The column “Controversies” was started
in January, 1980, with Vilas K. Shah and Rajan R. Vora as the initial
contributors. Harish N Motiwalla took over from 1985-86 to 1993-94. Pradip
Kapasi contributed from May, 1992, and has not stopped rolling out controversy
after controversy till today. That is 27 years of monthly contributions. Gautam
S Nayak joined as co-author in April, 1996 and is now an experienced
‘controversialist’ for 23 years. Their unbeaten partnership is perhaps the
longest under BCAJ! The authors have been bringing out a new controversy every
month, month after month. So far, they would have brought out a record 275
controversies. Bhadresh Doshi joined them in June, 2018.
This is not a digesting feature, but an
ANALYTICAL FEATURE. The process starts with identifying a suitable controversy
where there are two conflicting views on a legal issue which are not settled by
the Supreme Court. Currently forum based or subject based issues are covered.
Pradip Kapasi says: “The authors, in the initial years used to ‘conclude’ the
issue, under consideration, in the end which practice for long has been
substituted with the authors offering their comments in the form of
‘observations’ leaving the debate open for readers.”
In the era of law driven by judgements,
the authors bring observations, record decisions, and also alternative
contentions that help resolve or reconcile controversies. In answer to the
question – what keeps them going – Pradipbhai said: “At an early age, the
feature taught that no view, even of the high court, is final and that there is
always another view which at times can be a better view.” Gautambhai answered
thus: “Writing this column is time consuming, but exhilarating, as one has to
consider all aspects of the issue thoroughly, while giving the observations.
After writing on an issue, one becomes completely aware of all the nuances of
the issue, as well as case laws on the subject, which definitely helps in one’s
practice, when one comes across similar issues.”
Book-Profit for payments to
partners –
Section 40(b)
ISSUE FOR CONSIDERATION
Section 40(b)
limits the deduction, in the hands of a firm, in respect of expenditure on
specified kinds of payments to partners. Clause(1) of section 40(b) prohibits
the deduction for payment of remuneration to a partner who is not a working
partner. Clause(2) provides that a deduction for payment of remuneration to a
working partner is allowed in accordance with the terms of the partnership
deed. Clause (5) has the effect of limiting the deduction for remuneration to
working partners, to the specified percentage of the “book-profit” of the firm.
“Remuneration”
includes any payment of salary, bonus, commission or remuneration by whatever
name called. The term “book-profit” is defined exhaustively by
Explanation 3 to section 40(b) which reads as under “Explanation 3-For the
purpose of this clause, ”book-profit” means the net profit, as shown in the
profit and loss account for the relevant previous year, computed in the manner
laid down in Chapter IV-D as increased by the aggregate amount of the
remuneration paid or payable to all the partners of the firm if such amount has
been deduced while computing the net profit”
‘Book-Profit’, as
per Explanation 3, means the net profit as per the profit and loss account of
the relevant year, computed in the manner laid down in Chapter IV-D. The
requirement to take net profit as shown in profit and loss account is quite
simple, but the requirement to compute the same in the manner laid down in
Chapter IV-D has been the subject matter of debate.
It is usual to
come across cases wherein the profit and loss account is credited with receipts
such as interest, rent, dividend, capital gains and such other income, which
may or may not have any relationship to the business of the firm. It is in such
cases that an issue arises while computing the Book-Profit of the firm, wherein
the firm is required to ascertain as to whether the interest and such other receipts
credited to profit and loss account are required to be excluded from the net
profit or not to arrive at the figure of the book-profit.
Conflicting
decisions of the high court are available on the subject of determination of
the book-profit for the purpose of section 40(b) of the Act. While the Calcutta
high court has favoured the acceptance of the net profit as per the profit and
loss account as representing the book-profit, the Rajasthan high court has
recently ordered for exclusion of such receipts from the net profit.
MD SERAJUDDIN
& Bros.’ CASE
The issue arose
before the Calcutta High Court in the case of
Md. Serajuddin & Bros. vs. CIT, 24 taxmann.com 46 (Cal.). In
that case, the assessee, a partnership firm, filed its return of income for the
relevant assessment years 1995-96 to 1998-99 by claiming deduction for
remuneration paid to partners which was calculated on the basis of the net
profit of the firm as per the profit & loss account of the year, which inter
alia included the credits for consultancy fees, interest on bank deposits,
profit on disposal of assets and interest on advance tax, which had been shown
as income under the head ‘other sources’. The returned income was accepted by
the Assessing Officer on issue of the intimation u/s. 143(1)(a). Subsequently,
the AO held that the income by way of consultancy fees, interest on bank
deposit, profit on disposal of assets and interest on advance tax, which had
been shown as income under the head ‘other sources’, could not be considered as
part of the book profit for the purpose of computation of allowable partners’
remuneration. He recomputed the deduction for remuneration by reworking the
book profit and disallowed the excess remuneration by applying the provisions
of section 40(b) of the Act. The Commissioner (Appeals) rejected the appeal of
the assessee. On further appeal, the Tribunal, without giving any reasonable
opportunity to the assessee, dismissed the appeal.
The High Court
admitted the appeals of the assessee firm on the following substantial question
of law on the issue under consideration, besides a few other aspects of the
issue not germane for the discussion :-
“Whether and
in any event, on a proper construction of the provisions of Section 40(b)(v)
and explanation 3 thereto, book profit comprises the entire net profit as shown
in the profit and loss account or only profit and gains of business assessed
under Chapter IV-D?”
On behalf of
the assessee firm, it was highlighted that for the purpose of Explanation 3 to
section 40(b)(v), the appellant had taken into consideration its net profit as
shown in the profit and loss account, which included consultancy fees, interest
on bank and company deposits, profit on disposal of cars used in the business
and interest on refund of advance tax paid and other items of incomes, which
were shown in the return under heading ‘income from other sources’. In support
of its action, it was submitted that;
- the said Explanation 3 of section 40(b)(v)
provides for taking the net profit as shown in the profit and loss account and
not the profit computed under the head ‘profit and gains of business or
profession’;
- unlike Explanation (baa) to section 80HHC
and section 33AB, both of which mentioned profit as computed under the head
‘profit and gains of business or profession’, Explanation 3 to Section 40(b)(v)
did not refer to any head of income and instead mentioned ‘net profit as shown
in the profit and loss account’;
- had the intention been to restrict the
deduction only to the profit computed under the head ‘profits and gains of
business or profession’, the expression used in Explanation (baa) to section
80HHC and section 33AB would have also found place in Explanation 3 to section
40(b).
- that none of the sections 30 to 43D, of part
IV –D, provided for exclusion of any item of income because it did not fall
under the head of ‘profits and gains of business or profession’.
- the reasons for making the computation
provisions of Chapter IV-D applicable for computing the book profit was only to
ensure that all deductions had been allowed, as otherwise an assessee might
compute the book profit at a higher figure and thereby claim a higher amount by
way of remuneration for the purpose of deduction.
- the quantum of deduction in computing income
under the head ‘profits and gains of business or profession’ ought be computed
with reference to the income falling under all the heads of income, including
the head ‘income from other sources’.
- the decision of the Supreme Court in case of
Apollo Tyres Ltd. vs. CIT, 255 ITR 273 confirmed that the decision as to
which item of income should be taken into account for computing the quantum of
deduction, depended upon the language of the statutory provision allowing the
deduction.
The Revenue, in
response, contended that the assessee himself had offered the receipts in
question under the head ‘income from other sources’; that from a plain reading
of section 40(b)(v) r.w. Explanation 3 thereto, it was manifestly clear that
the term ‘book profit’ meant only that net profit which was computed in the
manner laid down in Chapter IV-D of the Act, which chapter dealt only with the
profit and gains of business or profession, and did not include profits
chargeable under Chapter IV-F under the head ‘income from other sources’; that
in a taxing statue, the words of the statue were to be interpreted strictly;
that section 40(b)(v), Explanation 3 made it abundantly clear that the net
profit had to be computed in the manner laid down in Chapter IV-D and such
profit did not include profit referred to in Chapter IV-F of the Act.
The Calcutta
High Court, on due consideration of the rival contentions, held that chapter
IV-D nowhere provided that the method of accounting for the purpose of
ascertaining net profit should consider the income from business alone and not
from other sources; section 29 provided for the manner of computing the income
from profits and gains of business or profession which had to be done as
provided u/s. 30 to 43D; by virtue of section 5 of the said Act, the total
income of any previous year, included all income from whatever source derived;
for the purpose of section 40(b)(v) read with Explanation there could not be
separate method of accounting for ascertaining net profit and/or book-profit;
the said section nowhere provided that the net profit as shown in the profit
and loss account should be the profit computed under the head profits and gains
of business or profession, only.
The Calcutta
High Court, citing the following paragraphs from the decision of the Supreme
court in the case of Apollo Tyres Ltd.(supra) , observed that the said
decision provided for an appropriate guidance on the point as to what should be
done in order to ascertain the net profit in case of the nature before the
court.
“Sub-section
(1A) of section 115J does not empower the Assessing Officer to embark upon a
fresh inquiry in regard to the entries made in the books of account of the
company. The said sub-section, as a matter of fact, mandates the company to
maintain its account in accordance with the requirements of the Companies Act
which mandate, according to us, is bodily lifted from the Companies Act into
the Income-tax Act for the limited purpose of making the said account so
maintained as a basis for computing the company’s income for levy of
income-tax. Beyond that, we do not think that the said sub-section empowers the
authority under the Income-tax Act to probe into the accounts accepted by the
authorities under the Companies Act. If the statute mandates that income
prepared in accordance with the Companies Act shall be deemed income for the
purpose of section 115J of the Act, then it should be that income which is
acceptable to the authorities under the Companies Act. There cannot be two
incomes one for the purpose of the Companies Act and another for the purpose of
income-tax both maintained under the same Act. If the Legislature intended the
Assessing Officer to reassess the company’s income, then it would have stated
in section 115J that “income of the company as accepted by the Assessing
Officer”. In the absence of the same and on the language of section 115J,
it will have to held that view taken by the Tribunal is correct and the High
Court has erred in reversing the said view of the Tribunal.”
“The fact that it is shown under a
different head of income would not deprive the company of its benefit under
section 32AB so long as it is held that the investment in the units of the UTI
by the assessee-company is in the course of its “eligible business”.
Therefore, in our opinion, the dividend income earned by the assessee-company
from its investment in the UTI should be included in computing the profits of
eligible business under section 32AB of
the Act.”
Relying heavily
on the findings of the apex court, the Calcutta High Court held that once the
income from other sources was included in the profit and loss account, to
ascertain the net profit qua book-profit for computation of the
remuneration of the partners, the same could not be discarded for the purposes
of computing the deductible amount of remuneration to partners. The appeal of
the assessee firm was thus allowed and the orders of the lower authorities were
set aside.
ALLEN CAREER INSTITUTE’S CASE
Recently, the
issue again arose before the Rajasthan High Court in the case of CIT vs.
Allen Career Institute. 94 taxmann.com 157. In this case, the Rajasthan
High Court, admitting the Revenue’s appeals, framed the following substantial
questions of law:
“Whether
in the facts and circumstances of the case the ITAT is justified in considering
the interest as part of the book profit in contravention of Section 40(b) i.e
as per Section 40(b) the book profit has to be computed in the manner laid down
in Chapter-IV D?”
“Whether
the Tribunal was legally justified in deleting the disallowance of
Rs.2,30,00,796/- made on account of remuneration to partners by taking the
interest earned on FDRs as part of book profit and business income under
Section 28 specifically when it was “Income from other sources” and
contrary to Section 40(b), Explanation 3 and Section 40(b) (v) (2)?”
On behalf of
the Revenue it was contended that Chapter IV-D, consisting of section 28 to 44,
provided for computation of the income under the head profits and gains of
business or profession; that the investment in the FDRs was not made as a
business necessity, without which the business of the assessee could not be
run, and, in fact, the FDRs were made out of the surplus funds available with
the assessee, and the income from bank FDRs could not be said to be business
income and was to be treated as income from other sources.
On behalf of
the assessee, it was contended that the interest income from the FDRs, credited
to the profit & loss account, should not be excluded from the net profit
for the purposes of determining the quantum of deduction in respect of the
payment of remuneration to the partners while applying the provisions of
section 40(b). Reliance was placed on the decisions in the case of CIT vs.
J.J. Industries, 358 ITR 531 (Guj.) and Md. Serajuddin & Bros. vs.
CIT, (supra) and Apollo Tyres Ltd. vs. CIT(supra). In addition, the
decision in the case of CIT vs. Hycron India Ltd. 308 ITR 251 (Raj.),
was relied upon to contend that the expression “profits and gains” as
used in section 2(24), had a wider expression, and was not confined to
“profits and gains of business or profession”. Further, the language
of section 10B, again, provides for exemption, with respect to any
“profits and gains” derived by the assessee, and was not confined to
“profits and gains of business and profession” as provided u/s. IV-D.
That ‘profit’ was an elastic and ambiguous word, often properly used in more
than one sense; its meaning in a written instrument was governed by the
intention of the parties appearing therein, but any accurate definition thereof
must always include, the element of gain. The meaning of word “gain”
has been given as acquisition, and has no other meaning. Gain was something
obtained or acquired, and was not limited to pecuniary gain. The word
“profit”, as ordinarily used, means the gain made upon any business
or investment. “Profits” is capable of numerous constructions, and
for any given use, its meaning must be derived from the context. In addition,
it was contended that had the intention been to limit the scope of the term
‘profit’ to the income determined under the head profits and gains of business
or profession, then it would have been so done as was done in the case of
section 115J of the Act.
The Rajasthan
High Court rejected the contentions of the assesse made in support of inclusion
of the income from interest and other sources for the purposes of computing the
quantum of the deduction in respect of the remuneration paid to partners,
holding that the interest and other income taxable under the head ‘income from
other sources’ was not to form part of the book profits for the purposes of section
40(b) of the Act, and was therefore required to be excluded from the net profit
as per the profit & loss account.
OBSERVATIONS
Section 14
requires the total income to be classified into five different heads of income
for the purpose of charge of income tax. Subject to such classification, the
total income of an assessee remains unchanged. The charge of the tax is on the
total income of the firm, and is not changed on account of its classification
into different heads of income.
There are
several provisions in the Income Tax Act, for grant of relief or otherwise,
where the legislature has used such language that expressly refers to the
income computed under the head ‘profits and gains from business and
profession’. For example, the benefit of deduction u/s. 10B is not restricted
to the income computed under the head ‘profits and gains from business and
profession’ but is allowed in respect of the ‘profits and gains’. Again,
section 115JB deals with the profit and loss account of an assessee in its entirety,
and covers the profit of the company as shown by the profit and loss account,
without restricting the same to the income of business. Explanation 3 also
employs a similar terminology while defining the term “book-profit” to mean the
net profit as shown in the profit and loss account for the relevant previous
year. In contrast, the provisions of section 33AB and section 80 HHC restrict
the relief to profits computed under the head ‘profits and gains of business or
profession’.
The use of the
words “computed in the manner laid down in Chapter IV-D” in Explanation
3 that follows the words ‘net profit, as per profit & loss account for
the relevant previous year’ may not presently change the amount of net
profit for the following reasons;
- Unlike adjustments to book-profit required
to be made u/s. 115JB for MAT, no specific guidelines are provided in section
40(b) for adjusting the net profit. Reference may also be made to provisions of
section 33AB and section 80HHC, which expressly provide for restricting the
relief to profits computed under the head ‘profits and gains of business or
profession’ .
- Chapter IV-D by itself cannot be considered
to provide any help in the matter of computation of book profit. Any attempt to
compute the book profit by applying all and sundry provisions of Chapter IV-D
would lead to a “book-profit” that would be devoid of any reality and may
result in allowing remuneration in excess of even the net profit of the firm.
- Explanation 3 requires the net profit to be
increased by the amount of remuneration paid to partners of the firm. This
specific requirement is an example of an adjustment expressly provided by the
legislature to the net profit for quantification of the remuneration payable.
- Needless to say that any attempt to exclude
certain receipts from net profit will have to be followed by the exclusion of
the expenditure incurred for earning such income. Such an exercise may be
extremely difficult and if attempted, may reflect inaccurate results.
None of the provisions for allowing deduction u/s.
30 to 43D of Chapter IV-D contains a provision that restricts the deduction
thereunder to the profits computed under the head ‘profits and gains of
business or profession’. There cannot be a separate method of accounting for
ascertaining net profit/book-profit and therefore, any income, if credited to
profit and loss account, should be eligible to be classified as book profit.
Ordinarily
unless otherwise provided, an income, even though computed under the different
heads of income, would not cease to be the income of the business more so where
the objective of the assessee such as a firm or company is to carry on business
for the entity.
The issue under
consideration has also been addressed by the Gujarat High Court in the case of CIT
vs. J.J.Industries, (supra), wherein the court allowed the deduction of
remuneration to partners calculated on net profit that included receipts of
interest and a few other items taxed under the head ‘ income from other
sources’.
The term
“profits and gains” used in section 2(24), clause(i) is wide enough to include
all the receipts of an assessee firm, and its scope need not be restricted to
the ‘profits and gains of business or profession’. Profit is an ambivalent and
multi-faceted term which connotes different meanings at different times and in
different contexts. The Supreme Court, in the case of Apollo Tyres Ltd.
(supra), clarified that the true meaning of the ‘profit’ should be gathered
with reference to the intention of the legislature in enacting the particular
provision. Any attempt to ascribe a general and all purpose meaning to the term
“profit” should be avoided and only such a meaning that fits into the context
should be supplied. The Rajasthan high court in fact, in the case of Hycron
India Ltd (supra), in a different context, has held that the term ‘profits
and gains’ need not necessarily be confined to ‘profits and gains of business
or profession’.
Attention is
invited to the decisions of the Jaipur bench of the tribunal in the case of S.P.
Equipment & Services 36 SOT 325, and Allen Career Institution 37 DTR 379
and the Madras High Court in the case of Sri Venkateshwara Photo Studio,
33 taxmann.com 360 and the Rajkot Bench in the case of Sheth
Brothers, 99 TTJ189 and the Mumbai Bench in the case of Suresh A. Shroff &
Co., 27 taxmann.com 291, all of which have held that, for the purpose of
computing the deduction for payment of remuneration to partners in the hands of
the firm, the items of income credited to the profit & loss account should
not be excluded, even where such items have otherwise been taxed under the head
‘income from other sources’.
The better view
therefore is the one propounded by the Calcutta & the Gujarat High Courts
that takes into consideration the larger meaning of the ‘profits & gains’
which fits into the context of section 40(b) and takes into consideration the
method of accounting employed by the firm for determining the net profit of the
firm.
The case for
inclusion of interest and such other receipts in the book profit is stronger in
cases where such receipts have been taxed under the head ‘profits and gains of
business or profession’. In such cases, there should not be any opposition from
the AO, who has otherwise accepted the character of such receipts as a business
income and assessed and brought to tax such receipts under the head ‘profits
and gains from business and profession’.
There is no
leakage or very little leakage of revenue in the whole exercise, in as much as
what is allowed in the hands of the firm is taxed in the hands of the partners.
Further what is disallowed in the hands of the firm is to be excluded from the
income of the partners. All of this is made clear by the express provisions of section28(v) of the Act.
