Applicability of Section 14A – Interest To Partners

Issue for Consideration

Section 14A(1) of the Income-tax Act, 1961 provides that for
the purposes of computing the total income, under the chapter (Chapter IV –
Computation of Total Income), no deduction shall be allowed in respect of an
expenditure incurred by the assessee in relation to the income which does not
form part of the total income under the Act.

Under the scheme of taxation of partnership firms, a
partnership firm is entitled to deduction of interest paid to partners, and
such interest paid is taxable in the hands of the partners, under the head
‘profits and gains of business and profession, vide section 28(v) of the Act. The
deduction of such interest to partners, in the hands of the firm, is governed
by the restrictions contained in section 40(b)(iv), which section provides that
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 in so far as such amount
exceeds the amount calculated at the rate of 12% simple interest per annum,
shall not be allowed as deduction.

A question has arisen before the Tribunal in various cases as
to whether interest paid to partners, which is allowable as a deduction to the
partnership firm, can be regarded as an ‘expenditure incurred’ by the assessee
firm, and can therefore form part of the disallowance u/s.14A, to the extent
that it has been incurred in relation to the income arising on investment made
out of the funds received from the partners and on which interest is paid by
the firm, which income does not form part of the total income of the partnership
firm.

While the Ahmedabad and Mumbai benches of the Income Tax
Appellate Tribunal have held that such interest, in the hands of the firm,
would be regarded as an expenditure subject to disallowance u/s. 14A, the Pune
bench of the Tribunal has taken a contrary view holding that interest paid by a
partnership firm on its partners’ capital cannot be regarded as an expenditure amenable to section 14A.

Shankar Chemical Works’ case

The issue first came up before the Ahmedabad bench of the
Tribunal in the case of Shankar Chemical Works vs. Dy CIT 47 SOT 121.

In this case, relating to assessment year 2004-05, the
assessee was a partnership firm carrying on the business of manufacturing of
chemicals. It had invested in various financial assets, such as debentures,
bonds, mutual funds and shares to the extent of Rs. 1.93 crore, the income from
some of which investments was exempt from tax to the extent of Rs. 43.48 lakh.
The assessing officer noted that the assessee had borrowings to the extent of
Rs. 15.57 lakh, on which an interest of Rs. 1.54 lakh had been paid. Besides,
the firm had paid interest on partners’ capital. The assessing officer
concluded that investments in all these mutual funds, shares and securities had
been made out of the funds of the firm, which were either out of the partners’
capital or from borrowings from others. The interest payment on these funds
were made either to partners or to the persons from whom borrowings were made.
He therefore disallowed an amount of Rs. 17.04 lakh out of the total interest expenses of Rs. 23.23 lakh u/s. 14A.

On appeal before the Commissioner(Appeals), the disallowance
of interest u/s. 14A was upheld. The Commissioner(Appeals) held that the
capital was employed for the purpose of investment in mutual funds, shares and
debentures and bonds, and not for the business of the assessee firm for which
the partnership was formed. He also held that the provisions of section 40(b)
were not applicable, and the funds were utilised for the purpose of investment
rather than the business. He upheld the working of the disallowance of interest
made by the assessing officer in proportion to the amount of investment and
total funds employed, and held that the partners of the firm were entitled to
relief under the explanation to section 10(2A) in respect of the that part of
interest of the firm which was not allowed as a deduction to the firm.

Before the Income Tax Appellate Tribunal, on behalf of the
assessee, it was argued that no nexus had been established between the interest
payment and the earning of the exempt income. It was further argued that as per
section 28(v), interest paid to a partner of a firm was chargeable to tax in
the hands of the firm. Therefore, disallowance of such interest u/s. 14A, in
the hands of the firm, would amount to a double taxation. It was further argued that the
firm and the partners were not different entities.

Reliance was placed on paragraph 48 of the CBDT Circular No.
636 dated 31^st August 1992, where the provisions of the Finance act,
1992, regarding assessment of the firm were explained. In the circular, it was
stated that share of a partner in the profits of the firm would not be included
in computing, his total income u/s. 10(2A). However, interest, salary, bonus,
commission or any other remuneration paid by the firm to the partner would be
liable to tax as business income in the partner’s hands. An explanation has
been added to section 10(2A) to make it clear that the remuneration or
interest, which was disallowed in the hands of the firm, would not suffer
taxation in the hands of the partner. It was further pointed out that in the
case of the assessee, the partners to whom interest was paid were taxable at
the maximum rate.

It was further argued on behalf of the assessee that the
amendment to the scheme of assessment of a firm had been made to avoid double
taxation of the income. Interest paid to partners was distribution of profit
allocated to the partners in the form of interest and as such it could be taxed
once either in the hands of the firm or in the partners’ hands, but could not
be taxed in both places. Since the partners had paid tax on interest received
from the firm, and all the conditions laid down in section 40(b) had been
fulfilled, no portion of interest paid to partners could be disallowed, and if
it was disallowed it would amount to double taxation.

On behalf of the revenue, it was contended that no interest
free funds were available to the assessee, and therefore disallowance had
rightly been made. The investments were made from capital of the partners, on
which interest at the rate of 10.5% per annum was paid.

The Tribunal rejected the contention of the assessee that
there was no nexus between the exempt income and partners’ capital, since no
interest-free funds were available with the firm. Importantly, in respect of
the assessee’s argument that any disallowance of interest u/s. 14A would amount
to double disallowance, the Tribunal noted that as per the provisions contained
in section 14A(1), an expenditure incurred for earning exempt income was not to
be considered for computing total income under chapter IV. This implied that
such expenditure was to be allowed as deduction while working out the exempt
income under chapter III. In case of expenditure which was incurred for earning
exempt income, a specific treatment was to be given, that such expenses should
be disregarded for computing total income under chapter IV and should be
reduced from exempt income under chapter III. Hence, according to the Tribunal,
there was no double addition or double disallowance.

The Tribunal observed that partners had a share in all the
incomes of the firm. As per the above treatment in the hands of the firm,
regarding expenses incurred for earning exempt income, taxable income of the firm
would increase and exempt income of the firm would go down by the same amount,
total of both remaining the same. The total share of profit of the partner in
the income of the firm would also remain the same, but his share in income
which was exempt in the hands of the firm would be less, and his share in
income which Is taxable in the hands of the firm would be more. However, the
entire share of profit receivable by a partner from a firm was exempt, and
hence there was no impact in the hands of a partner. According to the Tribunal,
since there was no disallowance as such in the hands of the firm, but the
expenditure incurred for earning exempt income was not allowed to be reduced
from taxable income, and instead was to be reduced from exempt income, there
was no effective disallowance in the hands of the firm of the expenses incurred
for earning exempt income, and hence there was no question of any double
allowance or double disallowance.

It also noted that under the proviso to section 28(v), where
there was a disallowance of interest in the hands of the firm due to the
provisions of section 40(b), then and only then the income in the hands of the
partner had to be adjusted to the extent of the amount not so allowed to be
deducted in the hands of the firm. Hence, the proviso to section 28(v) would
come into play only if there was some disallowance in the hands of the firm
u/s. 40(b). According to the Tribunal, in the case before it, the disallowance
was u/s. 14A, and not u/s. 40(b), and therefore, the proviso to section 28(v)
was not applicable and therefore, the partner of the firm was not entitled to
any relief under the said proviso. In any case, since the appellant before the
Tribunal was the firm, and not the partners, the Tribunal did not give any direction
on this aspect of taxability of the partners.

Examining section 10(2A) and the explanation thereto, the
Tribunal rejected the assessee’s argument that if any interest was disallowed
in the hands of the firm, the same could not form part of the total income in
the hands of the partner. According to the Tribunal, the explanation to section
10(2A) did not support such a contention, as the total income of the firm, as
assessed, should alone be considered, and the share of the concerned partner in
such assessed income should be worked out as per the profit sharing ratio as
specified in the partnership deed, and it was such share of the relevant
partner, which only would be considered as exempt u/s. 10(2A).

The Tribunal next addressed the assessee’s argument that
interest paid to partners was distribution of profits allocated to the partners
in the form of interest and hence interest to partners could be taxed once,
either in the hands of the firm or in the hands of the partner, and could not
be taxed in both hands. It also considered the argument of the assessee that
since the partners had paid tax on interest received by them from the firm, no
portion of interest paid to partners could be disallowed, and if disallowed, it
would amount to double taxation. According to the tribunal, such arguments were
devoid of any merit, because interest paid to partners by the firm was not
distribution of profit by the firm, since interest was payable to the partners
as was prescribed in the partnership deed, even if there was no profits in the
hands of the firm. If a firm had a loss and paid interest to the partners, the
loss of the firm would increase to that extent, which would be allowed to be
carried forward in the hands of the firm. Therefore, according to the Tribunal,
interest, to partners was not a distribution of profits by the firm to the
partners and there was no double taxation.

Addressing the assessee’s argument that interest paid to
partners was not an expenditure at all, but was a special deduction allowed to
the firm u/s. 40(b), the tribunal observed that there was no deduction allowed
under section 40(b). According to the Tribunal, section 40(b) was a restricting
section for various deductions allowable under sections 30 to 38. Analysing the
provisions of section 40(b), the Tribunal was of the view that this section was
really restricting and regulating deduction allowable to the firm on account of
payment of interest to partners, and was not an allowing section. According to
the Tribunal, the section allowing the deduction of interest remained section
36(1)(iii), and therefore payment of the interest to partners was also an
expenditure, which was hit by the provisions of section 14A, if it was incurred
for earning exempt income.

The Tribunal accordingly rejected the assessee’s appeal, and
thereby upheld the disallowance of interest to partners u/s. 14A.

This decision of the Tribunal was followed by the Mumbai
bench of the Tribunal in the case of ACIT vs. Pahilajrai Jaikishin 157 ITD
1187, where the Tribunal held that such interest paid to partners on their
capital was an expenditure subject to disallowance u/s. 14A, if it was incurred
in relation to exempt income.

Quality Industries’ case

The issue again came up for consideration before the Pune
bench of the Tribunal in the case of Quality Industries vs. Jt CIT 161 ITD
217.

In this case, relating to assessment year 2010-11, the
assessee firm was engaged in the business of manufacture of chemicals, and had
earned tax-free income of Rs. 24.64 lakh from investment in mutual funds of Rs.
4.42 crore. The assessee had claimed deduction for interest of Rs. 75.64 lakh,
consisting of interest to partners of Rs. 74.88 lakh and interest on bank loans
of Rs. 0.76 lakh.

The assessing Officer, observing that investment in mutual
funds was made out of interest-bearing funds, which included interest-bearing
partners capital, was of the view that the assessee had incurred expenditure,
including interest expenses, which was attributable to earning income from
investment in mutual funds, which was exempt. He, therefore, disallowed
estimated expenditure incurred in relation to such income from mutual funds in
terms of the formula under rule 8D amounting to Rs. 29.25 lakh, including
interest of Rs. 27.85 lakh.

The Commissioner(Appeals) observed that the main source of
investment in mutual funds was partners’ capital, which bore interest at 12%
per annum. According to the Commissioner(Appeals), such interest was relatable
to income from mutual funds, which did not form part of the total income.
Therefore, the Commissioner(Appeals) upheld the disallowance made by the
assessing officer observing that the provisions of section 14A were attracted
to such expenditure.

Before the Tribunal, it was argued on behalf of the assesse,
that the assessee had fixed capital of Rs. 6.24 crore, received from the
partners, on which interest at the rate of 12% per annum had been charged to
the partnership firm. The firm also had current capital from partners that was
received from time to time, which amounted to Rs. 1.14 crore at the end of the
year, on which no interest was paid. It was argued that interest payable on
fixed capital from partners did not bear the characteristic of expenditure per
se as contemplated u/s. 14A. It was pointed out that as per the scheme of
taxation of firms, the payment to the credit of partners in the form of
interest and salary was chargeable to tax in the respective hands as business
income by operation of law.

Reliance was placed on behalf of the assessee on the decision
of the Supreme Court in the case of CIT vs. R M Chidambaram Pillai 106 ITR
292 for the proposition that payment of salary represented special share of
profits, and was therefore taxable as business income. On the same footing, it
was argued that interest on partners’ capital was a return of share of profit
by the firm to the partners. Both interest and salary to partners were not
subjected to TDS, and both fell for allowance under section 40. It was argued
that section 40(b) was not just a limiting section, notwithstanding the fact
that some fetters on the rate of interest had been put thereunder. Salary to
partners and interest paid on partners’ capital was made allowable in the hands
of the firm only from assessment year 1993-94, subject to limits and
restrictions placed u/s. 40(b), and was not allowable prior thereto and
supported the view that section 40(b) was not merely meant for limiting the
deduction, as had that been the case, interest would have been allowable in the
hands of the partnership firm since the birth of the income tax law.

It was further submitted that section 14A was applicable only
where an expenditure was incurred, and not in respect of any and every
deduction or allowance. It was argued that an expenditure was needed to be
incurred by the party, which was absent in view of the mutuality present in a
partnership firm between the firm and its partners. The firm had no separate
existence from its partners, and it was a separate assessable entity only for
the purposes of the Income-tax Act. The Partnership Act, 1932 did not recognise
the firm as a separate entity.

It was further argued on behalf of the assessee that any
disallowance of interest of capital would lead to double disallowance of the
same expenditure, as the partners were already subjected to tax on interest on
capital in their respective personal returns.

The Tribunal analysed the nuances of the scheme of taxation
of partnership firms. It noted that prior to assessment year 1993-94, the
interest charged on partners’ capital was not allowed in the hands of the partnership
firm, while it was simultaneously taxable in the hands of the respective
partners. The amendment by the Finance Act, 1992 by insertion of section 40(b)
was to enable the firm to claim deduction of interest outgo payable to partners
on the respective capital subject to some upper limits. Therefore, according to
the tribunal, as per the present scheme of taxation, the interest payment on
partners’ capital in a sense was not treated as an allowable business
expenditure, except for the deduction available u/s. 40(b).

The Tribunal noted that partnership firms, on complying with
the statutory requirements, were allowed deduction in respect of interest to
partners, subject to the limits and conditions specified in section 40(b), and
in turn those items would be taxed in the hands of the partners as business
income u/s. 28(v). Share of partners in the income of the firm was exempt from
tax u/s. 10(2A). Therefore, the share of income from a firm was on a different
footing from the interest income, which was taxable as business income.

The Tribunal also noted that interest and salary received by
the partners were treated on a different footing by the Act, from the ordinary
sense of the terms. Section 28(v) treated interest as also salary received by a
partner of the firm as a business receipt, unlike different treatment given to
similar receipts in the hands of entities other than partners. It also noted
that under the proviso to section 28(v), the disallowance of such interest was
only with reference to section 40(b), and not with reference to section 36 or
section 37. According to the tribunal, it gave a clue that deduction towards
interest to partners was regulated only u/s. 40(b), and that the deduction of
such interest was out of the purview of sections 36 or 37.

The Tribunal observed that there was no amendment to the
general law provided under the Partnership Act, 1932. The amendment to section
40(b) had only altered the mode of taxation. The partnership firm continued not
to be a separate legal entity under the Partnership Act, and it was not within
the purview of the Income-tax Act to change or alter the basic law governing
partnership. Therefore, interest or salary paid to partners remained the
distribution of business income. The tribunal referred to the decision of the
Supreme Court in the case of R. M. Chidambaram Pillai (supra) for this
proposition. The tribunal also referred to the decision of the Supreme Court in
the case of CIT vs. Ramniklal Kothari 74 ITR 57, for the proposition
that the business of the firm was business of the partners of the firm. Hence,
salary, interest and profits received by the partner from the firm was business
income, and therefore expenses incurred by the partner for the purpose of
earning this income from the firm was admissible as deduction from such share
of income from the form in which he was a partner. Thus, even for taxation
purposes, the partnership firm and partners have been seen collectively, and
the distinction between the two was blurred in the judicial precedents.

Since the firm and partners of the firm were not separate
persons under the Partnership Act, though they were a separate unit of
assessment for tax purposes, according to the Tribunal, there could not be a
relationship inferred between the partner and firm as that of lender of funds
(capital) and borrowal of capital from the partners. Therefore, section
36(1)(iii) was not applicable at all. According to the Tribunal, section 40(b)
was the only section governing deduction towards interest to partners. In view
of section 40(b), according to the Tribunal, the assessing officer had no
jurisdiction to apply the test laid down under section 36, to find out whether
the capital was borrowed for the purposes of business or not. Thus, the
question of allowability or otherwise of the deduction did not arise, except
for section 40(b).

According to the Tribunal, the interest paid to partners
simultaneously getting subjected to tax in the hands of the partners was merely
in the nature of contra items in the hands of the firm and partners.
Consequently, interest paid to partners could not be treated at par with the
other interest payable to outside parties. Thus, in substance, the revenue was
not adversely affected at all by the claim of interest on capital employed with
the firm by the partnership firm and partners put together. Capital diverted to
mutual funds to generate alleged tax-free income did not lead to any loss in
revenue due to the action of the assessee. In view of the inherent mutuality,
as per the Tribunal, when the partnership firm and its partners were seen
holistically and in a combined manner, with interests paid to partners
eliminated in contra, the investment in mutual funds, generating tax-free
income bore the characteristic of an expenditure that was attributable to its own capital, where no disallowance
u/s. 14A read with rule 8D was warranted.

The Tribunal therefore held that the provisions of section
14A read with rule 8D were not applicable to interest paid to partners, but
applied only to interest payable to parties other than partners.

Observations

The logic of the Pune bench of the Tribunal, that the amount
introduced by the partners into the partnership firm is not a borrowing of
capital by the partnership firm but is an introduction of capital by the
partners for constituting the partnership firm and carrying on its business,
does seem fairly attractive at first sight.

The scheme of taxation of the partnership firm and its
partners under tax laws is also relevant. It is only by an artificial provision
that the entire income of the partnership firm is divided into two components
for convenience of taxation – one component taxable in the hands of the firm,
and the second component taxable in the hands of the partners. Section 40(b) read
with the proviso to section 28(v) clearly brings out this intent that what is
taxable in the hands of the firm, is not taxable in the hands of the partners,
while what is taxable in the hands of the partners is not taxable in the hands
of the firm. Therefore, viewed from that perspective, the view of the Pune
Tribunal that the interest to partners was not an expenditure, but was a mere apportionment of the income of the firm, also seems attractive.

This view is also supported by the fact that though salaries
and interest are subjected to tax deduction at source, remuneration and
interest to partners are not so subject to the provisions of tax deduction at
source. In a sense, the tax laws now recognise the fact that such remuneration
and interest to partners stands on a different footing from the normal
expenditure of salaries and interest.

However, to a great extent, the answer to this question is to
be found in the decision of the Supreme Court in the case of Munjal Sales
Corpn vs. CIT 298 ITR 298. In this case, relating to assessment years
1993-94 to 1997-98, the Supreme Court was considering a situation where
interest free loans had been granted to sister concerns in August/September
1991, and interest paid had been disallowed u/s. 36(1)(iii) by the Assessing
Officer. The Tribunal had deleted the disallowance for assessment years 1992-93
and 1993-94, holding that interest free loans had been given out of the
assessee’s own funds. The disallowances for assessment years 1994-95 to 1996-97
were however upheld by the Tribunal.

Before the Supreme Court, the assessee contended that section
40(b) was a standalone section having no connection with the provisions of
section 36(1)(iii), and that section 36(1)(iii) did not apply, as it was a case
of payment of interest to a partner on his capital contribution, which could
not be equated to monies borrowed by the firm from third parties.

In this case, while holding that since the loans were
advanced for business purposes, the interest on such loans would not be subject
to any disallowance under section 36(1)(iii) read with section 40(b)(iv), the
Supreme Court observed as under:

“Prior to the Finance Act,
1992, payment of interest to the partner was an item of business disallowance.
However, after the Finance Act, 1992, the said section 40(b) puts limitations
on the deductions under sections 30 to 38 from which it follows that section 40
is not a stand-alone section. Section 40, before and after the Finance Act,
1992, has remained the same in the sense that it begins with a non obstante clause.
It starts with the words ‘Notwithstanding anything to the contrary in sections
30 to 38’ which shows that even if an expenditure or allowance comes within the
purview of sections 30 to 38, the assessee could lose the benefit of deduction
if the case falls under section 40. In other words, every assessee, including a
firm, has to establish, in the first instance, its right to claim deduction
under one of the sections between sections 30 to 38 and in the case of the
firm, if it claims special deduction, it has also to prove that it is not
disentitled to claim deduction by reason of applicability of section 40(b)(iv).
Therefore, in the instant case, the assessee was required to establish in the
first instance that it was entitled to claim deduction under section 36(1)(iii
), and that it was not disentitled to claim such deduction on account of
applicability of section 40(b)(iv). It is important to note that section 36(1)
refers to other deductions, whereas section 40 comes under the heading ‘Amounts
not deductible’. Therefore, sections 30 to 38 are other deductions, whereas
section 40 is a limitation on those deductions. Therefore, even if an assessee
is entitled to deduction under section 36(1)(iii), the assessee-firm will not
be entitled to claim deduction for interest payment exceeding 18/12 per cent
per se. This is because section 40(b)(iv) puts a limitation on the amount of
deduction under section 36(1)(iii). 

It was vehemently urged on
behalf of the assessee that the partner’s capital is not a loan or borrowing in
the hands of a firm. According to the assessee, section 40(b)(iv) applies to
partner’s capital, whereas section 36(1)(iii) applies to loan/borrowing.
Conceptually, the position may be correct, but in the instant case, the scheme
of Chapter IV-D was in question. After the enactment of the Finance Act, 1992,
section 40(b)(iv) was brought to the statute book not only to avoid double
taxation, but also to bring on par different assessees in the matter of
assessment. Therefore, the assessee-firm, in the instant case, was required to
prove that it was entitled to claim deduction for payment of interest on
capital borrowed under section 36(1)(iii), and that it was not disentitled
under section 40(b)(iv). There was one more way of answering the above contention.
Section 36(1)(iii) and section 40(b)(iv) both deal with payment of interest by
the firm for which deduction can be claimed. Therefore, keeping in mind the
scheme of Chapter IV-D, every assessee, who claims deduction under sections 30
to 38, is also required to establish that it is not disentitled under section
40. The object of section 40 is to put limitation on the amount of deduction which the assessee is entitled to under sections 30 to 38. Section 40
is a corollary to sections 30 to 38 and, therefore, section 40 is not a
stand-alone section.”