The Hindu Business Line : On a firm paying interest to its partner

Every assessee, including a firm, has to establish its right to claim deduction under one of the Sections 30 to 38 and in the case of a firm, if it claims deduction, it has to prove that it is not disentitled to do so by reason of applicability of Section 40(b)(iv).

H. P. Ranina

The deductibility of interest that a firm pays when it borrows monies from its partners has recently been explained elaborately by the Supreme Court. Before the enactment of the Finance Act, 1992, payment of interest by the firm to any partner of the firm constituted business disallowance per se.

After the Finance Act, 1992, section 40(b)(iv) of the 1961 Act places limitations on the deductions under section 30 to 38. Prior to the Finance Act, 1992, the 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.

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 30 to 38 and in the case of a firm, if it claims deduction, it has to prove that it is not disentitled to do so by reason of applicability of section 40(b)(iv).

Therefore, an assessee is required to establish in the first instance that it is entitled to claim deduction under section 36(1)(iii) and that it is 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”.

Sections 30 to 38 are other deductions, whereas section 40 is a limitation on that deduction. Therefore, even if an assessee is entitled to deduction under section 36(1)(iii), the assessee will not be entitled to claim deduction for interest payment exceeding the specified rate.

This is because section 40(b)(iv) puts a limitation on the amount of deduction under section 36(1)(iii).

Claim disallowed

In Munjal Sales Corporation v C.I.T. (298 I.T.R. 298), the facts were that in August/September 1991, the appellant-assessee granted interest-free advances to its sister concerns, which were disallowed by the Department on the ground that the advances were not given from the firm’s own funds but from interest bearing loans taken by the assessee from third parties. Accordingly, the assessee’s claim for deduction under section 36(1)(iii) was disallowed by the Department for the assessment year 1992-93.

However, the Tribunal deleted the disallowance stating that the assessee had given such advance from its own funds. In the next assessment year 1993-94 as well, the Tribunal deleted the disallowance for the assessment year 1993-94.

It is important to note that the Department accepted the orders passed by the Tribunal in favour of the assessee for both the assessment years 1992-93 and 1993-94.

The interest-free advance given to the sister concern was repaid on a year-to-year basis. The advance was finally repaid in the financial year relevant to the assessment year 1997-98.

During the assessment year 1994-95, no further advances were made by the assessee in favour of its concerns. However, during the assessment year 1995-96, an interest-free loan of Rs 5 lakh was advanced by the assessee to its sister concern as during this year the assessee had profits of Rs 1.91 crore.

Before the Finance Act, 1992, amended the tax law, payment of interest to the partner was an item of disallowance. Therefore, it had to be added back to the assessable income of the firm. After April 1, 1993, the interest became an item of deduction, provided that the amount of interest does not exceed the prescribed rate of interest per annum (section 40(b)(iv)).

For the assessment year 1994-95, the Department, in this case, disallowed the claim for deduction under section 40(b)(iv) on the ground that there was diversion of funds by raising of interest-free loans.

The Assessing Officer did not accept the submission of the assessee that advance(s) made by the assessee were out of income of the firm. According to the Assessing Officer, the interest-free advances to sister concerns were out of monies borrowed by the firm from third parties on payment of interest. Hence the assessee was not entitled to deduction under section 40(b) of the 1961 Act. This view was confirmed by the Tribunal.

For the assessment years 1995-96 and 1996-97, the Tribunal held that during the years, no interest-free advances to sister concerns were made and, therefore, there was no nexus between “interest bearing loans” taken and “interest-free advances”.

However, the Tribunal found that there was no material to show that advances were made to sister concerns out of the firm’s own income. Therefore, the assessee was not entitled to deduction under section 40(b).

The question that arose for determination was whether section 40(b) is a stand-alone section or whether it operates as a limitation to the deduction under sections 30 to 38 of the Act.

Object behind enactment

The Additional Solicitor General, appearing for the Department, submitted that the object behind the enactment of the Finance Act, 1992, is not only to avoid double taxation but also to put the firm as an assessee on a par with other assessees.

Therefore, after the amendment was made by the Finance Act, 1992, the assessee has to establish the veracity of deductions under section 30 to 38 and it has also to prove that it is not disentitled under section 40 of the Act.

On behalf of the assessee, it was argued that the partner’s capital is not a loan or borrowing in the hands of a firm. Section 40(b)(iv) applies to partner’s capital, whereas section 36(1)(iii) applies to loan or borrowing.

The Supreme Court observed that as far back as in August/ September, 1991, the assessee had given interest-free advances to its sister concerns. These advances stood reduced over a period, until the financial year 1996-97.

Each year the balances stood reduced. Further, the Tribunal held that, for the assessment year 1992-93, the assessee had given interest-free advances from its own funds and not from interest bearing loans taken by the firm from third parties. Consequently the assessee was entitled to claim deduction under section 36(1)(iii).

In other words, the Tribunal held that the advances were given for business purposes. Similarly, for the assessment year 1993-94, the Tribunal had taken the view that the advances given to the firm’s sister concerns were for business purposes.

Accordingly, the Tribunal had deleted the disallowances during the assessment years 1992-93 and 1993-94. For the assessment year 1994-95, the Tribunal took a contrary view in view of the change in law brought about by the Finance Act, 1992.

For the assessment years 1992-93 and 1993-94, the Tribunal had arrived at the finding of fact that the advances given to the sister concerns were out of the firm’s funds and that they were advanced for business purposes.

Once it is found that the loans granted in August/September, 1991, continued up to the financial year relevant to the assessment year 1997-98 and that the loans were advanced for business purposes and that interest paid thereon did not exceed the prescribed rate, the assessee was entitled to deduction under section 36(1)(iii), read with section 40(b)(iv) of the Act.

The importance of this judgment lies in the clarification that has been given in respect of the deductions under sections 30 to 38. The limitations prescribed under section 40 govern these provisions. The Supreme Court has explained the law in the context of the mandate of Chapter IV-D of the Act.

The author, a Mumbai-based advocate specialising in tax laws, can be contacted at ranina@bom2.vsnl.net.in

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