Interest on borrowings to purchase securities

Borrow money, buy a bond with it, and two cash flows appear. Interest comes in from the bond. Interest goes out on the loan.

Taxing the first and ignoring the second would tax something the investor never kept. So the Act allows the outgoing interest as a deduction.

The workbook shows it as a line in the computation of income from other sources. Start with gross interest from securities. Subtract collection charges. Subtract interest on borrowings obtained to purchase the securities. Subtract any other revenue expenditure laid out wholly and exclusively to earn that income. What is left is taxable.

Notice what the deduction is set against. It comes off interest on securities, not off the whole of the taxpayer's income.

And notice what it is not. This is not the housing loan deduction. Interest on money borrowed to buy a house is Section 24 territory, under a different head of income entirely.

Where it sits. The computation proforma in Chapter 9 runs as follows. The workbook prints amounts as xxx because the proforma is generic.

What the workbook attaches to it, and what it does not. The workbook lists this as a permissible deduction and stops. It states no ceiling, no percentage and no rupee cap for it, so none should be supplied in an answer. It is a revenue deduction against the interest income, set alongside collection charges and other wholly-and-exclusively expenditure.

The nearest comparable rule does carry a cap, and the contrast is examinable. Chapter 11, section 11.2.2, deals with interest borrowed to earn dividend income and limits it hard:

So the same borrowing can be fully deductible or capped at 20% depending entirely on whether the security pays interest or a dividend.

The accounting basis follows the income. Section 145 makes interest on securities computable on the method of accounting the assessee regularly employs — accrual under the mercantile system, receipt under the cash system. The deduction is taken in the same computation, so it follows the same basis.

What is not deductible here. Interest on a borrowing used to buy a capital asset is not an expense of earning interest income. On sale it may only come in as expenditure wholly and exclusively incurred in connection with the transfer, if it qualifies at all, which is a capital gains question and not this one.

Illustrative figures; the workbook prints this proforma with xxx amounts.

Mr Deshmukh borrows Rs 20,00,000 at 9% a year and invests the whole of it in listed corporate debentures paying 11%. He also pays his bank Rs 4,000 a year in collection charges for crediting the coupons.

At a 30% slab his tax is Rs 10,800. Without the borrowing deduction he would be taxed on Rs 2,16,000 and pay Rs 64,800 — on a spread he never earned.

Now switch the investment to shares. Suppose he had borrowed the same Rs 20,00,000 at 9% and bought equity shares yielding a dividend of Rs 2,20,000 instead.

Tax at 30% is Rs 52,800. The same loan against the same Rs 2,20,000 of income produces Rs 10,800 of tax on a debenture and Rs 52,800 on a share, purely because of the 20% cap in Chapter 11.

And if he were a non-resident receiving that dividend, no expenditure would be deductible at all, and the whole Rs 2,20,000 would be taxed at the applicable special rate subject to any DTAA.

Chapter 9 (Income from Other Sources), section 9.3, sets out interest on securities and then gives the computation of taxable income, in which this is the second permissible deduction. The proforma sub-heading is mis-numbered 9.1-1 in the workbook although it sits under 9.3, so do not go looking for a separate section 9.1. Chapter 11, section 11.2.2, supplies the contrasting 20% cap on interest borrowed to earn dividend income.

Expect a computation question that gives gross interest, collection charges and borrowing interest and asks for taxable income from securities. The harder version pairs it with the dividend rule and asks which deduction is capped.

• This deduction runs against interest on securities, not against dividend. Interest borrowed to earn dividend is capped at 20% of total dividend income under Chapter 11, and nothing else is allowed alongside it.
• The workbook states no ceiling for this deduction. Do not import the 20% dividend cap into the interest computation, and do not invent a rupee limit.
• It is not the housing loan deduction. Interest on capital borrowed to buy, build or repair a house is Section 24(b) under income from house property, with its own Rs 2,00,000 and Rs 30,000 limits.
• Collection charges are a separate line. They are allowed against interest on securities but expressly disallowed against dividend, where commission or remuneration to a banker for realising the dividend gets no deduction.
• A non-resident gets no expenditure deduction against dividend at all, and no Sections 80C to 80U relief either.
• The borrowing must have been obtained to purchase the securities. A general-purpose loan that happens to coexist with a bond portfolio is not the same thing.
• The deduction follows the accounting basis of the income under Section 145 — accrual on the mercantile system, receipt on the cash system.