I passed borrowed money to my sister concern interest-free. Can the AO disallow the interest I paid?
Only if the advance fails the commercial expediency test. Interest on borrowed funds advanced interest-free to a sister concern is deductible under s.36(1)(iii) where the advance was made on grounds of commercial expediency, an expression of wide import covering what a prudent businessman spends for the purposes of business, with no need for a legal obligation.
Decided by the Supreme Court (S.B. Sinha J and Markandey Katju J) on 2006-12-14, reported as [2007] 288 ITR 1 (SC); [2007] 158 Taxman 74 (SC); [2006] 206 CTR 631 (SC); Civil Appeal Nos. 5811 and 5812 of 2006. It bears on section 36(1)(iii), section 37(1), section 28, section 154 of the Income Tax Act 1961, in Deductions & Disallowances matters.
This is the answer to the standard proportionate interest disallowance where money moves to a group company. It also tells the officer what he must do rather than what he may assume: put himself in the assessee's shoes and ask how a prudent businessman would act, instead of substituting his own view of what should have been done. The case is not a blanket allowance — borrowings diverted for personal or sentimental reasons, the Court's example being a donation to a college, do not qualify, and the matter here went back to the Tribunal because nobody had applied the test at all.
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For assessment year 1990-91 the Assessing Officer found that the assessee had transferred Rs 82 lakh to its subsidiary, SAB Credits Ltd, out of a cash credit account carrying a large debit balance, and disallowed proportionate interest of Rs 5,66,729. The Commissioner (Appeals) held on 15 April 1993 that only Rs 18 lakh of the Rs 82 lakh had a clear nexus with borrowed funds, the balance having come from client receipts on which no interest was paid, and restricted the disallowance accordingly. For assessment year 1991-92 a further Rs 37,85,000 was advanced to the same subsidiary and interest of Rs 20,08,836 was disallowed, reduced by the Commissioner (Appeals) to Rs 10,03,538 on 28 July 1994 and by a further Rs 1,48,464 under s.154 on 6 September 1995. On cross appeals the Tribunal held on 20 June 2002 that the whole of the Rs 82 lakh had come out of the overdraft account and restored the Assessing Officer's disallowance, and it followed that view for the later year. The Punjab and Haryana High Court dismissed the assessee's appeals on 13 May 2004, holding that the Tribunal's finding disclosed no factual or legal infirmity. The Tribunal had also recorded that the assessee had not explained the purpose of the advance and that there was no material showing any business benefit from it (paras 4 to 12, 17).
The appeals were allowed, the judgments of the High Court, the Tribunal and the authorities below were set aside on the interest point, and the matter was remanded to the Tribunal for a fresh decision in accordance with law and in the light of the Court's observations (para 36). The deduction was not allowed. The test where an assessee borrows and lends interest-free to a sister concern is whether that was done as a measure of commercial expediency (para 21); if it was, the interest should be allowed (para 24), and the fact that the borrowed money was not used in the assessee's own business is not really relevant (para 31). None of the authorities below had examined that question (para 28), nor had they examined the purpose of the advance and what the sister concern did with the money (para 30). The Court expressly cautioned that it is not in every case that interest has to be allowed where the assessee advances to a sister concern, that it depends on the facts, and that money used by the sister concern's directors for their personal benefit could not be commercial expediency; but where a holding company with a deep interest in its subsidiary advances borrowed money that the subsidiary uses for business purposes, the deduction would ordinarily follow (para 35). The Court also made clear that it was not setting aside the orders below on any point other than the deduction of interest on borrowed funds (para 37).
Section 36(1)(iii) allows interest on capital borrowed for the purposes of the business, and Madhav Prasad Jatia establishes that 'for the purpose of business' is wider than 'for the purpose of earning income, profits or gains' (paras 19, 20, 29). Because s.37 uses the same expression, the s.37 authorities apply equally to s.36(1)(iii), and those authorities hold that the expression covers expenditure voluntarily incurred for commercial expediency, it being immaterial that a third party also benefits (para 22). The Court applied the House of Lords test in Atherton - that it is enough that money is expended not of necessity and for direct and immediate benefit but voluntarily on grounds of commercial expediency and to indirectly facilitate the carrying on of the business - noting it had been approved in Eastern Investments and Chandulal Keshavlal (para 23). Commercial expediency is an expression of wide import covering expenditure a prudent businessman incurs for the purpose of business, and need not rest on any legal obligation (para 25). Conversely, Madhav Prasad Jatia shows that a borrowing donated for sentimental or personal reasons - there, to a college commemorating the assessee's deceased husband - is not commercial expediency (paras 26, 27). Agreeing with the Delhi High Court in Dalmia Cement (Bharat) Ltd., the Court held that once a nexus between the expenditure and the purpose of the business is established - and that business need not be the assessee's own - the revenue cannot put itself in the businessman's armchair or in the board's position and decide what expenditure is reasonable; no businessman can be compelled to maximise profit, and the authorities must put themselves in the assessee's shoes and see how a prudent businessman would act (para 34). The Bombay High Court's contrary view in the two Phaltan Sugar Works decisions, that s.36(1)(iii) requires the capital to be borrowed for the assessee's own business, was held to be incorrect (paras 32, 33).
The expression "commercial expediency" is an expression of wide import and includes such expenditure as a prudent businessman incurs for the purpose of business.
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Handle my notice → Ask a CA on WhatsAppOnly if the advance fails the commercial expediency test. Interest on borrowed funds advanced interest-free to a sister concern is deductible under s.36(1)(iii) where the advance was made on grounds of commercial expediency, an expression of wide import covering what a prudent businessman spends for the purposes of business, with no need for a legal obligation. This was decided by the Supreme Court (S.B. Sinha J and Markandey Katju J) and bears on section 36(1)(iii), section 37(1), section 28, section 154 of the Income Tax Act 1961. It is reported as [2007] 288 ITR 1 (SC); [2007] 158 Taxman 74 (SC); [2006] 206 CTR 631 (SC); Civil Appeal Nos. 5811 and 5812 of 2006. This is the answer to the standard proportionate interest disallowance where money moves to a group company. It also tells the officer what he must do rather than what he may assume: put himself in the assessee's shoes and ask how a prudent businessman would act, instead of substituting his own view of what should have been done. The case is not a blanket allowance — borrowings diverted for personal or sentimental reasons, the Court's example being a donation to a college, do not qualify, and the matter here went back to the Tribunal because nobody had applied the test at all. If it applies to you, the first step is this: Record on the file the business reason for the advance — supply security, a group undertaking, protection of your own receivables — rather than asserting commercial expediency as a label.
For assessment year 1990-91 the Assessing Officer found that the assessee had transferred Rs 82 lakh to its subsidiary, SAB Credits Ltd, out of a cash credit account carrying a large debit balance, and disallowed proportionate interest of Rs 5,66,729. The Commissioner (Appeals) held on 15 April 1993 that only Rs 18 lakh of the Rs 82 lakh had a clear nexus with borrowed funds, the balance having come from client receipts on which no interest was paid, and restricted the disallowance accordingly. For assessment year 1991-92 a further Rs 37,85,000 was advanced to the same subsidiary and interest of Rs 20,08,836 was disallowed, reduced by the Commissioner (Appeals) to Rs 10,03,538 on 28 July 1994 and by a further Rs 1,48,464 under s.154 on 6 September 1995. On cross appeals the Tribunal held on 20 June 2002 that the whole of the Rs 82 lakh had come out of the overdraft account and restored the Assessing Officer's disallowance, and it followed that view for the later year. The Punjab and Haryana High Court dismissed the assessee's appeals on 13 May 2004, holding that the Tribunal's finding disclosed no factual or legal infirmity. The Tribunal had also recorded that the assessee had not explained the purpose of the advance and that there was no material showing any business benefit from it (paras 4 to 12, 17). The matter was decided on 2006-12-14 by the Supreme Court (S.B. Sinha J and Markandey Katju J). On those facts the Supreme Court held as follows. The appeals were allowed, the judgments of the High Court, the Tribunal and the authorities below were set aside on the interest point, and the matter was remanded to the Tribunal for a fresh decision in accordance with law and in the light of the Court's observations (para 36). The deduction was not allowed. The test where an assessee borrows and lends interest-free to a sister concern is whether that was done as a measure of commercial expediency (para 21); if it was, the interest should be allowed (para 24), and the fact that the borrowed money was not used in the assessee's own business is not really relevant (para 31). None of the authorities below had examined that question (para 28), nor had they examined the purpose of the advance and what the sister concern did with the money (para 30). The Court expressly cautioned that it is not in every case that interest has to be allowed where the assessee advances to a sister concern, that it depends on the facts, and that money used by the sister concern's directors for their personal benefit could not be commercial expediency; but where a holding company with a deep interest in its subsidiary advances borrowed money that the subsidiary uses for business purposes, the deduction would ordinarily follow (para 35). The Court also made clear that it was not setting aside the orders below on any point other than the deduction of interest on borrowed funds (para 37).
Section 36(1)(iii) allows interest on capital borrowed for the purposes of the business, and Madhav Prasad Jatia establishes that 'for the purpose of business' is wider than 'for the purpose of earning income, profits or gains' (paras 19, 20, 29). Because s.37 uses the same expression, the s.37 authorities apply equally to s.36(1)(iii), and those authorities hold that the expression covers expenditure voluntarily incurred for commercial expediency, it being immaterial that a third party also benefits (para 22). The Court applied the House of Lords test in Atherton - that it is enough that money is expended not of necessity and for direct and immediate benefit but voluntarily on grounds of commercial expediency and to indirectly facilitate the carrying on of the business - noting it had been approved in Eastern Investments and Chandulal Keshavlal (para 23). Commercial expediency is an expression of wide import covering expenditure a prudent businessman incurs for the purpose of business, and need not rest on any legal obligation (para 25). Conversely, Madhav Prasad Jatia shows that a borrowing donated for sentimental or personal reasons - there, to a college commemorating the assessee's deceased husband - is not commercial expediency (paras 26, 27). Agreeing with the Delhi High Court in Dalmia Cement (Bharat) Ltd., the Court held that once a nexus between the expenditure and the purpose of the business is established - and that business need not be the assessee's own - the revenue cannot put itself in the businessman's armchair or in the board's position and decide what expenditure is reasonable; no businessman can be compelled to maximise profit, and the authorities must put themselves in the assessee's shoes and see how a prudent businessman would act (para 34). The Bombay High Court's contrary view in the two Phaltan Sugar Works decisions, that s.36(1)(iii) requires the capital to be borrowed for the assessee's own business, was held to be incorrect (paras 32, 33). In the words reproduced by the source cited on this page: "The expression "commercial expediency" is an expression of wide import and includes such expenditure as a prudent businessman incurs for the purpose of business." The decision followed or applied Atherton v. British Insulated & Helsby Cables Ltd. [1925] 10 TC 155 (HL); Eastern Investments Ltd. v. CIT [1951] 20 ITR 1 (SC); CIT v. Chandulal Keshavlal & Co. [1960] 38 ITR 601 (SC); CIT v. Malayalam Plantations Ltd. [1964] 53 ITR 140 (SC); CIT v. Birla Cotton Spg. & Wvg. Mills Ltd. [1971] 82 ITR 166 (SC).
It was decided by the Supreme Court on 2006-12-14 and is reported as [2007] 288 ITR 1 (SC); [2007] 158 Taxman 74 (SC); [2006] 206 CTR 631 (SC); Civil Appeal Nos. 5811 and 5812 of 2006. Binding on every court and authority in India. A Supreme Court decision binds every assessing officer, every Commissioner (Appeals), every bench of the Income Tax Appellate Tribunal and every High Court in India. An officer who declines to follow it is acting contrary to law, and that refusal is itself a ground of appeal. On section 36(1)(iii), section 37(1), section 28, section 154, the practical question is whether the facts of your own notice match the facts of this case closely enough for the same rule to apply.
It cuts both ways and is cited by both sides. The appeals were allowed, the judgments of the High Court, the Tribunal and the authorities below were set aside on the interest point, and the matter was remanded to the Tribunal for a fresh decision in accordance with law and in the light of the Court's observations (para 36). The deduction was not allowed. The test where an assessee borrows and lends interest-free to a sister concern is whether that was done as a measure of commercial expediency (para 21); if it was, the interest should be allowed (para 24), and the fact that the borrowed money was not used in the assessee's own business is not really relevant (para 31). None of the authorities below had examined that question (para 28), nor had they examined the purpose of the advance and what the sister concern did with the money (para 30). The Court expressly cautioned that it is not in every case that interest has to be allowed where the assessee advances to a sister concern, that it depends on the facts, and that money used by the sister concern's directors for their personal benefit could not be commercial expediency; but where a holding company with a deep interest in its subsidiary advances borrowed money that the subsidiary uses for business purposes, the deduction would ordinarily follow (para 35). The Court also made clear that it was not setting aside the orders below on any point other than the deduction of interest on borrowed funds (para 37). It arises in Deductions & Disallowances matters, on section 36(1)(iii), section 37(1), section 28, section 154 of the Income Tax Act 1961, and was decided by S.B. Sinha J and Markandey Katju J. Before relying on it, read the source linked on this page and check whether it has since been distinguished, overruled or overtaken by an amendment to the Income Tax Act. In practice the steps that follow from it are these. Point out in the reply if no authority below actually applied the commercial expediency test, because that failure is what caused the remand here. Keep the personal or non-business advances out of the same argument; mixing them in invites the officer to treat the whole claim as diversion. Be ready for the department to say the decision is under a cloud, and meet that with the later Supreme Court application of it.
Still good law. In Addl. CIT v. Tulip Star Hotels Ltd. (SLP (CC) No. 7140 of 2012, dated 30-4-2012) the Supreme Court was of the opinion that S.A. Builders, 288 ITR 1, needed reconsideration and issued notice on the SLP; no decision reconsidering it was located. The Supreme Court nevertheless applied S.A. Builders in Hero Cycles (P) Ltd v. CIT (5 November 2015). That finding was checked against a published source, which is linked on this page, on 2026-08-25. Checking whether an authority still stands matters as much as knowing what it held: a decision may be overruled on one point and survive on another, or the provision it interprets may have been amended since. Read the source and the editor's note on this page before relying on it in a reply to an Assessing Officer or in an appeal.
This decision allows the appeals and remands; it does not hold the deduction allowable on these facts, and the Court said so twice - the matter goes back to the Tribunal to apply the commercial expediency test (para 36), and nothing else in the orders below is disturbed (para 37). The Court also set its own limits at para 35: interest is not automatically deductible whenever an advance goes to a sister concern, it depends on the facts, and money the sister concern's directors use for personal benefit is not commercial expediency. The decision approved CIT v. Dalmia Cement (Bharat) Ltd. [2002] 254 ITR 377 / 121 Taxman 706 (Delhi) and disapproved the Bombay High Court in Phaltan Sugar Works Ltd. v. CWT [1994] 208 ITR 989 / 72 Taxman 325 and Phaltan Sugar Works Ltd. v. CIT [1995] 215 ITR 582 / [1994] 73 Taxman 518. On later history: in Addl. CIT v. Tulip Star Hotels Ltd. (SLP (CC) No. 7140 of 2012, 30 April 2012) the Supreme Court said this case needed reconsideration and issued notice; no decision actually reconsidering it could be traced, and the Supreme Court went on to apply it in Hero Cycles (P) Ltd v. CIT [2015] 63 taxmann.com 308 (SC), 5 November 2015. Expect the reconsideration point to be raised against you and cite the later application. The outcome of the Tulip Star reference - whether a larger Bench ever reconsidered this decision - was not established. Nor is the outcome of the remand to the Tribunal recorded in this judgment, so the deductibility of the interest on these facts remains undetermined here. This library shows the verification state of every entry openly. This entry has not yet been read in full by a chartered accountant. The summary reflects the sources listed on this page. Read the source before you rely on it in a reply to an Assessing Officer or in an appeal before the Commissioner (Appeals) or the Income Tax Appellate Tribunal.
The appeals were allowed, the judgments of the High Court, the Tribunal and the authorities below were set aside on the interest point, and the matter was remanded to the Tribunal for a fresh decision in accordance with law and in the light of the Court's observations (para 36). The deduction was not allowed. The test where an assessee borrows and lends interest-free to a sister concern is whether that was done as a measure of commercial expediency (para 21); if it was, the interest should be allowed (para 24), and the fact that the borrowed money was not used in the assessee's own business is not really relevant (para 31). None of the authorities below had examined that question (para 28), nor had they examined the purpose of the advance and what the sister concern did with the money (para 30). The Court expressly cautioned that it is not in every case that interest has to be allowed where the assessee advances to a sister concern, that it depends on the facts, and that money used by the sister concern's directors for their personal benefit could not be commercial expediency; but where a holding company with a deep interest in its subsidiary advances borrowed money that the subsidiary uses for business purposes, the deduction would ordinarily follow (para 35). The Court also made clear that it was not setting aside the orders below on any point other than the deduction of interest on borrowed funds (para 37).
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