There is good news for you. You will not be taxed at all.

A recent ruling by Income Tax Appellate Tribunal (ITAT) in the case of Chandrakant Shah stated that if you borrow interest-free money from friends and colleagues neither you nor the lender will have to pay tax.

This ruling was given by the tribunal on 12th January 2009. Let us take a look at how this ruling came into effect.

Prior to 1997, one of the taxes that existed was Gift Tax. As per the rules of the Gift Tax Act, the person lending the money to his acquaintances was taxed. And the tax rate here was exorbitantly high.

You ended up paying around 30 per cent of the value of the taxable gift. For e.g. if the value of the gift was Rs 1 lakh, you ended up paying Rs 30,000 to the income tax department.

This made many people wary of lending money to their friends and colleagues. Even the recipients of such gifts were not spared. As a result, many people did not use this good source of financing, even though their friends did not charge them any interest.

However in 1997, gift tax was abolished. So both the donor as well as the recipient did not have to pay any tax on the gifts received. Consequently, people started misusing the vacuum left behind by scrapping of gift tax. There was a widespread transfer of insincere gifts from the non-relatives. In order to fill up this void, Section 56 (2)(v) of Income Tax Act was passed in 2004.

As per Section 56 (2)(v) of the Income Tax Act , any amount exceeding Rs 25,000 obtained by a person or a Hindu Undivided Family (HUF) without any consideration from non-relative would be taxed. The only cases exempted were the gifts given during marriage, inheritance left behind in a will or if the payer has died.

In the case of Chandrakant Shah, the assessing officer of income tax, used this section and considered the interest-free loans given to Shah by his non-relatives as amount without consideration and taxed it.

This made Shah approach the Commissioner of I-T (Appeals) for relief, but failed. Subsequently he appealed the Mumbai [ Images ] ITAT, and his lawyer argued that the lower authorities made the wrong interpretation of this section.

Moreover, his lawyer argued that an interest-free loan does not fall within the purview of Section 56 (2)(v), since the loan repayment itself can be regarded as consideration between both the parties and not as an amount without consideration.

Also Shah's balance sheet showed the amount as unsecured loan liability and so cannot be regarded as an addendum to the capital, which is true in case of gifts.

He also referred to the judgment given by the Court of Appeal of State of California, which stated that loan was a contract between two parties. As per this contract, one party lent money to other party, who then agreed to repay the money in future, with or without interest. His argument was upheld by the ITAT bench and so gave the ruling favoring Shah.