Section 40(b) and Interest to partners

For allowance of an interest to the partner, it is
essential that the payment is authorised by and is in accordance with
the terms of the partnership deed and relates to a period falling after
the date of partnership deed and the amount does not exceed the amount
calculated at the rate of 12% simple interest per annum.

It is
usual that the interest is paid to a partner on the capital introduced
by him as increased by the deposits made by him and the share of profits
credited to his account and as reduced by the amounts withdrawn by him
and the share of losses debited to his account. At times, the account is
credited with the share of notional profits arising on revaluation or
is debited with the transfer to reserves created to meet certain
contingencies.

Section 40(b) is silent about the ‘base amount’,
with reference to which the interest of 12% is to be calculated. It also
does not specify the manner in which such base amount is to be
calculated. In the circumstances, issues regularly arise about the
determination of the base amount, with reference to which the interest
payable to a partner is to be ascertained so as to face no disallowance.
Unlike section 115JB, it does not provide for the manner of preparation
of the profit & loss account, nor does it lay down any guidelines
for ascertaining the book profit of the firm, the share of which is to
be credited to the partner’s account.

A controversy has arisen
about the need and necessity to provide depreciation by the firm in its
books of account, while ascertaining the amount of the profit or loss of
the year, to be shared amongst the partners and credited to their
respective accounts. Providing no depreciation or a lower depreciation
results in higher profits being credited to partners’ accounts which in
turn helps in payment of higher interest to them. Is this practice of
not providing depreciation in the books in accordance with the
provisions of the Act, for allowance of interest in the hands of the
firm, is a question that has been addressed by the different benches of
the Tribunal to arrive at the different and conflicting views.

The relevant part of section 40(b), pertaining to interest to partners, reads as under:

“Amounts not deductible.

40.
Notwithstanding anything to the contrary in sections 30 to 38, the
following amounts shall not be deducted in computing the income
chargeable under the head ‘Profits and gains of business or profession’,
—

(b) in the case of any firm assessable as such:

(i) ……………..

(ii)
any payment ………….., or of interest to any partner, which, in
either case, is not authorised by, or is not in accordance with, the
terms of the partnership deed; or

(iii) any payment
……………. , or of interest to any partner, which, in either case,
is authorised by, and is in accordance with, the terms of the
partnership deed, but which relates to any period (falling prior to the
date of such partnership deed) for which such payment was not authorised
by, or is not in accordance with, any earlier partnership deed, so,
however, that the period of authorisation for such payment by any
earlier partnership deed does not cover any period prior to the date of
such earlier partnership deed; or

(iv) any payment of interest
to any partner which is authorised by, and is in accordance with, the
terms of the partnership deed and relates to any period falling after
the date of such partnership deed insofar as such amount exceeds the
amount calculated at the rate of twelve per cent simple interest per
annum; or………………”

The Visakhapatnam Bench of the
Tribunal had an occasion to deal with the issue, wherein the Tribunal
held that the Assessing Officer (‘AO’) was not entitled to recompute the
balance of capital account of the partners, so determined by the
assessee firm. In deciding the said issue, the Bench did not follow the
findings to the contrary of another Bench of the Visakhapatnam Tribunal
on the subject.

Arthi Nursing Home’s case

The
issue under consideration was examined by the Visakhapatnam Tribunal in
the case of Arthi Nursing Home v. ITO, 119 TTJ 415 (Visakha).

 In
that case, Arthi Nursing Home, a partnership firm, had claimed
deduction of interest paid to partners on their respective capital
accounts. Consequent to the findings in the course of the survey
operations conducted on the firm and during the course of assessment
proceedings, it was noticed by the AO that the firm was not providing
for depreciation in the books of account, but was claiming depreciation
in computation of taxable income. The AO was of the view that the firm
by following the practice of not providing the depreciation was
inflating the capital accounts of the partners on which higher interest
was paid. He observed that the said practice was for the purposes of
claiming higher deduction, towards payment of interest, in the hands of
the firm. He was of the view that the firm was required to draw its
profit & loss account by debiting the depreciation. The AO
recomputed the balances in capital accounts of the partners after
charging depreciation. Consequently, the claim for deduction of interest
to partners was disallowed u/s.40(b) as the balance in the capital
accounts of the partners had turned negative after apportioning the
recomputed profits and losses.

 On appeal before the CIT(A), the
action of the AO in disallowing the deduction of interest to partners
u/s.40(b) was confirmed for the following reasons:

• The
  assessee claimed benefit of depreciation in computing the total income,
  but did not provide the same in computing the profit of the firm to be
  shared amongst the partners. The said practice led to showing higher
  amount of profits in the books of account which inflated the capital
  balances of the partners and the consequent interest to partners;
• Depreciation,
  like any other head of expenditure, was required to be debited to the
  profit and loss account to arrive at the real profits of the business;
•  Debiting of depreciation was a cardinal principle of mercantile system of accounting; and
•  The
  figures of accretion to the capital balances, were exaggerated and
  fictitious, not in accordance with any principles of accountancy.

The
assessee firm’s contention that the AO could not have rewritten books
of account of the firm based on the decisions in the cases of Ambica
Chemical Products v. Dy. CIT, (ITA No. 612/Vizag./1999, dated 31st May,
2005 and 9/Vizag./1999) dated 9th January, 2009, respectively; and ACIT
v. Sant Shoe Store, 88 ITD 524, (Chd.) (SMC) was negatived by the CIT(A)
by holding that the AO had only undertaken an exercise of discovery of
correctness of accounts which was not an exercise of rewriting the books
of account.

Aggrieved with the order of the CIT(A), on appeal
before the Tribunal, the following additional arguments were made by the
firm:

• Section 40(b) did not provide for the manner of
  computing the profit of the firm for the year and did not have any
  relevance to the claims made in computing the total income; and

•   
  The firm had been consistently over the years not charging depreciation
  in the books of account, but had claimed depreciation in computing the
  taxable income, which had been accepted by the Revenue authorities.

Likewise, the following additional contentions were raised by the Revenue:

•    
  Explanation 5 to section 32 of the Act and the Accounting Standards
  prescribed by ICAI required charging of depreciation in the books of
  account; and

•     The Apex Court in the case of CIT
  v. British Paints India Ltd., (188 ITR 44) held that the books disclosed
  the true state of accounts and the correct income.

The Tribunal after considering the rival submissions upheld the contention of the Revenue authorities for the following reasons:

•    
  In light of the Apex Court decision in the case of British Paints Ltd.
  (supra), the AO was duty bound to recompute the profit/accretion to the
  capital account of the partners after charging depreciation to the
  profit and loss account;

•     Explanation 5 to
  section 32 and the Accounting Standards prescribed by the ICAI required
  mandatory charging of depreciation to determine profit and loss of the
  firm for the year; and

•     The profit and loss
  account prepared without charging depreciation did not reflect the true
  and correct state of affairs of the partnership firm.

The
Tribunal concluded that the AO was justified in correcting the aforesaid
error, thereby disallowing the interest claimed by the assessee firm
u/s.40(b).

Swaraj Enterprises case

The issue under consideration subsequently came up before the Division Bench of the Visakhapatnam

Tribunal in the case of Swaraj Enterprises v. ITO, 132 ITD 488.

In
this case, the assessee firm, like in the case of Arthi Nursing Home
(supra), did not charge depre-ciation in the books of account, but
claimed depre-ciation in computing the total income. As a result the
partners’ accounts were credited with higher share of profits on which
interest was paid to the partners. The AO, by relying on the several
decisions of the High Courts, held that the depreciation was a charge on
profits of the firm and the same should be provided for in computing
the profit that was distributed amongst the partners. He recomputed the
capital account balances of the partners and interest thereof.

On
appeal the CIT(A) relying on the decision in the case of Arthi Nursing
Home (supra) upheld the action of the AO of recomputing the interest to
partners for the purposes of section 40(b).

Aggrieved with the order of the CIT(A), the assessee firm filed an appeal before the Tribunal and contended that:

•    
  There was no provision under the Act that allowed an AO to rework the
  capital balances of the partners and to recompute the interest to
  partners u/s.40(b);

•     There was no statutory compulsion for partnership firms to provide for depreciation under the Indian Partnership Act, 1932;

•    
  The determination of profit for the purposes of the books of account
  and the computation of total income for income tax were two different
  exercises and hence the allowance or disallowance made in computing the
  total income under the Act did not in any way affected the balances in
  the capital accounts of the partners disclosed in the books of account;
  and

•     Without prejudice, the firm in any case had
  the discretion to select the method of charging depreciation and also
  the rates at which such depreciation was charged, which discretion was
  not vested in the AO.

The Revenue contended that the
depreciation was a charge on the profits of the year and it was a must
for the firm to provide for depreciation to arrive at the true profits
of the firm; that the AO following the British Paints’ case was duty
bound to rework the profit; that action of the firm was not in
accordance with the Accounting Standards and principles and that the
Explanation 5 to section 32 required that the depreciation was charged
to the accounts.

After considering the rival submissions and the decision in the case of Arthi Nursing Home (supra), the Tribunal held as under:

•    
  The findings of the Apex Court in the case of British Paints Ltd.
  (supra) for reworking the profits were in context of determination of
  taxable income and could not be employed for recomputing the capital
  account of the partners;

•     The total taxable
  income of the firm remained the same, since the depreciation was already
  claimed in computing the taxable income;

•    
  Under, the Partnership Act, 1932, there was no statutory compulsion to
  provide for depreciation in the books of account or to follow the
  Accounting Standards prescribed by ICAI;

•     The
  Companies Act that required an enterprise to follow the mercantile
  method of accounting and employ the Accounting Standards did not apply
  to a partnership firm;

•     Explanation 5 to section
  32 provided for compulsory depreciation for the purpose of computation
  of taxable income under the Act and nowhere it was provided that it was
  to be applied even in preparing the books of account;

•    
  U/s.40(b), the AO was allowed only to verify whether the payment of
  interest to any partner was authorised by and was in accordance with the
  terms of partnership deed and whether the period of interest so paid
  fell after the date of partnership deed. The AO could not have reworked
  or redetermined the balance in the capital accounts of the partners; and

•    
  Even if the depreciation was required to be charged in the books of
  account, the choice to determine the method and the rate of depreciation
  would be at the discretion of the assessee firm and not of the AO.

Based
on the aforesaid findings, the Tribunal ignored its own findings in the
case of Arthi Nursing Home (supra) and upheld the claim of deduction of
inter-est to partners.

Observations

Section 40(b)
is silent as to the amount on which the interest to partners is to be
calculated. As noted, the ‘base amount’ remains to be defined by the
provision. In the context of interest, it has no reference to the books
of account, nor to the book profit unlike the provisions of section
115JB or even those within the section that provide for calculating the
quantum of remuneration payable to the partners. It may not be incorrect
to state that the claim of interest, in the context, is independent of
the books of account.

Unlike section 115JB, this section does not
provide for the method of accounting to be followed, the method of
depreciation to be employed and the rates at which the assets are
required to be de-preciated.

Section 40(b) provides that no
disallowance shall take place where the interest to partners is;
authorised by the partnership deed; in accordance therewith; for the
period falling after the date of partnership deed and the rate of
interest does not exceed 12%. In the circumstances, what is of paramount
importance is that the interest to partners should be authorised by the
deed and if it is so what remains to be seen is that such interest is
paid in the manner provided by the said deed which of course should be
in conformity with the other stipulations stated above. Nothing, beyond
these simple rules, is required to be read in to the provision.

The
computation of total income, under the Act, is largely independent of
the books of account. A debit or credit does not decide the taxability
or allowance of an income or an expenditure. Unless otherwise expressly
stated, the books of account do not determine the taxability or
otherwise under the Act. The allowance or a deduction and the taxability
of an income is governed by the provisions of the Income-tax Act and
not the books of account.

Explanation 5 to section 32 has a very
limited relevance and its application is mainly restricted to the
provisions of section 32(1) and section 43(6) which provide for
determination of the written down value of an asset or a block of
assets. The said provision, at the most, has the effect of altering the
total income that is computed under the Act and does not travel beyond,
to the computation of the book profit, not even for the purposes of
section 115JB.

The Partnership Act, 1932 does not prescribe the
manner in which the books of account are to be maintained, nor do they
provide for the method of accounting to be followed by the firm for
determining its profit or loss. They also do not prescribe for
compulsory depreciation and the rate thereof.

The Companies Act
has no application to the partnership firms and the provisions therein
for mercantile system of accounting, true and fair profit and the
mandatory application of the Accounting Standards do not apply to the
partnership firms.

The Chandigarh Bench of the Tribunal in Sant
Shoe Store’s case was concerned with the allowance of interest on the
capital account of the partners which included credits on revaluation of
the assets, not involving any inflow of funds. The Tribunal even in
such a case approved of the claim of interest made by the firm. Again,
the Tribunal in Ambica Chemical Products approved of the claim of
interest in circumstances where the firm had not provided for
depreciation in the books of account; the claim was allowed to the firm
in two different appeals vide orders passed after a gap of four years
and one of it was passed after the decision in the case of Aarthi
Nursing Home was rendered. A useful reference may be made to the
decision of the Pune Bench in the case of Deval Utensils Factory, 98 TTJ
501 wherein the action of the AO in reworking the capital account
balance, on the basis of which interest was paid to partner was
disapproved.

The rewriting of the books by either side should
be discouraged. If permitted, it may invite the tax-payers to indulge
in creative accounting, for example; by adding back the provision for
taxation where debited to the profit & loss account so as to enhance
the amount of share of profit that is credited to the capital accounts
by holding out that the tax is not an allowable deduction in computing
the total income. The example amplifies the need to stick to the books
of account and the need to avoid importing the computation provisions in
calculation of interest.

The interest to the partners, where
allowed in the hands of the firm, is taxable in the hands of the
partners as business income by virtue of section 28(v). The one that is
disallowed in the hands of the firm, is not taxable in the hands of the
partners by virtue of the proviso to the said section 28(v) of the Act.
The disallowance largely does not result in any loss or gain of revenue
for either side.

This essentially leaves us with the conclusion
that no disallowance shall take place under the provisions of section
40(b) in cases where the interest to partners is authorised by the
partnership deed and the same is calculated as per the terms of the
partnership deed. The case of the firm gets forti-fied where the deed
does not make it mandatory for the firm to charge depreciation in
computing the profit for the year.