Interest income is a common source of earnings for individuals and businesses alike. However, how this income is taxed under the Indian Income Tax Act depends largely on whether it is classified as business income or income from other sources. The distinction can significantly impact the amount of tax payable. In this blog, we explore the key provisions, court rulings, and principles that guide the taxation of interest income in India.
What is Interest Income?
Interest income refers to the earnings accrued on deposits, loans, securities, or bonds. Depending on the source and purpose of the investment, interest income can be taxed under two primary heads:
- Business Income (assessed under Section 28 of the Income Tax Act)
- Income from Other Sources (assessed under Section 56(2)(id) of the Income Tax Act)
The challenge lies in determining which category the interest income falls into.
1. Business Income vs. Income from Other Sources
Business Income Defined
Under Section 2(13) of the Income Tax Act, “business” includes any trade, commerce, manufacture, or adventure in the nature of trade. This definition is broad and covers various forms of organized activity carried out for profit. Interest income can be considered business income if it is earned through regular business activities.
For example, if a company systematically invests its funds as part of its business operations, the interest generated could be classified as business income. This was affirmed by the Supreme Court in the case of Narain Swadeshi Weaving Mills v. CEPT, where a systematic and organized course of activity was recognized as a valid business.
Income from Other Sources
In all other cases where interest is earned passively, such as through fixed deposits or idle funds, it is categorized under “Income from Other Sources” (Section 56). The general rule is that interest from surplus funds, unless closely linked to business operations, falls under this head.
For instance, if a business temporarily parks surplus funds in bank deposits to earn interest, this income is taxed as “Income from Other Sources.” The courts have consistently upheld this classification unless the interest arises from direct business activities.
2. Pre-Commencement Interest
Interest earned before the start of business activities is typically considered income from other sources. The landmark case of Tuticorin Alkali Chemicals & Fertilizers Ltd. v. CIT (1997) clarified this issue. The Supreme Court ruled that interest earned on surplus funds before the commencement of business operations should be taxed under Section 56 as income from other sources.
This ruling emphasized that unless there is a direct link between the interest earned and the business project, it cannot be treated as business income.
3. Surplus Funds and Business Operations
If surplus funds are invested for a purpose unrelated to the core business, the interest income is treated as income from other sources. For example, in CIT v. Murli Investments Co. (1987), the Rajasthan High Court held that interest on surplus funds, invested to avoid keeping them idle, should be taxed under the head “Income from Other Sources.”
However, if the surplus funds are regularly used as part of the company’s lending operations or financial dealings, the interest can be classified as business income. The Rajasthan Land Development Corporation case (1995) outlines that interest on funds used as part of a company’s core business activity (such as lending) may be treated as business income.
4. Key Judicial Interpretations
The classification of interest income has been shaped by various court rulings:
- CIT v. Shree Rama Multi Tech Ltd. (2013) – The Gujarat High Court ruled that interest earned on deposits made from share application money was not taxable under “Income from Other Sources” as it was linked to capital-raising activities.
- Bokaro Steel Ltd. v. CIT (1999) – The Supreme Court held that income from temporary arrangements, such as renting out plant and machinery, during the construction of a plant is not income from other sources but is capital in nature.
- CIT v. Karnal Co-operative Sugar Mills Ltd. (1998) – The Supreme Court ruled that interest earned on money deposited for opening a letter of credit to purchase machinery is capital income as it is directly linked to the business project.
- Principal CIT v. Canara Bank Securities Ltd. (2020) – The Bombay High Court held that interest income on fixed deposits, where the funds were temporarily surplus, was rightly classified as business income, given that the company was engaged in the business of dealing in securities.
5. Tax Implications of Interest on Securities
Under Section 56(2)(id), income from interest on securities is taxable as Income from Other Sources unless it is held as part of the company’s stock-in-trade. Interest on government securities, debentures, or bonds falls under this category unless the entity is engaged in a business where such securities are part of its trading assets.
The case of Tuticorin Alkali Chemicals & Fertilizers Ltd. v. CIT (1997) is a prominent example where the Supreme Court ruled that interest on surplus funds invested in short-term deposits was taxable under the head “Income from Other Sources”, even though the company planned to use the funds for business purposes later.
FAQs
- When is interest income considered business income? Interest income is considered business income when it arises from funds utilized as part of regular business operations, such as in the case of financial institutions or businesses involved in lending.
- Is interest on fixed deposits always taxable as income from other sources? Generally, yes. Interest on fixed deposits is treated as income from other sources unless the deposits are part of the company’s core business activity, such as in the case of financial institutions.
- How is pre-commencement interest treated for tax purposes? Interest earned before a business starts its operations is classified under income from other sources, as per the Supreme Court ruling in Tuticorin Alkali Chemicals.
Conclusion
The classification of interest income under business income or income from other sources depends on the specific facts of each case. Courts have laid down guiding principles based on the nature of the income and the purpose behind the investment. It’s crucial for businesses and individuals to evaluate their financial activities to ensure proper tax treatment of their interest earnings.
Whether you’re a business looking to optimize your tax strategy or an individual aiming to understand your tax liability, consulting a tax expert is recommended to navigate the complexities of the Income Tax Act.
