Jaswantrai P. Mehta vs Commissioner of Income Tax

R.C. Mankad, J.—The assessee is an individual and the assessment year with which we are concerned in this reference, is 1974-75, the year of account being Samvat Year 2029, which ended on 26-10-1973. The assessee, as karta of his HUF, is a partner in C. Prabhudas & Co., a partnership firm. The assessee has an account with the firm of C. Prabhudas & Co. in his individual capacity also. He had borrowed money from C. Prabhudas & Co. and invested the borrowed money in purchase of shares. The assessee''s major investments are in Polysteels (India) Ltd. and Polygas Ltd. According to the ITO, the investments are made in the said companies for controlling the affairs of the company rather than for earning income as envisaged u/s 57(iii) of the income tax Act, 1961 (''the Act''). In Polysteels (India) Ltd., other members of the assessee''s family, namely, his wife, brother, brother''s wife, mother and other private limited companies in which the assessee and/or other members of his family have interest, are holding shares. Opening balance in the assessee''s individual account with C. Prabhudas & Co. was Rs. 3,17,685. The assessee had paid interest of Rs. 40,193 on the outstanding amount in this account and claimed that, interest to the extent of Rs. 39,801 should be allowed as deduction u/s 57(iii), while computing income chargeable under the head ''Income from other sources''. However, since, in the view of the ITO, investments made out of the money borrowed from C. Prabhudas & Co. were for controlling the affairs of the aforesaid companies, and not for earning the income as envisaged u/s 57(iii), the assessee was not entitled to claim deduction of the interest amount of Rs. 39,801 as claimed by him. He, therefore, rejected the claim of the assessee and proceeded to compute the total income for the assessment year 1974-75. The total income computed came to Rs. 1,81,144 as against the returned total income of Rs. 1,18,920. Being aggrieved by the assessment made by the ITO, the assessee carried the matter in appeal before the AAC. The AAC following his decision in the appeals for the assessment years 1972-73 and 1973-74, allowed the assessee''s claim for deduction of interest amount of Rs. 40,193. It is not disputed that the AAC had committed mistake in allowing the deduction of entire interest amount of Rs. 40,193 since the assessee himself had restricted his claim of deduction of interest amount to Rs. 39,801. We are told that the mistake committed by the AAC is later on corrected.

The revenue, being aggrieved by the decision of the AAC, carried the matter in appeal before the Tribunal. The Tribunal observed that, out of the opening balance of Rs. 3,17,665 in the assessee''s individual account with C. Prabhudas & Co. Rs. 2,87,578 represented investments where interest was allowable as deduction. In the preceding assessment year, i.e., assessment year 1973-74, the assessee was liable to pay interest of Rs. 30,773, on the amounts borrowed for making investments. The assessee had claimed deduction of interest amount of Rs. 30,773 u/s 57(iii) in the assessment for the assessment year 1973-74 and he was allowed such deduction. It is not disputed that the assessee had not paid the said interest of Rs. 30,773 to C. Prabhudas & Co. and he was allowed deduction thereof as liability to pay such interest had arisen. In the year under reference, i.e., assessment year 1974-75 also, the assessee had not paid the said amount of Rs. 30,773, due in the preceding year. Since the assessee did not pay the interest amount of Rs. 30,773, it was debited to the assessee''s account with C. Prabhudas & Co. and the opening balance of Rs. 3,17,665 for the assessment year under reference included the said interest amount of Rs. 30,773. In the year under reference, i.e., assessment year 1974-75, the assessee claimed deduction of interest at the rate of 12 percent on the said sum of Rs. 30,773, which represented interest payable in the preceding year u/s 57(iii). According to the assessee, the said interest on the interest amount of Rs. 30,773 was in the nature of compound interest and, therefore, allowable as deduction u/s 57(iii). The revenue on the other hand contended that such interest could not be allowed as expenditure u/s 57(iii). The Tribunal held that the assessee''s claim could not be accepted, inasmuch as, interest, deduction of which the assessee claimed, was interest payable on the interest amount of the preceding year. Such interest became payable because the interest of the preceding year remained unpaid. It was not paid on the borrowings utilized for the purchase of shares and, therefore, it had no connection with the earning of dividend income as such. The Tribunal observed that, if the assessee''s claim were to be accepted, it would lead to the result that, the debtor need not pay the interest regularly, but utilize that amount for other purpose and make the revenue pay compound interest payable by him, and, thus, derive an advantage out of his own omission. The Tribunal sought to derive support for the conclusion reached by it from the decision of the Supreme Court in Shew Kissen Bhattar Vs. The Commissioner of Income Tax, Calcutta, . The Tribunal, therefore, directed the ITO to exclude interest paid on the said interest amount of Rs. 30,773 while allowing the deduction of interest. The assessee felt aggrieved by the decision of the Tribunal and, therefore, at his instance, the following question has been referred to us, for our opinion, u/s 256(1) of the Act:

Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the interest paid by the assessee on the amount of interest payable for earlier years cannot be allowed as an expenditure u/s 57(iii) of the Act?

The question which arises for our consideration is whether the assessee is entitled to claim deduction of interest paid on interest payable in the preceding year or years. Section 57(iii) under which the assessee claims deduction, reads as follows:

Deductions. - The income chargeable under the head ''Income from other sources'' shall be computed after making the following deductions, namely:--

(i) and (ii) ****

(iii) any other expenditure (not being in the nature of capital expenditure) laid out or expended wholly and exclusively for the purpose of making or earning such income.

The assessee contends that he had borrowed money for making investments in shares and he was liable to pay interest on such borrowings. He further contends that, if he did not pay interest payable on the borrowings, he was also liable to pay interest at the rate of 12 percent per annum on the interest, which remained unpaid would become part of the principal amount in the next year and he would be liable to pay interest on the entire principal amount including interest which had remained unpaid. In other words, according to the assessee, he is liable to pay compound interest to the creditor. It is contended that, if the interest payable on the borrowings is allowable expenditure u/s 57(iii), interest which he pays on such interest is also allowable deduction, inasmuch as, it is an expenditure, which is directly connected with the borrowings, which he had made for the purpose of making investments. Although section 57(iii) requires that expenditure, should be incurred for the purposes of making or earning such income, it is not necessary that income should be actually earned. Once it is held that such an expenditure is incurred, any further or incidental expenditure incurred in relation to the same transaction cannot have a different nature of character. Therefore, according to the assessee, the expenditure he has incurred by way of interest on outstanding interest of the preceding year is an expenditure incurred in relation to the some transaction and, such interest will have the same character as the interest payable on the borrowing. It was urged that applying the test of commercial expediency, the expenditure, deduction whereof is allowable u/s 57(iii), may have direct or indirect connection with the making or earning such income. If the assessee has bona fide and voluntarily incurred expenditure out of commercial expediency, the expenditure is deductible and it is immaterial whether it is beneficial for the assessee to incur such expenditure or whether it is expedient on his part to do so. In the alternative, it is urged that the expenditure by way of interest on outstanding interest will have the same character as the interest on the borrowings. Under the principles of accountancy also interest would include compound interest. According to the assessee, there is no prohibition to allow deduction of compound interest.

We do not find any substance in the contention of the assessee. As pointed out above, the assessee had claimed and was allowed deduction of Rs. 30,773. When represented interest payable on the amount borrowed, which was utilized for making investment in shares in the preceding assessment year, i.e., 1973- 74. Deduction of the said interest amount was allowed on the basis that the assessee had become liable to pay such interest to his creditor. It is not disputed that, in fact, the assessee has not paid such interest to the creditor. The question which is sought to be raised in the year under reference, is that the assessee is liable to pay interest at the rate of 12 percent on the interest of Rs. 30,773, which was payable in the preceding year but was not actually paid and the assessee is entitled to claim deduction of such interest u/s 57(iii). Had the assessee paid the interest of Rs. 30,773 to his creditor in accordance with the terms of borrowings, he would not have been liable to pay further interest of 12 percent on the amount of interest. Whether the interest, which the assessee became liable to pay is called interest on interest or compound interest or interest payable on the principal amount, including the interest payable in the preceding year, is of no consequence. The question is whether liability to pay such interest can be considered to be an expenditure laid out or expended wholly or exclusively for the purpose of making or earning income chargeable under the head ''Income from other sources ''.The answer to this question has to be in the negative. The interest, which the assessee is liable to pay on the amount borrowed by him for the purpose of making investments, is undoubtedly an expenditure laid out or expended wholly and exclusively for the purpose of making or earning income chargeable under the head ''Income from other sources''. But the interest, which the assessee has become liable to pay on account of his failure to pay interest, which is deduction as expenditure, cannot be said to be an expenditure laid out or expended wholly and exclusively for the purpose of earning such income. What the assessee is entitled to deduct is the interest payable by him on the principal amount borrowed and not the additional interest, which, because of his failure to pay the interest on the due date, had been considered part of the loan or the principal amount borrowed. It is the principal amount which he borrowed and invested in the shares which is relevant for the purpose of computing interest which could be treated an expenditure for the purpose of earning income. As rightly observed by the Tribunal, if the assessee''s contention is correct, all that the debtor need to do is not to pay interest regularly, but utilize that amount for other purposes and make the revenue pay compound interest payable by him and, thus, derive advantage out of his own omission. Such an interpretation of section 57(iii) is not permissible.

We derive support, in the view which we are inclined to take, from the decision of the Supreme Court in Shew Kissen Bhatter''s case (supra), on which reliance was placed by the Tribunal, that was a case in which the assessee was a trustee of a house property at Chandmari Road, North. In respect of that house, there was a title suit filed by one Durga Prasad Chamria against Smt. Anardevi and others, claiming title over that property and for other reliefs. A consent decree was passed in that suit on 19-4-1928. Under the terms of that decree the aforementioned house property was held to belong to Smt. Anardevi Senthani, but she was to make payment of Rs. 8,61,000 to the plaintiff therein. There was stipulation for payment of compound interest on the unpaid amount at 63/4 percent with yearly rests. It was further provided therein that Rs. 4,25,000 was to be paid on the execution of the terms of settlement and, thereafter, monthly instalments of Rs. 35,000 for seventeen months and the balance in the eighteenth month. The terms of compromise were not adhered to, inasmuch as, there were defaults in payment of interest. After making the payment on 19-2-1945, there still remained outstanding Rs. 2,75,536. The interest on this amount at 6 3/4 percent for a year worked out to Rs. 18,000. The assessee, however, calculated the total interest payable at Rs. 38,221 for the assessment year 1956-57, relying on the clause in the agreement providing for payment of compound interest. The ITO gave deduction of Rs. 18,000 only, on the basis of simple interest at the rate of 63/4 percent per annum. The assessee''s appeal against this order was dismissed by the AAC and later on, by the Tribunal. The question of law, which referred to the High Court at the instance of the assessee, was also answered by the High Court in favour of the revenue. The matter was carried in appeal to the Supreme Court. The question, which arose before the Supreme Court, was whether, on true construction of the words ''interest payable on such capital'' in section 9(1)(iv) of the Indian income tax Act, 1922, the amount of interest allowable was Rs. 18,000 or Rs. 38,221. In other words, the question which arose before the Supreme Court was whether the assessee was entitled to deduct the compound interest payable by him in accordance with the terms of the contract or whether he was entitled to deduct simple interest at the rate of 63/4 percent per annum. The Supreme Court observed that, what the law permitted was the deduction of the ''amount of any interest on such mortgage or charge''. The interest payable by the assessee on the capital charge was at the rate 63/4 percent per annum. But if he failed to pay that in accordance with the terms of the contract, he was liable to pay compound interest. In other words, if he failed to pay interest in accordance with the contract, he was liable to pay interest on interest. Or, to put it differently, when the interest payable is not paid, the same became a part of the principal and, thereafter, interest had to be paid not only on the original principal but also on the part of the interest which had become part of the principal amount. The Supreme Court held that, it could not be said that the interest which became part of the principal could be considered as capital charge. What the assessee was entitled to deduct was the interest payable by him on the capital charge and not the additional interest, which, because of his failure to pay the interest on the due date, had been considered as a part of the loan. In fact, the real capital charge was that which was originally due. The other portion was merely an interest on which the assessee had agreed to pay interest. The Supreme Court, therefore, did not accept the contention of the assessee that the interest paid on interest was an interest paid on the capital charge. The Supreme Court rejected the assessee''s contention that law permitted him to deduct any interest payable by him on the capital borrowed or charged and ''any interest'' included compound interest also. The Supreme Court observed that compound interest was payable not on the capital charge, but on that part of interest on which he had agreed to pay interest. That was not capital taken note of by section 9(1)(iv). The Supreme Court further observed that, if the assessee''s contention was correct, then the door will open for evasion of tax. It was observed, "all that the debtor need to do is not to pay interest regularly but utilize that interest for other purpose and make the revenue pay compound interest payable by him and thus derive advantage out of his own omission. Such an interpretation is impermissible". The Supreme Court upheld the view taken by the High Court.

It is true that the above decision, which the Supreme Court has given, is in the context of section 9(1)(iv). But in our opinion, the reasons given by the Supreme Court while rejecting the assessee''s claim in that case will apply with equal force to the instant case. It was urged that section 57(iii) of the 1961 Act was in much wider terms than section 9(1)(iv) of the 1922 Act and, therefore, the decision of the Supreme Court in Shew Kissen Bhatter''s case (supra) can have no application. We find ourselves above the reasons which the Supreme Court has given in the context of section 9(1)(iv) apply with equal force while considering allowability of expenditure u/s 57(iii) in a case like that of the assessee. The assessee had borrowed money to make investment in shares and, therefore, while computing dividend income falling under the head ''Income from other sources'' the assessee can legitimately claim deduction of interest payable on such borrowed amount as expenditure u/s 57(iii), However, interest, which the assessee is required to pay on account of his failure to pay interest payable on the borrowed amount, cannot be considered to be an expenditure as laid out or expended wholly and exclusively for the purpose, of making or earning the said income. The unpaid interest may become part of the principal amount under the principles of accountancy; but it cannot be considered to be part of the amount borrowed for the purpose of investment. That the assessee is entitled to deduct is the interest payable by him on the principal amount borrowed by him which he invested in the shares and not the additional interest which, because of his failure to pay the interest on due date, had been considered to be part of the loan or the amount borrowed. We, therefore, find ourselves unable to accept the assessee''s contention that an interest paid on interest takes the colour of the interest payable on the amount borrowed. Which was invested and that the nature and character of such interest is not different from the interest payable on such borrowed amount. Whether, interest payable on interest is part of the same transaction and whether it becomes part of the principal amount borrowed under the principles of accountancy, is of no consequence.

There is another aspect of the matter which requires serious consideration. As pointed out above, the assessee was allowed deduction of the interest amount of Rs. 30,773 in the preceding year, i.e., assessment year 1973-74. The assessee is now claiming deduction of interest paid on the said amount of interest of Rs. 30,773 in the year under reference. In our opinion, the assessee''s liability in regard to the interest of Rs. 30,773, deduction whereof has already been granted in the preceding year, ceased to exist for the purpose of the income tax. So far as income tax proceedings are concerned, the assessee has already been allowed the benefit of deduction of his liability to pay interest amount of Rs. 30,773 irrespective of the fact whether or not he has actually paid the amount. Therefore, that liability for the purpose of income tax stands wiped out, subject to any provision for adding it back in case of remission thereof given by the creditor in future. Once the liability for the purpose of income tax stands discharged or wiped out, it is difficult to appreciate how the assessee can claim deduction of interest payable on such non-existing liability. It may be that so far as the creditor is concerned, the assessee continues to be liable to pay interest and compound interest on the amount borrowed by him, but so far as proceedings under the Act are concerned, as already observed above, the liability to pay interest stands discharged, inasmuch as, deduction thereof as allowable expenditure has been granted in the preceding year by the income tax authority. On the above ground also, in our opinion, the assessee''s claim cannot be sustained. We may mention that, the above aspect of the matter did not arise for consideration before the Tribunal or the other taxing authorities.

In the result, we endorse the view taken by the Tribunal and answered the question referred to us, for our opinion, in the affirmative and against the assessee. Reference answered accordingly, with no order as to costs. At this stage, Mr. D.A. Mehta, the learned counsel for the assessee prays that, we may certify this to be a fit case for appeal to the Supreme Court u/s 261 of the Act. In our opinion, having regard to the facts and circumstances of the case, this is not a case fit for appeal to the Supreme Court. We, therefore, reject Mr. Mehta''s prayer to grant certificate as provided in section 261.