No Interest Disallowance When Sufficient Interest-Free Funds Exist Despite Partners’ Drawings: ITAT

The Ahmedabad Bench of the Income Tax Appellate Tribunal (ITAT) has deleted an interest disallowance of Rs. 2.88 crore made under Section 36(1)(iii) of the Income Tax Act, 1961, holding that no diversion of borrowed funds can be alleged merely because partners made drawings, when the assessee possessed ample interest-free funds. The bench of Sanjay Garg (Judicial Member) and Makarand V. Mahadeokar (Accountant Member) set aside the orders passed by the Assessing Officer (AO) and the Commissioner of Income Tax (Appeals), National Faceless Appeal Centre (NFAC). The Bench comprised Judicial Member Shri Sanjay Garg and Accountant Member Shri Makarand V. Mahadeokar. The assessee, engaged in the business of ship recycling, had originally declared an income of ₹7.69 crore. During scrutiny assessment, the AO noted that two partners had withdrawn funds from the firm’s overdraft account without being charged interest. According to the AO, these withdrawals lacked business purpose and led to higher interest liability, resulting in a disallowance of ₹2.88 crore under Section 36(1)(iii) on the ground of alleged diversion of borrowed funds for non-business purposes. The CIT(A) upheld the disallowance, observing that the assessee failed to establish commercial expediency and that interest-free funds, even if available, were not used to reduce the overdraft. The appellate authority concluded that withdrawals routed through the overdraft account justified proportionate disallowance of interest. Before the ITAT, the assessee strongly contested this view, explaining that the negative capital balances of two partners at the beginning of the year were due to a non-cash accounting entry relating to permanent diminution in the value of investments in an earlier year. This diminution loss had already been disallowed for tax purposes and did not involve any actual outflow of funds. When this non-cash adjustment was neutralised, the partners’ capital balances were substantially positive. The assessee further demonstrated, through detailed tables and day-wise workings, that it had massive interest-free funds in the form of partners’ capital, accumulated profits, trade payables and current liabilities—far exceeding the partners’ withdrawals at all relevant points of time. Reliance was placed on settled judicial principles that where mixed funds exist and interest-free funds are more than the advances, a presumption arises that such advances are made out of interest-free funds. After examining the records, the Tribunal found that the lower authorities had erred in focusing only on debit balances and withdrawals while ignoring the overall financial position of the firm. The ITAT observed that a mere accounting provision for diminution in value cannot be equated with actual erosion of capital and cannot be used to infer diversion of borrowed funds. The Tribunal also held that routing of partners’ drawings through an overdraft account, by itself, does not establish a nexus between borrowed funds and non-business use, especially when the assessee’s own funds are demonstrably sufficient. It noted that the Revenue failed to rebut the assessee’s detailed workings or establish any direct link between the borrowings and alleged non-business withdrawals. The ITAT deleted the disallowance of ₹2.88 crore under Section 36(1)(iii). Consequential grounds relating to levy of interest under Sections 234A, 234B, 234C and 234D, as well as initiation of penalty proceedings under Section 270A, were treated as infructuous. Case Details Case Title: R.K. Industries Unit- II LLP Versus ACIT Case No.: ITA No. 1318/Ahd/2024 Date: 05/12/2025 Counsel For Appellant: Hiren Trivedi, AR Counsel For Respondent: Santosh Kumar, Sr. DR Click Here To Read Order Read More: CESTAT Remands Dispute on Proportionate Cenvat Credit on Pre-Tax Insurance Services Availed by Reliance Industries

No Interest Disallowance When Sufficient Interest-Free Funds Exist Despite Partners’ Drawings: ITAT

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