In a first-of-its-kind judgement, the Income-Tax Appellate Tribunal (ITAT) recently ruled that a recipient of an interest-free loan from a non-relative is not liable to pay tax. The judgement will come as a major relief for people who borrow money from friends and colleagues and latter grapple with notices from tax authorities.

Section 56 (2)(v) of the Income Tax Act provides for taxing any sum of money in excess of Rs 25,000 received without consideration by an individual or a Hindu Undivided Family (HUF) from any source other than a relative. Occasions where the recipient is exempted from tax are during a marriage, or in cases where the amount is received under a will, or by way of inheritance or in contemplation of death of the payer.

Applying this section, an income-tax assessing officer treated interest-free loans amounting to Rs 54.7 lakh received by one Chandrakant Shah from non-relatives as a sum without consideration and taxed it.

The assessee approached the Commissioner of I-T (Appeals), but was not granted relief. He then appealed before the Mumbai ITAT, where his legal counsel said that the lower authorities had misinterpreted the new section, which came into effect on September 1, 2004. Furthermore, Mr Shahs counsel said the sum of interest-free loans taken by him even before that date (September 1, 2004) did not fall within the ambit of the amended section.

Bhupendra Shah, Mr Shahs counsel, argued before a division bench comprising Madhavi Devi and VK Gupta that an interest-free loan could not be taxed under Section 56 (2)(v), as the repayment of a loan itself is treated as consideration between two parties and not a sum without consideration. The counsel said the amounts were shown in the balance sheet by the assessee as unsecured loan liabilities, and, hence, could not be treated as an addition to capital as in the case of a gift.

The counsel contended that the term loan meant delivery by one party to and receipt by another party of a sum of money upon agreement expressed or implied condition, to repay it with or without interest. He maintained that it was inessential for an interest component to make a transaction of lending of money a loan transaction, by referring to a decision of the Court of Appeal of State of California. The US court had observed that a loan of money was a contract by which one delivered a sum of money to another, and the latter agreed to return at a future time without interest that sum which he borrowed.

The bench upheld the counsels argument, saying: We hold that a transaction of loan can be without interest and a transaction of loan implies an agreement to repay the money that is borrowed, which also gives reply to the revenues query regarding the existence of the obligation to repay the money at the time of taking such loan.

Section 56 (2)(v) was introduced to fill up the vacuum created by the abolition of the Gift Tax Act in 1997, which was donor-based, meaning the giver of a gift was taxed. After the abolition, both donor and donee were exempt from paying tax, which led to several non-genuine gifts being introduced from non-relatives on a large scale. It was to deal with such purported gifts that the amendment was made.