‘Interest on loans for investment forms part of acquisition cost’

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: Under the Indian Income-Tax laws, tax under the head ‘capital gains’ is leviable on the profits and gains arising from the transfer of capital assets effected in the year.

The cost of acquisition, which is an important determinant of capital gains, has not been defined in the Income-Tax Act and often becomes a subject matter of litigation. One such area of dispute is whether interest paid on the money borrowed by the taxpayer for the acquisition of shares constitutes the ‘cost of acquisition’ for computing capital gain /loss from sale of shares.

The problem becomes especially acute in cases where substantial sums of money are borrowed by the holding company for acquiring shares of a group company and these shares are subsequently sold. In this regard, various judicial precedents have laid down the basic principle of law that cost would include anything that the taxpayer has in fact expended or laid out for the purpose of acquiring the asset. Therefore, it is settled law that interest on capital borrowed for acquiring the asset is to be included in the cost of acquisition.

However, the question arises whether the same principle can be applied in case of acquisition of shares also. The Karnataka High Court in the case of Maithreyi Pai (1985) (152 ITR 247) has had an occasion to specifically examine this issue in case of shares. The court opined that the interest on borrowings was undoubtedly an expenditure incurred for the acquisition of the shares and hence it constituted the ‘cost of acquisition’ for purposes of computing capital gains.

The court also took note that if the interest paid on borrowings is already a subject matter of deduction under Section 57 (income from other sources), it would not find a place again for the purpose of computation under Section 48 as no taxpayer under the scheme of the Indian Income-Tax Act could be allowed deduction of the same amount twice over.

However, the issue that was being viewed as quite settled has been recently made controversial by a decision of the Mumbai Tribunal in the case of Macintosh Finance Estates (2007) (12 SOT 324). In this case, the tribunal extended the analogy of the above decision to hold that once it is found that the interest expense is an allowable expenditure under the head ‘income from other sources’, it cannot be allowed to be added to the cost of the investment even if in that year, no deduction was actually allowable (dividend income having been made exempt).

This decision has raised a controversy as to whether in such cases the investor stands to lose the deduction of interest from both ends – i.e. as expenditure for earning income from other sources (dividend income being exempt) and as cost of acquisition for computing capital gains (as considered to be allowable under Section 57 even if not actually allowed).

In this context, the decision of the Bombay High Court in the case of Amrita Ben R Shah (1999) (238 ITR 777) would be worth nothing. In this case, the court took specific note of the purpose of investment and held that in case the shares were purchased by the taxpayer for acquiring controlling interesting in the company and not for earning dividends, interest on borrowings made for acquisition of shares would not be allowable as a deduction under Section 57 of the Income-Tax Act.

In the case of Macintosh, the tribunal distinguished the above judgment of the Bombay High Court as there was nothing on record to show that the shares were acquired by the taxpayer for acquiring controlling interest in the companies and proceeded on the presumption that interest expense was an allowable expenditure under the head “Income from other sources”.

Therefore, it appears that if it can be substantiated that the investment is for the purpose of acquiring controlling interest, interest on borrowings can be claimed to form part of acquisition cost.