The Hindu Business Line : Conversion of arrear interest into loan

Section 43B of the Income-Tax Act provides for deduction of certain expenditures only on actual payment basis. This is irrespective of the method of accounting followed by the assessee.

Clauses (d) and (e) to Section 43B deals with interest on loans and advances taken from public financial institutions and scheduled banks respectively. Clause (d) covers interest on loan or borrowing from any public financial institution or State financial corporation or State industrial investment corporation paid in accordance with the terms and conditions of the agreement governing such loan or borrowing. Clause (e) covers interest on any loan or advance from a scheduled bank paid by the taxpayers in accordance with the terms and conditions of the agreement governing such loan or advance.

In a nutshell, interest on such borrowings would be deductible only if the actual payment is made by the taxpayer. Where the arrear interest on a borrowing is not serviced or paid and the lender and the borrower enter into an agreement for converting the arrear interest into loan or advance, whether such conversion would enable the assessee to claim the same as a deduction under Section 43B was discussed in Kalpana Lamps & Components Ltd vs Deputy CIT (2002 255 ITR 491 Madras).

The court held that the conversion of arrear interest into loan cannot be treated as discharge of interest and, hence, not eligible for deduction under Section 43B. But a pending issue was how the taxpayer can claim deduction in respect of arrear interest in the future.

The Finance Act, 2006 inserted Explanations 3C and 3D to Section 43 B which affirmed the aforementioned court decision.

In other words, the explanations provide for denying deduction upon conversion of arrear interest into loan. The arrear interest would be eligible for deduction only upon actual payment is the dictum of the new explanations.

The Central Board of Direct Taxes (CBDT), through Circular No. 7 of July 17, 2006, explains how the taxpayer is eligible for deduction in respect of arrear interest relating to loan or advance from public financial institutions and banks.

The circular further says that it is not possible to visualise all kinds of arrangements that may be entered into between the borrowers and the lenders in respect of variation in repayment arrangements or schedules for the loans, advances, etc. It goes on to advise the assessing officers (AOs) to seek a certificate from the assessee, who in turn has to obtain certificate from the lender bank or financial institution as regards the actual payment of interest during the previous year, for allowance of deduction under Section 43B.

This circular has visualised only four such instances where the arrear interest can be converted into loan by mutual consent of the borrower and the lender. It would be useful to keep note of the following in this regard:

The borrower even upon conversion of arrear interest into loan may keep the arrear interest in a separate ledger account for identification purpose.

The amounts paid by the borrower subsequent to rearrangement or rescheduling would be appropriated according to the terms of the new agreement or arrangement. The arrear interest portion accordingly could be claimed as a deduction under Section 43 B as and when paid.

Where the borrower again defaults in regularising the dues, then the appropriation of the lender may provide the lead for identifying the payments and appropriating the payments towards arrear interest, current interest and towards principal amount of loan.

Where the arrear interest is outstanding at any point of time and the loan is not rescheduled or modified for repayment, the borrower may keep note of the general practice of bankers, as regards the order of appropriation of the amount remitted viz towards (i) arrear interest (ii) current interest (iii) arrear principal and (iv) current principal.

(The author is an Erode-based chartered accountant.)

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