(2021) 438 ITR 1 (SC)
Heads of income; expenditure relating to exempt income
No. A presumption arises that the investments were made out of the taxpayer's own funds where those funds exceed the investments, and proportionate disallowance of interest is not warranted.
Where a taxpayer has both interest-free funds and borrowings, and its own funds exceed the tax-free investments, can interest expenditure still be disallowed as relatable to exempt income?
The appellants were banks which held investments in tax-free bonds and securities yielding exempt income. They also accepted deposits and incurred substantial interest expenditure in the ordinary course of banking. Their own funds — share capital, reserves and surplus, and current account deposits not bearing interest — exceeded the value of the investments yielding exempt income. The Revenue disallowed a proportionate part of the interest expenditure on the footing that borrowed funds must have been deployed, at least in part, in acquiring the tax-free investments, without establishing any direct link between particular borrowings and particular investments.
The Kerala High Court decided against the banks. Conflicting views existed among the High Courts, with the Bombay High Court having adopted the own-funds presumption in earlier decisions. The Supreme Court resolved the conflict in the banks' favour.
For the assessee
Where a taxpayer's interest-free funds exceed the investments yielding exempt income, the presumption is that those investments came from its own funds, and no interest disallowance arises. Funds in a banking business are held in a common pool and cannot be traced item by item; the Revenue established no nexus between any borrowing and any tax-free investment.
For the Revenue
A bank funds its operations substantially from interest-bearing deposits. Where such funds are part of the pool from which investments are made, a proportionate part of the interest cost is necessarily referable to the exempt income, and apportionment is appropriate.
The Court approved the presumption that had been developed in earlier High Court decisions. Where a taxpayer's own interest-free funds — comprising capital, reserves, surplus and non-interest-bearing deposits — exceed the value of the investments yielding exempt income, it is to be presumed that the investments were made from those own funds, and a proportionate disallowance of interest is not justified. The Court reasoned that in a business where funds are held in a common pool, tracing particular rupees to particular investments is impossible, and in the absence of any material establishing a direct nexus between specific borrowings and the tax-free investments, the Revenue cannot simply assume one. The burden of demonstrating such a nexus rests on the Revenue, and it had not been discharged. The Court was careful to confine its holding to the interest component: the presumption addresses interest expenditure and does not exclude disallowance of administrative or other expenditure genuinely relatable to earning the exempt income.
Read together with Maxopp, this gives the practical framework under Section 14 of the IT Act 2025: exempt income triggers disallowance, but the interest component falls away where own funds comfortably cover the investments. It is the standard authority for banks, non-banking financial companies, insurers and any taxpayer with mixed funding, and makes the own-funds-to-investments comparison a routine part of the computation.