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Ascertaining amount of borrowed capital used for financing non-business advances must necessarily precede disallowance of interest expenditure: ITAT

2019-TIOL-1543-ITAT-AMRITSAR

IN THE INCOME TAX APPELLATE TRIBUNAL
BENCH, AMRITSAR

ITA No.97/Asr/2017
Assessment Year: 2012-13

SUNIL GROVER
PROP J S GROVER STONE CRUSHER
G T ROAD, MALIKPUR, PATHANKOT
PAN NO: ABFPG0019B

Vs

ASSISTANT COMMISSIONER OF INCOME TAX
CIRCLE-VI, PATHANKOT

Sanjay Arora, AM & N K Choudhry, JM

Date of Hearing: January 24, 2019
Date of Decision: March 20, 2019

Appellant Rep by: Sh P N Arora, Adv.
Respondent Rep by:
 Sh Charan Dass, DR

Income Tax – Section 36(1)(iii).

Keywords – Disallowance of interest expenditure – Sufficient interest-free funds.

THE assessee, a firm in stone crushing and transport business, filed its return for relevant AY. During assessment proceedings, AO noted that assessee had advanced Rs. 15.48 lacs during the year to one, Shikha Grover, daughter of the assessee who, along with some other members of the family, had already been advanced Rs. 25.50 lacs during an earlier year/s, including Rs. 7.50 lacs to her. The purpose of the advance was clearly personal in nature. The non-business user of the capital to that extent was not disputed; in fact, admitted. The AO made disallowance of the interest expenditure. On appeal, CIT(A) partly upheld the order of AO. The assessee’s argument before Tribunal was that no disallowance, nevertheless, could yet be made for the current year qua an advance made during a preceding year. Similar disallowance made for the preceding year stands deleted by the first appellate authority on the basis that the assessee had sufficient interest-free funds. The same had not been appealed against by the Revenue, so that it had attained finality. As regards the advance/s made during the current year, the same would stand to be deleted on the same basis. The assessee submitted that the availability of sufficient non-interest bearing funds would imply or invite a presumption of their application for non-business purposes, precluding any disallowance of interest (to that extent) was a proposition that had found favour with the Courts.

On appeal, Tribunal held that,

Whether before making disallowance of interest expenditure, it is important to find out amount of borrowed capital used for financing non-business advances – YES : ITAT

Whether non-disallowance of interest expenditure in the past does not by itself signify that the non-business purpose advance is out of interest-free funds – YES : ITAT

++ as against a fixed asset portfolio of Rs.483.83 lacs, the assessee has a term finance of Rs.127.36 lacs only. The balance Rs.356.47 lacs is met by own capital (Rs.155.61 lacs)-which thus gets fully absorbed, and other borrowed capital of Rs.139.63 lacs, leaving still a shortfall of Rs.61.23 lacs. The same (i.e., the fixed assets) to the extent of Rs.61.23 lacs, as well as the entire non-current assets (Rs.47.73 lacs), i.e., including an advance of Rs.6.75 lacs to Smt. Rekha Grover-again, a relative, is met by trade credit, an interest-free source of finance. The assessee thus does not clearly have sufficient funds of his own. The shortfall, however, is made good by trade credit-an interest-free source, in surplus by Rs.108.95 lacs (as on 31/3/2012). No disallowance of interest u/s. 36(1)(iii) is therefore called for as per the closing balance-sheet. This, though, cannot be said with regard to the opening state of financing, which would require, similarly, an analysis of the opening balance-sheet, i.e., as at 01.4.2011. This is as financing is dynamic, and interest-which is the time cost of funds, relatable to the period for which it obtains, would arise. The additional reliance on borrowed capital as on that date is, again, patent. The firm has repaid borrowed capital to the extent of Rs.230.13 lacs during the current year, so that it was indebted by borrowed capital to that additional extent as at the beginning of the year, and which is much higher than the non-business advance of Rs.25.50 lacs as obtaining thereat. The average non-business advance for the year, thus, works to Rs.33.24 lacs ((Rs.25.50 lacs + Rs. 40.98 lacs)/2). We do so as the date of the additional advance (Rs.15.48 lacs) made during the year is not clear. Applying the rate of 12% p.a. (as by the AO) yields an interest of Rs.3.989 lacs for the year. The borrowed capital (as at the beginning of the year) has been substituted by trade credit as at the year-end. The date/s of substitution is though not clear. It is accordingly presumed to have occurred evenly during the year. This in fact is supported by the fact that the total interest for the year (Rs.43.31 lacs) works to about 11% (i.e., close to the rate of 12%) of the average advance-reckoned at the average of the opening and closing borrowed capital, of Rs.382.04 lacs (Rs. 497.10 lacs + Rs. 266.97 lacs)/2). The interest disallowance thus works to Rs.1,99,450 (Rs. 3.989 lacs/2);

++ it was decided to proceed to determine the extent of reliance on borrowed capital-for financing non-business advances, ourselves, rather than remitting the matter back, for two reasons. First, the amount involved is nominal, and therefore remission would burden both the parties. Two, it was already found that no borrowed capital is invested in the amount advanced as at the year-end, while the firm is indebted to a much larger extent as at the beginning of the year, so that it’s being acutely short of interest-free capital at the beginning of the year is patent. The only presumption therefore is with regard to the date/s of the substitution of the borrowed capital with interest-free funds (in the form of trade credit), and which have, accordingly, presumed as evenly during the year. The presumption gets validated with reference to the average interest rate on the borrowed capital, which agrees-with a minor difference, with the interest rate applied, so that the matter, which some approximation, gets resolved.

Assessee’s appeal partly allowed

ORDER

Per: Sanjay Arora:

This is an Appeal by the Assessee directed against the Order by the Commissioner of Income Tax (Appeals)-2, Amritsar ‘(CIT(A)’ for short) dated 10.11.2016, partly allowing the assessee’s appeal contesting his assessment under section 143(3) of the Income Tax Act, 1961 (‘the Act’ hereinafter) dated 30.03.2015 for Assessment Year (A.Y.) 2012-13.

2. The only issue arising in this appeal is the disallowance of the interest expenditure under section 36(1)(iii), made at Rs. 3,83,761, by working out the interest expenditure attributable to the application of the borrowed funds for non-business purposes.

3. The facts in brief are that the assessee, a firm in stone crushing and transport business, returned its’ income for the year at Rs. 56.80 lacs on 31/3/2013. It was during assessment proceedings found to have advanced Rs. 15.48 lacs during the year to one, Shikha Grover, daughter of the assessee who, along with some other members of the family, had already been advanced Rs. 25.50 lacs during an earlier year/s, including Rs. 7.50 lacs to her. The purpose of the advance/s by the assessee-borrower, stated at page 6 of the assessment order (followed by discussion at paras 5.2 & 5.3/pgs. 7-8 of the said order) is clearly personal in nature. The non-business user of the capital to that extent is not disputed; in fact, admitted. The assessee’s argument before us is two-fold. One, that no disallowance, nevertheless, could yet be made for the current year qua an advance made during a preceding year. In fact, similar disallowance made for the preceding year stands deleted by the first appellate authority on the basis that the assessee had sufficient interest-free funds. The same has not been appealed against by the Revenue, so that it has attained finality. As regards the advance/s made during the current year (Rs. 15.48 lacs), the same would stand to be deleted on the same basis, i.e., sufficient interest-free capital, as the assessee’s balance-sheet (as on 31/3/2012) shows the proprietor’s capital (which is interest-free) at Rs. 155.61 lacs, as against the total such (non-business) advances at Rs. 40.98 lacs (as at 31.03.2012/PB pg. 10)(the AO has inadvertently taken the figure at Rs. 31.98 lacs; the advance to Paramjit Singh, made during an earlier year, being at Rs. 10 lacs, and not Rs. 1 lac). That the availability of sufficient non-interest bearing funds would imply or invite a presumption of their application for non-business purposes, precluding any disallowance of interest (to that extent) is a proposition that has found favour with the Hon’ble Courts, including the Hon’ble jurisdictional High Court in Gurdas Garg v. CIT (in ITA No. 413 of 2014, dated 16/7/2015) = 2015-TIOL-1839-HC-P&H-IT, reference to which stands in fact made by the first appellate authority in his order for the preceding year (PB pgs. 13-24). No disallowance, accordingly, is called for.

4. We have heard the parties, and perused the material on record.

Discussion

4.1 A balance-sheet as at any particular date gives a snap shot of the sources and the application of funds (as on that date), stated on the two sides of a horizontal divide, more properly termed as ‘liablities’ and ‘assets’ respectively. We say so as not all liabilities would stand to be classified as a source of funds, i.e., liquid funds, which only could be diverted or applied by way of cash loans (for a non-business-as in the present case, or even a business purpose). Trade creditors, also called spontaneous liabilities, are, for example, in that sense, non-fund liabilities, as they represent amounts payable against goods purchased (on services availed). Money becomes available only on the realization of the sale proceeds of the goods/services, sold either as such or upon conversion into some other form, i.e., on completion of what is called the ‘working capital cycle’. Liquid funds in respect of trade liabilities, thus, get generated only after a gestation period marking the stocking period of raw material, work-in-progress, finished goods, through which stages the goods purchased pass before being sold, as well as the bills receivable (or trade debtors) phase, i.e., upon their sale. Rather, if this period, in aggregate, i.e., the cash to cash cycle, is more than the credit period allowed by the trade creditors, as is usually the case, liquid funds would be required to finance the working capital, either through borrowed or proprietary capital, which could be either interest bearing or otherwise, as interest is paid in some cases even on equity, as partners’ capital in a partnership firm. From this stand-point, the vertical form of the balance-sheet better represents the sources and application of funds inas- much as it highlights only the fund based liabilities and assets, i.e., financed by equity or borrowed capital, though in some cases even the equity capital could be interest bearing, so that to the extent it finances the non-business assets, proportionate interest is liable to be disallowed. A typical vertical form (V-Form) of balance-sheet is as under:

Table 1

   (say)
Fixed Assets (after depreciation) xxx1000
Current Assets (Net)   
– Stock in trade xxx 
– Trade debtors xxx 
– Other current assets xxx 
  xxx 
Less:   
– Trade creditorsxxx  
– other creditorsxxxxxx1000
Non-current assets xxx100
  xxx2100
    
Equity Capital xxx(1000)
Borrowed Capital xxx(1100)
  xxx(2100)

NB: Figures under column ‘say’ are representative figures.

The assets of a business enterprise are, accordingly, financed by equity and borrowed capital and, generally speaking, in that ratio. The trade liabilities would, as shall be apparent, contribute thereto only where they exceed the current assets, i.e., where the net current assets (i.e., current assets (-) current liabilities) is at a negative, which is a rarity, as indeed-as we shall presently see, is in the instant case [at (-) Rs. 108.95 lacs, as on 31.3.2012]. The non-business loans/advances, which are at Rs. 40.98 lacs as on 31.3.2012, fall in the category of non-current assets. The V-form, thus, reveals the funding pattern of the assets, at (say) X% and Y% as at the year end. (being at 47.62% and 52.38% in the example). This may be, as indeed it would be, different at the beginning of the year or, for that matter, at any time of the year, which could be ascertained by drawing a statement of the obtaining assets and liabilities at the time, with equity capital being the balancing figure, i.e., where not accompanied by, to save the tedium, the preparation of the operating statement along with.

4.2 The funds in a going concern being in a state of flux, the funding pattern at different times of the year would reveal as to how it has varied over the year, or that which obtains on an average during the year. Clearly, a higher number of data points would give a better average, which is relevant in-as-much as interest is based only on the actual funding as obtaining over the year (as against that at any given point of time). Again, without doubt, the purport being to arrive at as good an average as possible, a higher variability (in the funding pattern) over the year would warrant a larger sample set. The change in the funding pattern over two points of time, be it a year or a month (or any other), is also captured by what is called the ‘cash flow statement’, which clearly shows where the funds (over the said period) come from and are applied. To put this in perspective, the funds locked in fixed assets normally remain so. Rather, though not cast in stone, and could alter with time, the opening balance-sheet, defining the financing as obtaining at the beginning of the year, crystallizes the funding of the various assets of an enterprise. Only that obtaining during the year, captured by the cash flow statement afore-referred, becomes relevant. The said statement, it may be clarified, would also depict the changes in the funding pattern of the firms’ brought forward assets, as where the brought forward loans are repaid.

Further, to the extent the borrowing is dedicated, viz., the fixed assets financed by term loan/s, or current assets by working capital loan/s or advance/s, the relevant assets have to be regarded as financed accordingly. Where so, this would significantly alter the ratio of financing, i.e., the X% and Y% referred to earlier, which may now be presented as follows:

Table 2.1

 TotalDBBalance
Fixed Assetsxxx(1000)xxx(400)xxx (600)
Net Current Assetsxxx(1000)xxx(400)xxx (600)
Non-current assetxxx (100)______xxx (100)
Totalxxx(2100)xxx(800)xxx(1300)
    
Equity Capital  xxx(1000)
Borrowed Capital  xxx (300)
   xxx(1300)
DB => Dedicated Borrowing   

Excluding dedicated borrowings (Rs. 800 in our example), it is only the assets to the extent not covered thereby, whose funding would therefore need to be examined, and relevant for the purpose of attribution of the borrowed capital, if any, and therefore, interest thereon, i.e., for non-business purposes. That is, the question, if at all, could arise only in respect of the attribution of the interest on the undedicated borrowing (of Rs. 300, in the example); the balance Rs. 800 being for business purposes, where the non-current assets (Rs. 100 in the example) is for non-business purpose. In fact, the figures in the example clearly show adequate own (equity) capital, so that the same would-applying the presumption afore-said (refer para 3), finance the non-business purpose asset of Rs. 100 in full, attracting no disallowance u/s. 36(1)(iii). Further, here it needs to be clarified that as borrowing agreements normally provide for a margin, implying risk capital (equity), which, accordingly, is to be regarded as dedicated to that extent, even as the repayment of borrowed capital though could be from either equity or nondedicated borrowing. That would, thus, modify the funding pattern still further, as may be exemplified by redrawing the table afore-stated:

Table 2.2

 TotalDBECBalance
Fixed Assetsxxx(1000)xxx(400)xxx(200)xxx (400)
Net CAxxx(1000)xxx(400)xxx(200)xxx (400)
Non-CAxxx (100)xxx (100)
Totalxxx(2100)xxx(800)xxx(400)xxx (900)
     
Equity Capital   xxx (600)
Borrowed Capital   xxx (300)
    xxx (900)
DB => Dedicated Borrowing    
EC => Equity Capital    

As borrowing arrangements are not without margin stipulation, it is Table 2.2, a variant of Table 2.1, that is to be normally regarded. Further, the presumption as to the equity capital going to finance the non-current assets, which surely could be validly drawn, is only with reference to the undedicated risk (equity) capital. To clarify the implication of this presumption, even as all the (uncovered) assets could reasonably be regarded as financed by borrowed capital in the ratio of 200:1300 (2:13, as per Table 2.1, or 1:3 as per Table 2.2) (assuming these figures to represent the average financing for the year), considering availability of surplus equity, the same can be considered as funded solely by equity capital. This, of course, is subject of any contractual obligation. This also clarifies that if the opening non-current assets have been regarded as financed by equity capital, drawing the presumption afore-referred, the same shall hold for the current year as well, unless, of course, financing being a dynamic phenomenon, the same is substituted by borrowed capital during the current year. It may be further clarified that the presumption of own capital, where otherwise available, for funding non current assets, shall apply even if the same is apparently financed by borrowed capital, as by issuing a cheque from an overdraft account, etc. This is as, as famously stated, money has no bones. Finally, the availability of equity capital, to the extent attributable to the profits for the year, has to be regarded as inuring evenly during the year. As interest is essentially a charge toward the time cost of funds, where own funds are available-whether introduced or generated later during the year, the same may give rise to some interest attribution, i.e., relatable to the period for which the adequate capital was not available, i.e., was in deficit, for a part of the year, though stood met by the end of the year, as where the same was introduced, or the profits came to be generated, later.

4.3 The financing of a firms’ assets can therefore be ascertained with reasonable accuracy. The afore-stated exercise can, in fact, be done on a daily basis in case of computerized accounts, feeding the algorithm therein, yielding the borrowed capital applied for non-business purpose/s for each date and, thus, on an average. The adequacy or otherwise of equity (risk) capital is to be examined with reference to the contractual obligations and the corresponding assets in which the said capital, as any other, could be regarded as having been applied, i.e., as per the business plan/project financing. Merely comparing the (absolute) value of the capital with reference to specific-business or other-than-for-business, advance/s, and conclude on that basis that the enterprise has sufficient interest-free funds, is fallacious. Where, however, the assessee has sufficient ‘interest-free funds’-a finding of fact, the presumption that it is these that finance the non-current or nonbusiness application (of funds), is apposite, i.e., in contrast to the borrowed funds being so applied or being so even proportionately. The equity capital locked in financing fixed assets and non-current assets as at the beginning of the year is determined with reference to the opening balance-sheet. Cash flow for the year would reveal the financing pattern obtaining over the year. The presumption of equity capital funding the non-current assets generated during the year would apply, subject, of course, as afore-stated, the availability of the said capital, given the opening position as well as the contractual obligation-the margin requirements, afore-referred. For example, the opening equity capital could be regarded as financing, among others, the non-current assets to the extent of Rs. 25.50 lacs in the present case. As we shall presently see, the equity capital is however not sufficient even to finance the firm’s business assets, not to speak of its’ non-business assets.

Findings

5. The interest, if any, on borrowed capital relatable to the personal (nonbusiness) loans/advances, thus, would require being worked out on the fore-going basis, being purely a matter of fact, drawing presumptions, as afore-explained, as admissible or feasible in the given facts and circumstances. This is also the ratio of the case law cited. In Gurdas Garg (supra) (PB pgs. 37-46), relied upon by the assessee, the decision by the Hon’ble Court rested on the finding by the tribunal of the assessee having sufficient interest-free funds-a matter of fact, which it discerns as the question at large. In the facts of that case, the AO had himself accepted the same (refer para 11 of the judgment). In the present case, on the contrary, no such plea (of sufficient interest-free capital) stands raised before the AO, or even before the CIT(A). As it appears, the same is a conscious decision inas- much as the assessee has a net negative working capital as at 31.03.2012 (balance-sheet at PB pgs. 4-12), with, as afore-stated, the net current assets being at (-) Rs.108.95 lacs. The finding by the first appellate authority for AY 2011-12, not carried to the tribunal, is based on a misreading of the decision in Gurdas Garg (supra), which it purportedly follows. The sufficiency or otherwise of funds has necessarily to be with reference to the corresponding application of funds and not regarded in isolation, i.e., by comparing one item on the liability (source of funds) side with one item on the asset (application of funds) side of the balance-sheet, as the first appellate authority has. Further, the same can definitely be examined in the proceedings for the current year in-as-much as it has a direct bearing on the disallowance under reference. In fact, but for this finding by the first appellate authority (for AY 2011-12), which though is not binding on us, the assessee’s case would stand to be dismissed at the threshold in-as-much as no plea of sufficient interest-free funds, i.e., qua a matter of fact, was taken earlier, and on which there is no therefore no finding by any of the Revenue authorities. The non-appealing by the Revenue for AY 2011-12 would not hit it adversely (Gangadharan (C.K.) v. CIT [2008] 304 ITR 61 (SC)) = 2008-TIOL-140-SC-IT-LB. This would also meet the assessee’s argument of no disallowance of interest for the current year where no disallowance qua the ‘other than for business purpose’ advance/s has been made in the past. The nondisallowance of interest in the past, where based on a finding of fact, would normally obtain. To state it as a proposition, i.e., that no disallowance for the current year could be made because no disallowance was made in the past, canvassed with reference to the decision in ITO v. Europe Infrastructure and Power Ltd. (in ITA No. 571/Asr/2013, dated 26.03.2015), is, however, difficult to accept. In fact, it has not been in many a case by the tribunal, as in CIT v. Autolite (India) Ltd. [2017] 81 taxmann.com 436 (Trib, Jaip) = 2016-TIOL-1453-ITAT-JAIPURLiberty Marketers (in ITA Nos. 409/Coch/2014 and 85 & 86/Coch/2016, dated 03.04.2018-refer para 8.2). The reason is simple. Non-disallowance in the past does not by itself signify that the non-business purpose advance/s is out of interest-free funds, being essentially a question of fact. On a conceptual plane, if the interest on funds borrowed in the past, applied for business purposes, would stand to be allowed for the current year, i.e., in the absence of any finding of a change of user, the same position would obtain for said funds where found to be applied for non-business purposes, irrespective of whether any disallowance was or was not made thereat. In short, the matter is quintessentially factual, and does not admit of any proposition as sought to be advanced.

The matter, then, ordinarily speaking, should be restored back for fresh determination in light of the fore-going. However, the firm, as a mere browse of the balance-sheet as at 31.03.2012, the relevant year-end, reveals, is heavily overfinanced. As against a fixed asset portfolio of Rs.483.83 lacs, the assessee has a term finance of Rs.127.36 lacs only. The balance Rs.356.47 lacs is met by own capital (Rs.155.61 lacs)-which thus gets fully absorbed, and other borrowed capital of Rs.139.63 lacs, leaving still a shortfall of Rs.61.23 lacs. The same (i.e., the fixed assets) to the extent of Rs.61.23 lacs, as well as the entire non-current assets (Rs.47.73 lacs), i.e., including an advance of Rs.6.75 lacs to Smt. Rekha Grover-again, a relative, is met by trade credit, an interest-free source of finance. The assessee thus does not clearly have sufficient funds of his own. The shortfall, however, is made good by trade credit-an interest-free source, in surplus by Rs.108.95 lacs (as on 31/3/2012). No disallowance of interest u/s. 36(1)(iii) is therefore called for as per the closing balance-sheet. This, though, cannot be said with regard to the opening state of financing, which would require, similarly, an analysis of the opening balance-sheet, i.e., as at 01.4.2011. This is as financing is dynamic, and interest-which is the time cost of funds, relatable to the period for which it obtains, would arise. The additional reliance on borrowed capital as on that date is, again, patent. The firm has repaid borrowed capital to the extent of Rs.230.13 lacs during the current year, so that it was indebted by borrowed capital to that additional extent as at the beginning of the year, and which is much higher than the non-business advance of Rs.25.50 lacs as obtaining thereat. The average non-business advance for the year, thus, works to Rs.33.24 lacs ((Rs.25.50 lacs + Rs. 40.98 lacs)/2). We do so as the date of the additional advance (Rs.15.48 lacs) made during the year is not clear. Applying the rate of 12% p.a. (as by the AO) yields an interest of Rs.3.989 lacs for the year. The borrowed capital (as at the beginning of the year) has been substituted by trade credit as at the year-end. The date/s of substitution is though not clear. It is accordingly presumed to have occurred evenly during the year. This in fact is supported by the fact that the total interest for the year (Rs.43.31 lacs) works to about 11% (i.e., close to the rate of 12%) of the average advance-reckoned at the average of the opening and closing borrowed capital, of Rs.382.04 lacs (Rs. 497.10 lacs + Rs. 266.97 lacs)/2). The interest disallowance thus works to Rs.1,99,450 (Rs. 3.989 lacs/2).

We have proceeded to determine the extent of reliance on borrowed capital-for financing non-business advances, ourselves, rather than remitting the matter back, for two reasons. First, the amount involved is nominal, and therefore remission would burden both the parties. Two, we have already found that no borrowed capital is invested in the amount advanced as at the year-end, while the firm is indebted to a much larger extent as at the beginning of the year, so that it’s being acutely short of interest-free capital at the beginning of the year is patent. The only presumption therefore is with regard to the date/s of the substitution of the borrowed capital with interest-free funds (in the form of trade credit), and which we have, accordingly, presumed as evenly during the year. The presumption gets validated with reference to the average interest rate on the borrowed capital, which agrees-with a minor difference, with the interest rate applied, so that the matter, which some approximation, gets resolved.

We decide accordingly.

6. In the result, the assessee’s appeal is partly allowed.

(Order pronounced in the open court on 20.03.2019)

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