Interest on borrowed funds deduction under Section 57

Employees often fund fixed deposits using short-term loans or overdrafts, then discover their TDS does not reflect the interest expense. A new tribunal ruling gives a clear path to claim that deduction.

What the ITAT Surat ruling says and why it matters

The Income Tax Appellate Tribunal, Surat, has held that interest paid on borrowed funds used to earn taxable interest income can be deducted under Section 57(iii). In plain terms, if someone borrows specifically to place money in an instrument that yields taxable interest, the interest expense may be netted off while computing income from other sources.

Source: ITAT Surat ruling summary on TaxGuru: Section 57(iii): Interest on borrowed funds deductible against taxable interest income.

For HR and payroll teams, this has a practical impact in 2026 during year-end TDS adjustments. Employees who disclose such interest expenses may have a lower net taxable interest income, which can reduce March TDS spikes or later tax dues.

Section 57(iii) in simple words

Section 57(iii) allows deduction of expenses that are laid out wholly and exclusively for the purpose of making or earning income that is taxed under the head Income from Other Sources. Interest on a loan taken to earn taxable interest is a typical example.

Two tests usually matter in practice:

• Purpose nexus: the borrowing should be directly for earning that taxable interest income.
• Wholly and exclusively: the expense should not be partly personal or for a different purpose.

The employer angle in 2026

Even though employers primarily deduct TDS on salary, employees often ask payroll to consider other income and eligible deductions so that monthly TDS is smoother. You can choose to factor in employee declarations for interest income and the related Section 57(iii) deduction during year-end TDS adjustments, or you can decline and ask employees to self-manage via advance tax or at return filing.

Either way, you should set a clear policy, a short evidence checklist, and a cutoff date for 2026 so there are no last-minute disputes about March payroll.

If you are reviewing your payroll workflow, map this change alongside your existing process. A good place to start is revisiting your payroll processing steps in India to see where other-income declarations sit and when proofs are collected.

Eligibility matrix: when is interest deductible under Section 57(iii)?

How payroll should operationalize this

Decide whether your company will consider employee-declared interest income and Section 57(iii) deductions for TDS computation. If yes, keep it tight and evidence based. If no, give a standard guidance note so employees can plan advance tax and avoid interest costs.

1. Policy choice: Will you consider other income and Section 57(iii) deductions for TDS? State this in your year-end tax memo.
2. Declaration window: Open a short window in January or February 2026 for employees to submit declarations and proofs.
3. Template: Provide a simple declaration form that captures the instrument, lender, amount borrowed, purpose, and expected interest income.
4. Proof checklist: Ask for loan agreement, bank statements, investment proof, and interest certificates. See checklist below.
5. Verification: Do a reasonableness check. You are not auditing, but you should see a clear money trail.
6. TDS cutover: Apply accepted deductions in February and March payroll runs to smooth the final TDS.
7. Recordkeeping: Store declarations and proofs with the payroll file for the financial year to support any future queries.

Evidence to collect if you consider the deduction for TDS

• Loan sanction letter or overdraft agreement with interest rate and borrower name.
• Bank statement tracing the borrowed funds to the investment or deposit.
• Investment proof such as fixed deposit receipt, bond allotment, or demat statement.
• Interest certificate from the bank or issuer.
• A short employee note confirming that the borrowing was wholly and exclusively for earning the stated taxable interest.

What not to accept at payroll stage

• Cases where the earned interest is exempt from tax.
• Borrowings with mixed personal and investment use where the split is not documented.
• Vague declarations without a bank trail linking the loan proceeds to the interest-earning asset.
• Requests to offset business-interest expenses here. Business expenses belong in business income computations, not under Section 57(iii) at payroll.

Handling TDS vs employee’s final tax

Employers deduct tax on salary. You may optionally consider other income and TDS credits reported by employees to reduce year-end surprises. If you accept Section 57(iii) deductions for TDS purposes, keep documentation. If you choose not to consider them, tell employees early so they can pay advance tax or plan for a return-time refund or payment.

Whichever path you take, set expectations. Add a sentence in your memo that the employer’s role is limited to TDS on salary and that final tax liability remains with the employee.

For broader context on coordinating tax changes within a year, see our guide on managing payroll when two income-tax regimes shift in one year. It shows how to communicate choices and documentation windows without derailing payroll timelines.

Scenarios HR will likely face

Overdraft used for a fixed deposit

An employee uses a short-term overdraft to place a fixed deposit that carries a higher interest rate. The bank issues an interest certificate for both the OD and the FD. If the bank trail clearly shows the flow from OD to FD and the FD interest is taxable, the employee may claim the OD interest as a Section 57(iii) deduction against that interest income. At payroll stage, you can reflect this if your policy allows and documents are complete.

Borrowing for mixed purposes

An employee takes a personal loan, of which part goes into a bond investment and the rest into personal spending. Without a clear allocation and bank trail, treating the entire interest as deductible is risky. HR should decline at payroll stage and advise the employee to reconcile and claim at return filing if they can evidence the split.

Investment in tax-free bonds

If the income itself is exempt, the related borrowing cost is not deductible under Section 57(iii). This should be an easy decline at payroll review.

Recordkeeping and audit trail

Store declarations and proofs with the March payroll working papers. Keep a simple index: employee name, PAN, instrument, lender, accepted deduction amount as per payroll, and reviewer initials. This protects the company if there is a later query about why TDS was reduced.

Encourage employees to cross-check their payslip and tax summary after the March run. A quick reminder along with a link to a clear explainer like how to verify items in the salary pay slip often avoids disputes close to Form 16 issuance.

Cutoff dates and 2026 calendar realities

Many teams align proofs and final declarations in January to March 2026. Publish your internal cutoff in advance. If you manage a compliance calendar, add this item next to other statutory dates to avoid bunching tasks at year end. For a bigger picture of the month-by-month load, bookmark our roundup of employer tax deadlines for November 2026 and build from there.

Common pitfalls to avoid

• Accepting handwritten self-declarations without any proof.
• Applying offsets against exempt interest income.
• Ignoring mixed-use borrowings where purpose is not exclusively to earn taxable interest.
• Leaving March TDS recalculations to the final run, creating net pay shocks.
• Not documenting the policy decision on whether you consider other income at payroll.

Practical checklist for HR this month

1. Decide your stance: will payroll consider Section 57(iii) declarations for TDS in 2026.
2. Issue a one-page memo with eligibility, proofs, and a submission deadline.
3. Publish a simple declaration template and a proof checklist.
4. Open a help thread for borderline cases. Resolve with a short, written outcome.
5. Run a dry TDS recomputation before the March payroll to catch anomalies.
6. Archive all documents with your FY payroll workings.

Key takeaway

The ITAT Surat view supports a straightforward principle: if an employee borrows specifically to earn taxable interest, the related interest cost can be deducted under Section 57(iii), provided the purpose nexus is clear and documented. Translate that into payroll practice with a short policy, a proof-driven review, and timely March adjustments. Your team reduces last-minute TDS friction, and employees get a fairer tax outcome without surprises.

If you are refreshing your broader payroll playbook alongside this change, revisit your end-to-end payroll steps to place the declaration window and review controls at the right time in the month.