TMI Blog2016 (10) TMI 56X X X X Extracts X X X X X X X X Extracts X X X X ..... purposes of computation of interest to partners under section 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 under section 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. 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tal is not expenditure refer in Sec 14A , it is allowance given to partnership firm. This interest on capital is taxable in hands of partners and disallowance will lead to double taxation in hands of partner as well as firm. 4. The appellant craves leave to add, alter, amend or delete any of the above grounds of appeal. 3. The relevant facts germane to the issue in brief are that the assessee is a partnership firm which is engaged in the business of manufacturing of chemicals etc. The assessee firm filed return of income for the relevant assessment year 2010-11 under section 139(1) of the Act declaring total income of ₹ 95,65,090/-. While making assessment under section 143(3), the Assessing Officer noticed that the assessee has inter-alia earned tax free dividend income amounting to Rs. ₹ 24,63,700/- from investment in mutual funds which was claimed as exempt income under section 10(35) of the Act. The Assessing Officer in a sequel thereto, also noted that the assessee has shown investment of ₹ 4,41,88,955/- held in various mutual funds as on 31.03.2010. The corresponding investment in the mutual fund as on the last day of the preceding financial ye ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... artners. The assessee firm is a separate entity under Income Tax Act only for taxation purposes. These is the very reason that deduction of interest and salary to partners is allowed as separate deduction and not as an expenditure under separate section from sections 30 to 43 of the Act. These interests and salaries to partners for this very reason are not liable for TDS provisions under the Income Tax Act. It was further submitted on behalf of the assessee that section 14A covers amount in the nature of expenditure and not all statutory allowances. 4.2 The assessee also contended before the Assessing Officer that no capital was introduced for investment purposes and therefore disallowance of interest on capital was not justified. 4.3 However, the Assessing Officer discarded the various pleas of the assessee. He observed that the investments in mutual fund giving rise to tax free dividend income is sourced out of partner s capital and loans and consequently interest paid on partner s capital is also susceptible to Rule 8D(2)(ii) of the Rules. The Assessing Officer accordingly invoked Rule 8D of the Rules and computed disallowance of interest at ₹ 27,84,771/- in terms ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... partners towards fixed capital which has been charged to profit and loss account of the partnership firm during the year. Similarly, another interest expenditure of ₹ 75,615/- has been incurred on certain loans from banks etc. On these facts, the Ld. AR raised a substantial question in relation to disallowance of proportionate interest in relation to partners capital by invoking Rule 8D(2)(ii) of the Act. It was contended on behalf of the assessee that interest payable on fixed capital received from its partners does not bear the characteristics of expenditure per se as contemplated under S. 14A of the Act . Reference was invited to S. 28(v) of the Act and it was pointed out that as per the scheme of taxation, the payment to the credit of partners in the form of interest and salary is chargeable to tax in their respective hands as business income by operation of law. He made reference to the decision of the Hon ble Supreme Court in the case of CIT vs. R.M. Chidambaram Pillai reported in (1977) 106 ITR 292 (SC) and submitted that payment of salary to partners represent as special share of profits and therefore taxable as business income. He thus contented that on the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... as per law. The Ld. AR, in conclusion, sought appropriate relief in accordance with law. 9. The Ld. Departmental Representative (DR) for the Revenue, on the other hand, relied upon the order of the CIT(A) and in furtherance submitted that while making the assessment of the firm, the Revenue is entitled to invoke section 14A of the Act together with Rule 8D of the Rules to deny deduction in respect of expenditure claimed towards interest on partner s capital. He therefore submitted that no interference with the order of the CIT(A) is called for. 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 taxation. We note that prior to amendment of taxation laws from AY 1993-94, the interest charged on partners capi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... er 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 th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X
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