ITAT Delhi Allows Interest on Borrowed Funds Advanced to Wholly Owned Subsidiary as Business Expenditure

Overview of the Dispute

The Income Tax Appellate Tribunal, Delhi Bench, in the case of Moonrock Hospitality (P) Ltd. Vs ACIT, examined whether interest on borrowed funds could be disallowed under Section 36(1)(iii) of the Income Tax Act 1961 when such funds were advanced, without charging interest, to a wholly owned subsidiary for business purposes.

The assessee challenged the order dated 6 May 2019 passed by the CIT(A)-6, New Delhi for Assessment Year 2016-17, where a proportionate interest disallowance was upheld on the allegation that interest-bearing funds had been diverted to an interest-free loan granted to a subsidiary company.

The Tribunal ultimately ruled in favour of the assessee, holding that the advance to the subsidiary was made out of commercial/business expediency and that interest on such borrowed funds is allowable under Section 36(1)(iii).

Factual Matrix

Business Profile of the Assessee

• The assessee, Moonrock Hospitality (P) Ltd., is a company engaged in investment and business activities linked with hospitality and allied sectors.
• It holds investments in wholly owned subsidiaries and also provides loans to such group entities.
• For AY 2016-17, the assessee filed its return of income on 30 August 2016, reporting a loss of Rs. 52,06,669.

Loan to Subsidiary and Interest Claim

1. The assessee had obtained unsecured loans from various companies on which it paid interest at 9%.
2. Out of these borrowed funds, the assessee had advanced an interest-free loan of Rs. 2,49,50,000 to its wholly owned subsidiary M/s Vinu Promoters Pvt. Ltd.
3. This advance was originally granted in earlier years, and an outstanding balance of Rs. 2,52,00,000 existed at the beginning of the relevant previous year.
4. The assessee claimed interest expenditure on its borrowings as a deduction under Section 36(1)(iii).

Assessment Proceedings

During scrutiny assessment, the Assessing Officer (AO):

• Observed that interest-bearing funds had been used to grant an interest-free loan to the subsidiary.
• Issued a show cause to the assessee seeking justification for allowing interest expenditure when borrowed funds had allegedly been diverted for non-business purposes.

The assessee replied that:

• The subsidiary was a wholly owned company.
• Funds were advanced to the subsidiary to support its business activities, and thus the advance was on account of commercial expediency.
• Consequently, the interest paid on borrowed capital remained a deductible business expenditure under Section 36(1)(iii).

The AO, however, rejected this explanation.

Disallowance Made by the AO

The AO’s reasoning and computation were as follows:

• He treated the loan to the subsidiary as diversion of interest-bearing funds to a related concern without charging interest.
• Applied an interest rate of 9% on the interest-free advance of Rs. 2,49,50,000 and worked out the proportionate interest at Rs. 22,56,750.
• Total expenditure claimed by the assessee was Rs. 54,38,294.
• Out of this, the AO had already made a disallowance of Rs. 41,49,856 under Section 14A.
• The assessee itself had voluntarily disallowed Rs. 2,00,000 under Section 14A in its computation.
• The balance interest expenditure of Rs. 10,88,438 was then disallowed by the AO under Section 36(1)(iii), treating it as interest relatable to the interest-free loan to the subsidiary.

Accordingly, an addition of Rs. 10,88,438 was made to the total income.

Order of the CIT(A)

In first appeal, the CIT(A):

• Agreed with the AO’s finding that interest-bearing funds had been diverted for non-business purposes.
• Upheld the disallowance of Rs. 10,88,438 under Section 36(1)(iii).
• Did not accept the assessee’s contention that the loan was driven by commercial expediency and related to its business objects.

This led to the second appeal before the ITAT Delhi.

Arguments Before the Tribunal

Submissions of the Assessee

The assessee’s counsel mounted a detailed legal defence based on established jurisprudence and the company’s own constitutional documents.

1. Reliance on CIT vs.