Section 40(b) — Partners may choose not to provide depreciation in books and in such case AO is not entitled to deduct the cumulative depreciation from capital balances for working out interest u/s.40(b).
Facts:
The assessee paid interest to its partners and claimed the same as deduction. There was no dispute that the partnership firm had complied with the conditions prescribed u/s.40(b) of the Act. The dispute was related to the determination of the capital account balances of the partners on which the interest is payable. The assessee claimed interest on the capital account balances of the partners as disclosed in its books of account. However, during the course of assessment proceedings, the AO noticed that the firm did not provide for depreciation on the fixed assets in its books. However for the purpose of computing the total income, it has claimed depreciation in accordance with section 32 of the Act. Thus it was noticed that the net profits for book purposes have been shown at a higher figure by not charging depreciation, which would consequently increase the capital balances of the partners. In that case, the assessee would claim deduction of more amount of interest on the capital balances so inflated by not providing depreciation on the fixed assets. The AO felt that it is compulsory for the assessee to provide for depreciation in the books also.
Hence the AO reworked the capital balances of the partners by reducing the cumulative amount of depreciation therefrom and accordingly allowed the interest computed on such reduced capital balances. The learned CIT(A), confirmed the order of the A.O. The learned CIT(A) relied upon the decision of the SMC Bench of Visakhapatnam in the case of Arthi Nursing Home v. ITO, (2008) 119 TTJ (Visaka) 415 in order to reject the appeals filed by the assessee before him.
Held:
In the case of Arthi Nursing Home (supra), the SMC Bench, inter alia, placed reliance on the decision of the Supreme Court in the case of British Paints Ltd. (1991) 188 ITR 44, wherein it was held that the AO has a right and also duty to consider whether the books disclose the true state of accounts and the correct income can be deduced therefrom. The computation of total income is not affected by the amount of depreciation provided for in the books of account and the position remains the same even if no depreciation is provided for in the books. Hence, in our view, the ratio laid down in the case of British Paints Ltd. (supra) shall not apply in respect of depreciation, as it will not affect the computation of total income under the Income-tax Act.
Under the Partnership Act, there is no statutory compulsion to provide for depreciation in the books of account or to follow the accounting standards prescribed by the ICAI, though it may be in the interest of the partnership firms to follow the said accounting standards.
In Explanation 5 to section 32, the words ‘whether or not the assessee has claimed the deduction in respect of depreciation’ would show that the assessee has an option not to claim depreciation while computing his total income, but the said option shall be ignored by the AO and he will deduct depreciation from the total income of the assessee. Thus, there is no statutory compulsion for the partnership concerns to provide for depreciation in the books of account under Explanation 5 to section 32.
The AO is authorised only to verify whether the payment of interest to any partner is authorised by and is in accordance with the terms of partnership deed and also it relates to the period falling after the date of partnership deed. Besides the above, the AO should restrict the rate of interest, if the rate authorised in the partnership deed is more than the rate specified in section 40(b)(v) of the Act. Thus, it could be seen that nowhere it is provided that the AO is entitled to disallow the payment of interest to partners by reworking the capital account balances of the partners.
