ITAT Mumbai: Disallowance Under Section 36(1)(iii) Unsustainable When Interest-Free Funds Surpass Capital Advances — Presumption Operates in Favour of Assessee

Case Reference

Fairchem Organics Limited Vs ACIT (ITAT Mumbai)
Assessment Year: 2020–21
Order Date: 20.03.2026

Background and Context

The question of whether interest on borrowed funds can be disallowed under Section 36(1)(iii) of the Income Tax Act, 1961 merely because an assessee has simultaneously made interest-free capital advances — without establishing any direct link between such advances and the borrowed funds — has been a matter of recurring litigation. The Mumbai Bench of the Income Tax Appellate Tribunal has now rendered a significant ruling in the case of Fairchem Organics Limited Vs ACIT, firmly settling the position in favour of the assessee by applying the well-established presumption recognised by the Hon'ble Supreme Court.

Profile of the Assessee

The assessee in this case is a company engaged in the manufacture, supply, and export of speciality oleo chemicals and intermediate nutraceuticals, products derived from by-products generated during the refining of crude vegetable oil. For Assessment Year 2020–21, the assessee filed its return of income on 15.02.2021, declaring total income of Rs. 34,71,14,410/- and book profit under Section 115JB of the Act at Rs. 36,41,95,611/-. The case was subsequently selected for scrutiny under CASS, and notices under Section 143(2) and Section 142(1) of the Act were duly served upon the assessee, which in turn furnished the requisite details and explanations.

Assessment Proceedings and Addition Made

Observation by the Assessing Officer

During the assessment proceedings, the Assessing Officer examined the balance sheet of the assessee and noticed that capital advances aggregating to Rs. 6,53,87,800/- had been made, ostensibly for the procurement of plant and machinery. At the same time, the Assessing Officer noted that the assessee carried total borrowings of Rs. 60,70,53,313/-, comprising non-current borrowings of Rs. 16.33 crores and current borrowings of Rs. 44.37 crores. The assessee had also claimed a deduction for interest expenditure of approximately Rs. 6.57 crores.

The Assessing Officer formed the view that the assessee had effectively diverted interest-bearing borrowed funds towards non-interest-bearing capital advances extended to third parties, and accordingly called upon the assessee to explain the source and purpose behind such advances.

Assessee's Explanation

The assessee submitted that:

  • The capital advances were given exclusively for the acquisition of fixed assets and were commercial advances made in the ordinary course of business.
  • Such advances were funded entirely from internal accruals and not from any borrowed funds.
  • Net cash generation during the relevant financial year stood at approximately Rs. 43.01 crores.
  • Current borrowings were deployed solely for working capital requirements such as inventory management and trade receivables.
  • Non-current borrowings were utilised for acquisition of fixed assets, and no specific borrowing was raised for the purpose of granting capital advances.
  • Advances for capital goods are a routine and accepted business practice, are generally non-interest-bearing, and are ultimately adjusted against the final purchase consideration.

Rejection by the Assessing Officer

The Assessing Officer was not persuaded by these explanations. He held that the assessee had failed to demonstrate that interest-bearing funds were not channelled towards interest-free advances. He further held that despite claiming sufficient internal accruals, the assessee continued to carry substantial external borrowings, which rendered the explanation unsatisfactory. Additionally, the Assessing Officer held that the assessee had not established commercial expediency for granting such advances and had failed to draw a clear nexus between own funds and the advances in question.