Regal Theatre vs Commissioner Of Income-Tax
1996 Latest Caselaw 1035 Del

JUDGMENT

M. Jagannadha Rao, J.

 (1) This is a reference under Section 256 of the Income Tax Act,1961 by the Income Tax Appellate Tribunal (Delhi Bench) in respect of the assessment-year 1973-74 for which the relevant previous year ended on 31.10.1972. The question referred is as follows:    "WHETHER,on the facts and in the circumstances of the case, the Tribunal was legally correct in holding that a part of the borrowing had been directed by the assessee to its non-business purposes and that the assessee is not entitled to claim interest on those borrowings under Section 36(1)(iii) of the Income Tax Act,1961?"  

(2) The petitioner is a partnership concern running a cinema called Regal Theatre in Delhi as also a restaurant. The dispute relates to disallowance of deduction towards interest in a sum of Rs. 23,166 out of a total claim for interest-deduction in a sum of Rs.26,108.   

(3) The Income-tax Officer in his order dated 20.10.73 noticed that the return filed by the assessee was of income of Rs. 2,67,617 and assessed the firm to a net income of Rs.1,90,741 and demanded a tax of Rs.64,442.   

(4) In regard to claim for deduction towards interest in a total amount of Rs. 26,108, the Officer observed that deduction in a sum of Rs. 23,166 be disallowed. He found that the partner's account showed debit balances. The assessee was asked to explain as to why interest on debit balances from the partners' had not been charged. It was explained that originally a loan was taken in order to purchase the machinery etc. and that there were debit balances because of depreciation allowed in earlier years on the fixed assets. It was explained that according to the terms of the agreement amongst the partners, no interest was to be charged on the debit balance. The Officer rejected the contention on the ground that (i) the fixed assets get depreciated and they were rightly reduced to the extent the depreciation was allowed (ii) the assessee should have returned loans to the creditors instead of permitting partners to draw excess money in their account. Under those circumstances, noting that the assessee had been paying interest at 12% on borrowed money, he calculated 12% interest on the average debit balances in the capital account and he arrived at Rs. 23,166 as interest which could not be deducted from the net income.

(5) In the appeal, the Appellate Assistant Commissioner of Income-tax in his order dated 2.8.74, after a very elaborate discussion of the facts and law, partly allowed the appeal. He held that the partners had overdrawn in the assessment years 65-66,66-67 and 67-68 and thereafter w.e.f. assessment year 68-69, the withdrawals were less than their capital with the firm. Only withdrawals over and above their capital would amount to diversion of capital for non-business purposes to the extent they are covered by the borrowing made by the firm. After referring to the borrowings during 1965-66 to 73-74, he held that loans amounting Rs.2,43,140 were made by the appellant, that the investment in fixed assets amounted to Rs.2,15,985 only. This showed their total loans were not invested in fixed assets. At the close of the accounting period relevant to the assessment year 65-66, the partners had overdrawn to the extent of Rs. 39,367 and this represented the diversion of loans for non-business purposes. The position for 66-67,67-68, were similarly computed. On those facts, he held that the fresh loans of Rs. 3650 were diverted for non-business purposes. In the assessment years for 68-69,69-70, there was no fresh loans taken and no question of diversion of loans arose. In 1970-71,71-72,72-73 and 73-74, fresh loans taken amounted to Rs.57,428, Rs,18,500, Rs.3610 and Rs. 50,790 respectively. The capital of the partners in the assessment years 70-71,71-72,72-73 and 73- 74 was in excess of the withdrawals since the partners did not draw over and above their capital in those assessment years, and therefore, he held that there was no diversion of loans for non-business purposes. He worked out that, on the whole, the loans diverted for non-business purposes were only in a sum of Rs. 43,017. The interest rate of 12% on the amount of Rs.43,017 worked out to about Rs.5000.00 . He allowed deduction for the balance interest amount of Rs,18,166.

(6) The Income-tax Appellate Tribunal, in its order dated 31.5.1976, partly allowed the appeal of the department. It summarised the order of the appellate Assistant Commissioner in para 5 of its order, and referred to the contentions of the department in para 6 and held that the appellate authority was in error. It referred to Roy A.Roulke's Practical Financial Statement Analysis (6th Ed) and observed that the partners of a business were entitled to share only the profits of the business, that the concept of "profit" was quite different from the concept of "funds" at the disposal of the concern, that profit in a commercial sense could be arrived at only after all the outgoings were adjusted against gross receipts and that the depreciation, though not payable in cash immediately, was one of such outgoings. Fixed asset depreciates over a number of years at the end of which it requires replacement. One of the methods of replacement is by debiting the profit and loss account of each year with certain percentage of its value. The Tribunal observed that corresponding credit is given either to a separate fund or by making adjustment in the value of the asset itself, and that it would be incorrect to say that profits of a business could be arrived at without charging the depreciation to the profit and loss account of that year. Such a procedure would be contrary to the established principles of accountancy. The partners would,therefore, not be entitled to a share in the inflated figure if arrived at without charging the depreciation. It was the admitted position before the Tribunal that there was no excess charge of depreciation in either of the years than what was permissible in law. Once that position was accepted, the profits could not be increased to the extent of the amount of depreciation charged in the profit and loss account of various years and those profits could be utilised or withdrawn by the partners for their personal purpose. On the aforesaid reasoning, the Tribunal rejected the contention of the assessee that the accounts of the partners showed a credit balance in the year of assessment, and the Tribunal agreed with the Ito that a major part of the borrowing had been diverted by the assessee firm to its non business purpose and the assessee,therefore, was not entitled to claim deduction of interest on those borrowings under Section 36(1)(iii) of the Act. The Tribunal further agreed with the appellate authority that the current profits would also not be held to be available to the assessee. Though current profits could not be held to be available to the assess that aspect lost significance inasmuch as the Ito had worked out the disallowable amount of interest only at the end of the assessment year under appeal after the accounts had been adjusted and the current amount of debit to the account of the partners had been found. The Tribunal,therefore, restored the addition made by the Ito subject to its adjustment with reference to the correct amount of debit balance to the accounts of the partners which should be taken as Rs. 1,73,645 instead of Rs. 1,93,049 as calculated by the ITO. The Income Tax officer was directed to recalculate the disallowed amount of interest on the above basis. Consequently, the cross-objections of the assessee were also rejected. This was the order of the Appellate Tribunal.

(7) In this reference it has been contended for the assessee that the view taken by the Tribunal was not sustainable in law. Counsel contended that there could be no dispute that correct profits could be computed only after the debit of depreciation was made. But merely because the amount of profit was to be determined by reducing the amount of depreciation, it could not be said that the monies borrowed had not been borrowed for the purpose of business or were diverted to the partners for non business purposes. The Tribunal was wrong when it said that the monies borrowed could be regarded in law to have been diverted for non business purposes where, as a result of debit of depreciation on a notional basis, the debits of the partners increased.

(8) Learned counsel for the assessee gave a simple example for the purpose to understanding the real issue involved in this case, which according to us, is very apt in the circumstances.

(9) Let us assume that "A" an Advocate in the course of his profession borrowed Rs.500.00 and invested the same in the purchase of his office equipments and on such investment the depreciation he would get is Rs.15 in a year. On the above amount borrowed, let us assume he is paying interest of Rs.20 per year. If his annual income is Rs.100, then income after depreciation would be Rs.85. If he withdrew the entire available cash amount of Rs.100 as profit in that year, could it be said that the interest paid on the monies borrowed became not allowable only for the reason that the net income after depreciation was Rs.85, whereas the withdrawal was Rs.100 ? If it is admitted that the borrowal of Rs. 500 was invested in the business for the purpose of profession, and the income before depreciation was Rs.100, then if he had not drawn any amount above Rs. 100, the interest amount of Rs.20 accruing on the borrowing of Rs.500 invested in business, should be allowed as a deduction.

(10) In our view, the above illustration is very apt. It will be noticed that the assessee borrowed Rs. 500 and claimed deduction for interest on the said borrowal at the rate of Rs.20 per year. For the purpose of deciding the said question the consideration would be whether there was a borrowal of Rs.500, and whether the said amount was invested for purposes of business, and interest on borrowal was repaid in the financial year and claimed as a deduction. If his net income before depreciation was Rs.100, he could as a matter of fact withdraw the entire available amount of Rs.100, and not merely Rs. 85.00 . Withdrawal above Rs. 85.00 and upto Rs.100.00 cannot be treated a diversion of capital. It cannot be said that out of withdrawal of Rs.100 available in that year towards profit, Rs. 15 was to be treated as a diversion for non business purposes. That, in our view, is the correct position in law.

(11) Under Section 36(i)(iii) of the Income Tax Act,1961 it is provided as follows:-    "36- Other deductions .- (1) The deductions provided for in the following clauses shall be allowed in respect of the matters dealt with therein, in computing the income referred to in Section 28 - (i) ... ... ... (ia) ... ... ... (ib) ... ... ... (ii) ... ... ... (iii) the amount of the interest paid in respect of capital borrowed for the purposes of the business or profession."  

(12) Conditions for getting deduction in respect of interest are (i) money must have been borrowed by the assessee, (ii) it must have been borrowed for the purpose of business, and (iii) the assessee must have paid interest on the said amount and claimed it as a deduction. See Madhav Prasad vs. Income Tax Commissioner ((1979) Vol.118 Itr 200 ((208).   

(13) Learned counsel for the assessee also referred to Commissioner of Income Tax, Bombay City-II, Bombay vs. Bombay Samachar Limited,Bombay (1969 (Vol.74) Itr 723 at 731 D.B. Bombay).   

(14) In the Bombay case it was not disputed before them that the amount borrowed from outsiders on which interest had been paid, had been used for the purpose of business of the assessee. The Ito thought that if the assessee had collected the outstandings which were due to it from others, the assessee would have been able to reduce its indebtedness and thus save a part of the interest which it had to pay on its own borrowings and,therefore, the assessee would not be justified in allowing its outstandings to remain without charging any interest thereon while it was paying interest on the amounts borrowed by it, and therefore to the extent to which it would have been in a position to collect interest on the outstandings due to it from others, it could not be permitted to claim as an allowance interest paid by it to outsiders. The learned Judges held that the view taken by the Ito was unsustainable, that as had been pointed out by the Madhya pradesh High Court in Ram Kishan Oil Mills vs. Commissioner of Income Tax (1965) 56 Itr 186, the only conditions required to be satisfied in order to enable the assessee to claim deduction in respect of interest under Section 10(2)(iii) were firstly that the money must have been borrowed by the assessee; secondly, it must have been borrowed for the purpose of business, and thirdly, the assessee must have paid interest on the said amount and claimed it as a deduction. It is not the requirement of the law that the assessee must further show that the borrowing of the capital was necessary for the business so that if at the time of borrowing the assessee had sufficient amount of its own, the deduction could not be allowed. Learned Judges also relied upon a Judgment of the Madras High Court in Amna Bai Hajee Issa vs. Commissioner of Income Tax (1964) 51 I.T.R. 835) which held that in deciding whether a claim for interest on borrowing could be allowed, the fact that the assessee had ample resources at its disposal and need not have borrowed, was not a relevant matter for consideration. The question to be decided was whether the amount of interest was paid in fact on the capital borrowed for the business.

(15) It may also be noticed that in the Supreme Court decision in Madhav Prasad vs. Income Tax Commissioner (1979 (Vol.118) Itr 200, already referred to, their Lordships distinguished the decision of the Bombay High Court in Bombay Samachar case (supra) on the ground that that case did not touch the issue raised before them but did not think that the Bombay case was wrongly decided.

(16) The above principles of law do not, in our opinion, go against the principle that the net profit must be calculated after giving allowance to the depreciation. Nor do they contradict the view that interest can be disallowed if the borrowed funds are used for non-business purposes.

(17) Learned counsel for the respondent has contended that the High Court cannot go against the opinion of the Tribunal, nor go behind the facts mentioned by the Tribunal, nor disturb any findings of fact arrived at by the Tribunal. We are of the view that the question is one purely of law as to the conditions required by Section 36(1)(iii) of the Income Tax Act and has been referred to us for a decision by the Tribunal. While dealing with the question, we have not disturbed any findings of fact arrived at by the Tribunal. The contention that the Tribunal had given a finding of fact that a part of the borrowings had been diverted by the assessee to its non business purposes is in our opinion not a finding of fact, but was an inference drawn by the Tribunal on the basis that the interest paid on the capital borrowed was not in law an allowable deduction from the profit in case the profit minus depreciation was in excess of the withdrawals made by the partners and in such a case, the withdrawals should be deemed to be in part from the capital account and would mean that the original borrowing was utilised for other purposes and not for business purposes. The finding of the Tribunal in this behalf is purely an inference in law. It ignores the law laid down by the Supreme Court and in the Bombay case that once the three conditions laid down there are satisfied, the deduction under Section 36(1)(iii) must be given. Again the contention that the correct amount of debit balance to the account of the partners should be taken as Rs.1,,73,643 instead of Rs. 1,93,049 as calculated by the Ito is again a figure arrived at as a matter of law.

(18) For the aforesaid reasons, we answer the reference in favour of the assessee and that the Tribunal was not legally correct in holding that a part of the borrowing had been directed by the assessee for its non-business purposes. We also opine that the assessee was not disentitled to claim the interest on those borrowings under Section 36(1)(iii) of the Income Tax Act. Reference is disposed of accordingly.