Commissioner of Income Tax vs P. Ganu Rao and Sons

V. Ratnam, J.—In this reference u/s 256(2) of the income tax Act, 1961 (''the Act''), at the instance of the revenue, the following question of

law has been referred to the opinion of this Court:

Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in deleting the disallowance of interest of Rs. 17,123

representing interest attributable to the advances made by the firm to the HUF of Shri Ganu Rao for non-business purposes, vis., construction of

building'' for the HUF?

The assessee is a firm carrying on business in supplying leather goods, metal goods, textile and woollen goods to the Police and Military

Departments. While finalising the assessment for the assessment year 1976-76 the ITO considered the question of allowing the payment of interest

on advances secured by the firm and it was found that the firm had advanced monies to the HUP for the construction of a house. Thereupon, the

assessee was asked to state why interest attributable to diversion of funds to the HUF should not be disallowed and the assessee maintained that

the entire loans were utilised for purposes of business only and adequate funds were available in the partners current and capital accounts and there

was, therefore, no diversion of bank borrowals towards the building account. However, the ITO found that the stand of the assessee that the entire

borrowals from the bank were, utilised for business purposes cannot be accepted and the assessee had no other interest free capital or other funds

and in that view, disallowed interest of Rs. 17,123. On appeal by the assessee, the AAC found that the firm was not in possession of other funds,

on which, it paid no interest and, therefore, all the funds available to the firm bore interest and the diversion of funds from the firm to the family, free

of interest, called for disallowance of interest paid by the firm and in that view, upheld the disallowance. On further appeal before the Tribunal, it

took the view that the authorities below had disallowed interest on a misconception and that though the amounts paid to the HUF for purposes of

house construction were not reflected in the accounts of the firm, as relating to personal drawings, yet, the circumstance that the partners of the firm

chose to debit these amounts invested in the construction of the family house in a separate account and there was no nexus between a particular or

specific borrowing by the assessee and its investment in the building constructed established there was no justification for the disallowance and

accordingly deleted the addition of Rs. 17,123. That is how the question of law set out earlier, has come up before this Court.

The learned counsel for the revenue submitted that the assessee-firm and the HUF are two distinct and separate entitles and that even as per the

statement of accounts relied on by the assessee-firm, there is nothing to indicate that the amounts borrowed by the firm, had not been utilised by it

for the purpose of house construction and this justified the disallowance of the interest, as done by the authorities below. Reference was made in

this connection to Milapchand R. Shah v. CIT [19651 58 ITR 525 (Mad.) and P. Rm. S. Ramanathan Chettiar Vs. Commissioner of Income Tax,

On the other hand, the learned counsel for the assessee contended that there is no acceptable proof of diversion of funds by the firm for the

purpose of construction of the family house and that, in any event, the circumstance that from out of the borrowed amounts as well as the other

funds, the expenditure in connection with the construction of the house had been incurred, would not make any difference to the allowability of the

interest paid by the firm on its borrowals. Reference in this connection was made to COMMISSIONER OF Income Tax, ANDHRA PRADESH

Vs. GOPIKRISHNA MURALIDHAR., and Commissioner of Income Tax, Madras Vs. Coimbatore Salem Transport (Private) Limited., The

Tribunal proceeded to hold that there was no justification for the disallowance of interest by the authorities below on the ground that there was

adequate credit balance in the capital and current accounts of all the partners of the firm and that there was no nexus established between any

particular borrowing by the firm and the incurring of expenditure on house construction by the partners of the firm. Even while holding so, the

Tribunal noticed that the assessee had shown the amounts spent for the house construction relating to the HUF as a loan by the firm for the

purpose of such house construction. The Tribunal also stated that if the drawings for the house construction had been made in the respective

personal accounts of the partners, then, the objection regarding the disallowance of interest would not be sustainable, as there was adequate credit

balance in the capital and current accounts of all the partners. It is, thus, seen from even the accounts maintained by the assessee-firm that the

amounts borrowed by the firm for its business purposes, had been entered as having been advanced as a loan to the HUF for purposes of house

construction, instead of being shown as drawings in the partners'' personal accounts. It would, thus, even on the findings of the Tribunal, follow that

borrow ed funds had been utilised not for the purposes of the business of the ten, but had been advanced as a loan to the HUF for the purpose of

meeting the house construction expenses. Undoubtedly, this would constitute a diversion justifying the disallowance of interest on the borrowals in

the assessment of the firm. Further, even on the entries in the accounts, the assessee-firm and the HUF, have been treated as two distinct and

different entities altogether and advances by the firm to the HUF cannot be considered to be for the purpose of meeting the expenditure connected

with the firm and its business activities. Such amounts as have been advanced by the assessee to the HUF during the accounting year 1975-76,

could not, therefore, be regarded as amounts utilised by the firm for the purposes of its business. It may be that the partners'' capital account and

current account during the relevant accounting year may show availability of substantial funds, but the funds advanced to the HUF have not been

shown to have been paid out of the capital account or current account of the partners of the firm, and though this has been noticed by the Tribunal,

yet, it took the view that this would not justify the disallowance of the Interest on the amounts diverted to the HUF from the firm for the purposes

of house construction. We are unable to agree with this view, even on the accounts relied on by the assessee, which, as pointed out earlier, clearly

show that no amount from the capital and current account of the partners has been paid out to the HUP, and it follows that such payments should

have come only out of the funds of the firm borrowed for its business purposes. From out of the funds so borrowed, the assessee-firm had

diverted the borrowed funds for purposes other than its business requirements and to that extent, the interest on borrowals should have been

disallowed. On the facts and the circumstances of the case and the state of accounts relied on by the Tribunal, we hold that the Tribunal was not

right in deleting the disallowance of interest. We find it unnecessary to make a reference to any of the cases relied on either by the counsel for the

revenue or the counsel for the assessee. We, therefore, answer the question referred to us in the negative and in favour of the revenue. There will

be no order as to costs.