Interest Deduction Admissibility – Builders- Loan for Construction of Residential Unit

Interest Deduction Admissibility – Builders- Loan for Construction of Residential Unit

In this piece, I am articulating a view that, in present regime, it will be difficult for builders, engage in construction and sale of Residential unit (Business Activity), to claim deduction of “Entire” Interest on loan taken for said Business Activity.

To begin, brief recapitulation of inter-play of various sections involved in above proposition is stated as under:-

a.       Section 23(5)(Inserted by Finance Act 2017) – It provide that Annual value of House property, being stock in trade  and not being let out, shall be NIL for the period of ONE year from the end of financial year in which certificate of Completion is obtained.  Thus through section 23(5), legislation indirectly clarified that Annual value of House Property, being stock in trade, is taxable under the head Income from House Property, setting aside controversy in this aspect. It is this provision, which is coming into forefront, in restricting interest deduction, exemplify later on

b.      Section 24(b) – Interest on Capital borrowed for acquisition, construction, repairing etc. is allowed as deduction in computing income chargeable under the head “Income from House Property”.

c.       Section 29- It stipulates that income referred to in section 28 shall be computed in accordance with provisions contained in Section 30 to 43D.

d.      Section 36(1)(iii)

i)                    Interest on capital borrowed for purpose of business is allowed as deduction.

ii)                   Exception – Interest on capital borrowed for acquisition of asset is not allowed as deduction for the period- from the date of borrowing till the date on which said asset is put to use. Such Interest may be capitalized in the books.

e.      Section 71(3A) – It specify that loss under the head Income from House property can be set-off against other heads of Income to the extent of Rs. 2 lacs.

f.        Section 71B – It stated that where loss under the head Income from house property cannot be set-off against other head of income under section 71, then such unabsorbed loss be carried to succeeding  assessment year (upto 8 years) for being set-off against Income from House Property.

Let me explain my proposition with an example

1.       Builder borrows Rs. 10 Cr for construction of 10 House.

2.       The Interest expenditure in first 4 years will be as under:-

a)      First FY – Rs. 1 Cr

b)      Second FY – Rs 1 Cr

c)       Third FY – Rs. 90 lacs

d)      Fourth FY – Rs. 90 lacs

3.       One of the house was completed at the end 2^nd FY  and it was sold in mid of fourth FY

Analysis of Deduction of Interest Expenditure in various FY in above example

1.       First FY – Assessee is engaged in business activity and Interest deductibility will be governed by Section 36(1)(iii). The loan is taken for construction of business asset. Since asset is not completed in First FY, the interest is not allowed as deduction and same will be capitalized in books. Thus interest of Rs. 1 Cr will be apportioned among 10 houses and Rs. 10 lacs will be added to cost of each house.

2.       Second Year – Since one of house is completed at the end of year, so in this year also, the Interest will not be allowed as deduction and same will be added to the cost of house. Thus till second year, Rs. 20 lacs has been added to cost of each house.

3.       Third Year – This year begin the ambiguity relating to completed house, elucidated as under:-

a)      The asset remain the business asset, but the income therefrom (till it is sold) is taxable under the head Income from House Property, though it will be NIL in this year, by virtue of section 23(5) in this year.

b)      The point for consideration is whether interest (Rs. 9 lacs) deductibility corresponding to completed house will be administered by Section 24(b) or section 36(1)(iii) (as assets is completed at the end of 2^nd year). Determination of relevant section assumes importance in view of restriction of inter-head loss adjustment postulated in section 71(3A). Explain as under:-

i)                    If Interest deduction is allowed under section 36(1)(iii), then same will be business expenditure and will be allowed to be set-off against other business income.

ii)                   If Interest deduction is to be governed by Section 24(b), then due to absence of any income under head Income from house property only Rs. 2 lacs will be allowed to be set-off against business income (section 71(3A)) and balance Rs. 7 lacs will be carried forward to next year for being set-off against Income from house property

iii)                 Thus in 3^rd Year, assessee will be denied deduction of interest of Rs. 7 lacs , if the same is be considered u/s 24(b).

c)       Under Income Tax legislation, expenditure is tagged to Income. If Income is taxable u/s 28, then deductibility of expenditure will be determined under section 30 to 43D. If income is taxable u/s 22, then deductibility of expenditure will be as per section 24.

d)      Thus in instant case, in my view, interest deduction will be as per section 24(b), as Income is being made taxable u/s 22, even though asset is business asset.

4.       Fourth year- The Interest deductibility in this year relating to completed house will as under:-

a)      The Annual value of house will be determined u/s 23(1). Generally rental yield on the house is 2%. So if sale price of house as taken as 2 Cr, the annual rental value will be 4 lacs.

b)      Since house is sold in mid of the year, Gross Annual value for 6 months will be Rs. 2 lacs and Interest for said period will be Rs. 4.5 lacs (50% of Rs. 9 lacs). Thus assessee will have loss of Rs. 2.5 lacs under Income from House property. Out of said loss, Rs.2 lacs will be set-off against business income and rest  Rs. 50,000 will be carried forward.

c)       Since out of 10 houses, one house has been sold and other 9 are under construction phase, the Interest for remaining 6 months corresponding to sold house will be capitalized among 9 houses.

5.       So in above example, the interest deductibility on completed house is summarized as under:-

FY	Interest Amount	Treatment	Remark
1st	10,00,000	Added to Cost of House.	Indirect deduction.
2nd	10,00,000	Added to Cost of House.	Indirect Deduction.
3rd	9,00,000	Rs. 2 lacs is allowed as deduction.	Rs. 7 lacs is carried forward U/H IHP, which will remain unutilized for assesse.
4th	4,50,000	Rs. 2 lacs allowed as deduction u/s 24(b). Rs. 2 lacs is set-off against business income.	Rs. 0.50 lacs Rs. is carried forward U/H IHP, which will remain unutilized for assesse.

Thus in above example, out of Interest of Rs. 33.50 lacs, only 26.50 lacs is allowed as deduction and rest Rs. 7.50 lacs will be dead cost (from income tax perspective).

Tax on accreted Income- Section 115TD of Income Tax Act

Tax on Accreted Income- Section 115TD

1.       Objective of Section

a)      Trust or institution registered u/s 12AA enjoy tax exemption on its income

b)      If due to charging event, specified in section 115TD, income of such trust or institution is made taxable currently, then section 115TD provides for charging tax on “accreted income” (past exempted income) of such trust or institution

c)       The measurement of accreted income is FMV of assets less book value of liabilities on Specified Date

d)      Tax on accreted income is to be paid at Maximum Marginal rate (30% currently)

2.       Charging event- if any of the following event occurs, then section 115TD will be applicable and Trust/institution has to pay tax on accreted income

a)      Case- 1 – Trust/Institution is converted into any FORM, which is not eligible for grant of registration u/s 12AA. It consist of following 2 situations:-

i)                    Case 1(a) – Registration under section 12AA has been cancelled

ii)                   Case 1(b) – Trust/Institution has undertaken modification of its object, which do not confirm to conditions of registration and

·         Case 1(b)(i) – has not applied for fresh registration u/s 12AA

·         Case 1(b)(ii) – has applied for fresh registration u/s 12AA but application has been rejected

b)      Case 2 – Trust/Institute has merged with any other entity, other than entity registered u/s 12AA and has its object similar to trust/institution

c)       Case 3 – Trust/Institution has been dissolved but failed to transfer its assets and liabilities to either Trust/institution registered u/s 12AA or other institution registered u/s 10(23C)((iv)/(v)/(vi/(via), within period of 12 months from the end of the month in which dissolution take place.

3.       Previous year in which accreted income is taxable, specified date for computing accreted Income, Payment of tax on accreted income

Case	Situation	PY in which accreted Income is taxable	Specified date for computing accreted income	Date of Payment of Tax (max time)
1(a)	No appeal has been filed against cancellation order	FY in which order is passed by Commissioner cancelling the registration	Date of order of Commissioner cancelling the registration	74 (60+14) days from the date, on which order of Commissioner cancelling the registration is received
1(a)	Appeal is filed but cancellation of registration is confirmed in appellate proceedings	FY in which appellate order is received	Date of order of Commissioner cancelling the registration	14 days from the date on which appellate order is received
1(b)(i)	Has not applied for fresh registration u/s 12AA on modification of objects	FY in which modification of object is done	Date on which modification of object is done	14 days from the end of the previous year in which modification of object is done
1(b)(ii)	No appeal is filed against order rejecting application	FY in which order is passed by Commissioner rejecting the application.	Date on which modification of object is done	74 days from the date, on which order of Commissioner rejecting the application is received.
1(b)(ii)	Appeal is filed but rejection of registration in confirmed in appellate proceedings	FY in which appellate order is received	Date of order of Commissioner rejecting the application.	14 days from the date on which appellate order is received
Case 2		FY in which merge is done	Date of Merger	14 days from the date of merger
Case 3		FY in which 12 months from end of month in which dissolution take place falls	Date of dissolution	14 days from the date on which said period of 12 months expires.

4.       Examples

i.                     Example 1

a)      Registration of Trust is cancelled on 01/03/2018 and such order is received on 05/03/2018

b)      No appeal is filed against such order

PY in which accreted income is taxable	Specified Date	Date of Payment of tax
PY 17-18 (FY in which order is passed by Commissioner)	01/03/2018 (date of order cancelling registration	74 days from 05/03/2018

ii.                   Example-2

Registration of Trust is cancelled on 01/03/2018, appeal is file against said order with ITAT,ITAT confirm cancellation by an order dated 01/05/2019 and order is received on 15/05/2019. No further appeal is filed

PY in which accreted income is taxable	Specified Date	Date of Payment of tax
PY 19-20 (FY in which ITAT order is passed received)	01/03/2018 (date of order cancelling registration)	14 days from 15/05/2019

iii)                 Example- 3

a)      Modification of objects of trust is done on 1/2/2018 , which do not confirm to condition of registration u/s 12AA

b)      No application is made for fresh registration u/s 12AA

PY in which accreted income is taxable	Specified Date	Date of Payment of tax
PY 17-18 (FY in which modification of object is done)	01/02/2018 (date of modification of object)	14 days from 31/3/2018 (14 days from the end of the PY in which modification of object is done)

iv)                 Example – 4

a)      Modification of objects of trust is done on 1/2/2018 , which do not confirm to condition of registration u/s 12AA

b)      Application is made for fresh registration u/s 12AA on 1/3/2018

a)      Order is passed by commissioner rejecting the application on 30/9/18 and order is received on 4/10/2018

PY in which accreted income is taxable	Specified Date	Date of Payment of tax
PY 18-19 (FY in which application for fresh registration is rejected)	01/02/2018 (date of modification of object)	74 days from 04/10/2018.

v)                  Example- 5

c)       Modification of objects of trust is done on 1/2/2018, which do not confirm to condition of registration u/s 12AA

a)      Application for registration is rejected; appeal is filed before ITAT, which confirm rejection. ITAT passed the order on 1/6/2019 and order is received on 10/6/2019. No further appeal is filed

PY in which accreted income is taxable	Specified Date	Date of Payment of tax
PY 19-20 (FY in which ITAT order is received)	01/02/2018 (date of modification of object)	14 days from 10/06/2018.

5.       Special point relating to computation of accreted income:-

a)      Accreted income is FMV of assets and Liabilities of trust/institution as on specified date

b)      In computing FMV of assets, following assets shall not be included:-

i)                    Assets, which have been acquired directly out of agriculture income referred to in section 10(1).

ii)                   Assets which have been acquired between the period beginning from the date on which trust in created and ending on the date on which registration u/s 12AA become effective, if no benefit u/ 11 and 12 is given during said period.

iii)                 In case of dissolution of trust , the assets which have been transferred to either Trust/institution registered u/s 12AA or other institution registered u/s 10(23C)((iv)/(v)/(vi/(via), within period of 12 months from the end of the month in which dissolution take place

Thin Capitalization- Section 94B- Operational Analysis

Thin Capitalization- Section 94B- Operational Analysis

1.       Applicability to

a)       Indian Company

b)      Permanent Establishment of Foreign Company

(Referred to as Entity in subsequent discussion)

2.       Charging Provision

a)       Entity incur DEDUCTIBLE Interest expenditure in Previous Year in computing income under the head PGBP, in respect of debt (direct & Indirect) taken from Associated Enterprise.

b)      The amount of such deductible Interest expenditure exceeds Rs. 1 Cr.

c)       If afore-said conditions are satisfied, then Excess Interest will be disallowed to Entity in a previous year.

d)      When Entity borrow money from Non-AE, but Associated enterprise either provides implicit or explicit guarantee to lender (for amount lend to entity) or deposit equivalent amount with lender, then it shall be treated as indirect borrowing from AE

e)      Section 94B is not applicable where entity is engaged in banking or insurance business.

Analysis - Deductible expenditure against PGBP

i)                    If Interest expense is being disallowed u/s 40a(i), then same being not deductible expenditure in a previous year, it will not be taken into consideration in computing One Crore yardstick

ii)                   Suppose an Indian company borrow money from AE. It could not deploy the funds in business project and earn interest income by investing the borrowed funds. Since the said interest income is chargeable to tax under the head Income from other sources and Interest payable to AE is being set-off against said interest income, said Interest expense will not be considered for calculating One Crore Benchmark, as same was not deductible expenditure under PGBP.

3.       Computation of Excess Interest

The Excess Interest is lower of the following: -

i)                    Total Interest Expenditure (Payable to AE and Non-AE) Less 30% of Earning before Interest, Taxes Depreciation and amortization (EBITDA) or

ii)                   Interest paid or payable to Associated Enterprise

Analysis

i)                    EBITDA is not defined in section 94B. The point for consideration is whether EBITDA is to be computed as per books of accounts or same is to computed with by imputing provision of Income Tax Act.

ii)                   My view is that EBITDA be computed as per books of accounts. Income tax legislation used the terminology as Gross Total Income or Total income or Income under respective head and nowhere it used the words “Earning” or “Amortization”. EBITDA is term used in accounting parlance and legislator must have used the definition in the same sense only.

iii)                 Illustration of computation of Excess Interest

                

S.No	Particulars	Case 1	Case 2	Case 3
1	EBITDA	5,00,00,000	5,00,00,000	5,00,00,000
2	Interest Paid to Non-AE	30,00,000	1,50,00,000	70,00,000
3	Interest Paid to AE	1,10,00,000	1,10,00,000	1,10,00,000
4	TOTAL Interest Expenditure	1,40,00,000	2,60,00,000	1,80,00,000
5	30% of EBITDA	1,50,00,000	1,50,00,000	1,50,00,000
6	Total Interest- 30% of EBIDA	-10,00,000	1,10,00,000	30,00,000
7	Interest Paid to AE	1,10,00,000	1,10,00,000	1,10,00,000
8	Excess Interest - Lower of 5 or 6	0	1,10,00,000	30,00,000
9	Interest Allowed (4-8)	1,40,00,000	1,50,00,000	1,50,00,000
10	Excess Interest Carried Forward to Next year (8)	0	1,10,00,000	30,00,000

iv)                 The excess interest is allowed in subsequent year to the extent of limits specified in point 3 above i.e. aggregate of Interest (Current year and unabsorbed Interest) should not exceed 30% of EBITDA

4.       Treatment of Excess Interest of First Year Carried forward to next year/subsequent year.

a)      Whether carried forward Excess Interest be considered in computing benchmark of 1 Cr of subsequent year or not

i)                    Suppose Interest Payable to AE in next year is Rs. 80 lacs. Whether we need to add the excess interest (case 2) of Rs. 110 lacs to Rs. 80 lacs, to arrive at benchmark interest amount of Rs 1 Cr determining the applicability of Charging provision of section 94B.

ii)                   In my understanding, it should not be added. The reasons are two-folded:-

a.       Section 94B(1), charging section, used the words where entity “incurs any expenditure by way of Interest-----“. Thus benchmark is to be evaluated based on Interest expenditure incur in previous year

b.       Considered the case- 3 above. In this case, it is indeterminable whether excess Interest relates to AE or non-AE. Since the law does not provide the basis for evaluation of the same, it is not possible to assess the subsequent year benchmark by adding previous year excess Interest.

b)      Limit on deduction of Excess Interest in Subsequent year, if charging provision is not applicable in said subsequent year

i)                    The Itinerary of section 94B is as under: -

a.       Section 94B(1) is charging section, which disallow the excess interest, if the Interest payable to AE is in excess of Rs 1 Cr.

b.       Section 94B(2) provide for computation of Excess Interest.

c.       Section 94B(3) provides the exclusion of section 94B to Banking or Insurance Company.

d.       Section 94B(4) provides for carry forward of excess Interest and further provides for its deduction in subsequent year to the extent specified in section 94B(2). Section 94B(4) reads as under:-

“Where for any assessment year, the interest expenditure is not wholly deducted against income under the head "Profits and gains of business or profession", so much of the interest expenditure as has not been so deducted, shall be carried forward to the following assessment year or assessment years, and it shall be allowed as a deduction against the profits and gains, if any, of any business or profession carried on by it and assessable for that assessment year to the extent of maximum allowable interest expenditure in accordance with sub-section (2)” (Emphasis supplied)

ii)                   Under Section 94B(2), Maximum allowable Interest is to the extent it does not exceed Excess Interest. The Excess Interest is computed only, when charging provision as per section 94B(1) is applicable. If charging provision is not applicable, then there is no computation of excess Interest, hence no restriction on allowability of Interest. In this scenario, Excess interest of past year, should be allowed in entirety in next year, in my view.