By TIOL News Service

JAIPUR, JULY 30, 2015: THE issue before the Bench is - Whether when assessee pays interest on interest, deduction for such sum is not allowable as per provisions of Sec 36(1)(iii). YES is the verdict.

Facts of the case

The assessee is an individual. A return declaring income of Rs.38,590/- was filed alongwith the statement of total income, copies of trading and P/L account, balance-sheet and its annexures. The audit report was also filed u/s 44AB. The assessee had not submitted satisfactory explanation on the claim for deduction of interest of Rs.3,82,187/-. AO observed that the assessee had claimed interest, however, he failed to give break up of interest attributable to interest on interest and the interest attributable to original Principal. From the accounts it was seen that the amounts more than the principal loan stand repaid, therefore, the credit balance represents only cumulative interest on interest for the past so many years, therefore, the interest liability claimed was wholly referable to interest on interest. Since interest amounting to Rs.14985/- had already been disallowed on ingenuine credits, the balance amount of Rs.3,67,202/- was disallowed.

On appeal, the Appellate Authority, partly allowed the appeal of the assessee on the claim of interest on the ground that the provisions of Section 36(1)(iii) and Section 37(1) entitle such deduction; the AO was not justified in disallowing the claim and in adding the interest on interest. On further appeal, Tribunal had dismissed the same and observed that the right to interest on interest was recognized in CIT Vs. Narendra Doshi - 2002-TIOL-561-SC-IT-LB in the case of SC. Although this interest was to be charged on the refund amount in relation to Sec.214, in our opinion the AO disallowed this claim of the assessee as according to him the assess was not entitled to deduction in respect of interest on interest, and that the assessee was not able to compute the element of interest on interest included in the total claim of Rs.3,82,187. But AO had nowhere refuted the claim of the assessee that the assessee had utilized the borrowed fund only for the purpose of business. When the interest was paid on the interest, the same became allowable u/s 36(1)(iii) and Sec.37(1). The facts of the SC's decision and the Gujarat HC decision relied by AO were not relevant because in whose cases only computation of income from house property and income from other sources were in question.

Held that,

++ the Gujarat HC in Jaswantrai P.Mehta V/s CIT ((1992) 61 Taxman 71 (Guj.)) with reference to Section 57(iii) held that the interest paid on account of failure to pay interest for preceding year cannot be considered as expenditure laid out or expended wholly or exclusively for purpose of making or earning income. The Bombay High Court in CIT V/s Hindustan Conductors (P) Ltd. ((2000) 108 Taxman 258 (Bom.) considered the same question with respect of allowability of the interest on interest u/s 36(1)(iii) and held that that in the normal course the ITO cannot disallow any part of the interest on the ground that the rate of interest is high but that does not mean that he has to allow anything and everything claimed by the assessee as interest on amounts borrowed, even if he finds that in fact all that has been paid is not 'interest'. As the essence of interest is that it is a payment which becomes due because the creditor has not had his money at the due date. It may be regarded either as representing the profit he might have made if he had use of the money, or conversely, the loss he suffered because he had not that use. The general idea is that he is entitled to compensation for the deprivation. (per Lord Wright in Riches v. Westminister Bank Ltd. [1947] AC 390 at 396, 398 HL). It is only interest in the above sense which is deductible u/s 36(1) (iii). If in the garb of interest something more is paid over and above 'interest', that something cannot be allowed as deduction under this section. It will not be correct to say that once a claim is made for deduction of any amount by way of interest on the amount borrowed for the purpose of business, the ITO has no power even to examine whether the amount claimed as 'interest' is really an interest, wholly or in part, and if he finds that it is not wholly interest to ascertain that part of it which is interest and restrict the allowance of deduction u/s 36(1)(iii) only to that part which represents interest and to disallow the balance. In our opinion, u/s 36(1)(iii),the assessee is entitled to deduction only of that part of the amount paid by him for money borrowed which can genuinely be regarded as interest. Any and every payment in the garb of interest in excess of what can really be termed as 'interest' cannot be allowed as a deduction under that section;

++ in the present case, the assessee had failed to give break up of the interest attributable to interest on interest and the interest attributable to original principal. It was seen from the accounts that the amounts more than the principal loan stood repaid. The credit balance represented only cumulative interest on interest for the past so many years and therefore, the AO held that the interest liability claimed is wholly referable to interest, which is not permissible u/s 36(1)(iii). The deduction of interest claimed was thus not attributable directly to business. We do not find that the Appellate Authority and the ITAT have given sufficient and cogent reasons in holding that the assessee is entitled to deduction under section 36(1)(iii) and Section 37(1). The ITAT has relied on the judgment of the SC in CIT V/s Narendra Doshi 2002-TIOL-561-SC-IT-LB, which was related to the issue of interest to be charged on the refund amount and not interest on interest. Section 37(1) is not applicable in view of specific Section 36(1)(iii) under which the assessee could have claimed the amount of interest and which provides that the amount of interest paid in respect of capital borrowed for the purposes of the business or profession, can be claimed as permissible deduction. Interest on interest is payable either on default contemplated under the agreement or by way of penalty or the amount shown in the account books to be paid for the settlement of the account. In either of the case, it is not deductible as the assessee is in default. Further, we are of the view that interest on interest cannot be said to be a benefit extended in carrying on the business. It is an element of default, which attracts the interest by way of penalty and which is not permissible deduction. In the present case, there is an additional feature that assessee failed to explain the amount which was claimed to be deducted u/s 36(1)(iii). It was found that the entire capital was paid and what was remaining in the account was interest on which the interest was shown and which was sought to be deducted. The AO was not satisfied with the genuineness of the entry. He observed that since the interest amounting to Rs.1,49,85/- has already been disallowed on ingenuine credits, the balance amount was also disallowed. He had rightly relied on the judgment of SC in Shew Kissen Bhatter V/s CIT, West Bengal and judgment of Gujarat HC in Jaswantrai P.Mehta V/s CIT. In view of the aforesaid discussion, the question is returned in favour of the Department and against the assessee. The Department will proceed accordingly.

(See 2015-TIOL-1722-HC-RAJ-IT)