Decoding Section 40(b) of INCOME TAX ACT: Deductibility of INTEREST PAID TO PARTNERS in the hands of PARTNERSHIP FIRM.
In previous Article 'UMP approach while preparing for CA Final Examination May 2019/ Nov 2019', I suggested 70% allocation of time on 'Understanding the depth of the provisions of Income Tax Act”.
In this context, let's decode the provisions of section 40(b) of the Act along with its cross-references - Section 194 A and Section 28(v).
Section 40(b): CONDITIONS FOR CLAIMING DEDUCTION OF INTEREST PAID TO PARTNERS:
In order to claim deduction of interest paid to partners, the firm shall fulfil following conditions:
- Payment of interest to any partner is authorised by the partnership deed and it shall be in accordance with the terms of such deed. (Refer Case Study 1 in Q & A format given below)
- Payment of interest pertains to the period on or after the date of partnership deed. (Refer Case Study 2 given below)
- The amount of interest shall not exceed amount calculated at the rate of 12 % simple interest p.a.
Case Study 1
Firm paid interest on partners' capital account as well on current accounts at the rate of 12%. However, interest on current account transaction was not authorized by partnership deed. Can firm claim deduction of interest on current account transactions?
Kerala High Court in case of Novel Distributing Enterprises vs. DCIT & ANR. 251 ITR 704 held that partnership deed did not authorize payment of interest on current accounts of the partners, therefore, same cannot be allowed as deduction in view of the provisions of section 40(b) of the Act.
Case Study 2
Mr. Jayesh, a chemical engineer, was an employee of the partnership firm since 2015. The partnership firm, as a condition of employment contract, used to retain 1/3rd of his salary as interest free security deposit and such deposit shall be released on successful completion of 3 years. On completion of three years of employment, Mr. Jayesh was admitted as a partner to the partnership firm with effect from 01-04-2018. And it was further agreed that the security deposit shall be taken as his capital contribution on which interest shall be paid at 12% per annum (simple) w.e.f. 01-04-2015. The partnership firm would like to claim deduction of entire interest credited to the capital account of Mr. Jayesh in the previous year 2018-19. Advise partnership firm regarding deductibility of such interest.
One of the conditions for claiming deduction under section 40(b) is that the payment of interest to partner shall pertain to the period on or after the date of partnership deed. Therefore, in the present case, partnership firm cannot claim deduction of interest credited to the capital account of Mr. Jayesh for the period 01-04-2015 to 31-03-2018, reason being he has been admitted to the partnership firm w.e.f. 01-04-2018. As a result, firm can avail deduction of interest for the period 01-04-2018 to 31-03-19 only.
Explanations to Section 40(b): When the recipient of interest acts in a representative capacity
Explanation 1 provides that where an individual is a partner in a firm on behalf, or for the benefit, of any other person, (to be called partner in a representative capacity) interest paid by the firm to such individual, otherwise than as partner in a representative capacity, is not taken into account, for the purposes of section 40(b).
Example: Ramesh(HUF) is a partner in a partnership firm represented by Karta, Mr. Ramesh, then provisions of section 40(b) shall not be applicable if interest is paid by the Firm to Mr. Ramesh. That is to say, if Mr. Ramesh has given loan to the firm in his personal capacity at the rate of say 18%, then restriction of 12% as mentioned under section 40(b) shall not be applicable to the Firm while claiming deduction because in this case, Ramesh is not a partner, he is just representing Ramesh(HUF) and it is the Ramesh (HUF) who is a partner.
Explanation 2 provides that where an individual is a partner in a firm, otherwise than in a representative capacity, interest paid by the firm to such individual will not be taken into account for the purposes of section 40(b), if such interest is received by him, on behalf, or for the benefit, of any other person.
Example: The opposite would be the example when Ramesh is a partner and interest is given by the firm to Ramesh (HUF), then restriction contained in section 40(b) shall not be applicable since Ramesh (HUF) is not a partner.
Section 28(v): Taxability on interest, remuneration in the hands of partners
As per section 28(v) of the Act, any interest, salary, bonus, commission or remuneration, by whatever name called, due to, or received by, a partner of a firm, to the extent firm claimed deduction, shall be taxable in the hands of partners under the head 'Profits and Gains from Business or Profession”.
Section 194A: Tax deduction at source on interest other than interest on securities
As per the provisions of section 194A(3)(iv), firm is not required to deduct TDS on interest paid to resident partner.
PRACTICAL SITUATIONS FOR BRAINSTORMING:
X and Y are equal partners of ABC & Co. On 1st day of previous year, Mr. X contributed capital of Rs.10,00,000 @ 15% p.a. On the same day, Mr. X had given a loan of Rs. 25,00,000 to the firm @18% p.a. While Mr. Y contributed capital of Rs. 5,00,000 @15% p.a.
Discuss tax consequences in the hands of firm as well as partners assuming that all partners are residents.
Continuing above problem, what would have been the tax consequences in the hands of firm if loan is given by X-HUF instead of Mr. X?
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