1. Two questions of law have been referred to us in this tax case by the Income-tax Appellate Tribunal. They are as follows :
'1. Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in holding and had valid materials to hold that allowing the directors to take loans from the company without interest did not amount to a benefit or amenity within the meaning of the provisions of section 40(c) of the Act and, therefore, the addition made on that score should be deleted
2. Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in holding that for purposes of invoking the provisions of section 40(c) of the Income-tax Act, 1961, there should be established that there was a direct or indirect link between the assessee-company's interest-bearing borrowings from outsiders and the advance made by the company to its directors without any interest ?'
2. The two questions really raise but a single point for our consideration. The assessee in this case is a private company. In its assessment for 1972-73, relevant to the previous year ended March 31, 1972, the assessee claimed deduction in respect of interest paid on capital borrowed for purposes of its business. The ITO found that the assessee-company had really borrowed money from the banks and had to pay interest on the borrowings. At the same time, the ITO found that the managing director of the assessee-company had heavily drawn from the company's offers for his own private purposes. The officer put the average of the amounts overdrawn by the managing director at Rs. 1,21,482. The officer also found that no interest was debited against the managing director against these overdrawings. In these events, the officer invoked s. 40(c) of the I.T. Act, 1961, and disallowed a sum of Rs. 10,933 which was calculated on the basis of working out the interest at the rate of 9% per annum, which was the assessee's borrowing rate, on the debit balance of Rs. 1,21,482 in the account of the managing director. The assessee appealed against this disallowance under s. 40(c) of the Act. The AAC held that this provision for disallowance cannot be applied to the facts of this case. He observed that there was no evidence to show utilized for the drawings made by the managing director for his private purposes.
3. From this decision of the AAC, the Department appealed to the Tribunal. The Tribunal, however, confirmed the AAC's order. The Tribunal observed that there was no factual link between the borrowings effected by the assessee-company from the banks and the withdrawals effected by the managing director from the funds of the company. According to the Tribunal, s. 40(c) contemplated that there must be a link between the two, either direct or indirect.
4. The Tribunal's view of s. 40(c) of the Act is challenged in this reference in the form of the two questions of law which we have set out earlier in this judgment.
5. The matter really turns on the construction of s. 40(c) of the Act. Under the statutory scheme of the charge to tax on profits and gains of a business, the Legislature provides for various allowances, deductions and charges. They are dealt with, in detail, is ss. 30 to 39 of the Act Section 40, on the other hand, lays down what are expenses which shall not be deducted in the computation of an assessee's taxable business profits. The opening words of s. 40 are :
'Notwithstanding anything to the contrary in sections 30 to 39.'
2. The disallowance under s. 40, therefore, is of items of expenditure which, but for disallowance, would be eligible for deduction under one or other of ss. 30 to 39. Interest on capital borrowed for the purpose of the business is specifically made deductible under s. 36(1)(iii) of the Act. In this case, there is no dispute as to the nature of the capital borrowed by the assessee-company, for the interest paid by the assessee-company barring Rs. 10,933 has been allowed by the ITO as a deduction obviously under s. 36(1)(iii). The disallowance of the amount of Rs. 10,933 is, therefore, of that part of the interest which was claimed by the assessee as interest on borrowed capital. The ITO relied on the words of s. 40(c)(i) of the Act, which are to the effect that in the case of an assessee who is a company, any expenditure which results directly or indirectly in the provision of any remuneration or benefit or amenity to a director or to a person who has a substantial interest in the company or to a relative of the director or of such person, shall not be deducted in computing the company's chargeable business profits if certain other conditions are present. It is unnecessary to go into the question whether in this case those conditions are present or not, since that question can arise only on the footing that the amount sought to be disallowed by the ITO represents expenditure which results directly or indirectly in the provision of any benefit to the managing director in this case.
3. We have earlier referred to the basis on which both the AAC and the Tribunal had dealt with the matter of application of s. 40(c) of the Act. According to them, there must be a factual link established between the expenditure to be disallowed and the benefit or amenity to the director concerned, whether the link is direct or indirect or something of both. The AAC and the Tribunal held against the Department on this aspect of the case only because the ITO had not established the nexus between the expenditure by way of payment of interest by the assessee-company to the bank, on the one hand, and the benefit to the director in the shape of his withdrawals from the company, on the other.
4. Although the question of applicability of s. 40(c) was considered by the Tribunal and the AAC within the narrow confines of an inquiry as to the existence of a factual link up of the company's expenditure and the director's benefit, we think that the matter can be decided on a more fundamental approach to the construction of s. 40(c)(i) of the Act. We have earlier pointed out that what is disallowance under this provision is an expenditure which but for the disallowance would have to be allowed under s. 36(1)(iii) of the Act. What is allowable under s 36(1)(iii) is interest on borrowed capital. It is that expenditure as part of it which would come in for disallowance under s. 40(c)(i). The requirement under this provision is that expenditure, namely, payment of interest, must result directly or indirectly in the provision of any benefit to the director. In this case, the only fact relied on by the Department is that the director was in a position to go withdrawing funds from the company overdrawing his account, without having to pay any interest on the balance to his debit in his personal account. In these events, the question for consideration in terms of the language of s. 40(c)(i) is whether the payment of interest by the assessee-company on the borrowings effected by it from the banks resulted directly or indirectly in the withdrawal of funds by the managing director. The answer plainly is in the negative. It might possibly be maintained that a portion of the capital borrowed by the assessee-company had been diverted to the use of the managing director. But in that event, the benefit resulting to the director is only the proceeds of the borrowing so diverted. The benefit does not result from the payment of interest by the company on borrowed capital. What the section requires is not that anything connected with the expenditure must be connected in some way to the benefit of the director. On the contrary, the connection to be established under this provision must be between the expenditure as such (in this case, the payment of interest on borrowed capital) and the benefit to the director. As we observed earlier, it might well be that the act of borrowing from the company's borrowed funds without having to pay interest can be regarded as a benefit to the managing director. Even so, it cannot be said that this benefit is the consequence or result, either direct or indirect, of the payment of interest by the company on the amount borrowed by it from the bank as and towards its capital.
5. On the construction of the section, which its words clearly indicate, the section cannot fit in with the facts of the case. We may go farther and say that it may never fit in with any case of this nature or cases of similar nature. The only connection in these kinds of cases which can be established by the Department, either directly or indirectly, is that the proceeds of borrowing have been diverted to the personal needs of the directors concerned but a connection so established will not, however, bring to operation the provisions of s. 40(c)(i) of the Act.
6. This conclusion of ours on the construction and application of the relevant provision leads to the same view as the one reached by the Tribunal. We accordingly answer the reference in favour of the assessee and against the Department, although mainly, if not wholly, for different reasons. This conclusion of ours makes it unnecessary for us to answer the two questions referred to us in terms of the language of their text. Both the questions only touch the aspect of the factual presence of a link between the expenditure and the director concerned. This, as we have shown, may be a matter for inquiry wherever any link at all can be established between the expenditure and the benefit in transactions of this kind. But this is not such a case.
7. Since our conclusion is in accord with that of the Tribunal, the board answer to the reference must be stated to be that s. 40(c) does not apply to this case which is an answer in favour of the assessee. However, there will be no order as to costs.