited in its books. It is the net profit disclosed by the firm’s own Profit and Loss Account. In the system of double entry in which the books are written, the credit appearing in the capital accounts of the partners has as its counterpart a debit to the Profit and Loss Account and not a debit to cash, to bank or to any asset. The entry therefore does not record the receipt of any money or of any thing of value by the firm. It records only the appropriation, among the persons entitled to it, of a profit which the accounts have already disclosed. A credit of that description does not answer the description of a sum credited whose nature and source call for explanation, for the simple reason that nothing has come into the firm by reason of the entry.

20. Even if the matter is tested on the touchstone of nature and source, the explanation stands furnished on the face of the record. The nature of the credit is the book profit of the firm for the year under consideration. Its source is the business receipts of the year, which are recorded in the books of account, are supported by the audited financial statements and were placed before the AO in the course of the assessment proceedings. The AO has not doubted the turnover disclosed by the assessee, nor has he disputed any item of receipt or of expenditure appearing in the Profit and Loss Account. Having accepted the receipts and the expenditure out of which the figure of Rs. 66,26,524 emerged, he could not treat the resultant profit as a sum of unknown origin. There is no unidentified creditor in the picture and there is no unexplained inflow of money which requires to be traced to its source.

21. The finding recorded by the AO is itself destructive of the addition. He states in terms that the amount represents the profit credited in the capital accounts of the partners. Once the AO has himself identified the sum as the profit of the firm, the nature and the source of the credit stand determined by his own finding and nothing survives to be explained.

22. The addition also produces a result which the Act does not countenance. The computation of income filed along with the return, which the AO has himself extracted in paragraph 5.1 of the assessment order, begins with the net profit of Rs. 66,26,524 as per the Profit and Loss Account. To that figure items aggregating to Rs. 17,21,368 held to be inadmissible were added, and from the resulting sum of Rs. 83,47,892 the depreciation of Rs. 1,26,52,410 allowable under the Act was reduced, yielding the returned loss of Rs. 43,04,518. The AO accepted that computation as his starting point and proceeded to make the three additions referred to in paragraph 3 above. The consequence is that the same sum of Rs. 66,26,524 has been brought to tax twice over, once as the opening figure in the computation of the business income of the assessee and again as a cash credit under section 68 of the Act, the latter carrying with it the rigours of section 115BBE of the Act. Taxation of the same amount twice in the same assessment is not permissible, and an interpretation of section 68 of the Act which brings about such a result cannot be accepted.

23. If the AO was of the view that the book profit so arrived at by the assessee had a bearing on some other computation under the Act, the remedy, if any, lay in making the appropriate disallowance under the provision governing that computation. No such disallowance has been made in the assessment order and no such question arises for our consideration.

24. As regards the reasons which weighed with the CIT(A), we may observe that the depreciation of Rs. 1,26,52,410 was allowed by the AO himself and was never disturbed by him at any stage, so that the correctness of the depreciation claim was not in issue. The reconciliation which the CIT(A) found wanting is apparent on the face of the computation of income which formed part of the return and which stands extracted in paragraph 5.1 of the assessment order. His further observation touching the computation of remuneration payable to the partners does not carry the matter any further, because no disallowance of remuneration has been made and no such issue arises before us. In any event, the absence of a reconciliation, even if it were assumed to exist, could not supply the ingredients of section 68 of the Act where those ingredients are otherwise wanting.

25. For all the foregoing reasons, we hold that the ingredients of section 68 of the Act are not attracted to the credit of Rs. 66,26,524 appearing in the capital accounts of the partners, and that the addition made under that section is not sustainable in law. The same is directed to be deleted. Ground No. 3 is accordingly allowed.

26. In the result, the appeal filed by the Assessee is allowed.