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.”