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Facts
The Assessing Officer (AO) treated unsecured loans of Rs. 34,89,041 as unexplained cash credits and disallowed consequential interest. The AO also disallowed Rs. 25,01,730 under section 36(1)(iii) for alleged diversion of interest-bearing funds to non-business advances. The assessee contended that loans were genuine and interest-free funds were available.
Held
The CIT(A) deleted the additions under section 68 but sustained a partial disallowance of Rs. 7,70,069 under section 36(1)(iii) for lack of business expediency in fresh interest-free advances. The Tribunal found this partial disallowance unsustainable, given the findings of ample interest-free funds and no nexus between borrowed and advanced funds.
Key Issues
Justification for sustaining a partial disallowance under section 36(1)(iii) when it was found that the assessee had sufficient interest-free funds and no diversion of borrowed funds was established.
Sections Cited
68, 36(1)(iii), 143(3)
AI-generated summary — verify with the full judgment below
Income Tax Appellate Tribunal, “A” BENCH MUMBAI
Before: SHRI AMIT SHUKLA & SHRI MAKARAND VASANT MAHADEOKAR
आदेश / ORDER
PER MAKARAND VASANT MAHADEOKAR, AM:
This appeal filed by the assessee is directed against the order dated 10.07.2025 passed by the learned Commissioner of Income-tax (Appeals), National Faceless Appeal Centre, Delhi [hereinafter referred to as “CIT(A)”] under section 250 of the Income-tax Act, 1961 [hereinafter referred to as “the Act”]for M/s. Ashapura Developers Assessment Year 2014–15, arising out of the assessment order dated 16.12.2016 passed by the Assessing Officer under section 143(3) of the Income-tax Act, 1961.
The brief facts of the case are that the assessee is a partnership firm engaged in the business of builder and developer. For the assessment year under consideration, the assessee filed its return of income on 29.11.2014, declaring a total income of Rs. 21,67,520/-.The case was selected for scrutiny under the Computer Aided Scrutiny Selection (CASS). During the course of assessment proceedings, the Assessing Officer observed that the assessee had shown sales of bungalows of approximately Rs. 3.33 crore and closing work-in-progress of Rs. 7.56 crore. On examination of the details of unsecured loans, the Assessing Officer noticed discrepancies between the audit report and the particulars furnished during assessment. According to the Assessing Officer, in respect of certain loan creditors, the assessee failed to satisfactorily establish the identity of the creditors, their creditworthiness, and the genuineness of the transactions. On this basis, unsecured loans aggregating to Rs. 34,89,041/- were treated as unexplained cash credits under section 68 of the Act. Consequentially, interest expenditure of Rs. 3,13,109/- debited in the Profit and Loss account in respect of such loans was also disallowed. The Assessing Officer further noted that the assessee had debited interest expenditure of Rs. 81,17,604/- in the Profit and Loss account, while at the same time interest-free loans and advances M/s. Ashapura Developers amounting to Rs. 2,08,47,745/- were outstanding. It was also observed that the capital account of the assessee reflected a negative balance of Rs. 4,37,87,543/-.According to the Assessing Officer, the assessee had diverted interest-bearing funds for non- business purposes. Applying interest at the rate of 12 percent on the alleged interest-free advances, the Assessing Officer disallowed Rs. 25,01,730/- under section 36(1)(iii) of the Act. Accordingly, the total income of the assessee was assessed as under: Returned income : Rs. 21,67,520/- i. Addition under section 68 : Rs. 34,89,041/- ii. Disallowance of interest on unsecured loans : Rs. iii. 3,13,109/- Disallowance under section 36(1)(iii) : Rs. 25,01,730/- iv.
Thus, the assessed total income was determined at Rs. 84,71,400/-. Penalty proceedings under section 271(1)(c) were also initiated separately.
Aggrieved by the assessment order, the assessee carried the matter in appeal before the learned CIT(A). Before the CIT(A), the assessee furnished detailed written submissions, confirmations from creditors, bank statements, ledger accounts and comparative statements of assets and liabilities. It was contended that the unsecured loans were genuine and that the assessee had discharged the onus cast upon it under section 68 by establishing the identity and creditworthiness of the creditors and M/s. Ashapura Developers the genuineness of the transactions. With regard to the disallowance of interest under section 36(1)(iii), the assessee submitted that it had earned interest income of Rs. 52,48,549/- during the year, that substantial interest-free funds were available in the form of advances from customers, sundry creditors and deposits, and that no borrowed funds had been diverted for non-business purposes.
The learned CIT(A), after examining the material on record, recorded a categorical finding that the assessee had furnished sufficient evidence to establish the identity, creditworthiness and genuineness of the unsecured loan creditors. Accordingly, the addition of Rs. 34,89,041/- made under section 68 of the Act, along with the consequential disallowance of interest of Rs. 3,13,109/-, was deleted.
On the issue of disallowance of interest under section 36(1)(iii), the learned CIT(A) observed that the Assessing Officer had failed to consider the interest income earned by the assessee and had computed the disallowance on the entire outstanding balance of interest-free advances. The learned CIT(A) further recorded that the increase in interest-free advances during the year was only Rs. 64,17,245/-.
However, the learned CIT(A) held that the assessee failed to demonstrate business expediency in respect of the fresh interest- free advances to the extent of Rs. 64,17,245/-. Accordingly, the disallowance under section 36(1)(iii) was restricted to Rs.
M/s. Ashapura Developers 7,70,069/-, being interest computed at 12 percent on the said amount, and relief was granted for the balance. Thus, the appeal before the CIT(A) was partly allowed.
Aggrieved by the partial sustenance of the disallowance under section 36(1)(iii), the assessee has raised the following grounds before us –
On the facts and circumstances of the case and in law, the learned CIT(A) erred in retaining a part of disallowance at Rs. 7,70,069/- out of the disallowance of Rs. 25,01,730/- made by the Assessing Officer under section 36(1)(iii) in respect of claim of expenditure on interest.
It is therefore prayed that the aforesaid disallowance of Rs. 7,70,069/- may please be directed to be deleted.
The assessee craves leave to add, alter and/or delete any of the grounds of appeal
.
9. At the time of hearing, none appeared on behalf of the assessee, despite the matter being called out. On the other hand, the learned Departmental Representative was present and relied upon the order of the learned CIT(A). In view of the absence of the assessee and having regard to the material available on record, the appeal is being disposed of ex parte qua the assessee, after hearing the learned Departmental Representative and perusing the record.
10. The sole issue arising for our consideration is whether the learned CIT(A) was justified in sustaining a partial disallowance of interest of Rs. 7,70,069/- under section 36(1)(iii), out of the total disallowance of Rs. 25,01,730/- made by the Assessing Officer, despite having accepted the assessee’s contention regarding M/s. Ashapura Developers availability of substantial interest-free funds and absence of nexus between borrowed funds and interest-free advances.
11. From the orders of the Assessing Officer and the learned CIT(A), the following facts are not in dispute: i. The assessee had debited interest expenditure of Rs. 81,17,604/- in the Profit and Loss Account. ii. During the same year, the assessee earned interest income of Rs. 52,48,549/-, which substantially offset the gross interest expenditure. This include Rs.52,31,124/- interest received from partners. iii. Interest-free loans and advances as on 31.03.2014 aggregated to Rs. 2,08,47,745/-, out of which advances of Rs. 15,17,425/- were for purchase of land and directly relatable to business. iv. The effective interest-free advances thus stood at Rs. 1,93,30,320/-. v. The assessee demonstrated availability of interest-free funds aggregating to Rs. 5,86,81,943/-, comprising advances received against sale of bungalows, sundry creditors, and deposits from buyers. vi. The increase in interest-free advances during the year was only Rs. 64,17,245/-, whereas interest-bearing loans increased by Rs. 3,52,26,779/-. vii. The learned CIT(A) recorded a categorical finding that the Assessing Officer failed to establish any direct nexus between borrowed funds and interest-free advances.
The learned CIT(A), after an elaborate factual analysis, deleted the bulk of the disallowance made under section 36(1)(iii), holding that the Assessing Officer erred in considering gross interest instead of net interest effect, the assessee had sufficient M/s. Ashapura Developers interest-free funds far in excess of the advances, and no diversion of borrowed funds for non-business purposes was established. However, having accepted the aforesaid factual findings, the learned CIT(A) proceeded to sustain a disallowance of Rs. 7,70,069/-, being interest calculated at 12 percent on the incremental advances of Rs. 64,17,245/-, on the sole reasoning that the assessee failed to demonstrate business expediency in respect of such advances. In support, reliance was placed on paragraph 6.8 of the appellate order, wherein the learned CIT(A) observed that business funds are mixed up and that the existence of a negative balance in the capital account leads to an inference that interest-bearing funds were used for non-business advances.
We are unable to subscribe to the above approach. Once the learned CIT(A) himself has accepted that the assessee had ample interest-free funds, far exceeding the incremental advances, and has recorded a clear finding that no nexus between borrowed funds and interest-free advances was established, the sustenance of a residual disallowance merely on a presumption arising from a negative capital balance is legally unsustainable. A negative capital account, by itself, does not automatically lead to the conclusion that borrowed funds have been diverted for non- business purposes, particularly in the absence of any fund-flow analysis or identification of specific diversion.
M/s. Ashapura Developers 14. At this stage, an important and decisive aspect of the matter deserves emphasis. As noted above, a substantial portion of the interest income earned by the assessee during the year represents interest received from partners, which fact has not been disputed by the authorities below. Once it is an admitted position that the assessee has charged and recovered interest from partners on their debit balances, the mere existence of a debit balance in the capital account loses its relevance for the purpose of invoking section 36(1)(iii). The charging of interest from partners clearly neutralises the allegation of diversion, as the assessee stands duly compensated for the use of funds. In such circumstances, the reliance placed by the learned CIT(A) in paragraph 6.8 on the debit balance in the capital account becomes misplaced and legally irrelevant, particularly when there is no finding that borrowed funds, as opposed to interest-free or interest-compensated funds, were utilized for non-business advances.
Viewed holistically, the disallowance sustained by the learned CIT(A) is based on assumption rather than evidence, and is inconsistent with his own findings accepting availability of interest-free funds and absence of nexus. Once the foundational facts necessary to invoke section 36(1)(iii) are found to be absent, no part of the disallowance can survive.
Accordingly, we hold that the disallowance of Rs. 7,70,069/- sustained by the learned CIT(A) under section 36(1)(iii) is not justified. The same is directed to be deleted.
In the result, the appeal of the assessee is allowed. Order pronounced in the open court on 08.01.2026.