ITAT Deletes Rs. 2.88 Crore Interest Disallowance: Partners’ Withdrawals Cannot Be Treated as Diversion of Borrowed Funds

R.K. Industries Unit-II LLP, engaged in ship recycling, had declared income of Rs. 7.69 crore for AY 2016-17. The Assessing Officer completed the scrutiny assessment and made a disallowance of Rs. 2.88 crore under Section 36(1)(iii), alleging that two partners had withdrawn funds from the overdraft account without a business purpose, thereby causing diversion of interest-bearing funds. As per the AO, the firm incurred Rs. 10.63 crore interest expenditure and earned Rs. 7.97 crore interest income, leaving a net outgo of Rs. 2.66 crore, which he partly attributed to partners’ drawings.

Appeal Befpre CIT(A): Before the CIT(A), the assessee explained that the alleged negative partner capital was merely the result of a non-cash book entry for permanent diminution in value of investments in the last year. The CIT(A), however, upheld the disallowance, leading to the present appeal.

Main Issue: Whether the disallowance of Rs. 2.88 crore under Section 36(1)(iii) was justified on the allegation that partners’ drawings represented diversion of interest-bearing overdraft funds, despite the presence of substantial interest-free funds.

Tribunal Held: The Hon’ble Tribunal deleted the entire disallowance, finding the assessee’s interest-free funds to be far in excess of the partners’ withdrawals at all points during the year. Once the earlier year’s non-cash diminution entry was neutralized, partners’ capital and other interest-free liabilities stood at over Rs. 238 crore at the start of the year and Rs. 240 crore at its close, many times more than the amounts withdrawn. The Bench also noted that the AO and CIT(A) selectively focused on withdrawals while ignoring substantial credits such as profits, capital infusions and positive running balances.

The Tribunal accepted the assessee’s day-wise working, which showed surplus interest-free funds available even on dates of drawings. Relying on Reliance Utilities and Torrent Financiers, it reiterated that where mixed funds exist, the presumption is that interest-free funds are used first. Finding no nexus between overdraft borrowings and partners’ withdrawals, the Bench held that the disallowance under Section 36(1)(iii) was unsustainable.

To Read Full Judgment, Download PDF Given Below