1990 (2) TMI 1 - SC - Income Tax

Disallowance of the interest paid by a partnership firm to a partner under section 40(b) - interest paid by the partner on his borrowings from the firm - HELD THAT - The provisions of section 40(b) do not exclude or prohibit such an approach. If instead of the transactions being reflected in two separate or distinct accounts in the books of the partnership they were in one account the quantum of interest paid by the firm to the partner would to the extent of the drawings of the partner stand attenuated. The mere fact that the transactions are split into or spread over two or more accounts should not by itself make any difference if otherwise the substance of the transaction is the same. One of the relevant tests would be to see whether the funds on which interest is paid or received partake of the same character. In our opinion where two or more transactions on which interest is paid to or received from the partner by the firm are shown to have the element of mutuality and are referable to the funds of the partnership as such there is no reason why section 40(b) should be so construed as to exclude in quantifying the interest on the basis of such mutuality. In such circumstances the interest if any paid to a partner by the firm in excess of what is received from the partner could alone be excluded from deduction under section 40(b). In the result for the foregoing reasons these appeals are allowed ; the orders of the High Court under appeal are set aside and the question of law referred for opinion is answered in the affirmative in terms of para 12. Appeals allowed.

Summary

The core legal question considered in these appeals is whether, in disallowing interest paid by a partnership firm to a partner under section 40(b) of the Income-tax Act, 1961, the interest paid by the partner to the firm on borrowings should be taken into account and deducted, so that only the net interest paid by the firm to the partner is disallowed.

This question arises from conflicting judicial opinions among various High Courts. Some High Courts have held that only the net interest (interest paid by the firm to the partner minus interest paid by the partner to the firm) should be disallowed under section 40(b). Conversely, the Madras High Court, in a leading decision, held that the gross interest paid by the firm to the partner must be disallowed without any set-off for interest received from the partner.

The appeals stem from references made under section 256(1) of the Income-tax Act, where the High Court of Madras, following its earlier ruling, answered the question against the appellant firm, disallowing the gross interest paid to the partner without set-off.

The relevant statutory framework is section 40(b) of the Income-tax Act, 1961, which prohibits deduction of "any payment of interest, salary, bonus, commission or remuneration made by the firm to any partner of the firm" in computing the firm's income. Notably, an Explanation I was inserted into section 40(b) by the Taxation Laws (Amendment) Act, 1984, stating that where interest is paid by a firm to a partner who also pays interest to the firm, the amount of interest disallowed shall be limited to the excess of interest paid by the firm over that paid by the partner. However, this Explanation applies prospectively from assessment year 1985-86 and is not applicable to the assessment years in dispute.

In addition, Circular No. 33-D (XXV-24) of 1965 issued by the Central Board of Direct Taxes advised that where a firm pays and receives interest from the same partner, only the net interest should be considered for tax purposes, supporting the view that netting off is appropriate.

The Court analyzed the competing judicial views. The Madras High Court emphasized the mandatory language of section 40(b) disallowing "any payment of interest" by the firm to the partner, analogizing it to salary or bonus payments which cannot be netted off against any amounts received from the partner. It stressed that the provision is penal in nature and must be strictly construed, disallowing gross interest without set-off.

In contrast, other High Courts, including the Allahabad, Andhra Pradesh, Karnataka, Rajasthan, and Punjab & Haryana High Courts, held that only the net interest should be disallowed. They relied on equitable considerations and the practical realities of partnership accounting, viewing the cross-payments of interest as adjustments of profits rather than independent payments. They found support in the Circular of 1965 and the principle that the real economic effect should be reflected in tax computation.

The Court examined the appellants' contentions in detail:

(a) The appellants argued that section 40(b) is intended not to penalize but to ascertain the "real income" of the firm, and that interest paid and received between the firm and partner are components of the same profit adjustment mechanism. Therefore, only the net interest should be disallowed. The Court rejected this argument, holding that the statutory language is clear and mandatory, and the legislative intent cannot be overridden by notions of "real income" or equitable considerations. The Court emphasized that taxing statutes must be construed strictly and that artificial rules favoring taxpayers are inappropriate in fiscal legislation.

(b) The appellants contended that the judicial interpretation of similar provisions in the predecessor Act (section 10(4)(b) of the 1922 Act) by the Allahabad High Court in Sri Ram Mahadeo Prasad's case, which allowed netting off, should guide the interpretation of section 40(b) since the legislature used the same terms. The Court found this contention misplaced because the earlier decision was based on equitable grounds rather than a technical or legal definition of "interest." The Court highlighted that rules of statutory interpretation are aids, not binding masters, and the present statutory language must be construed on its own terms.

(c) The appellants argued that the legal nature of partnership law supports netting off interest payments because a firm is not a separate legal entity but a collective of partners, and partners cannot be debtors or creditors of the firm in the strict legal sense. The Court acknowledged the unique legal position of partners and the firm, citing authoritative precedents that a firm is not a separate legal person and that partners cannot be employees or creditors/debtors of the firm in the usual sense. However, the Court held that these general partnership principles cannot override clear statutory provisions. The Court also noted that the substance of the transactions should be considered, and where the interest paid and received relate to the same funds and reflect mutual dealings, the net amount may be the appropriate measure for disallowance. The Court analogized this to the principle of set-off in insolvency law and recognized that the fiction of the firm as a separate entity for tax purposes may require pushing the concept of mutuality to its logical conclusion.

The Court thus accepted the appellants' contention that where interest paid by the firm to a partner and interest received from the partner relate to the same funds and are mutual dealings, only the net interest should be disallowed under section 40(b).

(d) The appellants contended that the Circular of 1965 issued by the Central Board of Direct Taxes, which supports netting off, is binding on the authorities and should have been followed by the High Court. The Court rejected the broad proposition that circulars have binding legal effect on judicial interpretation. It held that circulars cannot override or alter the statutory provisions and that interpretation of the law is the exclusive domain of courts. However, the Court acknowledged that circulars may be considered as external aids to construction and found that the Circular of 1965 broadly accords with the Court's interpretation.

(e) The appellants argued that the Explanation I inserted into section 40(b) in 1984 was not a change in law but a legislative clarification of the existing law. The Court noted that the Explanation was expressly made prospective from assessment year 1985-86 and thus does not apply to earlier years. The Court declined to examine this contention further but implied that the Explanation supports the interpretation that netting off is appropriate.

In conclusion, the Court held that the interest paid by the firm to the partner, in excess of the interest paid by the partner to the firm, should alone be disallowed under section 40(b). The Court set aside the orders of the High Court and answered the question of law in the affirmative in this regard.

Significant holdings include the following verbatim excerpts:

"Section 40 opens with the non obstante clause and directs that certain outgoings specifically enumerated in it 'shall not be deducted' in computing the income chargeable under the head 'Profits and gains of business or profession'. As long as there is no ambiguity in the statutory language, resort to any interpretative process to unfold the legislative intent becomes impermissible."

"The test of 'real income' as one on which the operation of section 40(b) could be sought to be limited is not a reliable one."

"A partner may be the debtor or the creditor of his co-partners, but he cannot be either debtor or creditor of the firm of which he is himself a member, nor can he be employed by his firm, for man cannot be his own employer."

"Where two or more transactions on which interest is paid to or received from the partner by the firm are shown to have the element of mutuality and are referable to the funds of the partnership as such, there is no reason why section 40(b) should be so construed as to exclude in quantifying the interest on the basis of such mutuality."

"If, instead of the transactions being reflected in two separate or distinct accounts in the books of the partnership, they were in one account, the quantum of interest paid by the firm to the partner would, to the extent of the drawings of the partner, stand attenuated."

"The fiction may have to be pushed to its logical conclusion."

"Though equity and taxation are often strangers, attempts should be made that these do not remain always so and if a construction results in equity-rather than in injustice, then such construction should be preferred to the literal construction."

"Circulars cannot detract from the Act."

The Court's final determination is that, for the purpose of disallowance under section 40(b) of the Income-tax Act, where a partner pays interest to the firm and the firm pays interest to the partner, only the net amount of interest paid by the firm to the partner (i.e., the excess of interest paid by the firm over interest received from the partner) should be disallowed.