Interest-Free Advances from Share Capital Don not Attract Notional Tax: ITAT [Read Order]

The Mumbai Bench of Income Tax Appellate Tribunal (ITAT) ruled that notional interest cannot be brought to tax where an assessee advances interest-free funds to its director out of its own interest-free share capital and free reserves.

The appellant, SIP Infotech Limited, filed its return of income for Assessment Year 2019-20 with a loss. The case was reopened following a search and seizure action in a connected group case, pursuant to which reassessment proceedings were initiated under Section 147 read with Section 143(3) of the Income TaxAct, 1961.

During the assessment, the Assessing Officer (AO) noted that the appellant had advanced interest-free unsecured loans amounting to ₹1.66 crore to one of its directors, who also held a substantial shareholding in the company. The AO held that since no interest was charged on such advances, notional interest at the rate of 18% ought to be computed and taxed as income from other sources. Accordingly, an addition of ₹29.93 lakh was made.

On appeal, the Commissioner of Income Tax (Appeals) deleted the addition, holding that there was no provision under the Income Tax Act, 1961 permitting taxation of hypothetical or notional income. Aggrieved by this relief, the Revenue carried the matter in appeal before the ITAT.

The appellant contended that the advances were made entirely out of its own interest-free funds, namely share capital and free reserves, and no borrowed funds had been utilised.Further, there was no accrual of income, as no interest was charged or receivable on the advances.

The Revenue argued that the appellant had advanced substantial sums to its director without charging interest, despite incurring other expenses, and that such conduct justified the computation of notional interest. It was submitted that the director was a major shareholder and the funds advanced represented share capital and reserves, which, according to the AO, should have yielded a reasonable return.

The Bench comprising Justice (Retired) C.V. Bhadang, President, and Vikram Singh Yadav, Accountant Member, dismissed the Revenue’s appeal. The Tribunal observed that the advances had been made out of the assessee’s own interest-free funds and that no interest-bearing borrowings were diverted for this purpose. It was noted that the Revenue had not invoked any specific charging provision such as deemed dividend or transfer pricing provisions.

Relying on the principle laid down by the Supreme Court in Shoorji Vallabhdas & Co., the Tribunal held that income tax is levied only on real income and not on hypothetical or notional income. The Bench emphasised that where an assessee, in its commercial wisdom, chooses not to charge interest on advances made from its own funds, there is no legal basis for the AO to compute notional interest and bring it to tax.

Accordingly, the Tribunal upheld the order of the Commissioner of Income Tax (Appeals) and confirmed that interest-free advances made out of share capital and free reserves do not attract notional taxation under the Income Tax Act, 1961.

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