Partners’ Capital Contributions Cannot Be Taxed Under Section 68: Telangana HC

Nova Medicare Vs ITO (Telangana High Court)

Summary: The Telangana High Court considered Income Tax Tribunal Appeal No. 318 of 2006 filed by M/s. Nova Medicare against the order dated 28 October 2005 of the Income Tax Appellate Tribunal, Hyderabad Bench, concerning Assessment Year 1998-99. The appeal arose from the assessment order dated 31 December 1999 and the subsequent order of the Commissioner of Income Tax (Appeals), Hyderabad.

The assessee was a registered firm engaged in the business of export of medicines and I.V. fluids. For Assessment Year 1998-99, it declared export turnover and claimed deduction under Section 80HHC of the Income-tax Act, 1961, resulting in nil returned income. During scrutiny assessment, the Assessing Officer found credits relating to three persons: Smt. K. Sujatha, ₹2,00,000 with interest of ₹39,533; Smt. K. Shantha Kumari, ₹1,00,000 with interest of ₹5,000; and Sri K. Prabhakar Reddy, ₹1,00,000 with interest of ₹26,432.

Of the three persons, Smt. K. Sujatha and Sri K. Prabhakar Reddy were partners of the assessee-firm. Smt. K. Sujatha had introduced ₹2,00,000 towards capital of the firm, which was subsequently transferred to the unsecured loan account through a journal entry. The Assessing Officer examined her, concluded that she did not possess the creditworthiness to advance the amount and doubted the genuineness of the transaction. He invoked Section 68 of the Income-tax Act, 1961 and made the addition. Similar additions were made in respect of the other two persons. The CIT(A) upheld the additions, including the related interest amounts, and dismissed the assessee’s appeal. The Tribunal thereafter found no infirmity in the CIT(A)’s order and confirmed the addition of ₹4,70,966.

The assessee contended before the High Court that the Tribunal was not justified in sustaining the entire addition. It relied upon the decision of the Telangana and Andhra Pradesh High Court in Commissioner of Income Tax v. M. Venkateswara Rao, submitting that contributions made by partners towards the capital of a firm could not be assessed as income of the firm under Section 68 merely because the source of the partners’ contributions was not satisfactorily explained. According to the assessee, any enquiry regarding the source of the partners’ contributions could, at most, be undertaken in the individual assessments of the partners. The assessee also submitted that the decision in M. Venkateswara Rao had been followed by the Patna High Court in Commissioner of Income Tax-I v. Anurag Rice Mills.

The Revenue, on the other hand, relied upon the proviso to Section 68 and the Rajasthan High Court’s decision in Commissioner of Income Tax v. Kishorilal Santoshilal, contending that Section 68 made no distinction between a cash credit standing in the books of a firm in the name of a partner and one standing in the name of a third party. The assessee replied that the proviso to Section 68, introduced by the Finance Act, 2012 with effect from 1 April 2013, was subsequent to the assessment year involved and therefore did not apply. It also referred to the Supreme Court’s decision in Commissioner of Income Tax v. Lovely Exports (P.) Ltd..

The High Court held that the issue was squarely covered by its earlier binding decision in M. Venkateswara Rao. In that case, the Court had considered cash credits representing contributions made by partners to the capital of a firm. It held that such contributions constituted the very substratum of the firm’s business and could not ordinarily be treated as credits contemplated by Section 68. The Court further held that where the firm had explained that the amounts represented contributions by its partners, an enquiry into the source of the partners’ contributions could, at most, be undertaken against the individual partners and could not be undertaken against the partnership firm itself for purposes of Section 68.

The High Court reproduced the relevant reasoning from M. Venkateswara Rao, including its reliance upon the Patna High Court decision in CIT v. Anupam Udyog and references to the Bombay High Court decision in Naragandas Kedarnath v. CIT and the Allahabad High Court decision in CIT v. Jaistwal Motor Finance.

The Court also noted that, in Anurag Rice Mills, the Patna High Court had followed and applied the principle in M. Venkateswara Rao and held that unexplained cash credits pertaining to partners would have to be assessed in the hands of the partners rather than the firm.

Accordingly, the Telangana High Court answered the substantial questions of law in favour of the assessee and against the Revenue insofar as the cash credits pertaining to the two partners, Smt. K. Sujatha and Sri K. Prabhakar Reddy, were concerned. The Court consequently modified the Tribunal’s order dated 28 October 2005. The appeal was disposed of, miscellaneous applications, if any, were closed, and there was no order as to costs.

For background on the Section 68 principle concerning capital contributions by partners, TaxGuru has also published a detailed discussion of CIT v. M. Venkateswara Rao: [Whether Capital Contribution in Cash will Taxable as Cash Credit]

Cases Discussed

• Commissioner of Income Tax v. M. Venkateswara Rao, (2015) 370 ITR 212 (Andhra Pradesh and Telangana) — followed as the binding decision squarely covering the issue concerning capital contributions made by partners to a firm.
• Commissioner of Income Tax-I v. Anurag Rice Mills, [2017] 88 taxmann.com 420 (Patna) — referred to as having followed the principle in M. Venkateswara Rao that unexplained cash credits pertaining to partners are assessable in the hands of the partners rather than the firm.
• Commissioner of Income Tax v. Kishorilal Santoshilal, [1995] 216 ITR 9 (Rajasthan) — relied upon by the Revenue to contend that Section 68 makes no distinction between cash credits standing in the books of a firm in the name of a partner and those of a third party.
• Commissioner of Income Tax v. Lovely Exports (P.) Ltd., [2008] 216 CTR 195 (SC) — referred to by the assessee in response to the Revenue’s reliance on the law concerning unexplained credits and the source of amounts received.
• CIT v. Anupam Udyog, [1983] 142 ITR 133 (Patna) — referred to within the reasoning reproduced from M. Venkateswara Rao concerning cash credits in the accounts of partners.
• Naragandas Kedarnath v. CIT, [1952] 22 ITR 18 (Bombay) — referred to as one of the decisions upon which the Tribunal in M. Venkateswara Rao had rested its conclusions.
• CIT v. Jaistwal Motor Finance, [1983] 141 ITR 706 (Allahabad) — referred to as another decision considered by the Tribunal in M. Venkateswara Rao.

FULL TEXT OF THE JUDGMENT/ORDER OF TELANGANA HIGH COURT

Heard Ms. K.Manasa, learned counsel for the appellant and Mr. J.V.Prasad, learned Standing Counsel, Income Tax Department for the respondent.

2. This appeal has been preferred by the assessee as the appellant under Section 260A of the Income Tax Act, 1961 (briefly, ‘the Act’ hereinafter), against the order dated 28.10.2005, passed by the Income Tax Appellate Tribunal, Bench ‘A’ (SMC), Hyderabad (briefly, ‘the Tribunal’ hereinafter) lrl I.T.A.No.949/Hyd/03 for the assessment year 1998-99.

3. Though the appeal was admitted vide the order dated 30.10.2006 with an interim stay, no substantial question of law was framed. However, from the memo of appeal, we find that appellant has proposed the following questions as substaltial questions of law:

I. Whether on the facts and in the circumstances of the case, Tribuna.l was justified in upholding the investments made by the partners as addition of Rs.4,7O,966/- in the total income of the assessee on the ground that the investment made by the partners is undisclosed income of the firm?

II. Whether on the facts and in the circumstances of the case, Tribunal was correct in law in sustaining the addition of Rs.4,OO,OOO/- made by the assessing ofhcer under Section 68 of the Act on account of alleged unexplained loans taken by the partners and susta.ined the disallowance of Rs.7O,966 I – being the interest on the aforesaid loans?

III. Whether the order of the Tribunal dated 28- 10-2005 is not vitiated for ignoring t1.e relevant submissions/materials while sustaining the impugned addition and disallowance of interest?

4. From the above what is deducible is that the issue before us is whether Tribunal was justified in upholding the addition ol Rs.4,70,966.00 to the income of the appellant (also referred to as the assessee’ hereinafter) under Section 68 of the Act.

5. Section 68 of the Act says that where any sum is found credited in the books of an assessee maintained for any previous year and the assessee offers no explanation about the nature and source thereof or the explanation offered by him is not, in the opinion of the assessing officer, satisfactory, the sum so credited may be charged to income tax as the income of the assessee for that previous year

6. From the materials on record it is seen that appellant is an assessee under the Act having the status of a registered lirm. Assessment year under consideration is l99A-99. Assessee is engaged in the business of export of medicines ald l.V.fluids etc. In the return of income for the said assessment year, assessee declared export turnover and claimed deduction under Section 80HHC of the Act. Thus, assessee declared nil income. Case of the assessee was selected for scrutiny and in the course of assessment proceedings it was found that assessee had claimed to have taken loals from the following parties and in the following manner:

7. We may mention that out of the above three persons, Smt. K.Sujatha and Sri K.Prabhakar Reddy are partners of the assessee Iirm. Smt. K.Sujatha had introduced Rs.2,0O,OO0.0O towards capital of the assessee firm which was thereafter transferred to the unsecured loan account by way of a journal entry. Assessing officer examined her and came to the conclusion that she did not have the creditworthiness to advance the cash credit as above and doubted the genuineness of the transaction. Accordingly, Section 68 of the Act was invoked whereafter the aforesaid amount was added to the income of the assessee. Similar additions were made in respect of the other two parties.

8. Aggrieved by the above additions, assessee preferred appeal before the Commissioner of Income Tax (Appeals) IV, Hyderabad (hereinafter referred to as, `CIT (A)’). By the appellate order dated 02.08.2002, CIT (A) held that assessing officer was not satisfied with the creditworthiness of the creditors who had failed to furnish satisfactory evidence in the course of the assessment proceedings to prove the genuineness of the credits. Hence, assessing officer treated the credits as not genuine whereafter the same were added to the income of the assessee under Section 68 of the Act; so also the interest amounts relatable to the cash credits. Upholding the order c:5-the assessing officer CIT (A) dismissed the appeal of the assessee.

9. It was thereafter that assesscc preferred further appeal before the Tribunal. By the order dated 28.10.2005, Tribunal held that there was no infirmity in the order of CIT (A) and accordingly dismissed the appeal thereby confirming the addition of Rs.4,70,966.00.

10. Learned counsel for the appellant Ms. K.Manasa submits that Tribunal was not justified in confirming the entirety of the addition. Referring to a judgment of this Court in Commissioner of Income Tax v. M.Venkateswara Rao she submits that contribution of the partners of the firm cannot be added to the income of the firm under Section 68 of the Act even if the explanation is not satisfactory. At the most, such credits can be questioned in the assessment proceedings of the concerned partners. She further submits that the aforesaid decision of this Court in M.Venkateswara Rao (supra) has been followed by the Patna High Court in Commissioner of Income Tax-I v. Anurag Rice Mills². In the circumstances, learned counsel submits that the substantial questions of law may be answered in favour of the appellant and against the revenue.

11. On the other hand, Mr. J.V.Prasad, learned Standing Counsel referred to the proviso to Section 68 of the Act, though it came into the statute book only with effect from 01.04.2013 post the assessment year under consideration. However, justifying the order of the Tribunal he has placed reliance on a decision of the Rajasthan High Court in Commissioner of Income Tax v. Kishorilal Santoshilal³ to contend that Section 68 of the Act makes no distinction between the cash credit entry in the books of the firm whether it is of a partner or of a third party.

12. In her reply submissions, learned counsel for the appellant submits that reliance placed by learned Standing Counsel on the proviso to Section 68 of the Act is thoroughly misplaced inasmuch as the said proviso introduced by the Finance Act, 2012, came into effect from 01.04.2013, whereas the assessment year in the appeal is 1998-99. Therefore, the proviso will not be applicable to the facts of the present case. Insofar reliance placed by learned Standing Counsel on the decision of the Rajasthan High Court in Kishorilal Santoshilal (supra) is concerned, she submits that even in a case of share application money received by an assessee company from alleged bogus shareholders, Supreme Court has taken the view in Commissioner of Income Tax v. Lovely Exports (P.) Ltd⁴ that in such a scenario, department would be free to proceed to reopen the individual assessment in accordance with law but would not be entitled to invoke Section 68 of the Act to add such share application money to the income of the assessee company.

13. Submissions made by learned counsel for the parties have received the due consideration of the Court.

14. After thorough consideration of all relevant aspects, we are of the view that issue raised in this appeal is squarely covered by the decision of this Court in M.Venkateswara Rao (supra) which is binding on us. That was also a case where certain cash credits were advanced by the partners, which according to the revenue authorities remained unexplained and accordingly were added to the income of the firm. In the facts of that case, this Court held as follows:

7. It is a matter of record that the respondent-firm comprises of ten partners and each of them made contributions, be it in the form of cash or bank guarantees to be furnished to the Government, at the commencement of business. The returns submitted by the respondent-firm were processed, and the facts and figures furnished by it were accepted. However, the matter was reopened at a later point of time. The Assessing Officer treated the capital raised by the firm in the form of contributions made by the partners as income. This conclusion was arrived at on the ground that source of income for the partners was not explained. Learned counsel for the appellant placed reliance upon the judgment of the Patna High Court in CI7′ v. Anuparn Udyog [19831 142 ITR 133/15 Taxman 259. The Tribunal rested its conclusions upon the judgment of the Bombay High Court in Narayandas Kedarnath v. CITI19521 22 ITR 18 and that of Allahabad High Court in CIT u. Jaiswal Motor Finance [1983j 141 ITR 706.

8. Section 68 of the Act no doubt directs that if an assessee fails to explain the nature and source of credit entered in the books of account of any previous year, the same can be treated as income. In this case, the amount, that is sought to be treated as income of the firm, is the contribution made by the partners, to the capital. In a way, the amount so contributed constitutes the very substratum for the business of the firm. It is difficult to treat the pooling of such capital, as credit. It is only when the entries are made during the course of business that can be subjected to scrutiny under Section 68 of the Act.

9. Even otherwise, it is evident that the respondent explained the amount of Rs.76,57,263 as the contribution from its partners. That must result in a situation, where Section 68 of the Act can no longer be pressed into service. However, in the name of causing verification under Section 68 of the Act, the Assessing Officer has proceeded to identify the source for the respective partners, to make that contribution. Such an enquiry can, at the most be conducted against the individual partners. If the partner is an assessee, the concerned Assessing Officer can require him to explain the source of the money contributed by him to the firm. If on the other hand, the partner is not an assessee, he can be required to file a return and explain the source. Undertaking of such an exercise, vis-a-vis the partnership firm itself, is impermissible in law. In the judgment relied upon by the appellant itself, the Patna High court held as under (page 137 of 142 ITR):

“If there are cash credits in the books of a firm in the accounts of the individual partners and it is found as a fact that cash was received by the firm from its partners, then in the absence of any material to indicate that they are the profits of the firm, they cannot be assessed in the hands of the firm, though they may be assessed in the hands of the individual partners. Cash credits in the individual accounts of members of a joint family with third party cannot be assessed as the income of the family unless the Department discharges the burden of proof to the contrary.”

10. Therefore, the view taken by the Assessing Officer that the partnership firm must explain the source of income for the partners regarding the amount contributed by them towards capital of the firm cannot be sustained in law.

11. As regards the other amount i.e., unexplained credit entries, the Tribunal took the view that the amount represented the security deposits made by the retail dealers, and the source thereof was properly explained. Nowhere in the order of assessment, the Assessing Officer recorded any finding to the effect that he verified the matter from the respective retail dealers and that such dealers have denied of making deposits. In the field of Arrack business, it is not uncommon that the retail dealers are required to keep security deposits with the supplier. At any rate, it is a pure question of fact.

12. Therefore, the appeal is dismissed.

15. Following and applying the aforesaid decision of this Court, Patna High Court in Anurag Rice Mills (supra) held that in such circumstances the unexplained cash credits would have to be assessed at the hands of the partners of the firm and not the firm itself. Such amounts could not have been treated as income of the firm by relying upon Section 68 of the Act.

16. In view of the above position, we answer the substantial questions of law in favour of the appellant-assessee and against the respondent-revenue insofar the cash credits pertaining to the two partners of the appellant firm i.e., Smt. K.Sujatha and Sri K.Prabhakar Reddy only are concerned.

17. Consequently, order of the Tribunal dated 28.10.2005 would stand modified accordingly.

18. Appeal is disposed of.

Miscellaneous applications pending, if any, shall stand closed. However, there shall be no order as to costs.