ITAT Mumbai: No Interest Disallowance Under Section 36(1)(iii) Where Sufficient Own Funds Exist; Addition Deleted in Fairchem Organics Case

Key Facts and Tribunal Findings

The Mumbai Bench of the Income Tax Appellate Tribunal (ITAT) allowed the appeal of Fairchem Organics Limited for AY 2020–21, deleting disallowance of ₹68.14 lakh made under Section 36(1)(iii) on account of alleged diversion of borrowed funds. The Assessing Officer had observed that the assessee, despite having substantial borrowings of over ₹60 crore, had extended capital advances of ₹6.53 crore without charging interest. It was alleged that interest-bearing funds were diverted towards such advances, leading to proportionate disallowance of interest expenditure.

The assessee contended that the advances were made in the ordinary course of business for acquisition of capital assets and were funded entirely through internal accruals and interest-free funds. It highlighted that its equity and reserves amounted to approximately ₹128.56 crore, far exceeding the advances. The assessee also demonstrated substantial profitability and positive cash flows during the year. The CIT(A) upheld the disallowance, citing lack of documentary evidence and failure to establish nexus between own funds and advances. On further appeal, the ITAT examined the financial statements and found that interest-free funds were significantly higher than the advances. It also noted that the Revenue failed to establish any direct nexus between borrowed funds and the impugned advances.

Relying on the Supreme Court’s ruling in CIT v. Reliance Industries Ltd., the Tribunal held that where mixed funds exist and interest-free funds are sufficient, a presumption arises that advances are made out of such funds. It further observed that the advances were for business purposes, namely procurement of capital goods for plant upgradation, which was not disputed by the Revenue. Accordingly, the Tribunal held that the disallowance was based on mere presumption without supporting evidence and deleted the addition in full.

Legal Analysis and Practical Implications

The ruling reinforces a well-settled principle governing Section 36(1)(iii): disallowance of interest requires clear evidence of diversion of borrowed funds for non-business purposes. Mere existence of borrowings alongside advances does not justify disallowance. A key legal takeaway is the application of the presumption in favour of the taxpayer in cases of mixed funds. Where sufficient interest-free funds are available, the burden shifts to the Revenue to establish a direct nexus between borrowed funds and advances. Failure to discharge this burden renders disallowance unsustainable.

The Tribunal also reaffirmed that advances made for acquisition of capital assets in the ordinary course of business qualify as commercially expedient, thereby supporting allowability of interest. From a practical perspective, the decision provides clarity for corporates maintaining mixed fund structures. Robust financial disclosures demonstrating availability of internal accruals and reserves can effectively counter allegations of fund diversion.