Interest Deduction on Borrowed Capital Put into Firm: Kerala High Court’s View in Alice Arun Thomas Vs ITO

The Kerala High Court in Alice Arun Thomas Vs ITO has reaffirmed a crucial principle under the Income Tax Act 1961: an individual partner cannot claim deduction under Section 36(1)(iii) for interest on funds borrowed personally and then introduced as capital into a partnership firm, where the business is carried on by the firm and not by the individual partner in her own right.

This decision, arising from an appeal against an order of the Income Tax Appellate Tribunal (ITAT), Cochin Bench, underscores the importance of correctly identifying who is carrying on the business and in whose hands a deduction is legally claimable.

Background of the Dispute

Facts Presented by the Assessee

The assessee, an individual partner in a partnership firm, claimed deduction of interest under Section 36(1)(iii) on the following factual matrix:

  • The assessee borrowed money from the open market from various persons.
  • These borrowed funds were then invested as capital in a partnership firm in which she was a partner.
  • The firm paid her interest on this capital contribution in accordance with the terms of the partnership arrangement.
  • The assessee used the interest received from the firm to pay interest to the lenders from whom she had borrowed the money.

Relying on this structure, the assessee asserted that:

  • The borrowed capital was effectively used for a business purpose,
  • The interest she paid on such borrowings should be allowed as a deduction under Section 36(1)(iii),
  • The ITAT erred in concluding that her claim was hit by Section 37(1) and was otherwise not allowable.

Stand of the Revenue

The Revenue opposed the claim on foundational grounds:

  • Amounts received by the assessee from the partnership firm, including interest on capital, are in the nature of profits or share of income from the firm in her hands.
  • Such receipts cannot be characterized as “expenditure” incurred by the assessee personally for the purposes of her own business.
  • A deduction under Section 36(1)(iii) is permissible only when:
    • The assessee has borrowed capital, and
    • Such borrowings are for her own business or profession.
  • Since the business was undeniably that of the firm, any claim of deduction linked to that business could, if at all, be raised only by the firm, not by the individual partner.

The Revenue thus contended that the assessee’s approach was misconceived, and the ITAT’s refusal to allow the deduction was correct in law.

Proceedings Before the High Court

Scope of the Appeal

The appeal before the Kerala High Court challenged the order of the ITAT, Cochin Bench, which had refused the assessee’s claim for deduction of interest under Section 36(1)(iii). The impugned order was placed on record as Annexure-C.

Counsel for the assessee contended that:

  • The Tribunal had wrongly rejected a legitimate deduction, despite “cogent” evidence regarding the interest income and interest outgo.
  • The conclusion that the claim was barred by Section 37(1) of the Act was erroneous.

On the other hand, standing counsel for the Revenue maintained that: