Disallowance of interest on partner’s capital u/s 40(b) restricted to net advances out of interest bearing funds

Disallowance of interest on partner’s capital u/s 40(b) restricted to net advances out of interest bearing funds

ABCAUS Case Law Citation
ABCAUS 3503 (2021) (05) ITAT

In the instant case, the assessee had challenged the order passed by the CIT(A) in deleting the addition made by the Assessing Officer (AO) on account of excess payment of interest on capital claimed under section 40(b) of the Income Tax Act, 1961 (the Act)

During the assessment proceedings, AO noticed that, the firm had paid interest to partners on their capital during the year under consideration u/s 40(b) of the Act. 

The AO noted that against the total capital of the partners the assessee’s current assets included recoverable loan and advances given. It was also noticed that, the assessee had not charged any interest on these loans and advances.

In view of the above, the AO was of the view that out of partners’ capital, the firm had used capital for its business purpose to the extent of only total capital minus said loans and advances

So, he worked out the allowable interest to partners as percentage of adjusted capital against the assessee’s claim and proposed to disallow excess interest paid to partners.

In response to the show cause notice, the assessee replied that, section 40(b)(iii) of the Act provides interest payments on capital subject to the conditions being provided in the partnership deed. It implies that it is a condition of partnership business and when interest is paid on capital it is a return on investment and such interest is not paid due to debtor and creditor relationship but it is merely return agreed by partners on investment on capital.

However, the explanation given by the assessee was not accepted by the assessing officer and the amount of excess interest worked out was disallowed and added to the income of the assessee.

The CIT(A) observed that the AO had gone on a wrong track for disallowing interest. The assessee was a firm and sharing of profit is done as per the partnership deed made. The interest was also a part of partnership deed and the assessee had allowed the same correctly.

The CIT(A) opined that if at all, AO had noticed that the assessee had diverted the interest bearing funds to interest free advances and not used for business purpose then the same was to be made on net advances out of interest bearing funds. 

The Revenue challenged the order passed by the CIT(A).

The ITAT noted that before the AO, the assessee stated that disallowance if any was to be made on the amount of net interest free advances given which are to be arrived as under:

Total capital + interest free unsecured loans+creditors+profit for the year minus interest free loans and advances given

The Tribunal noted that CIT(A) too held that if at all, disallowances are to be made then the same is to be made regarding net advances out of interest bearing funds. Which was also the case of the assessee.

The ITAT declined to interfere with the order of CIT(A) in partly deleting the said addition there being no infirmity in the order.

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