ORDER
T.V.K. Natarqjachandran, Vice-President
1. These appeals by the assessee are consolidated and disposed of by a common order, for the sake of convenience as they involve common issues. The appeals pertain to the assessment years 1978-79, 1979-80, 1980-81 and 1981-82 and arise out of the separate orders of the CIT (Appeals).
2. The assessee is a resident company and as the very name suggests, it purchases brass and metal scrap and manufactures brass rods. It has adopted calendar year as the previous year. It also undertakes job work of conversion of raw materials.
3. The first common issue relates to the disallowance of interest paid on borrowed funds on the ground of diversion of funds to sister concern without charging any interest. For the sake of convenience, we shall discuss the assessment year 1978-79 in detail. The assessee-company made certain advances to sister concern Copper Strips (P.) Ltd. on which no interest was charged. In the original assessment for 1978-79, the Assessing Officer disallowed interest of Rs. 36,585 pertaining to those advances on the view that there was no indication in the books of account, that they were made against any material received or purchased from the sister concern.
4. On appeal, the then CIT (Appeals) restored the issue to the AO for examining the matter with reference to the balance sheet of the sister concern after giving opportunity to the assessee of being heard. Thereafter, the AO called upon the assessee to furnish the balance sheet of the sister concern but it was not filed. However, a photo copy of the certificate dated 31-12-1977 of sister concern was filed which indicated that raw material weighing 26738.400 kg. was given to the assessee on 31-12-1977 which is relevant for the assessment year 1978-79. However, it is not clear to the AO that the advances were made for the said raw material. He has also referred to the doubt cast in the earlier order by the then CIT (Appeals) on the nexus between the material received for conversion from sister concern and advances made to it by the assessee. On the aforesaid premise, the AO concluded that the advances made to the sister concerns were not for business purposes. Consequently, he disallowed the interest of Rs. 36,585 for the assessment year 1978-79.
5. On appeal, the assessee took the plea that against material sent for conversion, the assessee made certain advances in the normal course of business by way of security but there was no agreement. Therefore, taking into account the opinion of the predecessor CIT(A), the successor CIT(A) also held that no interest needs be charged on the advances made to directors and employees. He has also opined that on the part of the debit balance of Rs. 78,431 on 31-12-1977 representing conversion charges receivable, no disallowance of interest was called for. The opening debit balance as on 1-1-1977 was Rs. 1,30,893 and the closing debit balance was Rs. 2,76,503 at Bombay office. The CIT(A) directed to disallow 75 per cent interest on the closing balance as not relating to the business because the same balance did not continue throughout the year of account.
6. In the assessee’s letter dated 7-1-1988 addressed to the CIT(A) contained at pages 8 to 10 of the paper book, the assessee stated that the debit balance in the Bhopal office represented conversion charges due but did not represent advances made. At Bombay office, only advances from time to time were made which were duly returned to the assessee at periodic intervals. The stand taken by the assessee was that the advances represented current deposits by way of business security for the material lying with the assessee for purpose of conversion.
7. Similarly, the AO disallowed interest for assessment years 1979-80, 1980-81 and 1981-82 as detailed in the assessment orders. The CIT(A) by his consolidated orders dated 15-9-1989 excluded service charges included in the debit balances and upheld levy of interest on the balances.
8. At the time of hearing, learned counsel for the assessee reiterated the contentions raised before the authorities and referred to the agreement entered into by the assessee with the sister concern. The preamble of the said agreement mentions that the conversion job of raw materials was going on since last few years and the terms and conditions agreed to by both the parties were recorded in the agreement dated 15-11-1978. According to Clause(1) of the said agreement, no charges will be recovered for the material supplied for conversion and the material would lie with the assessee in trust. According to Clause (3), in case of delay or default in supply by the assessee, the sister concern would recover the loss in terms of money as settled between the parties.
Clause (4) of the agreement is very much relevant which is reproduced here below:
4. The material to be supplied by the first parry to the second party for conversion/manufacture, being voluminous, costly and worth of substantial amount of money for which the party of the first part desired to get the same secured and to keep deposit in the current account of the second party. The said deposit may not be of equivalent value of the material but should at least cover 75% to 100% value of the material, supplied and remained with the party of the second part. The party of the second part agree to the said proposal and confirm to keep deposit as a kind of security towards the material lying with them for conversion/manufacture as per specification of the party of the first part. The said deposit shall not bear any interest as agreed between both the parties. It is, however, further agreed that, in case in future date the parties of both the parts mutually agree, interest may be charged on such deposit.
9. Referring to the aforesaid agreement, the contention of the assessee was that the advances made were only for the purpose of business security for the material lying in possession of the assessee at any time. It was further contended that the AO has taken into account only the closing stock balance at the year end and he has not analysed day-to-day advances and repayments.
10. The learned Departmental Representative has been duly heard and he has supported the orders of the authorities.
11. We have duly considered the rival submissions, record and the paper compilation. The assessee is doing business of manufacturing brass rods on its own and also on job work basis. The assessee is required to make advances or payments by way of security for the value of the raw materials supplied to the assessee for the purpose of job work. This position is made clear by an agreement dated 15-11-1978 between the assessee and its sister concern which has supplied the bulk of job work to the assessee and which is a major source of income. A perusal of the paper book containing account of the sister concern in Bhopal Branch where the job work is done and also in the Bombay Branch shows that apart from the labour charges, other advances were also made to the sister concern and they were also repaid at a short interval. The account also reveals that the assessee has purchased certain raw materials out of the raw materials received for job work for which adjustment entries are passed in the accounts. Thus, there has been continuous out-flow and in-flow of funds between the assessee and the sister concern which conforms to the understanding existing between the parties. The custom of obtaining business security for the value of material supplied for job work is also prevalent in this line of business. The advances made by the assessee to the sister concern directly or indirectly facilitated carrying on business of job work done by the assessee which is the major source of income. Therefore, there is direct concern and direct purpose which is connected with the normal business carried on by the assessee and the connection is not remote or indirect. Therefore, the advances made by the assessee to the sister concerns are in the commercial expediency of the business carried on by the assessee because in order to ensure continuous flow of raw material for the purpose of job work, the assessee has been advancing funds and the closing amount of advances remaining unadjusted would represent a fraction of the market value of material lying with the assessee for processing. In this connection, the assessee has furnished certificate from the sister concern showing the quantity of copper material lying in stock for processing.
12. As regards the interest paid on borrowed funds, the decision of the Bombay High Court in the case of CIT v. Bombay Samachar Ltd. [1969] 74 ITR 723 permits deduction of interest if capital is borrowed by the assessee for the purpose of business and the assessee actually paid interest and claimed deduction. The whole exercise of diversion of borrowed funds to sister concerns came to be performed by the AO only on account of certain observation made by the predecessor CIT (Appeals) in his order dated 23-7-1984. While restoring the matter to the AO, he pointed out that there was no indication in the books of the assessee that the amounts advanced by the assessee to the sister concerns were against any material received or purchased. He also observed that merely because material for conversion was sent by the sister concerns, the assessee must necessarily have to make advances. He concluded that the material received by the assessee for conversion and lying with the assessee has no connection with the advances made. In other words, the inference drawn by him was that the advance was not made for business purpose. It is for this reason that the CIT (Appeals) asked for balance sheet of the sister concerns to find out its capital and whether it was running its business with the advances made by the assessee. Thus, certain doubts entertained by the CIT (Appeals) found in the fresh orders passed by the AO. The paper compilation filed by the assessee clearly showed that funds were flowing in and out between the assessee and the sister concerns regularly in the form of current account and it is not as if, the assessee has advanced borrowed funds only to make the sister concerns to carry on its business. The records show that the sister concern has greater potentiality and capacity for carrying on its business out of its own funds instead of depending on the funds advanced by the assessee. In assessment year 1980-81 in Bhopal Branch, the sister concern had advanced Rs. 96,50,824 to the assessee as against Rs. 87,45,000 advanced by the assessee which showed that the assessee received excess advance of Rs. 9,05,824. The interest payable by the assessee on the average advance of Rs. 8,04,235 worked out to Rs. 1,20,635 as against interest of Rs. 1,09,312 receivable by the assessee on average advance of Rs. 7,28,750. Thus, the average surplus interest payable by the assessee works out to Rs. 11,323 – vide working at page 45 of the paper book.
13. We shall now consider specific details year-wise. Taking the assessment year 1978-79, the assessee’s letter dated 7-1-1988 addressed to the CIT (Appeals) explained the case of the assessee. The minimum debit balance with sister concern was Rs. 20,520.84 and maximum debit balance was Rs. 2,76,502. Therefore, the assessee pleaded that the closing balance should not be taken as if outstanding for whole of the year. On 31-12-1976, relevant for the assessment year 1977-78, the sister concern had credit balance of Rs. 3,00,249.91 on account of purchase of material. This credit balance continued from 1-1-1977 to 30-1-1977. Then on 31-1-1977, the account of sister concern was debited at Rs. 4,18,000 as the material supplied by the sister concern was found to be defective. This resulted in a debit balance of Rs. 1,17,750. We have looked into the relevant account of the sister concern in the books of the assessee. The sister concern had paid back a huge amount and its balance stood at credit of Rs. 32,822.22 as on 9-11-1977. It stood at credit of Rs. 44,822.22 on 30-11-1977. On 31-12-1977, a debit of Rs. 78,430.81 was made to the account towards outstanding labour charges. Thus, almost till the end of November 1977, the account of sister concern has a credit balance and it is only on account of labour charges receivable, several debit entries have been passed in the month of December 1977 resulting debit balance of Rs. 78,430.81.
14. Coming to the Bombay Branch, in the current account, the opening debit balance was Rs. 1,30,893.16 against advances made by the assessee. Lump sum repayments were made by sister concern, viz., Rs. 90,000 on 12-1-1977, Rs. 10,000 on 17-1-1977, Rs. 10,000 on 17-1-1977, Rs. 20,000 on 5-3-1977, Rs. 10,000 on 7-3-1977, Rs. 15,000 on 5-8-1977, Rs. 30,000 on 25-5-1977 and Rs. 15,000 on 14-5-1977. Similarly, Rs. 40,000 on 15-6-1977, Rs. 26,000 on 30-8-1977, Rs. 30,000 on 20-9-1977 and Rs. 10,000 on 1-12-1977 were repaid by the sister concern. The advances to sister concerns and repayments from the sister concerns were only for short duration and the net increase in the debit balance over the period amounted to Rs. 1,45,609 against which 26738.400 kg. of copper material of the sister concern is lying with the assessee for fabrication. Although, there was no agreement for making advances towards the material lying with the assessee for fabrication, the later agreement dated 15-11-1978 contained at pages 25 to 77 of the paper compilation highlights the existing understanding with the parties for earlier years which were now put into writing on 15-11-1978. In other words, the same procedure was being followed by the assessee even in the earlier years.
15. Coming to the assessment year 1979-80, assessee’s letter dated 12-6-1989 explained the case of the assessee. The agreement provides for making deposits by the assessee as security against the value of the goods lying with the assessee for fabrication. Further, assessee’s letter dated 22-11-1988 shows that the closing debit balance of the sister concern in Bhopal Branch was Rs. 1,00,708.88 as on 31-12-1978 as against the opening debit balance of Rs. 78,430.81 which gives an increase in the debit balance of Rs. 28,577. It is needless to mention at this juncture that on 31-12-1978, the assessee has debited a sum of Rs. 43,681.58 as its conversion charges receivable from the sister concerns. Thus, the increase in the debit balance is due to debiting of labour charges in Bhopal Branch.
16. Coming to the debit balance in Bombay Branch, the closing debit balance as on 31-12-1978 was Rs. 6,04,878.93 as against the opening debit balance of Rs. 2,76,502.82. Even here, a sum of Rs. 2,72,777 has been debited, towards various items of conversion charges receivable from the sister concern. In other words, debit balance to the extent of Rs. 2,72,777 should be reduced from the closing debit balance because it was on account of labour charges, the debit balance has been increased. Excluding the labour bill, the closing debit balance works out to Rs. 3,32,102 and after adjusting the opening debit balance of Rs. 2,76,503, the net increase in the debit balance works out to Rs. 55,599. Against this balance, the material of 222.400 kg. supplied by the sister concern was lying in stock for purpose of fabrication.
17. Coming to the assessment year 1980-81, the assessee’s letter dated 8-6-1989 contained at pages 43 and 44 of the paper book explained the case of the assessee. The debit balance of Rs. 5,22,535 in the account of sister concern included Rs. 1,85,063.20 [vide page 56 of the paper book) being outstanding labour charges and which did not represent maximum balance throughout the year. An analysis of Bombay Branch account of the sister concern shows that it had opening debit balance of Rs. 2 lakhs and closing balance of Rs. 2,45,824.29 credit. Even after adjusting debit of Bhopal Branch of Rs. 34,865.22, the net credit balance stood at Rs. 2,10,959.07 (vide page 55 of paper book).
18. In Bhopal Branch advances made to sister concern were Rs. 87,45,000 and repayments received from sister concern were Rs. 96,50,824 resulting in excess receipts of Rs. 9,05,824 and net interest payable by the assessee on the difference of average advances and repayments works out to Rs. 11,323 – vide page 45 of the paper compilation.
19. The consolidated statement of Bombay and Bhopal Branches shows a mixed trend. The opening debit balance was Rs. 3,87,389 and the closing credit balance was Rs. 2,10,134.78. During the year there were debit balances for January, February, March, April, June and November while there were credit balances in May, July, August, September, October and December – vide page 57 of the paper book.
20. Coming to the assessment year 1981-82, assessee’s letter dated 14-6-1989 explains the case which is at pages 61-64 of the paper book. The consolidated Bombay and Bhopal Branches account at pages 70-71 shows opening debit balance of Rs. 96,840.78 and closing debit balance of Rs. 12,19,081.27. This according to the assessee included Rs. 7,45,582.45 which are outstanding labour charges receivable – vide pages 68-69. The net debit balance comes to Rs. 4,73,500 and interest chargeable works out to Rs. 78,128 only as against Rs. 87,572 already charged by the assessee.
21. On appreciation of all the facts and circumstances of the case, we consider that as a matter of commercial expediency and the normal trade practice disallowance of interest on the ground of diversion of borrowed funds is unwarranted and unjustified. Even on factual basis there are credit balances for some years one setting off against other. Accordingly, we reverse the decisions of the CIT (Appeals) on this point and direct the AO to delete the disallowance of interest for all the assessment years under consideration.
22. As regards the second common issue which relates to disallowances of interest under Section 40A(8), the Assessing Officer noticed that the assessee has paid interest both to non-resident and directors and shareholders. While the interest paid to the non-residents was not disallowed, the interest paid to the directors on current account was disallowed under Section 40A(8) by relying on the decision of the Tribunal, Indore Bench, in the case of ITO v. Rqjdoot Hotel Enterprises Corporation (P.) Ltd. [IT Appeal No. 1050 (Indore) of 1984, dated 8-10-1986]. Consequently, the Assessing Officer disallowed a sum of Rs. 18,163 for the assessment year 1978-79. Similarly, he disallowed a sum of Rs. 18,592 for assessment year 1979-80, Rs. 13,068 for assessment year 1980-81 and Rs. 22,398 for the assessment year 1981-82 respectively.
23. On appeal, for the assessment year 1978-79, the CIT (Appeals) noticed different decision by the Tribunal, Bombay Bench. Therefore, he restored the matter for the assessment year 1978-79 to the AO to pass fresh order in accordance with law. In appeal for the assessment year 1979-80, the issue was decided against the assessee on the ground that in the appeal filed against the original assessment the assessee has not raised any objection for such disallowance. However, for the assessment years 1980-81 and 1981-82, the issue was decided against the assessee by the CIT (Appeals) holding that the provisions of Section 40A(8) are applicable even in respect of current account of the directors.
24. After hearing the learned counsel for the assessee and the learned D.R. and also keeping in view the findings given in the orders of the authorities, we uphold the disallowance made by the AO and confirmed by the CIT (Appeals) for all the years other than 1978-79 wherein the issue was restored to the AO for fresh adjudication. Reliance is placed on the decision of the Tribunal in the case of Kaloomal Shorimal Sachdev Rangwala (P.) Ltd. v. First ITO [1985] 14 ITD 248 (Bom.)(SB).
25. Ground No. 3 relates to assessment year 1981-82 only. It pertains to addition of cash credits of Rs. 46,000. The AO disbelieved the loans advanced by Smt. Chandraben M. Sanghrajka Rs. 26,000 and Shri Mahesh M. Sanghrajka Rs. 20,000 on the ground that they were received in cash and they were not assessed to tax and the assessee had not identified the signature of the creditors. The financial capacity of the creditors was also doubted. Hence, he assessed the loans as income from undisclosed sources.
26. On appeal before the CIT (Appeals) except general explanation no evidence was produced to establish creditworthiness of the creditors. Accordingly, the CIT (Appeals) confirmed the additions.
27. After hearing the learned counsel for the assessee and the learned D.R., we uphold the decision of the CIT (Appeals) for except the confirmation letters, there is no corroborative evidence was produced for the availability of funds and the nexus with the loans advanced.
28. In the result, the appeals are partly allowed.