Business expenditure: Interest on borrowed capital: Section 36(1)(iii) and section 57(iii) of Income-tax Act, 1961: A.Y. 1986-87: Assessee borrowed money from sister concern for interest at the rate of 18% and purchased preferential shares from sister concern which carried dividend at 4%: Legal effect of the transaction cannot be displaced by probing into the substance of the transaction.

The assessee borrowed money from sister concern for interest at the rate of 18% per annum and purchased shares from sister concern, which carried dividend at the rate of 4%. The Assessing Officer held that there was no justification to borrow funds at 18% interest for making investment in shares, which would give a dividend of 4% only. Having regard to the fact that the borrowing was made from sister concern and investment was also in another sister concern, the claim for interest was disallowed. It was held that investment of shares was not for business purposes or business consideration. The Tribunal allowed the assessee’s claim and held that the assessee could not be prevented from making investment only because the returns from shares was low. The investment was incidental activity of the business and there was no effect on the Revenue as the assessee and the sister concerns belonged to the same group. The transaction was bona fide and not sham.

In the appeal filed by the Revenue, the following question was raised:

“Whether on the facts and in the circumstances of the case, the Tribunal was right in law in allowing interest claimed by the assessee at a higher rate on the borrowings though the investment had been made by the assessee in the shares of a sister concern which gave a fixed return of income?”

The Division Bench of the Punjab and Haryana High Court referred the matter to the Full Bench which considered the following question of law:

“Whether having regard to relationship between different concerns, where a transaction which is patently imprudent, takes place, the taxing authority should examine the question of business expediency and not go merely by the fact that the assessee had taken a decision in its wisdom which may be wrong or right?”

The Full Bench of the Punjab and Haryana High court held as under:

“(i) The Assessing Officer or the Appellate Authorities and even the Courts can determine the true legal relation resulting from a transaction. If some device has been used by the assessee to conceal the true nature of the transaction, it is the duty of the taxing authority to unravel the device and determine its true character.

(ii) However, the legal effect of the transaction cannot be displaced by probing into the ‘substance of the transaction’. The taxing authority must not look at the matter from their own viewpoint, but that of a prudent businessman.

(iii) Each case will depend on its own facts. The exercise of jurisdiction cannot be stretched to hold a roving enquiry or deep probe.”