IN THE HIGH COURT OF SINDH AT KARACHI

I.T.R.A. No.258 & 259 of 2010

The Commissioner (legal) Inland Revenue, LTU Karachi,

M/s. MCR (Pvt). Ltd., Karachi

PRESENT:

Mr. Justice Arshad Hussain Khan

Mr. Justice Amjad Ali Sahito

*****

Applicant : Through Mr. Faheem Ali Memon, Advocate.

Respondent : Through Mr. Shafqat Zaman, Advocate.

Date of hearing : 27.10.2026

Date of order : 03.11.2026

JUDGMENT

ARSHAD HUSSAIN KHAN J; Through these two Income Tax Reference Applications filed under Section 133 of the Income Tax Ordinance, 2001 (“the Ordinance”), the Applicant-Department has challenged the consolidated order dated 10.10.2009 (“the impugned order”) passed by the Income Tax Appellate Tribunal, Karachi Bench (“the Tribunal”). The impugned order arose out of four cross-appeals relating to Tax Years 2006 and 2007. ITA Nos.614 and 615/KB/2008 were filed by the Respondent-Taxpayer challenging the levy of Workers Welfare Fund, whereas ITA Nos.646 and 647/KB/2008 were filed by the Applicant-Department challenging the deletion of additions relating to interest-free loans advanced to employees. Through the impugned order, the Tribunal dismissed all four appeals. While dismissing the taxpayer's appeals on the ground that the levy of Workers Welfare Fund had already been upheld in its own case, the Tribunal dismissed the departmental appeals by maintaining the deletion of additions relating to interest-free loans advanced to employees, holding that under Section 13(7) read with Section 13(13) of the Ordinance, any taxable benefit arising from such loans was chargeable in the hands of the employees and not the employer. Aggrieved by the dismissal of its appeals, the Department has filed the present Reference Applications, which involve common questions of law and are being decided through this consolidated judgment, with ITRA No.258 of 2010 treated as the leading case.

2. Briefly, the Respondent-Taxpayer, a company engaged in the restaurant business under the franchise of Pizza Hut International, LLC, filed its returns of income for Tax Years 2006 and 2007, declaring taxable income of Rs.148,302,420/- and Rs.57,322,183/-, respectively. Subsequently, the assessments were amended under Section 122(5A) of the Ordinance on various grounds, including disallowance of financial charges attributable to interest-free loans advanced to employees. The Taxation Officer observed that the taxpayer had claimed financial charges of Rs.6,828,710/- while advancing interest-free loans to its employees and accordingly made additions of Rs.115,950/- and Rs.113,726/- for the respective tax years. On appeal, the Commissioner (Appeals), vide order dated 24.07.2008, deleted the additions, holding that any taxable benefit arising from such loans was chargeable in the hands of employees and not the employer. The Tribunal maintained the said findings, giving rise to the present references.

3. Learned counsel for the Applicant-Department, while assailing the impugned order, contends that the Tribunal failed to appreciate the distinction between taxation of benefits received by employees under Section 13 and the allowability of financial charges claimed by the employer under Section 28(1)(a) of the Ordinance. He submits that the taxpayer had incurred financial charges while advancing interest-free loans to its employees and that the proportionate expenditure attributable to borrowed funds utilized for non-business purposes was not allowable. According to learned counsel, the Tribunal erroneously deleted the additions merely on the ground that Section 13 applied to employees, without independently examining the Department's objection under Section 28(1)(a). He further submits that an incorrect reference to a statutory provision would not, by itself, invalidate an otherwise lawful disallowance. He accordingly prays that the proposed questions be answered in favour of the Department.

4. Conversely, learned counsel for the Respondent-Taxpayer supports the impugned order and submits that the additions were rightly deleted, as Section 13(7) of the Ordinance governs the taxation of benefits arising from interest-free loans advanced by an employer to its employees. He further maintains that the advances were made out of the taxpayer's operating profits and not borrowed funds, and that the Department failed to establish any nexus between the financial charges claimed and the advances made to employees. Reliance is placed upon Commissioner Inland Revenue (Zone-IV) v. Messrs Saima Packaging (Pvt.) Ltd. (2017 PTD 2413), wherein this Court declined to sustain additions relating to interest-free loans advanced to employees in the absence of the statutory requirements for invoking Sections 108 and 109 of the Ordinance. He accordingly prays for dismissal of the Reference Applications.

5. We have heard learned counsel for the parties and examined the available record, the impugned order and the relevant statutory provisions. The three questions proposed by the Applicant-Department substantially overlap and, therefore, for proper adjudication of the controversy, are consolidated and reformulated as follows:

“Whether, in the facts and circumstances of the case, the learned Tribunal was justified in maintaining the deletion of additions relating to interest-free loans advanced to employees solely on the basis of Section 13 of the Income Tax Ordinance, 2001, without examining the allowability of proportionate financial charges under Section 28(1)(a) of the Ordinance?”

6. The controversy requires consideration of the scope and application of Sections 13(7) and 28(1)(a) of the Ordinance. Section 13(7) governs the tax treatment of benefits arising from interest-free or concessionary loans advanced by an employer to its employees and provides for inclusion of the prescribed benefit in the employee's taxable salary, subject to the applicable statutory conditions. Section 28(1)(a), on the other hand, regulates the deductibility of profit on debt incurred by a taxpayer to the extent that the proceeds or benefit of such debt have been utilized for business purposes. The two provisions thus operate in distinct fields. While Section 13 concerns the taxation of benefits received by employees, Section 28(1)(a) concerns the allowability of borrowing costs incurred by the employer. Consequently, the mere fact that a benefit arising from an interest-free loan may be taxable in the hands of an employee does not, by itself, determine whether the corresponding financial expenditure claimed by the employer is deductible.

7. In the present case, the Taxation Officer made additions by applying the benchmark rates prescribed under Section 13 to the outstanding loans advanced to employees, while also referring to Section 28(1)(a). The Commissioner (Appeals) deleted the additions on the ground that the benefit arising from such loans was taxable in the hands of employees and not the employer. The Tribunal concurred with this reasoning without independently examining whether the financial charges claimed by the taxpayer were attributable to borrowed funds actually utilized for advancing interest-free loans. The taxpayer, however, had specifically maintained that the advances were made from its operating profits and not from borrowed funds. This material factual contention was neither expressly accepted nor rejected by the Tribunal.

8. In Commissioner Inland Revenue (Zone-IV) v. Messrs Saima Packaging (Pvt.) Ltd. (2017 PTD 2413), a Division Bench of this Court examined the tax treatment of interest-free loans advanced by an employer to its employees. It was held that an employee could not be treated as an associate merely by reason of employment and that, unless the Department established the statutory prerequisites for invoking Sections 108 and 109 of the Ordinance, an addition based upon the arm's-length principle could not be sustained. The said judgment is relevant to the extent that interest-free advances to employees cannot automatically be treated as taxable income of the employer merely by applying a notional rate of interest. However, the controversy in that case arose under Sections 108 and 109, whereas the present references additionally involve the allowability of financial charges under Section 28(1)(a). The cited judgment, therefore, does not dispense with the requirement of examining whether the borrowed funds were actually utilized for non-business purposes.

9. It is equally important to distinguish between an addition made on account of notional interest and disallowance of expenditure actually claimed by a taxpayer. Section 28(1)(a) does not, by itself, authorize the taxation of hypothetical interest income merely because an employer has advanced interest-free loans to its employees. Any disallowance under the said provision must relate to identifiable borrowing costs and be supported by a finding that the proceeds or benefit of the corresponding debt were not utilized for business purposes. The mere existence of interest-free advances alongside financial charges in the taxpayer's accounts would not, without establishing the requisite nexus, justify a proportionate disallowance. Moreover, the nature and purpose of employee advances and their connection, if any, with the taxpayer's business would also require consideration.

10. Examining the impugned order in the light of these principles, we find that although the Tribunal correctly recognized that Section 13(7) concerns the taxation of benefits in the hands of employees, it did not address the independent objection raised by the Department under Section 28(1)(a). At the same time, the assessment order does not disclose any definite finding, supported by an examination of the relevant financial record, establishing that the borrowed funds were actually utilized for advancing interest-free loans to employees. The additions appear to have been calculated by applying benchmark rates to the outstanding employee advances rather than by identifying the actual borrowing costs attributable to any established non-business utilization of funds. Such computation, without the necessary factual foundation, cannot automatically be treated as a valid disallowance under Section 28(1)(a).

11. In these circumstances, while the reasoning adopted by the Tribunal does not fully address the statutory controversy, the Department's claim for restoration of the additions cannot be accepted merely on that account. The essential factual question concerning the source of funds utilized for employee advances and their relationship with the financial charges claimed remains undetermined. Since this Court, while exercising reference jurisdiction under Section 133 of the Ordinance, is required to decide questions of law arising from the Tribunal's order, it would not be appropriate to undertake a fresh factual determination in the absence of findings on these material aspects.

12. Accordingly, the reformulated question is answered in the negative, to the extent that the Tribunal was not justified in disposing of the Department's objection under Section 28(1)(a) solely on the basis of Section 13 of the Ordinance. This answer, however, shall not be construed as affirming the additions made by the Taxation Officer or as holding that any portion of the financial charges claimed by the taxpayer was inadmissible.

13. Consequently, both Reference Applications are disposed of in the above terms, with no order as to costs. The impugned order dated 10.10.2009, to the extent that it relates to ITA Nos.646 and 647/KB/2008 concerning the disallowance of financial charges attributable to interest-free loans advanced to employees, is set aside, and the matters are remitted to the Tribunal for fresh decision strictly on this limited issue, in accordance with law and in the light of the observations made hereinabove. The Tribunal shall determine, on the basis of the material already available on record and after hearing the parties, whether the Department had established the requisite nexus between the borrowed funds and the interest-free advances, and whether any disallowance under Section 28(1)(a) was legally sustainable. No fresh grounds of addition or enhancement of the original disallowances shall be entertained. The findings concerning the levy of Workers Welfare Fund and all other matters not forming part of these references shall remain undisturbed.

A copy of this judgment shall be transmitted to the Tribunal under Section 133 of the Ordinance for compliance in accordance with law.

JUDGE