[2016] 73 taxmann.com 363 (Pune – Trib.) Quality Industries vs. ACIT A.Y.: 2010-11 Date of Order: 9th September, 2016

Section 14A   – interest paid on
partners’ capital does not qualify as `expenditure’ for the purpose of section
14A.

Facts

The assessee firm, engaged in the
business of manufacturing of chemicals etc., filed return of income for  assessment 
year  2010-11  declaring 
total  income of Rs.95,65,090/-.
in the course of assessment proceedings, 
the Assessing  Officer  (AO) 
noticed  that the assessee has,
inter-alia, earned tax free dividend income amounting to Rs.24,63,700/- from
investment in mutual funds which was claimed as exempt income under section
10(35) of the Act. The  AO also noted
that the assessee’s investments in mutual funds as on 31.3.2010 was Rs.4,41,88,955/- and the corresponding amount
as on 31.03.2009 was Rs.3,18,39,548/-. He observed that the partners of the
assessee firm were charging interest on capital introduced by them into the
firm. Total interest claimed as deduction against taxable income was Rs. 75,63,615
which comprised of interest on bank loans Rs.75,615/- and interest on partner’s
capital to the tune of Rs.74,88,000/-.

The  assessee contended that interest on partners
capital is not an `expenditure’ per se, as specified u/s.14A of the act and
that even income-tax law understands it this way as such interest in partners’
hand is taxable as “profits from business” and not as “income from other
sources”. It was also contended that expenditure needs presence of two parties
i.e. spender and earner. The firm has no separate existence from its partners.
The assessee firm is a separate entity under income-tax act only for taxation
purposes.  This   is the very reason that deduction  of interest and salary to partners is allowed
as a separate deduction and not as an expenditure under separate section from
sections 30 to 43 of the act. These interest and  salaries 
to  partners  are 
for this  very  reason 
not liable to TDS provisions under the act. The AO,  however, Held that assessee has incurred
expenditure including interest expenses which are attributable to earning
dividend income from investment in mutual funds which is exempt and not
includible in total income.  he invoked
the provisions of section 14a of the act read with rule 8D of the income-tax
rules, 1962 (“rules”) and disallowed the a sum Rs. 29,25,362 being estimated
expenditure incurred in relation to dividend income so earned in terms of the
formula provided under rule 8D of the rules.

Aggrieved, the  assessee 
preferred  an  appeal 
to  the CIT(A) who confirmed the
action of the AO.

Aggrieved, the assessee preferred
an appeal to the tribunal.

Held

The tribunal noted that interest
and salary received by the partners are treated on a different footing by the
act and not in its ordinary sense of term. Section 28(v) treats the passive
income accrued by way of interest as also salary received by a partner of the
firm as a ‘business receipt’ unlike different treatments given to similar
receipts in the hands of entities other than partners. The tribunal  observed that under proviso to section 28(v),
the disallowance of such interest is only in reference to section 40(b) and not
section 36 or section 37. This also gives a clue that deduction towards
interest is regulated only under section 40(b) and the deduction of such interest
to partners is out of the purview of section 36 or 37 of the act.

Firm and partners of the firm are
not separate person under Partnership act although separate unit of assessment
for tax purposes. There cannot therefore be a relationship inferred between
partner and firm as that of lender of funds (capital) and borrower, hence,
section 36(1)(iii) is not applicable at all. 
Section 40(b) is the only section governing deduction towards interest
to partners. In view of section 40(b) of the Act, the Assessing Officer
purportedly has no jurisdiction to apply the test laid down u/s. 36 of the Act
to find out whether the capital was borrowed for the purposes of business or
not. Thus,  the question of allowability
or otherwise of deduction does not arise except for section 40(b) of the act.

The interest paid to partners and
simultaneously getting subjected to tax in the hands of its partners is merely
in the nature of contra items in the hands of the firms and partners.
Consequently interest paid to its partners cannot be treated at par with the
other interest payable to outside parties. Thus, in substance, the revenue is
not adversely affected at all by the claim of interest on capital employed with
the firm by the partnership firm and partners put together. Thus, capital
diverted in the mutual funds to generate alleged tax free income does not lead
to any loss in revenue by this action of the assessee. In view of the inherent
mutuality, when the partnership firm and its partners are seen holistically and
in a combined manner with costs towards interest eliminated in contra, the
investment in mutual funds generating tax free income bears the characteristic
of and attributable to its own capital where no disallowance u/s.14A read with
rule 8D is warranted.  The tribunal Held
that it found merit in the plea of the assessee in so far as interest
attributable to partners.

The Tribunal allowed the ground
of appeal filed by the assessee to the extent of interest on partners capital.