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The Calcutta Tribunal in the case of ACIT v. Perfect Project Ltd. (253ITR16) upheld the disallowance out of interest paid with reference to interest free advance made to an interested party coming under the purview of the provisions of section 40A(2) of the Income tax Act, 1961. In this case the assessee pleaded that it was using the premises of the loanee party for which it did not pay any rent but it failed to produce any agreement of that sort to justify genuine business arrangement. The Bench in rejecting such a contention held that the loan was not advanced out of any business expediency.

In yet another case of K. Somasundaram and Brothers Vs. Commissioner of Income-tax (238ITR939) the Madras High Court in referring to section 36(1) (iii) held that the words “the amount of the interest paid in respect of capital borrowed for the purposes of the business or profession” pointed out that the capital so borrowed should not only be invested in the business, but that the amount borrowed should continue to remain in the business. So long as the amount borrowed is used in the business, the interest paid on such borrowing is expenditure, which is required to be deducted in the computation of the income from the business. The interest payable on the capital borrowed is a liability, which continues till such time as the amount borrowed is repaid. Such interest is allowable under the provision only for the reason that the amount on which interest is paid continues to be used in the business and the payment of such interest is therefore, necessary for the purpose of running the business. This provision cannot be construed as enabling an assessee to burden the business with interest even while taking the amount initially borrowed for the business, but subsequently taken out of the business by diverting it as interest- free loans to associates.

Similarly the Bombay High Court in the case of Commissioner of Income-tax Vs. Doctor and Co. (180ITR627) also upheld the disallowance based on average rate of interest paid and interest charged on concessional advances to interested parties.

However the position would be different where the recovery of the principal itself had become doubtful and therefore no interest is charged, the Calcutta High Court so held in the case of Commissioner of Income-tax Vs. Raigharh Jute Mills Ltd (132ITR702).

It is therefore advisable to review terms and conditions of all transactions with parties falling under specified categories of section 40A(2) to avoid disallowances of such nature.

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