Pune ITAT on Section 36(1)(iii): Interest-Free Funds Shield Interest-Free Advances to Trust

The Pune Bench of the Income Tax Appellate Tribunal (ITAT Pune) has reaffirmed an important rule in the context of Section 36(1)(iii) of the Income Tax Act 1961: where an assessee has sufficient interest-free funds that are higher than the interest-free advances made, it is presumed that such advances are sourced from those interest-free funds, and hence, no disallowance of interest is justified.

In ACIT Vs Mehul Construction Company Pvt. Ltd., the Tribunal upheld the deletion of an interest disallowance of ₹5,02,48,524/- for A.Y. 2016-17, and applied the same reasoning to A.Y. 2017-18 and A.Y. 2018-19, dismissing the Revenue’s appeals across all three years.

Background of the Case

Search Proceedings and Reassessment

  1. A search under Section 132 was conducted on 25.08.2022 in the case of Mehul Group and related entities.
  2. Mehul Construction Company Pvt. Ltd. (the assessee) was one of the main entities covered.
  3. During the search, the Department noticed that:
    • The directors of the assessee company and the trustees of M. M. Patel Public Charitable Trust (MMPPCT) are common.
    • The assessee had granted substantial interest-free loans to MMPPCT, which runs a medical college and hospital.
  4. The assessee had originally filed its return of income for A.Y. 2016-17 on 30.09.2016 declaring income of ₹6,82,55,180/-.
  5. In view of the findings during search, notice under Section 148 was issued. The assessee filed a return in response on 18.04.2023, reiterating the same income figure.
  6. The assessment was completed under Section 143(3) r.w.s. 147 on 30.05.2024, determining total income at ₹11,85,03,704/-, after making a key addition of ₹5,02,48,524/- towards interest disallowance.

Interest-Free Advances to M. M. Patel Public Charitable Trust

  • The assessee had extended interest-free loans aggregating to ₹33,49,90,162/- to MMPPCT as on 31.03.2016 / 31.03.2017 (closing balance of short-term/long-term advances).
  • Out of this, ₹30,18,90,162/- represented opening balance, and ₹3,31,00,000/- was advanced during the relevant year under assessment.
  • Simultaneously, the assessee had claimed interest expenditure of ₹5,15,52,654/- on borrowings from banks, financial institutions, directors and relatives.

The Assessing Officer (AO) formed a view that, since the assessee was paying interest on its borrowings while giving interest-free advances to a related trust, there was diversion of interest-bearing funds for non-business purposes. Accordingly, the AO computed and disallowed proportionate interest of ₹5,02,48,524/-.

Assessee’s Stand Before CIT(A)

Commercial Rationale and Regulatory Conditions

Before the Commissioner of Income Tax (Appeals) [CIT(A)], the assessee placed a detailed explanation covering:

  • Purpose of the loans:
    • The advances to MMPPCT were made to help the trust meet part of its margin money obligations for obtaining term loans from banks for developing a medical college with an attached hospital.
  • Charity Commissioner’s conditions:
    • The Charity Commissioner had specifically permitted the trust to accept only interest-free unsecured loans.
    • The assessee produced a copy of the Charity Commissioner’s order showing that the advances had to be interest-free.
  • Treatment by banks:
    • The banking institutions financing the trust’s project treated the unsecured loans from the assessee as quasi-capital, with a stipulation that such advances should not be repaid until the bank loans were fully discharged.
  • Business nexus and commercial expediency:
    • The assessee had been awarded a substantial construction contract for the medical college and hospital building, valued at approximately ₹102.81 crore, from MMPPCT.
    • The contract was obtained as the lowest bidder through a competitive process, approved by the office of the Charity Commissioner.
    • The assessee argued that supporting the trust’s project had a direct and proximate commercial connection with its core construction business.

Availability of Interest-Free Funds

A central plank of the assessee’s defence was that sufficient interest-free funds were available, far exceeding the advances made to MMPPCT: