Case Law Details
In this case basic issue to be decided was about the interest payment made by the partnership firm to the partners in light of the provisions of section 14A read with rule 8D of the Rules.
ITAT held that the interest paid by the firm to its partners and claimed as deduction is simultaneously susceptible to tax in the hands of its respective partners in the same manner. In the same vain, the firm is merely a compendium of its partners and its partners do not have separate legal personalities under the basic law as discussed. The interest paid to partners and simultaneously getting subjected to tax in the hands of its partners is merely in the nature of contra items in the hands of the firms and partners. Consequently interest paid to its partners cannot be treated at par with the other interest payable to outside parties. Thus, in substance, the revenue is not adversely affected at all by the claim of interest on capital employed with the firm by the partnership firm and partners put together. Thus, capital diverted in the mutual funds to generate alleged tax free income does not lead to any loss in revenue by this action of the assessee. In view of the inherent mutuality, when the partnership firm and its partners are seen holistically and in a combined manner with costs towards interest eliminated in contra, the investment in mutual funds generating tax free income bears the characteristic of and attributable to its own capital where no disallowance under S. 14A read with Rule 8D is warranted. Consequently, the plea of the assessee is merited in so far as interest attributable to partners. However, the interest payable to parties other than partners, in our view, would be subjected to provisions of Rule 8D(2)(ii) of the Rules.
Full Text of the ITAT Order is as follows:-
Challenging the order dated 11/05/20 15,of CIT (A)-29,Mumbai the assessee has filed the present appeal. Assessee-firm,engaged in the business of manufacturing of bulk drugs and intermediates, filed its return of income on 29/09/2012,declaring total income of Rs. 1.58 crore. The Assessing Officer(AO)completed the assessment u/s. 143(3)of the Act,on 30/01/2015,determining its income at Rs.2,00,12,590/-.During the course of hearing before us,grounds 2,4,5,6 and 8 were not pressed. Hence, same stands dismissed,as not pressed.
2.Effective ground of appeal (Gs.OA-3,5 and 7) is about disallowance made by the AO u/s. 14A of the Act,amounting to Rs. 41.68 lakhs During the assessment proceedings, the AO found that the assessee had received dividend income of Rs. 9.21 lakhs and long-term capital gain of Rs. 19.44 lakhs,that it had claimed exemption u/s. 10 (34) and 10 (38) respectively. He applied provisions of section 14A read with Rule 8D (ii) of the Income Tax Rules, 1962 (Rules) and disallowed Rs.38.78 lakhs under the head interest expenditure and 0.5% of average value of investment at Rs. 1.78 lakhs.
3.Aggrieved by the order of the AO, the assessee preferred an appeal before the First Appellate Authority (FAA).Before him,it was argued that assessee had debited interest expenditure of Rs. 65.99 lakhs,that it had paid interest of Rs. 4.34 lakhs on the loan amount to the mother of the partners who had kept her funds with the firm for more than 10 years, that interest was being credited to her account for last for many years, that she had not brought in any funds after 01/04/ 2006,that no fresh loans were received by the assessee, mother of the partners during the year under consideration, that no presumption could be raised that the said loan amount was utilised by the assessee for making investment that would generate exempt income, that it had paid interest to the partners aggregating to Rs.64.95 lakhs on their capital at the rate of 12% was provided in the partnership deed, that against the total expenditure of Rs.69.30 lakhs the assessee had received interest on fixed deposits of Rs.3 .30 lakhs, that the mat interest expenditure of Rs.65.99 lakhs was debited to the profit and loss account, that the interest paid by the firm to the partners was taxed in the hands of the partners u/s. 28 (v) under the head business income and not income from other sources, that the payment of interest to the partners was not interest expenditure, that it was one way of distributing profits of the business of the firm, that it could not be treated as interest expenditure to which provisions of section 14A could be invoked. The assessee relied upon the cases of Sudhir Kapadia (ITA/7888/Mumbai/2003, dated 26/02/2007), Sudhir Dattaram Pathe(2SOT678),Bharat S Raut(ITA/92 12/Mumbai/2004, dated 25/06/2008) Bihari Lal Aggarwal (ITA/1816/Kol/2009, dated 07/01/2011). It also referred to the case of RM Chidambaram Pillai (106 ITR 292) and further argued that it had interest-free funds in form of capital of the partners, amounting to Rs.7.02 crores, that the investment in shares was made out of the interest refunds, that no expenditure was incurred to make investment in the shares, that no the expenditure was incurred for making investment in shares, that no expenditure was debited to the profit and loss account in respect of investment in the shares, that disallowance made by the AO under rule 8D (2) (iii), being 0.5% of the average value of the investment, amounting two Rs. 1.97 lakhs should not have been made.
After considering the submission of the assessee and the assessment order, the FAA held that the partners capital was of Ruby 702.53 lakhs unsecured loan of 40.04 lakhs and investment in shares was for 56.09 lakhs,that during the year under consideration there was an increase in investment by about Rs. 125 lakhs,that sources of all funds invested in shares was either partners capital or unsecured loan or the borrowing from the banks, that interest was paid to partners on their capital on the unsecured loans and borrowings from the banks, that the assessee did not have any interest refunds available for making the investment in shares, that the assessee had no interest free-funds available for making investments, that all the funds used by it in its business, including funds used in making the investment,was interest-bearing funds, that interest expenditure was attributable to the investment,including the investment made during the year and also investment made in the past. Distinguishing the cases referred by the assessee, the FAA held that case under consideration was of a firm and not of the partners, that the issue involved was as to whether the interest expenditure incurred by the firm on the borrowed funds, including the partners interest-bearing capital utilised for making investment, would be allowable as deduction in view of the provisions of section 14A of the Act, that in the cases relied upon by the assessee for about reliability of interest expenditure incurred on borrowed funds used for making capital contribution to the firm in the hands of the partners who had received share of the profit from the firm and also remuneration/salary from the firm,that in those cases the tribunal had held that interest expenditure incurred by partner on funds borrowed for making investment in the firm as capital was allowable as deduction against salary/remuneration and interest received from the partnership firm, that the deduction of interest was not allowable against the share of profit, that in the case under consideration the partners account had interest-bearing credit balances, that the assessee had earned exempt income from such investments,that partly exempt income was arising out of the interest-bearing funds,that the tribunal had not deliberated upon the applicability of section 14A of the Act to investments made by a firm.Finally,the FAA upheld the disallowance made by the AO.
4.During the course of hearing before us, the authorised representative argued that interest paid to the partners by the partnership firm was not an expenditure, that remained of interest to them was distribution of profits as per the provisions of section 40 (b) of the Act that assessee had sufficient funds to make investments, that the investment made by the assessee during the year was less than the profits made. He relied upon the case of Quality Industries (ITA/2000/PN/2014 -AY.20 10-11,dated 09/09/2016) and Pahlajrai Jaikishin(ITA/6870/Mum/2012,AY.2009- 10,dated 1 1/03/2015).The departmental representative contended that assessee had utilised borrowed funds,that the firm and partners were separate entities, that the interest expenditure was incurred by the assessee,that the provisions of section 14A were applicable.
5.We have heard the rival submissions and perused the material before us. We find that the basic issue to be decided is about the interest payment made by the partnership firm to the partners in light of the provisions of section 14A read with rule 8D of the Rules.It is found that the Tribunal has dealt the issue,in detail,in the case of Quality Industries (supra). We would like to reproduce the relevant portion of the order of the tribunal and it reads as under:
10. We have carefully considered the rival submissions. The pre-dominant question that arises for our consideration is whether payment of interest to the partners by the partnership firm toward use of partner’s capital is in the nature of ‘expenditure’ or not for the purposes of section 14A of the Act and consequently, whether interest on partners capital is amenable to section 14A or not in the hands of partnership firm.
11. In order to adjudicate this legal issue, we need to appreciate the nuances of the scheme of the We note that prior to amendment of taxation laws from AY 1993-94, the interest charged on partners capital was not allowed in the hands of partnership firm while it was simultaneously taxable in the hands of respective partners. An amendment was inter alia brought in by the Finance Act 1992 in section 40(b) to enable the firm to claim deduction of interest outgo payable to partners on their respective capital subject to some upper limits. Hence, as per the present scheme of taxation, the interest payment on partners capital in essence is not treated as allowable business expenditure except for the deduction available under S. 40(b) of the Act.
11.1 Ostensibly, with effect from AY. 1993-94, partnership firms complying with the statutory requirements and assessed as such are allowed deduction in respect of interest to partners subject to the limits and conditions specified in section 40(b) of the Act. In turn, these items will be taxed in the hands of the partners as business income under s. 28(v). Share of partners in the income of the firm is exempt from tax u/s. 10(2A). Thus, the share of income from firm is on a different footing than the interest income which is taxable under the business income.
11.2 Similarly, we note that interest and salary received by the partners are treated on a different footing by the Act and not in its ordinary sense of term. The Section 28(v) treats the passive income accrued by way of interest as also salary received by a partner of the firm as a ‘business receipt’ unlike different treatments given to similar receipts in the hands of entities other than partners. In this context, we also note that under proviso to section 28(v), the disallowance of such interest is only in reference to section 40(b) and not section 36 or S. 37. This also gives a clue that deduction towards interest is regulated only u/s. 40(b) and the deduction of such interest to partners is out of the purview of s. 36 or 37 of the Act. Notably, there has been no amendment in the general law provided under Partnership Act 1932. The amendment to section 40(b) as referred hereinabove has only altered the mode of taxation. Needless to say, the Partnership firm is not a separate legal entity under the Partnership Act. It is not within the purview of the Income-tax Act to change or alter the basic law governing partnership. Interest or salary paid to partners remains distribution of business income.
11.3 Relevant here to refer to decision of Hon’ble Supreme Court in the case of CIT vs. R.M. Chimbaram Pillai (1977) 106 ITR 292 (SC) relied upon by the Assessee. Supreme Court has held in the case of R.M. Chidambaram Pillai, etc. (supra) held that: “A firm is not a legal person, even though it has some attributes of personality. In Income-tax law, a firm is a unit of assessment, by special provisions, but it is not a full person. Since a contract of employment requires two distinct persons, viz., the employeer and the employee, there cannot be a contract of service, in strict law, between a firm and one of its partners. Payment of salary to a partner represents a special share of the profits. Salary paid to a partner retains the same character of the income of the firm. Held accordingly, the salary paid to a partner by a firm which grows and sells tea, is exempt from tax, under rule 24 of the Indian Income-tax Rules, 1922, to the extent of 60 per cent thereof, representing agricultural income and is liable to tax only to the extent of 40 per cent.” Supreme Court has also held in the case of CIT vs. Ramniklal Kothari (1969) 74 ITR 57 (SC) that the business of the firm is business of the partners of the firm and, hence,salary, interest and profits received by the partner from the firm is business income and, therefore, expenses incurred by the partners for the purpose of earning this income from the firm are admissible as deduction from such share income from the firm in which he is partner. Thus, the ‘partnership firm’ and partners have been collectively seen and the distinction between the two was blurred in the judicial precedents even for taxation purposes.
11.4 Section 4 of the Indian Partnership Act 1932 defines the terms partnership, partner, firm and firm name as under : “Partnership” is the relation between persons, who have agreed to share the profits of a business, carried on by all or any of the partners acting for all. Persons who have entered into partnership with one another are called individually ‘Partners’ and collectively a ‘firm’ and the name under which their business is carried on is called the ‘firm name.” Thus, it is clear from the above that firm and partners of the firm are not separate person under Partnership Act although separate unit of assessment for tax purposes. There cannot therefore be a relationship inferred between partner and firm as that of lender of funds (capital) and borrowal of capital from the partners, hence section 36(1)(iii) is not applicable at all. Section 40(b) is the only section governing deduction towards interest to partners. In the light of what is already noted above that firm and partners not being two separate persons, the question of borrowing capital by the firm from its partners does not arise at all and, therefore, section 36(1)(iii) is not at all applicable for the purposes of computation of interest to partners u/s. 40(b) of the Act. To put it differently, in view of section 40(b) of the Act, the Assessing Officer purportedly has no jurisdiction to apply the test laid down u/s. 36 of the Act to find out whether the capital was borrowed for the purposes of business or not. Thus, the question of allowability or otherwise of deduction does not arise except for S. 40(b) of the Act.
11.5 As noted, as per the scheme of the Act, the interest paid by the firm and claimed as deduction is simultaneously susceptible to tax in the hands of its respective partners in the same manner. In the same vain, the firm is merely a compendium of its partners and its partners do not have separate legal personalities under the basic law as discussed. The interest paid to partners and simultaneously getting subjected to tax in the hands of its partners is merely in the nature of contra items in the hands of the firms and partners. Consequently interest paid to its partners cannot be treated at par with the other interest payable to outside parties. Thus, in substance, the revenue is not adversely affected at all by the claim of interest on capital employed with the firm by the partnership firm and partners put together. Thus, capital diverted in the mutual funds to generate alleged tax free income does not lead to any loss in revenue by this action of the assessee. In view of the inherent mutuality, when the partnership firm and its partners are seen holistically and in a combined manner with costs towards interest eliminated in contra, the investment in mutual funds generating tax free income bears the characteristic of and attributable to its own capital where no disallowance under S. 14A read with Rule 8D is warranted. Consequently, the plea of the assessee is merited in so far as interest attributable to partners. However, the interest payable to parties other than partners, in our view, would be subjected to provisions of Rule 8D(2)(ii) of the Rules. Similarly, in the absence of any specific plea from assessee towards disallowance under Rule 8D(3), we hold it sustainable in view of express mandate of law. The matter is accordingly remanded back to the file of the Assessing Officer for re-computation of disallowance under Rule 8D r.w.s. 14A of the Act in terms of our opinion expressed hereinabove.”
Respectfully following the above order of the Tribunal,we hold that interest expenditure incurred by the partnership firm on account of interest paid to the partners cannot be disallowed under provisions of section 14A of the Act.Gs.OA no.3 and 5 are decided in favour of the assessee
5.1.It is found that the assessee had made investment in real estate funds and guilt funds. Income arising from such investments could be taxable. Hence same should not have been considered for computing the disallowance u/s. 14A.We find that AO/FAA has not made proper investigation in that matter.Therefore, in the interest of Justice, we are restoring that the issue to the file of the AO for fresh adjudication.He is directed to afford a reasonable opportunity of hearing to the assessee.The assessee-firm would produce the documents related to taxable generating funds. Ground number seven is decided in favour of the assessee, in part.
As a result, appeal filed by the assessee stands partly allowed.
Order pronounced in the open court on 19th April, 2017.
