Article
Borrowed Cost and its Effect on Computation of Income
1. Introduction:
The treatment of borrowed cost, particularly interest paid on borrowed funds, has long been one of the most litigated areas under the Indian Income-tax Act, 1961. The controversy revolves around the circumstances in which interest on borrowed capital is deductible, capitalizable, or taxable, especially when funds are temporarily parked in deposits yielding interest before utilization for business purposes. Statutory provisions such as sections 36(1)(iii), 37(1), and 56 of the Act, along with judicial doctrines like the ‘real income’ theory, provide the framework for addressing these issues. Judicial precedents from the Supreme Court and High Courts, such as Tuticorin Alkali Chemicals, Bokaro Steel, and UCO Bank, as well as more recent ITAT decisions, have shaped the contours of this debate.
The introduction of Income Computation and Disclosure Standards (ICDS) has further complicated the landscape, as they sometimes diverge from traditional accounting standards (AS/Ind-AS) in recognizing interest costs and deemed income. For instance, ICDS mandates capitalization of interest until an asset is ready for use, whereas AS 16 provides more flexibility. This divergence has created significant compliance and interpretational challenges.
2. Judicial Evolution of Borrowed Cost:
2.1 Tuticorin Alkali Chemicals and Fertilizers Ltd. v. CIT [1997] 93 Taxman 502 (SC): The Supreme Court in Tuticorin Alkali Chemicals laid down a foundational principle: interest earned on surplus borrowed funds, even if temporarily parked before business commencement, is taxable as ‘Income from Other Sources’ under section 56. The Court emphasized that until the funds are utilized for business purposes, the character of income does not change. This decision has often been applied where assessees attempted to net off interest earned against interest expenditure.
Footnote: Tuticorin Alkali Chemicals v. CIT [1997] 93 Taxman 502 (SC).
2.2 Bokaro Steel Ltd. v. CIT [1999] 102 Taxman 94 (SC): : In contrast, Bokaro Steel Ltd. introduced an important exception. The Court held that if the receipt of interest is inextricably linked to the setting up of a plant, such income is not taxable but must be reduced from the project cost. The case distinguished Tuticorin Alkali by noting that the nature of the income is determined by the nexus with business activity rather than the mere form of the receipt. This principle has been significant for large infrastructure and capital-intensive industries.
Footnote: Bokaro Steel Ltd. v. CIT [1999] 102 Taxman 94 (SC).
2.3 CIT v. Motor Credit Co. (P.) Ltd. [1981] 6 Taxman 63 (Mad.): The Madras High Court in Motor Credit Co. reinforced the ‘real income’ principle by holding that income that cannot be realized should not be taxed merely on accrual. In the context of borrowed cost, this case is relevant because it underscores that the taxability of interest should depend on its real character and enforceability, rather than mechanical application of accrual rules. This reasoning was later affirmed in other sticky loan cases.
Footnote: CIT v. Motor Credit Co. (P.) Ltd. [1981] 6 Taxman 63 (Mad.).
2.4 CIT v. Ferozepur Finance (P.) Ltd. [1980] 4 Taxman 439 (P&H): In this case, the Punjab & Haryana High Court emphasized that interest which is not realizable due to the financial incapacity of the borrower does not constitute taxable income. Applying the real income theory, the Court underscored that mere entries in books cannot substitute for actual accrual of income. This doctrine is important for cases involving sticky loans and informs the treatment of borrowed cost and interest recognition.
Footnote: CIT v. Ferozepur Finance (P.) Ltd. [1980] 4 Taxman 439 (P&H).
2.5 2.5. CIT v. Eicher Ltd. [2009] 185 Taxman 243 (Delhi): The Delhi High Court considered whether interest on borrowings utilized for business purposes remained deductible even when projects were delayed. The Court held that as long as funds were used for the assessee’s business, deduction under section 36(1)(iii) could not be denied. This principle safeguards taxpayers against arbitrary disallowances when commercial expediency can be established.
Footnote: CIT v. Eicher Ltd. [2009] 185 Taxman 243 (Delhi).
2.6 CIT v. Elgi Finance Ltd. [2007] 293 ITR 357 (Madras): In Elgi Finance, the Madras High Court held that where interest-bearing loans are advanced in the ordinary course of business, the corresponding interest expenditure is deductible, provided there is a nexus with income-generating activities. The case reaffirmed that the Revenue cannot question commercial expediency unless the transaction is sham or lacks bona fides.
Footnote: CIT v. Elgi Finance Ltd. [2007] 293 ITR 357 (Madras).
2.7 Thermal Powertech Corporation India Ltd. v. DCIT [2018] 96 taxmann.com 545 (Hyd. Trib.): The Hyderabad Tribunal, applying Tuticorin Alkali, held that interest earned on temporary parking of borrowed funds in short-term deposits is taxable as ‘Income from Other Sources’. The Tribunal distinguished Bokaro Steel by noting that the deposits were not inextricably linked to the project. This decision reflects the continuing tension between the principles of Tuticorin Alkali and Bokaro Steel in project finance cases.
Footnote: Thermal Powertech Corporation India Ltd. v. DCIT [2018] 96 taxmann.com 545 (Hyd. Trib.).
2.8 Syndicate Bank v. DCIT [2020] 119 taxmann.com 147 (Karnataka HC): The Karnataka High Court dealt with interest deductions claimed by banks on borrowed funds. The Court held that since borrowing was part of banking business, interest expenditure is deductible in full. This case illustrates that for banks and financial institutions, borrowed cost is inherently revenue in nature and not subject to capitalization principles applicable to other industries.
Footnote: Syndicate Bank v. DCIT [2020] 119 taxmann.com 147 (Karnataka HC).
2.8 Vijayashanthi Builders Ltd. v. JCIT [2017] 88 taxmann.com 413 (Chennai Trib.): The ITAT held that interest on borrowed funds for real estate projects remains deductible even where project completion is delayed. The Tribunal emphasized that the funds were used for business and hence the deduction under section 36(1)(iii) applies. The case highlights the special issues faced by builders and developers in computing taxable income.
Footnote: Vijayashanthi Builders Ltd. v. JCIT [2017] 88 taxmann.com 413 (Chennai Trib.).
2.9 HGP Community P. Ltd. v. ITO [2019] 111 taxmann.com 277 (Delhi Trib.): In HGP Community, the Tribunal clarified that borrowed cost incurred by developers for construction activities should be allowed as revenue expenditure, provided the funds are directly linked with the project. The decision strengthens the position of developers who often borrow heavily and face disputes on capitalization vs. revenue treatment of interest.
Footnote: HGP Community P. Ltd. v. ITO [2019] 111 taxmann.com 277 (Delhi Trib.).
3. Borrowed Cost under ICDS vis-à-vis Accounting Standards: The introduction of ICDS created significant divergences in the treatment of borrowed costs. While AS 16 (Borrowing Costs) allows capitalization only when specific conditions are met, ICDS mandates capitalization of borrowing costs relating to qualifying assets until the asset is first put to use. This rigid rule under ICDS may increase the taxable income of assessees by deferring deductions. Courts have, however, continued to rely on established judicial principles even in the post-ICDS regime, leading to interpretational inconsistencies.
4. Applied Contexts: The treatment of borrowed cost varies across industries. For infrastructure and power companies, capitalization is often mandatory until projects commence operations. For builders and developers, interest on borrowed funds can be treated as part of stock-in-trade. For banks and NBFCs, borrowing is an integral part of business, and interest is treated as revenue expenditure. Judicial precedents have tailored principles to these specific contexts, ensuring that the doctrine of commercial expediency remains central.
5. Conclusion: The jurisprudence on borrowed cost illustrates the delicate balance between protecting revenue interests and ensuring fairness to taxpayers. The distinction between capital and revenue, the concept of inextricable nexus, and the real income theory continue to guide adjudication. While ICDS has sought to standardize computation, courts have preferred a purposive approach based on facts of each case. Going forward, alignment between statutory provisions, ICDS, and judicial doctrines will be essential to reduce litigation and provide certainty.