Section 28 of the Income tax Act,1961, provides for charging of income tax on the profits and gains of a business or profession carried on by the assessee. While computing the income under the head ?Profits and gains of business or profession?, certain deductions have been provided on account of expenses incurred by the assessee for earning such income and certain special deductions for promoting industrial activities.
Section 36(1)(iii) of the Act provides for deduction of the amount of interest paid in respect of capital borrowed for the purpose of a business or profession. The import of the proviso to section 36(1)(iii) is that the interest paid on the capital borrowed for the purpose of acquisition of an asset till the date such an asset is first put to use will not be allowed as a deduction.
Explanation 8 to section 43(1) and a combined reading of section 36(1)(iii) and section 43(1) show that these provisions are in consonance with the law laid down by the Supreme Court in Challapalli Sugars Ltd v CIT (98 ITR 167), wherein it is provided that any amount of interest paid on the capital borrowed for the purpose of acquisition of the asset up to the date it is first put to use is to be added to the cost of the asset.
Though the proviso to section 36(1)(iii) was added by the Finance Act, 2003, it is merely clarificatory. The language of Explanation 8 to section 43(1) does not make any distinction between acquisition of an asset when a new business is being set up or when expansion is being carried out.
Even a conjoint reading of section 36(1)(iii) as existing prior to the proviso thereto and section 43(1), Explanation 8 clearly shows that any interest paid on the capital borrowed for the acquisition of an asset cannot be allowed as revenue expenditure.
The capital might have been borrowed by an assessee for the purpose of business. However, once it is admitted that a part thereof was used by the assessee for the purpose of acquisition of an asset, which is not in the form of replacement or modernisation, the interest component thereon up to the date it is first put to use has to be dealt with in terms of the provisions of Explanation 8 to section 43(1). The point was considered by the Full Bench of the Punjab and Haryana High Court in CIT v Vardhman Polytex Ltd (299 ITR 152).
The facts in this case were that the assessee was engaged in the manufacture of yarn. For the assessment year 1992-93, the assessee claimed a deduction on account of Rs 1,97,290 and Rs 9,80,000 on account of interest under Section 36(1)(iii) and upfront fees, respectively.
This claim was made on account of loans raised for the setting up of a new unit. It was admitted in the return that the new unit had not yet come into commercial production.
However, the claim of the assessee was that it was nothing but expansion of its earlier business under the same management and administration. The assessing officer rejected the claim but the commissioner of income tax (appeals) and the tribunal allowed it.
The high court held that section 36(1)(iii) will not bring within its fold the capital borrowed for the purpose of setting up of a new unit, as the same would not amount to borrowing capital for the purpose of business or profession but for te setting up of a plant.
The new unit set up with borrowed capital had not yet started contributing to the business carried on by the assessee. It is only when an asset is first put to use and commercial production commences that it starts generating income.
The Punjab and Haryana High Court in Vardhman Polytex Ltd’s case came to the conclusion that a purposive interpretation is required to be given to section 43(1), Explanation 8, by holding that interest on the capital borrowed for acquisition of an asset for the period before the asset is first put to use is to be treated as part of its capital cost, but for the period thereafter it is not permitted to be added to the actual cost. The language of section 43(1) Explanation 8 does not in any manner make out a distinction in the acquisition of an asset when a new business is being set up or when the expansion is carried out.
In fact, the addition of the proviso to section 36(1)(iii) of the Act was to clarify the scheme of the Act providing for the manner in which the interest on the capital borrowed is to be dealt with. Even a conjoint reading of section 36(1)(iii) as existing prior to the proviso thereto and section 43(1), Explanation 8, clearly shows that any interest paid on the capital borrowed for the acquisition of an asset cannot be allowed as a revenue expenditure.
The capital might have been borrowed by an assessee for the purpose of business. However, once it is admitted that a part thereof was used by the assessee for the purpose of acquisition of an asset, which is not in the form of replacement or modernisation, the interest component thereon up to the date it being first put to use has to be dealt with in terms of the provision of section 43(1) Explanation 8. This is in conformity with law and accounting principles.
Thus, the Full Bench held that since the loan was not raised for the purpose of running the business for its day-to-day requirements but for the purpose of creating substantial additional assets by creating new capacity at a new location, the interest on the loan was not deductible under section 36.
The aforesaid decision makes it obligatory for a person starting a new unit to capitalise the interest on the monies borrowed up to the date of commencement of the unit. Such amount would, therefore, be eligible for depreciation under section 32 of the Act from the year in which the assets are put to use.
The author is advocate, Supreme Court