Introduction

Businesses often borrow funds to finance operations, purchase assets, or expand their operations. The Income Tax Act, 1961, allows businesses to claim deductions for the interest paid on borrowed capital. This provision, covered under Section 36(1)(iii), provides significant tax relief by reducing taxable income. In this blog, we will explore the conditions, eligibility, and scenarios where the interest on borrowed capital is deductible.

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What is Borrowed Capital?

Borrowed capital refers to funds obtained through loans or other borrowing mechanisms to finance business activities. The interest paid on such borrowings is considered a legitimate business expense, provided the funds are used for business purposes.

Examples of Borrowed Capital:

1. Loans taken for purchasing machinery.
2. Borrowings for working capital.
3. Loans to expand business infrastructure.

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Provisions Under Section 36(1)(iii)

Section 36(1)(iii) allows a deduction for interest paid on borrowed capital, provided the borrowed funds are used for:

1. Acquiring assets used in the business.
2. Working capital needs.
3. Day-to-day operations of the business.

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Conditions for Deductibility

1. Purpose of Borrowing

The borrowed capital must be used for business or professional purposes. Personal borrowings or those unrelated to business are not eligible.

2. Actual Payment of Interest

The interest must be paid or accrued during the financial year.

3. Asset Must Be Put to Use

If the borrowed funds are used to acquire an asset, the deduction is available only after the asset is put to use.

4. Capital vs. Revenue Nature

Interest paid for loans used for acquiring fixed assets (capital expenditure) is deductible only after the asset is put to use, while interest on loans for revenue expenditure (e.g., working capital) is deductible immediately.

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Eligible Scenarios for Deduction

1. Working Capital Loans:
   • Interest paid on loans taken for day-to-day operations, like purchasing raw materials or paying salaries, is deductible.
2. Loans for Asset Purchase:
   • Interest on loans taken to buy machinery, vehicles, or other fixed assets is deductible once the asset is operational.
3. Loans for Expansion:
   • Interest on borrowings for expanding business operations is deductible.
4. Refinancing of Existing Loans:
   • If a new loan is taken to repay an existing business loan, the interest on the new loan is also deductible.

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Non-Deductible Scenarios

1. Personal Borrowings:
   • Interest on loans used for personal expenses, such as buying a personal car or home, is not deductible.
2. Assets Not Put to Use:
   • Interest on loans for acquiring assets not yet put to use cannot be claimed as a deduction.
3. Illegal Activities:
   • Borrowings used for activities not recognized by law are not eligible for deduction.

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Practical Examples

Example 1: Loan for Working Capital

A business borrows ₹10,00,000 for purchasing raw materials and pays ₹1,00,000 as interest.
Deduction: The full ₹1,00,000 is deductible in the year of payment.

Example 2: Loan for Machinery Purchase

A company borrows ₹20,00,000 to buy machinery and pays ₹2,00,000 as interest. The machinery is operational in the same year.
Deduction: ₹2,00,000 is deductible in the year the machinery is put to use.

Example 3: Loan for Expansion

A retailer borrows ₹50,00,000 to open a new store and pays ₹5,00,000 as interest. The store opens in the next financial year.
Deduction: The ₹5,00,000 interest is deductible in the year the store becomes operational.

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Judicial Interpretations

1. Asset Not Put to Use:
   In DCIT v. Core Health Care Ltd., the Supreme Court ruled that interest on borrowings for acquiring an asset is deductible only when the asset is put to use.
2. Mixed-Use Borrowings:
   Courts have clarified that if a loan is partly used for personal purposes, only the business-related portion of the interest is deductible.
3. Pre-Operational Expenses:
   Interest paid before the commencement of business is not deductible as revenue expenditure but may be capitalized.

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FAQs

1. Can interest on personal loans be claimed as a deduction?
No, deductions are allowed only for loans used for business or professional purposes.

2. Is interest on loans taken for acquiring fixed assets immediately deductible?
No, the deduction is allowed only after the asset is put to use.

3. Can interest on overdraft facilities be deducted?
Yes, if the overdraft is used for business purposes, the interest paid is deductible.

4. How to claim deductions for interest on multiple loans?
Maintain proper records to segregate business-related borrowings and claim deductions accordingly.

5. Are there any upper limits on the amount of deduction?
No, there is no maximum limit for claiming deductions under Section 36(1)(iii), provided the conditions are met.

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Conclusion

Interest on borrowed capital is an essential deductible expense under Section 36(1)(iii) of the Income Tax Act, offering significant relief to businesses. Whether it’s for working capital, asset acquisition, or expansion, businesses must maintain proper documentation to substantiate the use of borrowed funds for claiming this deduction. Accurate compliance ensures that businesses can optimize their tax liabilities and focus on growth.

Additional Resources

Learn more about Tax Provisions on the official Income Tax India website.

Want to consult a professional? Contact us: 09463224996

For more information and related blogs, click here.

Additional Resources

Learn more about Tax Provisions on the official Income Tax India website.

Want to consult a professional? Contact us: 09463224996

For more information and related blogs, click here.