Holding

The deposits made by members were not loans; consequently, interest paid on them is not deductible under section 36(1)(iii) of the Income‑Tax Act, 1961.

Summary

The Bazpur Co-operative Sugar Factory Ltd., a cooperative society, required its producer‑shareholders to deposit amounts into a 'Loss Equalisation & Capital Redemption Reserve Fund' under a bye‑law. The deposits were used for the society’s business, including converting partly paid shares to fully paid shares and repaying a loan from the Industrial Finance Corporation. The society later paid interest on the fund’s balance to its members and claimed a deduction under section 36(1)(iii) of the Income‑Tax Act, 1961. While the Income Tax Officer, the Appellate Assistant Commissioner and the High Court disallowed the deduction, the Income Tax Appellate Tribunal allowed it, holding that the deposits represented capital borrowed. The Supreme Court reversed, holding that the deposits were not loans because there was no borrower‑lender relationship and no obligation to return the money, thus interest could not be deducted under s.36(1)(iii). The appeals were allowed and the High Court judgment set aside.

Issues considered

Whether the credit balances in the Loss Equalisation & Capital Redemption Reserve Fund, used by the assessee for its business, constitute 'capital borrowed' within the meaning of section 36(1)(iii) of the Income‑Tax Act, 1961.
Whether interest paid on such balances is allowable as a deduction under section 36(1)(iii).
Whether the payment of interest contravenes section 57 of the Uttar Pradesh Co‑operative Societies Act, 1965 (not finally decided).

Legislation cited

Income Tax Act, 1961s. 36(1)(iii)
Uttar Pradesh Co-operative Societies Act, 1965s. 57

Subjects

Income TaxSection 36(1)(iii)Interest deductionCo‑operative societyCapital borrowedBorrower‑lender relationshipTax lawLoss Equalisation Fund

Judgment

A COMMISSIONER OF INCOME-TAX, LUCKNOW
v. -+·
BAZPUR CO-OPERATIVE SUGAR FACTORY LTD.

MAY l, 1989

B [R.S. PATHAK, CJ. AND L.M. SHARMA, J]

Income Tax Act, 1961: Section J6( l)(iii)-Cooperative Society-
Amounts deposited by members in Loss Equalisation and CapitiM.,.
>--
Redemption Fund-Whether deduction admissible.

The respondent-assessee is a co-operative society running a sugar •
c mill. With a view to inducing its members to make further contribution
to its capital it incorporated a bye-law which provided for the establish-
ment of a 'Loss Equalisation & Capital Redemption Reserve Fund'.
Every producer-shareholder was required to deposit every year an
amount to this fund which was to be utilised for the purpose of making
D the l!artly paid shares fully paid, and after defraying the loan taken
· from the Industrial Finance Corporation the balance was to be
"'
refunded to the members. The money available in the Fund was utilised
by the society for the purpose of its business. A part of the amount was
eventually utilised for converting the partly paid shares into fully paid
shares. It was then decided by the society to pay interest on the balance ~.
E available in the ~·und. The interest thus paid to its members was sought
to be claimed as deduction in computing the income of the assessee.

The Income Tax Officer rejected the claim holding that the
amount did not represent loans taken by the assessee .or capital
borrowed for the purpose of its business. The Appellate Assistant
F Commissioner confirmed the disallowance. The Income Tax Appellate
Tribunal accepted the second appeal of the assessee and held that it was
not necessary that borrowing must contain an element of payment of
interest and that even if a deposit was made by the members of the )I..
society which was utilised for the purpose of the business of the assessee,
the funds represented by such deposit would be 'capital borrowed' for
G the purpose of s. 36(1)(iii) of the Income Tax Act,.1961. The High Court
agreed with the view taken by the Appellate Tribunal and answered the
questions referred to it in favour of the assessee and against the
Revenue.

While allowing the appeals and answering the questions in the
H negative in favour of the Revenue, this Court.
840
C.LT. LUCKNOW v. BAZPUR SUGAR FACTORY 841

+ HELD: (l) Section 36(I)(iii) of the Income Tax Act, I96I pro- A
vides that in computing the income chargeable under the head 'profits
and gains of business or profession' a deduction shall be allowed of the
amount of interest paid in respect of capital borrowed for the purposes
of the business or profession. [845G, HJ

(2) The words 'borrowed money' should not be given a strained B
,meaning and it should be considered whether in ordinary commercial
~sage the relationship was that of a borrower and lender and the trans-
actions were loan transactions .. To constitute borrowed money there

- must be a real borrowing and a reaUending. [846B, D]

(3) It is apparent that the deposits made by the members cannot
c
be regarded as loans advanced by the members to the assesse~. There
was never any intention between the assessee and its members to treat
the deposits made by the members as loans and that the relationship
between the assessee and the members should be that cif borrower and
lender. [847F, G J
D
Port of London Authority v. Commissioner of Inland Revenue,
[I922] 2 KB 599 (CA); Commissioner of Inland Revenue v. Port of
London Authority, [I923] AC 507; Inland Revenue Commissioner v.
Rowntree & Co. Ltd., [1948] 1 ALL ER 482 (CA); Commissioner of
Income-tax, Gujarat Iv. Rajkot Seeds, Oil & Bullion Merchants As-
sociation Ltd., [1975] IOI ITR 748; Commissioner of Excess Profits E
Tax, Central Calcutta v. Bhartia Electric Steel Co. Ltd., [1954] 25 ITR
I92; Bombay Steam Navigation Co. [1953]; Private Ltd. v. Commis-
sioner of Income-tax Bombay, [1965] 56 ITR 52 and Madhav Prasad
Jatia v. Commissioner of Income-tax Uttar Pradesh, [1979] ll8 ITR
200, referred to.
F
(4) A loan necessarily supposes a return of the money loaned. The
circumstance that there was no certainty that any balance would
remain for refund to the members would in itself indicate that the
deposits conld not be regarded as loans. [847G, H]

CIVIL APPELLATE lURISDICTION: Civil Appeals Nos. G.
1358-61 of 1979.

From the Judgment and Order dated 6.9.78 of the Allahabad
High Court in I.T.R. No. 114/78.

B.B. Ahuja, K.C. Dua and Miss. A. Subhashini for the appellants. H
842 SUPREME COURT REPORTS [1989] 2 S.C.R.

A S.C. Manchanda, Mrs. A.K. Verma and Joel Pares for the ~
respondent.

The Judgment of the Court was delivered by

PATHAK, CJ. These appeals by special leave are directed
B against the judgment of the High Court at Allahabad disposing of an
Income-tax Referenc.,. in favour of the assessee and against the
Revenue. •
'
The assessee is a co-operative society running a sugar mill. For
the assessment year 1968-69 it claimed payment of interest amounting
to Rs.1,81,716. This was interest paid to the accounts of its members,
-
c who had deposited certain amounts with the assessee in accordance
with Bye-law No. 50 and it was debited by the assessee to its profit and
loss account. In the initial years of the working of the Society, certain
partly paid shares were allotted to its farmer members. With a view to
inducing these members to make further contribution to the capital of
D the Society, bye-law No. 50 was incorporated in the Bye-laws of the
Society. The bye-law as amended provides:

"50. There shall be established a 'Loss Equalisation &
Capital Redemption Reserve Fund' in the society. Every -+
producer-shareholder shall deposit every year a sum not
E less than 0.32 paise and not more than 0.48 paise per quin-
tal of the sugarcane supplied by him to the society, as may
be determined by the Board until the shares to be sub-
scribed by the members are fully paid-up. The amount
standing to the credit of this fund presently or to be cre-
dited in future, shall be used for making the partly paid ~
F shares fully paid up. The balance of the said amount
shall be refunded to the members soon after the present
loan from the Industrial Corporation of India is repaid, ,._
whereafter the fund shall cease to exist."

The money available in the 'Loss Equalisation and Capital
G Redemption Reserve Fund' was utilised by the assessee for the :..,..
purpose of its business. A part of the amount was also utilised for
converting the partly paid up shares into fully paid up shares. On 8
September, 1967 the Board of Directors of the Society decided in their
meeting to pay interest at 6% on the balance available in the aforesaid
Fund to its various members to whom the balance money belonged. It
H was on this account that the Society claimed an amount of Rs. l, 18,716
for the assessment year 1968-69.
C.I.T. LUCKNOW v. BAZPUR SUGAR FACTORY [PATHAK, CJ.] 843

The claim was rejected by the Income Tax Officer. He took the
A
view that the amounts deposited by the members of the Society in the
'Loss Equalisation and Capital Redemption Reserve Fund' did not
represent loans taken by the assessee but constituted a contribution by
the members to convert partly paid up shares into fully paid up shares
and they could not be considered as capital borrowed for the purpose
of its business. He held thats. 36(1)(iii) of the Income-tax Act did not B
,:apply to such interest and that it was not admissible as a deduction in
'computing the total inaome of the assessee. For the assessment years

- 1969-70 to 1972-73 the claim to deduction on this account was as
follows:

1969-70 Rs.1,34,609
1970-71 Rs.1,34,609 c
1971-72 Rs.1,34,609
1972-73 Rs.1,34,609

The Income Tax Officer took the same view for these assessment years
as he did for the assessment year 1968-69. D

In appeals preferred by the assessee the Appellate Assistant
Commissioner of Income-tax confirmed the disallowance for the as-
..:'t- sessment year 1968-69 on the ground that Bye-law No. 50 did not
provide for the refund of the amount standing to the credit of the
' members at any time before the payment of the loan to the Industrial E
Finance Corporation of India, that the loan was still outstanding on 30
June 1967, the last day of the previous year relevant to the assessment
year 1968-69, and moreover the Bye-law did not provide for payment
of interest at all. He observed that the Directors could not pay any
)< interest unless the Bye-law was amended by the members of the asses-
see. He observed that the interest paid must be regarded as an ex- F
• gratia payment to the producer .members of the society who had con-
. tributed to the Fund, and that it was not made for the purpose of the
business of the assessee or on the ground of commercial expediency.
The same order was passed by the Appellate Assistant Commissioner
on the appeals for the remaining years.
G
In second appeals filed by the assessee for all the assessment
years the Income Tax Appellate Tribunal held that the amount stand-
ing to the credit of the 'Loss Equalisation and Capital Redemption
Reserve Fund' which was utilised by the assessee for the purpose of its
business represented moneys borrowed for the purpose of its business
and that imerest_paid on such moneys was eligible for deduction under H
844 SUPREME COURT REPORTS [1989] 2 S.C.R.

A s. 36(1)(iii) of the Income-tax Act, 1961. The Appellate Tribunal ~.
negatived the contention of the Revenue that only such deposits could
constitute 'capital borrowed' within the meaning of s. 36(1)(iii) of the
Act which were initially borrowed with the stipulation to pay interest
thereon. The Appellate Tqbunal observed that the expression 'capital
borrowed' had not been defined in the Income-tax Act and that its
B ordinary meaning woulJ have to be gathered in construing the mean-
ing of s. 36(l)(iii). It said that it was not necessary that borrowing must
contain an element of payment of interest and that even if a deposi~
was made by the members of the society which was utilised for the
purposes of the business of the assessee, the funds represented by such
deposit would be 'capital borrowed' for the purposes of s. 36(1)(iii) of
the Act. The Appellate Tribunal also recorded that it was not disputed
-
c that the deposits were taken for the purposes of the business. In the
circumstances, the Appellate Tribunal held that when the Board of
Directors of the assessee considered it proper to pay interest on those
deposits, such interest was admissible under s. 36(1)(iii) of the Act.

D During the hearing of the appeals for the assessment years 1970-
71and1971-72, it was pointed out by the Revenue that the auditors of
the assessee had observed in their audit report that the payment of
interest on the 'Loss Equalisation and Capital Redemption Reserve
Fund' should not have been made by the assessee in view of s. 57 of the
Uttar Pradesh Co-operative Societies' Act, which reads:
E •
"Fund not to be divided: Except as otherwise specifically
provided in this Act, no part of the Funds other than the
net profits of a co-operative society shall be paid by way of
bonus or dividend or otherwise distributed among its
members: ~
F
Provided that a member may be paid remuneration
on such scale as may be laid down in the bye laws for any ,i.
services rendered by him to the co-operative society."

The Appellate Tribunal held that s. 57 was not relevant as the
G payment of interest to the shareholders, on the amounts deposited by )..·
them, did not represent any payment by the Society by way of bonus or
dividend or otherwise, of any part of its funds other than its net
profits. The Appellate Tribunal also observed that the interest paid by
the assessee to the 'Loss Equalisation and Capital Redemption Re-
serve Fund' was met from out of the net profits of the assessee. It was
H found that the assessee had sufficient income out of which the interest
i

J
C.J.T. LUCKNOW v. BAZPUR SUGAR FACTORY [PATHAK, CJ.I 845

could be paid by it. For these reasons, it held that the payment of
A
interest was not affected by s. 57 of the Uttar Pradesh Co-operative
Societies Act.

At the instance of the Revenue the following two questions in
respect of the five assessment years were referred by the Appellate
Tribunal to the High Court at Allahabad for its opinion. B
--'\
•
.

"1. Whether the credit balances in the Loss Equalisation
and Capital Redemption Reserve Fund which were actually
used by the assessee for the purposes of its business re-
' presented capital borrowed by the assessee for the purpose
of its business within the meaning of s. 36(1)(iii) of the
Act? c
+
2. Whether the Tribunal was right in law in allowing in-
terest on such balances standing to the credit of the Loss
Equalisation and Capital Redemption Reserve Fund as a
deduction in computing the total imcome of the assessee?" D

A further question common to the assessment years 1969-70 to
1972-73 was also framed. It reads:
-)>-
"Whether the Tribunal was right in law in holding that the
impugned payments of interest did not contravene the pro- E
visions of s. 57 of the Uttar Pradesh Co-operative Societies
Act, 1965?"

The High Court agreed with the view taken by the Appellate
)< Tribunal and answered the questions in favour of the assessee and
against the Revenue. F

•• Before us, the parties have confined themselves to the first two
questions and it is requested that we need not consider the third
question.

In these appeals the question is whether the claim to deduction G
f under s. 36(1)(iii) of the Income-tax Act can be allowed. Section
36(1)(iii) of the Act provides that in computing the income chargeable
under the head 'profits and gains of business or profession' a deduction
shall be allowed of the amount of interest paid in respect of capital
borrowed for the purposes of the business or profession. Can it be said
that the credit balance in the 'Loss Equalisation and Capital Redemp- H
846 SUPREME COURT REPORTS (1989] 2 S.C.R.

A
tion Reserve Fund' represents capital borrowed by the assessee for the ~
purposes of its business? What is 'borrowed money' has been con-
strued by the Courts in England in a number of cases. In Port of
London Authority v. Commissioner of Inland Revenue, (1922] 2 KB
599 (CA), Lord Stemdale, M.R. observed that in order that there be
borrowed money there must be a borrower and a lender, and later,
when 1he Revenue took the case in appeal to the House of Lords, the ;..-...
House of Lords laid _down in Commissioners of Inland Revenue v. Porii
of London Authority, [1923] AC 507 that to conslitute borrowed ·

-
money there must be "a real borrowing and a real lending". Again in
Inland Revenue Commissioners v. Rowntree & Co. Ltd., [1948] 1 All
ER 482 (CA), the Court of Appeal considered the meaning of the
words 'borrowed money' and observed that the words should not be
c given a strained meaning and that it should be considered whether in
ordinary commercial usage the relationship was that of a borrower and i'"
a lender and the transactions were loan transactions. These cases were
relied upon by the Gujarat High Court in Commissioner of Income-
tax, Gujarat Iv. Rajkot Seeds, Oil & Bullion Merchants Association
D Ltd., [1975] 101 ITR 748 in support of the conclusion that on the facts
of the case before the High Court there was no relationship of bor-
rower and lender between the Rajkot Seeds and Oil and Bullion
Merchants Association and its members in so far as deposits by the ---.(~
members were concerned. It was held that the amounts were deposited
by way of security taken for the due performance of the.obligation of a
E member under the Rules of the Association for the discharge of his
obligations to the Association and to the other members of the Asso-
ciation. There was no loan or borrowing at all. This question had in
fact been considered by the Calcutta High Court as long ago as Com-
missioner of Excess Profits Tax, Central, Calcutta v. Bhartia Electric
Steel Co. Ltd., [ 1954] 25 ITR 192 in the context of the third proviso to """
F Rule SA of Schedule I to the Excess Profits Tax Act, 1940. The money
in question in that case had been obtained by the issue of shares, and it •.
was held that it could not possibly be said that the persons who had
taken up the deferred shares had ever intended to grant a loan or that
the Company which had obtained money on the shares had ever in-
tended to borrow. This Court in Bombay Steam Navigation Co. (1953)
G Private Ltd. v. Commissioner of Income-tax Bombay, [1965] 56 ITR J.:
52, was dealing with a claim to deduction under s. 10(2)(iii) of the
Indian Income-tax Act 1922 in a case where under an agreement cer-
tain assets were to be taken over by the assessee from the Scindia
Steam Navigation Company Ltd., and part of the consideration was
paid by the assessee while the balance remained unpaid. For agreeing
H to deferred payment of the balance of the consideration, the Scindias
C.l.T. LUCKNOW v. BAZPUR SUGAR FACTORY [PATHAK. CJ.] 847

Were to be paid interest. This Court observed:

-J
"An agreement to pay the balance of consideration due by
the purchaser does not in truth give rise to a loan. A loan of
money undoubtedly results in a debt, but every debt doe;
not involve a loan. Liability to pay a debt may arise from
diverse sources, and a loan is only one of such sources. B
Every creditor who is entitled to receive a debt cannot be
regarded as a lender. If the requisite amount of consi·

- deration had been borrowed from a stranger, interest paid
thereon for the purpose of carrying on the business would
have been regarded as a permissible allowance, but that is
wholly irrelevant in considering the applicability of clause C
(iii) of sub-sectiion (2) to the problem i<rising in this case.
The legislature has under clause (iii) permitted as an
allowance interest paid on capital borrowed for the pur·
poses of the business: if interest be paid, but not on capital
borrowed, clause (iii) will have no application." ·
D
The point was also discussed by this Court in Madhav Prasad
latia v. Commissioner of Income-tax, U.P., [1979) 118 ITR 200 where
the question was whether the interest claimed under s. 10(2)(iii) of the
Indian Income-tax Act, 1922 related to borrowing for the purpose of
the business.
E
In the present case, Bye-law No. 50 indicates that deposits were
to be made by the producer members in the 'Loss Equalisation and
Capital Redemption Reserve Fund' for the purpose of making the
partly paid shares fully paid up, and it was understood that the balance
.. ~ of the amount would be applied to the loan taken from the Industrial
Finance Corporation of India and thereafter whatever remained would F
be refunded to the depositing members resulting in the extinction of
the Fund. It is apparent that the deposits made by the members cannot
be regarded as loans advanced by the members to the assessee. The
moneys deposited represented contribution by the members for
converting the partly paid up shares into fully paid up shares and
thereafter for defraying the loan taken from the Industrial Finance G
Corpotation of India. Any balance remaining was to be refunded to

-
the members. The circumstances that there was no certainty that any
balance would remain for refund to the members would in itself
Indicate that the deposits could not be regarded as loans. A loan neces·
sarily sup11oses a return of the money loaned. Even under the original
-~ye-law No. 50, which provided for deposits by the members to the H
848 SUPREME COURT REPORTS [1989) 2 S.C.R.

A 'Loss Equalisation and Capital Redemption Reserve Fund', it was ~
contemplated that the deposits would be accumulated and be utilised
for repayment of the initial loan taken from the Industrial Finance
Corporation of India and thereafter for redeeming t:1e 'Government
share', and the balance of the deposit after meeting losses would be
converted into share capital and each producer member would be
B
issued shares of the assessee. There was never any intention between
,lo..
the assessee and its members to treat the deposits made by the mem-
bers as loans and that the relationship between the assessee and the
members should be that of borrower and lender. The High Court erred
•
in holding that the claim to deduction on account of interest paid by
the assessee to its members was admissible under s. 36(1)(iii) of the '
c Act.

It is urged by learned counsel for the assessee that if the claim to +
deduction cannot be rested on s. 36(1)(iii) of the Act, it should be
'
regarded as admissible under s. 37 of the Act. We are not satisfied that
all the facts necessary for considering a claim for deduction under s. 37
D are before us. It will be noticed in Madhav Prasad Jatia (supra) that
the question of law expressly took in the claim to deduction not only
with reference to s. lO(l)(iii) but alternatively with reference to
s. 10(2)(xv) of the Indian Income-tax Act, 1922. Whether or not it is
still open to the assessee to raise that question before the Appellate ~~ -
Tribunal when the case goes back to it for disposing it of in conformity
E with the opi.nion expressed by this Court in these appeals is a question
on which we propose to express no view at this stage.

In the result the appeals are allowed, the impugned judgmentof
the High Court in all these cases is set aside and the first and the
second questions framed by the Appellate Tribunal are answered in
F the negative, in favour of the Revenue and against the assessee. There
is no order as to costs.

R.S.S. Appeals allowed.

...