1.   Introduction

The allowability of interest on borrowed capital under tax law has historically been a fertile ground for litigation, particularly in cases involving intra-group transactions. The jurisprudence surrounding deductibility of interest expenditure under Section 36(1)(iii) of the erstwhile Income-tax Act, 1961 [“the Old Act”] has consistently evolved through the lens of business realities. The recent Supreme Court ruling in L.K. Trust v. CIT [TS-678-SC-2026] revisits this issue with renewed clarity, reiterating a principle that has long been embedded in judicial thinking but inconsistently applied in practice: the test of commercial expediency must prevail over a narrow profit-centric approach.

While the principle of “commercial expediency” is not new, its application continues to generate litigation, particularly where funds are routed through related parties or remain partly unutilised. As such, determining whether an expenditure is “for the purpose of business” has become a nuanced exercise. The Supreme Court’s ruling offers valuable guidance not only on the interpretation of Section 36(1)(iii) of the Old Act but also on how tax authorities should approach business decisions in a modern economic context.

2,   Legislative Framework: Understanding Section 36(1)(iii)

Section 36(1)(iii) of the Old Act, 1961 permits deduction of interest paid in respect of capital borrowed for the purposes of business or profession. While the provision appears straightforward, it’s application has three critical elements:

1. There must be borrowing of capital
2. Interest must be paid or incurred
3. Borrowing must be for business purposes

The first two elements are typically factual and easy to establish. The third, however, is interpretative and often contentious. The present case squarely turns on the meaning of “for the purpose of business”. The Supreme Court reiterated that “for the purpose of business” is significantly wider than “for earning income”, as used in Section 57(iii) of the Old Act.

3.    Factual Background: A Layered Transaction with Commercial Undertones

The taxpayer, a trust, was not a passive investment vehicle but an active participant in diverse business operations, including money lending, speculation, film distribution, and equity investments. The activity of the aforesaid trust also includes investments activity and therefore, borrowed INR 3.80 crore from a bank with the objective of acquiring shares of a company.

In Assessment Year (1988-89), the taxpayer entered an arrangement to acquire approximately 7.8 lakh shares of Shaw Wallace & Co. Ltd. for a total consideration of INR 3.80 crore. To finance this acquisition, it borrowed the corresponding amount from a bank, thereby satisfying the primary condition of “capital borrowed.”

However, instead of executing the acquisition directly, the taxpayer adopted an indirect route. The entire borrowed amount was advanced to a related entity i.e Gayatri Holdings Pvt. Ltd. [“GHPL”] which functioned as a sister concern. It is not explicitly evident from the record whether GHPL functioned as a subsidiary of the Taxpayer or merely as a related/sister concern. However, a majority of the references in the judicial order characterize the entity as a “sister concern”

GHPL further transferred the funds to another individual and group entities (notably G. Venkateshwaran and associated companies) to facilitate the acquisition of the shares. This multi-tiered routing of funds added complexity to the transaction and later became a focal point for the department to challenge.

The intended acquisition, however, did not proceed as envisaged. While a portion of the shares amounting to approximately INR 1.48 crore, was successfully acquired, the balance transaction failed to materialize. As a result:

• A significant portion of the borrowed funds (approximately INR 2.31 crore) remained unutilized for the intended share acquisition
• These funds continued to be held within the group structure, without reverting to the taxpayer
• The taxpayer nonetheless continued to service the full borrowing and paid interest amounting to INR 21.74 lakhs

From a transactional perspective, this created an apparent disconnect i.e funds borrowed for a specific purpose were only partially deployed for that purpose, with the balance neither directly utilized by the taxpayer nor immediately returned. However, from a broader commercial perspective, the arrangement reflects a business strategy executed through group entities, possibly driven by considerations such as structuring flexibility, operational convenience, or involvement of specialized entities in the acquisition process. The taxpayer treated the entire borrowing as part of its composite business operations. The interest expenditure was accordingly claimed as a deduction in its profit and loss account.

This factual background, though marked by certain ambiguities such as the exact nature of fund transfers (loan vs. share subscription) and the rationale for interposing multiple entities, set the stage for a key legal question:

Does partial or indirect utilization of borrowed funds, routed through group entities, satisfy the test of “business purpose” for claiming interest deduction?

The different views taken by various courts and tribunals showed that the issue was complex, until the Supreme Court finally settled the matter with its ruling.

4.   Litigation Trajectory: Divergent Approaches

The matter went through multiple levels of adjudication:

• The Assessing Officer allowed deduction only to the extent of funds actually utilized for share acquisition on pro rata basis and disallowed the rest. In the instant case, allowed interest deduction on pro rata basis of INR 8.5 lakhs to the extent that the borrowed funds and disallowed balance interest of INR 13.2 lakhs.
• The First Appellate Authority [CIT(A)] enhanced the disallowance and denied the deduction in entirety i.e disallowance of full interest amounting to INR 21.74 lakhs.
• The Income Tax Appellate Tribunal (ITAT) allowed the deduction in full, emphasizing the composite nature of the taxpayer’s business i.e allowance of full interest amounting to INR 21.74 lakhs. The Tribunal placed reliance on Supreme Court ruling in case of Madhav Prasad Jatia wherein it was held that since the Taxpayer was engaged in multiple business activities including share acquisition and considering composite nature of Taxpayer’s business, the borrowing was for business purpose. 
• The Karnataka High Court reversed the Tribunal’s ruling and upheld partial disallowance.

The High Court reasoned that since the funds were ultimately used by a sister concern and not directly by the taxpayer, the nexus with the taxpayer’s own business was insufficient. Subsequently, this reasoning has been ultimately rejected in Supreme Court.

5.    Supreme Court Ruling: Reasserting Commercial Expediency

The Supreme Court overturned the High Court’s judgment and allowed the deduction of interest in full. In doing so, the Court relied on established precedents, particularly:

• S.A. Builders Ltd. v. CIT [TS-30-SC-2006]
• Sharp Business Systems v. CIT [TS-1685-SC-2025]

The Supreme Court emphasized that the appropriate test is not whether the funds were used to generate profits, but whether they were deployed out of commercial expediency.

This principle represents a pragmatic approach to business realities, recognizing that commercial decisions are often driven by strategic considerations rather than immediate financial returns.

6.   Conceptual Clarity: What is Commercial Expediency?

Commercial expediency refers to any expenditure incurred by a business for the purpose of facilitating its operations or advancing its interests.

Importantly, the test is not objective profitability, but whether a prudent businessman would consider the expenditure reasonable in the given circumstances. The Court reiterated that tax authorities should not substitute their own judgment for that of the taxpayer in business matters, provided the decision is backed by commercial rationale.

7.    Restrictive view in the Karnataka High Court’s judgment

The Karnataka High Court had focussed on the ultimate use of funds by the sister concern and concluding that the expenditure did not serve the taxpayer’s business.

The Supreme Court found this approach flawed on multiple counts:

1. Ignoring Group Dynamics
   Modern businesses operate through integrated group structures, and financial support to related entities may be essential for overall business success.
2. Narrow Interpretation of Business Purpose
   By equating business purpose with direct benefit, the High Court disregarded the broader scope envisaged under Section 36(1)(iii) of the Old Act.
3. Misapplication of Nexus Test
   The Court clarified that the nexus need not be immediate or direct; an indirect or strategic link suffices.

8.    Practical Implications for Taxpayers

While the ruling provides significant relief to taxpayers engaged in intra-group financing arrangements, the following practical considerations may emerge:

1. Establishing Commercial Rationale
   Taxpayers should clearly document the underlying business purpose and commercial necessity for advancing funds.
2. Maintaining Evidence of Strategic Intent
   Relevant documentation such as board resolutions, internal memoranda, correspondence, and inter-company agreements should be maintained to substantiate commercial expediency.
3. Avoiding Artificial Transactions
   Transactions that lack a genuine business purpose or appear merely tax-driven may continue to attract regulatory scrutiny and challenge from tax authorities.
4. Understanding Limits of the Doctrine
   Although the doctrine of commercial expediency has a wide ambit, it does not provide blanket immunity, and factual scrutiny remains relevant.

In an era of increasing scrutiny on intra-group transactions, this balance between flexibility and discipline will continue to shape the framework of interest deductibility.

Views expressed above are personal.