Interest paid to partners under Section 40(b)(iv) cannot be disallowed by alleging diversion of non-interest-bearing funds.

The appellant-assessee, a manufacturer of spices, filed its return for AY 2004-05. Following an assessment under Section 143(3), the Commissioner of Income Tax (CIT) invoked revisionary powers under Section 263 of the Income Tax Act

The CIT set aside the original assessment, directing the Assessing Officer (AO) to recompute income specifically by examining whether interest paid to partners on their current accounts was for non-business considerations, given investments in residential buildings and non-business assets

On remand, the AO disallowed proportionate interest of Rs. 21,89,507/-, alleging that interest-bearing funds (including partners' current accounts) were diverted to non-business assets

This disallowance was confirmed by the CIT (Appeals) and the Income Tax Appellate Tribunal (ITAT)

1. Whether in the facts and circumstances of the case the Income Tax Appellate Tribunal was right in law in confirming disallowance of interest on partners' capital which was paid in accordance with Section 40(b)(iv)?

Section 40(b)(iv) of the Income Tax Act, 1961, which permits the deduction of interest paid to partners of a firm, provided such payment is authorized by the partnership deed and does not exceed the prescribed rate

Principle of "nexus," which requires the Revenue to prove a direct link between borrowed interest-bearing funds and their diversion for non-business purposes before making a disallowance under Section 36(1)(iii)

The High Court observed that the AO and the Tribunal failed to adhere to the specific directions issued by the CIT in the Section 263 revision order. The CIT had directed the AO to verify the nexus between borrowed funds and the acquisition of residential property and to compare interest rates earned versus paid

The Court found that there were no interest-bearing borrowed funds utilized for the investment; rather, the partners' capital account balance (approx. Rs. 7 crores) significantly exceeded the investment in property (approx. Rs. 5 crores)

Since the assessee possessed sufficient interest-free internal funds and profits (Rs. 1.84 crores), the presumption remains that investments were made out of such interest-free funds rather than diverted interest-bearing capital. The Revenue failed to establish a nexus between the interest-bearing liabilities and the non-business assets

It held that the disallowance of proportionate interest was legally unsustainable as the interest was paid to partners in accordance with Section 40(b)(iv) and no diversion of interest-bearing borrowed funds was proved. The appeal was allowed, and the orders of the lower authorities confirming the addition were set aside