Whether deduction(s) on account of salary/interest to partners of firm shall be admissible from income estimated in accordance with sections 44AD and 44AE
1. Sections 44AD and 44AE were inserted in the Income-tax Act, 1961, by the Finance Act, 1994, w.e.f. 1st April, 1994. Section 44AD provides for a method of estimating income from the business of civil construction or supply of labour for civil construction work, where the gross receipts from the business do not exceed Rs. 40 lakhs. Section 44AE provides for a method of estimating income from the business of plying, hiring or leasing trucks owned by a taxpayer owning not more than 10 trucks. Both the schemes are optional.
2. Sub-section (1) of sections 44AD and 44AE clearly provide that the income shall be estimated at the prescribed percentage/basis without regard to the provisions contained in sections 28 to 43C of the Act. In other words, the income estimated in accordance with sections 44AD and 44AE takes care of various deductions, etc., admissible under the aforesaid sections.
3. A doubt has been raised as to whether deduction(s) on account of salary/interest to the partners of a firm shall be admissible from the income estimated in accordance with sections 44AD and 44AE of the Act. The law is clear on this issue and no separate deduction is to be allowed under section 40(b) in such cases. The doubt has primarily arisen because of the erroneous clarification given in paras 31.3 and 32.2 of Explanatory Notes on provisions of the Finance Act, 1994 (Circular No. 684, dated 10-6-1994) (see Volume 4). The relevant portion of the Explanatory Note reads as under :23/23
“In the case of firms, the normal deductions to the extent allowed under clause (b) of section 40 will be allowed.”
4. Clause (b ) of section 40 lays down restriction on the deduction allowable on account of salary and interest to the partners and is not an enabling section for claiming deduction. The admissible deductions are specifically mentioned under sections 30 to 38 of the Income-tax Act. Hence, sections 44AD(2) and 44AE(3) only state this obvious position by way of clarification. However, in view of the non obstante clause in sub-section (1) of sections 44AD and 44AE, there is no ambiguity about the intention of the legislation in this matter and the provisions of the Act are quite clear. As already said above, the doubt has primarily arisen because of the error in the Explanatory Notes to Finance Act, 1994. Therefore, for the sake of clarity and removal of doubts in this regard, the following lines are deleted from paras 31.3 and 32.2 of Circular No. 684 dated 10th June, 1994 :
‘In the case of firms, the normal deductions to the extent allowed under clause (b) of section 40 will be allowed.’
Circular : No. 737, dated 23-2-1996.
JUDICIAL ANALYSIS
EXPLAINED IN – Ranjan Constructions v. CBDT [1998] 232 ITR 76 (Ori.) with the observation that a combined reading of the newly added provisos to sections 44AD(2) and 44AE(3) makes it clear that the effect of Circular No. 737 is lost and consequently assessments made on the basis of the circular cannot stand and they are liable to be vacated.
EXPLAINED IN – In Narinder Jain v. CBDT [1998] 96 Taxman 566 (Punj. & Har.) the assessee-firm was engaged in the business of civil construction supply of labour for construction, whose income was to be computed as per section 44AD. It claimed under section 40(b) deduction of salary and interest paid to partners in the computation of its total inocme by relying on the Board’s Circular No. 684, dated 10-6-1994. The Assessing Officer however, relying on the Board’s Circular No. 737, dated 23-2-1996, disallowed the assessee’s claim. the assessee had filed an appeal against the assessment order.
On writ challenging legality of the Board’s Circular No. 737, dated 23-2-1996, it was held that the assessee brought to the notice of the court that by the Finance Act, 1997 a proviso to section 44AD had been added with retrospective effect from 1-4-1994 clarifying that salary and interest paid by a firm to its partners shall be deducted from income computed under section 44AD(1) subject to conditions and limits specified in section 40(b), thereby restoring the position of law stated by Circular No. 684, dated 10-6-1994 and rendering Circular No. 737, dated 23-2-1996 as infructuous. Prima facie, the Court found force in the assessee’s submission but refrained to express any opinion on that and relegated the assessee to raise this point before the concerned authority (whether appellate or Assessing Officer) who would take that into consideration while deciding the case.
Again in Goswami & Bros. v. Union of India [1998] 96 Taxman 219 (Raj.), the facts of the care were fact in Circular No. 684 dated 10-6-1994, the Board had clarified, inter alia, that in computing profits and gains of business of civil constrution, etc., under section 44AD “in the case of firms, the normal deduction to the extent allowed under clause (b ) of section 40 will be allowed”. Subsequently, by Circular No. 737 dated 23-2-1996, the aforesaid words were deleted from the aforesaid Circular. In pursuance of Circular dated 23-2-1996, the income-tax authorities reopened the assessments of the petitioner and in some of the matters issued fresh assessment orders.
On writ praying for quashing Circular No. 737 dated 23-2-1996 :
The Court held that by the Finance Act, 1997, a proviso to sub-section (2) of section 44AD had been added giving it retrospective operating with effect from
1-4-1994, that is, with effect from assessment year 1994-95, providing that where the assessee is a firm, the salary and interest paid to its partners shall be deducted from the income computed under sub-section (1) subject to the conditions and limits specified in section 40(b). In view of this, the said circular was clearly erroneous and could not be permitted to stand.
Accordingly, the petition was allowed of said circular was quashed.
EXPLAINED IN – Venugopala Constructions v. ITO [1997] 227 ITR 164 (AP) with the following observation :
“The later circular of the Central Board of Direct Taxes in not extending the benefit of the earlier circular, had neither tried to deprive the assessee of any right nor had created any liability which was not already existing. If a wrong circular had been issued giving the impression that the assessee was entitled to the benefit of section 40(b ) as well as section 44AD, it is the inherent right of the authorities to cure their own error. The later circular of the Central Board of Direct Taxes had only attempted to do that and hence no exception could be taken to it. Circular No. 737, dated February 23, 1996, was valid.”
EXPLAINED IN – In Ambika Construction v. ITO [1998] 99 Taxman 561 (Pat.) the assessee’s case was selected for scrutiny under section 44AD. The assessee, therefore, submitted the return as per Circular No. 684 issued by the CBDT but the Assessing Officer while making final assessment on 18-11-1996 applied the procedures provided in the Board’s Circular No. 737 which came into effect from 23-2-1996. According to the assessee, applicability of any circular has to be made effective with reference to the year of assessment and not at the time of final assessment.
The Court held that there was a doubt that effect of any circular could not be applied retrospectively so as to deprive the assessee of the benefit of the earlier circular which was applicable at the time of assessment. But in the instant case at the time of the assessment by the Assessing Officer, the Circular No. 737 had already occupied the field, as the final order of the assessment was passed on 18-11-1996 whereas Circular No. 737 was brought into effect on 23-2-1996. Hence, no grievance could be made that such a circular had been applied retrospectively.
