The Hindu Business Line : Interest paid to partners

In the case of firms, interest on capital contributed by the partners is eligible for deduction, subject to conditions such as authorisation for payment of interest in the deed of partnership; rate of interest not exceeding 12 per cent per annum; and satisfying procedural requirements of Section 184.

While there is restriction on the quantum of deduction allowable in the case of partners’ salary, there is no monetary limit prescribed for restricting the payment of interest on capital.

Currently, the need for effective use of capital by the firm for allowance of interest is not contained in the statute book.

Hence, a firm can accept capital, of say Rs 10 lakh, from a partner and keep it as idle cash or bank balance and still pay and claim such interest payment to partners as expenditure in its income statement.

Section 36(1)(iii)

This section mandates allowance of interest paid or payable on capital borrowed for the purpose of business or profession. The conditions to be satisfied for getting the deduction, as per this provision, are: capital borrowed must be used for business or profession;

the outcome of venture (business) whether profit or loss is not a relevant factor for allowance of interest;

the borrowal must be money and not any other asset;

the borrowal must be on revenue account — for operating the business, and not for acquiring capital asset — not put to use;

use of borrowal for payment of tax or personal use is not eligible;

interest on unpaid expenditure is not a borrowal; and

diversion of borrowal to partners or allied concerns with direct nexus to borrowal without interest thereon is not eligible.

Apex court decision

In Manjal Sales Corpn vs CIT (2008 168 Taxman 43 / 298 ITR 298 SC), the issue of whether interest payment to partners contained in Section 40(b) is a standalone provision or not was discussed.

It was held that right to claim deduction of interest is on the taxpayer and equally the onus is on him to show that disentitlement contained in Section 40(b) does not apply to his case.

It was held that the firm has to prove that the amount contributed by the partner satisfies the requirement of Section 36(1)(iii) before being eligible for deduction under Section 40(b).

The court held that Section 40(b)(iv) puts a limitation on the amount of deduction under Section 36 (1)(iii).

Hence, unless the conditions of Section 36(1)(iii) are satisfied, such interest payment is not deductible, though it may satisfy the requirement of Section 40(b).

Tribunal decision

Interestingly, whether interest on capital paid to the partners could be disallowed as excessive was discussed in Syntholab Chemicals & Research vs Assistant CIT (2008 172 Taxman 38 Mum-Tribunal). Section 40A(2) empowers the assessing officer (AO) to disallow any expenditure to relative of a person having substantial interest in the concern if such expenditure, in the opinion of AO, is excessive or unreasonable.

The tribunal held that the interest on capital satisfying the conditions of Section 40(b) could not be restricted by applying the reason of excess payment. It held that Section 40(b) would prevail over Section 40A(2), as it is a specific provision and whereas the latter is a general provision.

In the light of the apex court decision referred above, the interest on capital is eligible for deduction in the case of firms only if the requirements of Section 36(1)(iii) are satisfied.

As Section 40(b) is a specific provision, the AO cannot disallow the interest on partners’ capital by invoking Section 40A(2) as excess payment.

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