TMI Blog1991 (11) TMI 8X X X X Extracts X X X X X X X X Extracts X X X X ..... 1985-86 and in that view directing to delete the add back of interest paid to the partners in their individual capacity as they represented their Hindu undivided family in the firm ?" Briefly stated, the facts are that the assessee, in its return for the assessment year 1984-85, for which the relevant previous year ended on October 15, 1983, claimed deduction in respect of interest amounting to Rs. 2,720 and Rs. 17,605 paid to Shri B. P. Kedia and Shri K. P. Kedia, respectively. The said persons were partners of the assessee-firm as kartas of their respective Hindu undivided families (for short, "the HUF"). The interest was claimed to be paid to the said persons in their individual capacity and not as kartas of the Hindu undivided families. It was claimed that the provisions of section 40(b) of the Act were not applicable to the said interest. The Assessing Officer rejected this contention. He was of the view that the Hindu undivided family as such could not be a partner and the said two partners were really partners in their individual capacity qua the other partners and they were accountable to their respective Hindu undivided families for the share income from the firm. He app ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 7,246 in one case and Rs. 48,426 in the other. The said two persons had also advanced loans to the assessee-firm in their individual capacity on which they were paid interest amounting to Rs. 2,720 and Rs. 17,605, respectively. It is evident from the assessment order and the allocation of income made by the Income-tax Officer that the loans advanced by the said two persons in their individual capacity and the interest paid thereon were accounted for separately in the books of the assessee-firm. In other words, in the books of the assessee-firm, there were two separate accounts-one in respect of the partner representing his Hindu undivided family and the other in respect of the loan advanced by him in his individual capacity, and the interest payable on the respective loans was separately calculated and credited to the respective accounts. The assessee's claim as to the inapplicability of section 40(b) was restricted to the interest credited to the individual loan accounts only, namely, the sums of Rs. 2,720 and Rs. 17,605. The assessee did not dispute that the interest of Rs. 87,246 and Rs. 48,426 paid to the partners representing their respective Hindu undivided families was to be ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... umber of amendments have been made to bring out the legislative intention more clearly so that further controversy and litigation regarding the true intent and purport of these provisions is avoided. To illustrate (b) It has also been clarified that where a person is a partner in his representative capacity, interest paid to him in his individual capacity will not be disallowed under the abovementioned provision and vice versa." It is thus evident that the insertion of Explanation 2 to section 40(b) has been expressly stated to be clarificatory in nature for bringing out the legislative intention more clearly so that further controversy and litigation regarding the true intent and purport of the said provision was avoided. This court in the case of Girdharilal Ghasiram v. CIT [1968] 69 ITR 890, considered a case of payment of salary made by a firm to its partner in the context of the provisions of section 10(4)(b) of the Indian Income tax Act, 1922. In that case, a karta of a Hindu undivided family who was receiving a salary for services rendered to a firm became a partner of the firm and the firm continued to pay salary to him as before. It was held that the remuneration pai ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he interest received will be income of the Hindu undivided family; while, if any coparcener including the manager has advanced a personal loan, the interest paid in respect of the personal loan cannot be treated as interest paid to the Hindu undivided family which is a partner through the manager. V was a partner in the assessee-firm in his capacity as representative of his Hindu undivided family. The interest received by him was not in his capacity as a representative of his Hindu undivided family but in his capacity as an individual. Therefore, the interest paid to V in his individual capacity would not be payment made to a partner so as to attract the provisions of section 40(b). The question came up for consideration before a Full Bench of the Gujarat High Court in the case of Chhotalal and Co. v. CIT [1984] 150 ITR 276. At pages 283 to 286, the court held as follows: "The position, therefore, is well-settled that there is no impediment in a Hindu undivided family becoming a partner of a firm through its representative. Such a partnership will not be invalid or against law, but partnership being a relationship between persons who have agreed to share the profits of a busine ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 61, is the Revenue to take note of the representative character of the assessee and make disallowance falling within the section in accordance therewith ? That is the question which we are really called upon to answer here. What is said for the Revenue is that while the Revenue may take note of the fact that Shri C. S. Virani really represents a Hindu undivided family when it makes the individual assessment on the Hindu undivided family of which he is a representative, that will have no bearing when the Revenue seeks to assess the firm to its tax. At that stage, it is said, the real character of Shri C. S. Virani does not call for consideration and he need be treated only as a partner and if so treated, whatever is paid as interest to Shri C. S. Virani irrespective of the character in which such payment is made is to be disallowed on account of section 40(b) of the Act. This approach would assume that, so far as the Revenue is concerned, the Revenue cannot take note of the capacity in which a person happens to be a partner of a firm. Such an approach is unsustainable in law, for whatever may be the obligations as between the partners, arising out of a contract, so far as the Revenu ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ld as follows: "It is true that there is a conflict of judicial opinion on this aspect (vide judgments of the Karnataka, Allahabad and Delhi High Courts above referred to on which reliance was placed by the learned standing counsel for the Revenue). We do not think that any case is made out for reconsideration of the judgments of this court in Addl. CIT v. Vallamkonda Chinna Balaiah Chetty and Co. [1977] 106 ITR 556 (AP) and Terla Veeraiah v. CIT [1979] 120 ITR 502 (AP) for two reasons : firstly, the view taken by this court finds support in the judgments of the Gujarat High Court and Madras High Court above referred to ; and, secondly, the principle enunciated by this court is now statutorily recognised by the Taxation Laws (Amendment) Act of 1984, which will be effective from the assessment year 1985-86. By section 10 of the above Amendment Act, three Explanations were inserted. Explanations 2 and 3 deal with the matter under consideration. The effect of these Explanations is : (a) if a person is partner in a firm in a representative capacity and if such partner lends to the partnership monies belonging to him individually, then the interest paid to such partner on the monies l ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... l capacity is not liable to be disallowed under section 40(b) of the Act, inasmuch as the partners were acting in a representative capacity so far as the partnership interest is concerned. " The Madhya Pradesh High Court in the case of Balchand Hashmatrai and Co. v. CIT [1986] 161 ITR 121 also considered the effect of the insertion of Explanation 2 in section 40(b). That was a case relating to the assessment year 1976-77. It was held that the provisions of Explanations 2 and 3 of section 40(b) of the Income-tax Act, 1961, and the circular make it clear that disallowance of interest paid by a firm can be made under section 40(b) only if the interest is paid by the firm to the partner in his capacity as partner. No disallowance can be made under section 40(b) if the interest is paid by the firm to the partners in a capacity other than the capacity of a partner. Where a member of a Hindu undivided family is a partner in his individual capacity, interest paid to him as a representative of the Hindu undivided family cannot be disallowed. Though Explanations 2 and 3 were inserted with effect from April 1, 1985, they point out the effect of interest paid in such cases. The Patna High ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... presentative capacity as karta of a Hindu undivided family, a partner of the assessee-firm, the interest paid to him in his distinct individual account must be disallowed under section 40(b). It appears to us that the Legislature inserted Explanation 2 in section 40(b) with effect from April 1, 1985, to settle the controversy on account of divergence of opinion among the High Courts on this point, there being no authoritative pronouncement of the Supreme Court. In this view of the matter, we are inclined to hold that Explanation 2 is merely declaratory of the existing law as contained in clause (b) of section 40 intended to remove the doubt raised on account of conflicting High Court decisions ; and it is not a new enacting provision carving out an exception from the general rule contained in clause (b). The ordinary purpose of an Explanation is to clarify that which is already enacted and not to enact something new. No doubt, the Explanation sometimes may be a distinct enacting provision itself. However, it would then not be performing its ordinary or normal function of an Explanation. We are of the view that the function of Explanation 2 inserted in clause (b) with effect from ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s [1990] 186 ITR 272, agreeing with the Gujarat, Bombay and Madhya Pradesh. High Courts held that, where the karta of a Hindu undivided family was a partner in a firm in his representative capacity, interest paid, by the firm to him on his individual investment could not be disallowed under section 40(b). Thus, the Andhra Pradesh, Bombay, Gujarat, Madhya Pradesh, Rajas than, Punjab and Haryana and Gauhati High Courts and the Madras High G: Court in its later decision have taken the view favourable to the assessee whereas the Allahabad, Delhi, Karnataka and Patna High Courts and the Madras High Court in its earlier decision have taken the other view. Preponderance of judicial opinion is in favour of the view that the dual capacity has to be recognised and that interest paid on individual investment of a partner representing his Hindu undivided family cannot be disallowed under section 40(b). Under section 40(b), any payment of interest made by a firm to any partner of the firm shall not be deducted in computing the income of the firm. For attracting the disallowance under section 40(b), the interest must be paid by the firm to a person in his capacity as a partner of the firm. N ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... such can be disallowed. In case a person is acting in a dual capacity, the interest paid to him only in his capacity as partner can be subjected to the disallowance under section 40(b). Interest paid to such person in any other capacity cannot be subjected to the disallowance under section 40(b). The payment in the latter case has to be treated on par with a payment made to a stranger. This position was accepted by the Central Board of Direct Taxes as is evident from the circular dated 26 ...... 1978. It provides as follows: "The kartas of their respective Hindu undivided families were not the partners in the firm in their representative capacities. They were partners in the respective firms in their own right as individuals. There are two separate accounts in the books and accounts of the firm, one in respect of the partner in his individual capacity and another in the name and style of the Hindu undivided family which appears simply as depositor and has nothing to do with the capacity of the karta as a partner. This is because the Hindu undivided family as such is not a partner in both the cases through its karta. The interest paid by the firm is debited to the profit and lo ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s of what was received from the partner. There was a divergence of opinion between the different High Courts on this aspect also and Explanation 1 inserted in section 40(b) by the said Amendment Act with effect from April 1, 1985, dealt with this aspect. Before the Supreme Court, a contention was raised on behalf of the assessee that the said Explanation 1 was merely clarificatory and had to be given retrospective effect. The contention of the Revenue is that the Supreme Court in fact has laid down that the Explanations to section 40(b) are prospective in operation land therefore until the assessment year 1985-86, the interest paid by the firm to its partners has to be disallowed under section 40(b). In our view, the Supreme Court did not decide finally the contention on the retrospective operation of the Explanation to section 40(b). This will be evident from the observations of the Supreme Court which we quote hereafter (at page 18): "Sri Ramachandran urged that the introduction, in the year 1984, of Explanation 1 to section 40(b) was not to effect or bring about any change in the law, but was intended to be a mere legislative exposition of what the law has always been. An ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the coparcenary, not even his male issue acquires any interest in it by birth, there is no reason why a "karta" who represents a firm on behalf of the Hindu undivided family cannot invest his separate or self-acquired property in the firm and earn interest therefrom which a stranger could have done. If a joint Hindu family, through the agency of its karta, can enter into contractual relations either with a stranger or even with an individual coparcenar in respect of his separate property and also with a firm, there cannot be any reason why a karta, although a partner of a firm representing his undivided family cannot invest his separate property in that firm and earn interest therefrom which he could have easily done by investing it in another firm where he is not a partner. For the reasons aforesaid, the first question in this reference is answered in the affirmative and in favour of the assessee. The second question is answered by saying that Explanation 2 to section 40(b) is clarificatory in nature and will govern the assessment year in question and as such the Tribunal was justified in deleting the addition of interest paid to the partners in their individual capacity. The ..... X X X X Extracts X X X X X X X X Extracts X X X X
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