Disallowances in case of Interest free loans given by a company to a sister concern or others.
In this regard it is pertinent to note that it is a well settled law that notional incomes are not taxable under the Income Tax Act, 1961. The Orissa High Court in the case of Tripty Drinks Pvt. Ltd. (1978) 112 ITR 721 held that, the profits that are charged under the Act are real profits and those which are regarded as profits in the commercial world. No tax may be levied on fictional or notional profits.
Therefore, no notional interest on such advances shall be taxable in the hands of the company making advances to its sister concern or others. However, if the advances are made without any business purpose and out of borrowed funds than proportionate interest paid or payable on such borrowed funds shall be disallowed.
The Delhi High Court in the case of Punjab Stainless Steel Industries (2010) 41 DTR 289 has held that, if the assessee failed to make out a case of commercial expediency in advancing interest free advances to its sister concern which where made from its CC account with a bank, proportionate interest paid by assessee on borrowing was rightly disallowed.
In yet another case, the Punjab & Haryana High Court in the case of Abhishek Industries Limited (2006) 286 ITR 1 has held that once it is borne out of record that the assessee has borrowed certain funds on which liability to pay tax is being incurred and on the other hand certain amounts has been advanced to sister concerns or others without carrying any interest or without any business purpose, the interest to the extent the advance has been made without carrying any interest is to be disallowed u/s 36(1)(iii).
However, the Chhattisgarh High Court in the case of Beekay Eng. Corporation (2010) 38 DTR 289 has held that, where there were sufficient funds of partners in the opening balance and sufficient profit has been earned during the year and no borrowed funds diverted as interest free funds to the sister / associate concerns. The assessing officer cannot disallow a part of the interest paid on the funds borrowed by the assessee.
Therefore, in my view, under following two circumstances the disallowance of the proportionate interest on borrowed capital can be negated:
1) If the commercial expediency for advancing loan can be proved.
2) If the advances are made out of profits. This can only be proved if the company has huge reserves and profits. Also, it is important that there should not be any direct nexus between the funds borrowed and the advances made.