ITAT Mumbai Grants Relief: Interest Expenditure on Borrowings for Earning Interest Income Held Deductible Under Section 57(iii) Despite Ex Parte Assessment
Background of the Dispute
In a significant ruling concerning deductions under Section 57(iii) of the Income Tax Act, 1961, the Mumbai Bench of the Income Tax Appellate Tribunal (ITAT) has provided substantial relief to the assessee in the matter of Ankur Chandulal Shah Vs ACIT. The adjudication centered around the disallowance of interest expenditure amounting to ₹1.06 crore which was claimed as a deduction against interest income reported under the head "Income from Other Sources".
The assessee, functioning as a partner in M/s Creative International, had submitted the return of income for Assessment Year 2017-18 declaring total income of ₹1,13,74,120. The return was filed on 31st October 2017. However, during the assessment proceedings, the case attracted scrutiny primarily due to the substantial deduction claimed under Section 57 of the Income Tax Act, 1961.
Assessment Proceedings and Ex Parte Order
A critical aspect of this case was that the assessee remained non-responsive to the statutory notices issued by the Assessing Officer (AO) during the assessment stage. Consequently, the AO proceeded to complete the assessment ex parte under Section 144 of the Income Tax Act, 1961. In this ex parte assessment order, the entire claim of interest expenditure aggregating to ₹1,06,32,156 was disallowed by the revenue authorities.
The assessee, being an individual engaged in business activities, had earned substantial interest income during the relevant assessment year. Specifically, the assessee had received interest income of approximately ₹1.77 crore from M/s Ariha Diamonds Jewellery Pvt. Ltd., a company in which the assessee held the position of Director and was also a shareholder.
Financial Transactions and Source of Funds
The transaction structure revealed that the assessee had extended loans and advances to M/s Ariha Diamonds Jewellery Pvt. Ltd., and these advances were financed through borrowings obtained from family members and other individuals. On these borrowings, the assessee had incurred interest liability amounting to ₹1,06,30,156. After offsetting this interest expenditure against the interest income received, the assessee offered net interest income of ₹70,51,426 to tax under the head "Income from Other Sources".
This arrangement was transparently disclosed in the computation of total income filed along with the return. The computation specifically mentioned interest received from M/s Ariha Diamonds Jewellery Pvt. Ltd. amounting to ₹1,76,81,584, apart from interest income from savings bank accounts.
First Appellate Proceedings Before CIT(A)
Since the assessment was completed ex parte, the assessee was unable to submit relevant supporting documentation before the AO. However, during the appellate proceedings before the Commissioner of Income Tax (Appeals), the assessee filed comprehensive additional evidence under Rule 46A of the Income Tax Rules, 1962.
The additional evidence included:
- Confirmation letters from M/s Ariha Diamonds Jewellery Pvt. Ltd.
- Confirmations from the parties from whom loans and advances were received
- Confirmations from parties to whom interest was paid
- Ledger accounts demonstrating the fund flow
- Detailed computation showing nexus between income and expenditure
The learned CIT(A) admitted these additional evidences and directed the AO to furnish a remand report. However, despite the submission of comprehensive documentation and the explanation provided by the assessee establishing the nexus between the interest income earned and interest expenditure incurred, the CIT(A) sustained the disallowance.
Findings Recorded by the First Appellate Authority
The CIT(A) upheld the disallowance primarily on the following grounds:
Burden of Proof: The CIT(A) observed that the burden lay on the assessee to establish a direct nexus between the expenditure (interest paid) and the income (interest received).
Lack of Documentary Evidence: It was held that the assessee failed to furnish adequate documents regarding the utilization of borrowed funds, such as loan agreements, fund flow details, and bank statements that could prove the usage of borrowings.
Failure to Demonstrate Direct Link: The CIT(A) concluded that the assessee failed to demonstrate a direct link between borrowed funds and the interest-earning loan advanced to the company.
Interpretation of Legal Precedents: While acknowledging the principle laid down in CIT v. Rajendra Prasad Moody (SC) that intention to earn income is sufficient, the CIT(A) held that this does not override the need to prove a nexus between expenditure and income.
Reliance on Case Law: The CIT(A) also relied on CIT v. Dalmia Jain & Co. Ltd., holding that deduction is allowed only when expenditure is directly related to the income earned.
Based on these observations, the CIT(A) dismissed the assessee's appeal and upheld the addition of ₹1,06,32,156.
Appeal Before the Income Tax Appellate Tribunal
Aggrieved by the order of the CIT(A) dated 27th August 2025, the assessee preferred an appeal before the Mumbai Bench of the ITAT. The sole ground of appeal challenged the disallowance of ₹1,06,32,156 claimed as deduction under Section 57(iii) of the Income Tax Act, 1961.
Arguments Advanced by the Assessee
Before the Tribunal, the assessee contended that:
There existed a clear, direct and proximate nexus between the interest income earned from M/s Ariha Diamonds Jewellery Pvt. Ltd. and the interest expenditure incurred on borrowings utilized for advancing loans to that company.
The entire transaction chain was transparently disclosed in the return of income and computation of total income.