The High Court of Mumbai on 3^rd March 2014 ruled in favor of the assessee, and allowed the investment of borrowed funds in Indian company, without maintaining a separated bank account.
In the given case the assessee had invested borrowed funds into an Indian Company, where the given dividend income was exempt from tax. In the above case the AO disallowed the deduction of interest expense, saying that if Income is exempt from taxes then the expenses for such income cannot be claimed. On first appeal the commissioner of Income Tax dismissed the claim of the AO stating “that investment in mutual funds was made directly from sales tax deferral amount available to assessee”.  

Interest on borrowed capital [Investment from non-interest bearing funds] assessee earned dividend income from investment in mutual funds. Assessing Officer noticed that assessee had borrowed certain sum during relevant year and had paid interest thereon. On above basis Assessing Officer concluded that a part of amount was invested out of borrowed funds. Assessing Officer thus disallowed a part of interest amount claimed as deduction under section 36(1)(iii). Commissioner (Appeals) recorded a finding of fact that investment in mutual funds was made directly from sales tax deferral amount available to assessee. He thus deleted disallowance made by Assessing Officer, Tribunal upheld order of Commissioner whether there is no requirement under law that assessee should have separate account in respect of non-interest bearing funds from that of interest bearing funds to establish that investments have been made out of its own funds i.e. non-interest bearing funds – Held, in favor of the assessee whether, therefore, impugned order passed by Tribunal was to be upheld.

Facts of the case are as follows:

Whether on the facts and in the circumstances of the case and in law, the Tribunal was correct in confirming the order of CIT(A) in deleting the disallowance of Rs.76.76 lacs made by the Assessing Officer under Section 36(1)(iii) of the Income Tax Act?

The Respondent-assessee filed its return of income for assessment year 2004-05 declaring a total income of Rs.100.76 crores. During the course of the assessment proceeding the Assessing Officer noted that the respondent had earned dividend income amount of Rs.63.73 lacs by way of dividend income from mutual funds. The dividend income earned from mutual fund was exempt from tax. However, the Assessing officer also noted that during the course of the year the Respondent-assessee had invested an amount of Rs.4147.44 lacs in mutual funds on which dividend was earned. The Assessing officer noticed that the Respondent-assessee had borrowed a sum of Rs.30 crores during the year and had paid total interest of Rs.613.26 lacs on the same. On the above basis the Assessing Officer concluded that the amount of Rs.4147 lacs was invested out of borrowed funds and disallowed expenditure on account of interest to the extent of Rs.77.76 lacs on the ground that the above interest was not attributable to business carried on by the Respondent-assessee. Thus, the Assessing Officer disallowed the expenditure of Rs.77.76 as interest under Section 36(1)(iii) of the said Act as not being for purposes of business.

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