ITAT explains the Law on exemption u/s 10(2A) for partners share of profit in the income of the firm

ITAT explains the law on exemption u/s 10(2A) for partners share of profit in the income of the firm. Revision order u/s 263 quashed as it failed to state what kind of enquiry AO failed to make.

Prelude:
Section 10 of the Income Tax Act, 1961 (the Act) deals with incomes which is not included in the total income. Subsection (2A) to section 10 of the Act reads as follows:

“in the case of a person being a partner of a firm which is separately assessed as such, his share in the total income of the firm”

Explanation.: For the purposes of this clause, the share of a partner in the total income of a firm separately assessed as such shall, notwithstanding anything contained in any other law, be an amount which bears to the total income of the firm the same proportion as the amount of his share in the profits of the firm in accordance with the partnership deed bears to such profits;”

Thus, partner’s share in the “total income”  of the firm is exempt u/s 10(2A) in the hands of the Partner of the firm.

Further, section 2 (45) defines total income to mean total amount of income referred to in Section 5, computed in the manner laid down in the Act. Thus, an income in order to come within the purview of that definition must satisfy two conditions. Firstly, it must comprise the “total amount of income, profits and gains.” Secondly, it must be “computed in the manner laid down in the Act”.

Chapter-II of the Act, from section 4 to 9 deal with Basis of Charge. Chapter-III of the Act, deals with income which do not form part of total income and are contained in Sections 10 to 13-B of the Act. Chapter IV deals with the computation of total income.

From the charging provisions of the Act, it is clear that both profit as well as loss which is negative profit must enter into computation.

In the instant case a controversy arose as to the correct amount exemption in the hands of the partners u/s 10(2A).

Law on exemption u/s 10(2A) for partners share of profit in the income of the firm

Law on exemption u/s 10(2A) for partners share of profit

ABCAUS Case Law Citation:
ABCAUS 2166 (2018) (01) ITAT

Important Case Laws Cited/relied upon by the parties:
Vidya Investment and Trading Company Pvt Ltd vs UDI (2014)
CIT. Delhi IV v. International Travel House, [2010] 194 taxman 324
CIT Vs. Gabriel 203 ITR 108 (Bom)

Brief Facts of the Case:
All four assessees in these appeals were inducted as incoming or new partners in the firm with effect from 1st January, 2013. Prior to it, the erstwhile  four partners were sharing in profits and loss at 1/4th each. As per the supplementary deed executed, the profit sharing ratio of four new partners were 24% each and the existing partners’ share were reduced to 1% each. The deed also provided that the existing partners shall finalize Accounts for 9 months from 1st April to 31st December. The loss upto 31.12.2012 was to be debited in the Accounts of the Existing Partners. The new partners were not be responsible for any Loss and Liability upto 31.12.2012.

For the relevant assessment year, the firm suffered a loss of Rs. 20,17,79,738/- upto 31.12.2013 which as per the term of the supplementary deed, was distributed amongst the existing partners alone. For the remaining period between 01.01.2013 to 31.03.2013 there was a profit of Rs.20,20,37,712/- which was distributed amongst the new partners in the ratio of 24% each and 1% each amongst the existing partners.

The partnership firm filed the return of income declaring the total income of Rs. 3,88,780/- after set off of loss suffered between 01.04.2012 and 31.12.  The loss of Rs.20,17.79,738/- was debited in the capital account of the existing partners only as per the supplementary deed . The share of each of the new partners in the profits was Rs.4,84,89,051/- which was claimed as exempt u/s.10(2A) of the Act

During the course of the assessment proceedings, the Assessing Officer (AO) required the assesses to furnish copy of set of accounts of the said firm, its PAN, evidence of filing its return of income for the relevant year and a certified copy of partnership deed. The assessee furnished all the details.

The AO passed order of assessments in the case of all the assessees. In this order there was no reference to the claim of the assessees for exemption u/s 10(2A) of the Act. There was however a reference in these orders to the notice u/s 142(1) and a reference to the receipt of replies to the queries raised in the notice. In the assessment order it was observed that reply had been submitted, perused and placed on record. The AO had also observed that submissions made had been discussed, examined and placed on record. The AO accepted the claim of the assessees for exemption u/s 10(2A)  as no addition was made on this account.

Subsequently, the Commissioner of Income Tax (CIT), in exercise of his powers u/s 263 of the Act, was of the view that the aforesaid orders of the AO were erroneous and prejudicial to the interest of the revenue. He accordingly issued a show cause notice u/s 263. According to the CIT, under the provisions of section 10(2A) of the Act, the assessee was entitled for exemption of Rs. 93,355/- only being 24% of Rs. 3,88,982/- Rs. 3,88,982/- which was profit before tax of the firm.

However, the CIT did not deal with the submissions made by the assessees in response to his notice and held that the order of the AO was erroneous and prejudicial to the interest of the revenue by holding that the AO before concluding the assessment did not make any enquiries on the all the aspects of exemption u/s 10(2A) of the Act and accordingly he set aside the order of the AO and directed the AO to make proper enquires on the subject.

Aggrieved by the aforesaid order of the Pr.CIT, all the four assessees were in appeal before the Tribunal.

The Question for determination:
Thus the issue falling for consideration was as to whether the assessee would be entitled to exemption u/s.10(2A) of the Act on the sum of Rs.4,84,89,051 being 24% of the share of profits of the firm for the period from 1.1.2013 to 31.3.2013 of Rs.20,20,37,712 which is the share of profits credited in his capital account with the firm or the sum of Rs.93,355 being 24% of the total income of the firm declared in the return of income by the firm for the relevant AY.

Observations made by the Tribunal:
The ITAT observed that section 10 of the Act deals with incomes which is not included in the total income. Subsection (2A) to section 10 of the Act provides that what is exempt u/s.10(2A) of the Act in the hands of the Partner of a Partnership firm is “his share in the total income of the firm”. Explanation to Sec.10(2A) of the Act makes it clear that the share referred to in the Section is share in “total income”.

The ITAT observed that Chapter-II of the Act, from section 4 to 9 deal with Basis of Charge. Chapter-III of the Act, deals with income which do not form part of total income and are contained in Sect. 10 to 13-B of the Act. Chapter IV deals with the computation of total income. Firstly income is categorized under various heads of income. This is laid down in Section 14 of the Act, which lays down that save as otherwise provided by this Act, all income shall, for the purposes of charge of income-tax and computation of total income, be classified under the following heads of income – Salaries, income from house property, profits and gains of business or profession, capital gains, income from other sources. Chapter V then brings income of other persons, which are to be included in the total income of an Assessee and this is contained in section 60 to 65 of the Act. Chapter-VI (containing sec. 66 to 80) then lays down provisions regarding aggregation of income and set off or carry forward of loss. The provisions of section 66 are not applicable to incomes which are absolutely exempt from tax as per Section 10, Section 11 etc., falling under Chapter III. This position is made clear by s. 66 itself as it speaks only of “incomes on which tax is not payable” and similar words are used in Chapter VII only thus leaving out by implication incomes which do not form part of total income at all as per Chapter III from the scope of section 66. From the charging provisions of the Act, it is clear that both profit as well as loss which is negative profit must enter into computation, wherever it becomes material. The charge is on total income of the Assessee.

The ITAT noted that Section 2 (45) defines total income to mean total amount of income referred to in Section 5, computed in the manner laid down in this Act. An income in order to come within the purview of that definition must satisfy two conditions; Firstly, it must comprise the “total amount of income, profits and gains.” Secondly, it must be “computed in the manner laid down in the Act”.

Applying the above provisions, the ITAT observed that the sum of Rs.3,88,982 was the total income of the firm computed in the manner laid down in the Act and only on this sum the share of profits of the Assessees in their profit sharing ratio as per the deed of partnership would be exempt u/s.10(2A) of the Act. This interpretation will be in tune with the purpose behind Section 10(2A) of the Act viz., the same income should not be taxed twice once in the hands of the firm and again in the hands of the partners.

The ITAT further observed that circular No.8/2014 of CBDT on the provisions of section 10(2A) of the Act clarified ‘total income’ of the firm for sub section (2A) of section 10 of the Act. It had been claried that Section10(2A) of the Act as interpreted contextually, includes income which is exempt or deductible under various provisions of the Act. In particular it was clarified by the CBDT that the income of a firm is to be taxed in the hands of the firm only and the same can under no circumstances be taxed in the hands of its partners. It had further been clarified in the said Circular that the entire profit credited to the partners’ accounts in the firm would be exempt from tax in the hands of such partners, even if the income chargeable to tax becomes NIL in the hands of the firm on account of any exemption or deduction as per the provisions of the Act.

The ITAT observed that going by the CBDT Circular, the profit credited to the partner’s account in the firm would be exempt from tax in the hands of partners, viz., the sum of Rs.4,84,89,051/- which was the profit credited to the partner’s account in the firm in the present case. The above clarification in the Circular implies that the share of profit in the hands of the partners is independent of the profits of the firm which is finally distributed among the partners. Even if the income of the firm chargeable to tax becomes NIL on account of exemption/deduction, it does not mean that the income before claiming exemption will be taxed in the hands of the partners.

The ITAT opined that in view of the above, there are two views possible on the issue as to whether the Assessee would be entitled to exemption u/s.10(2A) of the Act on the share of profits credited in the partner’s capital account with the firm or the share of total income of the firm declared in the return of income by the firm. It may be true that the CBDT Circular No.8/2014 was issued in the context of deduction in Chapter-VIA to a partnership firm and exemption in Chapter-III to the income of a partnership firm but the Circular is applicable to all profits credited in the books of the firm in the capital account of the partners, even though they are not declared by the firm in their return of income.

The ITAT observed that as pointed out by the Supreme Court, the prerequisite to the exercise of jurisdiction by the Commissioner suo motu under it, is that the order of the Income-tax Officer is erroneous insofar as it is prejudicial to the interests of the Revenue. The Commissioner has to be satisfied of twin conditions, namely, (i) the order of the Assessing Officer sought to be revised is erroneous; and (ii) it is prejudicial to the interests of the Revenue. If one of them is absent—if the order of the Income-tax Officer is erroneous but is not prejudicial to the interests of Revenue or if it is not erroneous but is prejudicial to the interests of Revenue—recourse cannot be had to section 263(1) of the Act. There can be no doubt that the provision cannot be invoked to correct each and every type of mistake or error committed by the Assessing Officer, it is only when an order is erroneous that the section will be attracted. An incorrect assumption of facts or an incorrect application of law will satisfy the requirement of the order being erroneous. In the same category fall orders passed without applying the principles of natural justice or without application of mind. The phrase ‘prejudicial to the interests of the Revenue’ is not an expression of art and is not defined in the Act. Understood in its ordinary meaning it is of wide import and is not confined to loss of tax. The phrase ‘prejudicial to the interests of the Revenue has to be read in conjunction with an erroneous order passed by the Assessing Officer. Every loss of revenue as a consequence of an order of the Assessing Officer cannot be treated as prejudicial to the interests of the Revenue. For example, when an ITO adopted one of the courses permissible in law and it has resulted in loss of revenue; or where two views are possible and the Income-tax Officer has taken one view with which the Commissioner does not agree, it cannot be treated as an erroneous order prejudicial to the interests of the Revenue, unless the view taken by the Income-tax Officer is unsustainable in law.

The ITAT opined that the AO has adopted one course permissible in law and therefore jurisdiction u/s.263 of the Act cannot be exercised merely because the CIT does not agree with the view of the AO.

The ITAT noted that in the show cause notice u/s 263 of the Act there was not even a mention that the AO failed to examine the assessee’s claim for eligibility of exempt u/s 10(2A) of the Act of a sum of Rs.4,84,80,951/-. However, in the impugned order the CIT had without deciding the correctness of the stand taken by him in the show cause notice u/s 263 proceeded to hold that the AO failed to make proper inquiries on this issue while completing this original assessment. Whereas, the AO before completing the assessment u/s 143(3) of the Act had called for all the details and examined the same. The question whether this enquiry was adequate or inadequate has not be spelt out in the impugned order u/s 263. The impugned order proceeded on the basis that there was no enquiry conducted by the AO before completing the assessment. Secondly, the CIT had passed the order on a totally different basis than what is stated in the show-cause notice.

The ITAT opined that where an enquiry is conducted by the AO and he was satisfied with a reply given on a query raised, then the CIT could not have intervened through revision for coming to a conclusion that the assessment order passed by the AO was erroneous and prejudicial to the interests of the Revenue for lack of or inadequate enquiry. The CIT in the impugned order had merely pointed out that the Assessee has claimed exemption u/s.10(2A) of the Act on a sum of Rs.4,84,89,051 as his share of profits from the firm whereas the firm has declared total income of only Rs.3,88,780/-. This aspect was clear from the records produced by the Assessee before the AO. The AO had mentioned in the order that all issues and documents were perused and discussed with the AR. The CIT on examination of the Assessment records has invoked his powers u/s 263 of the Act. He had not spelt out in the impugned order as to what was the kind of enquiry that the AO ought to have made and which he failed to make. The Bombay High Court laid down that the consideration of the Commissioner as to whether an order is erroneous insofar as it is prejudicial to the interests of the Revenue, must be based on materials on the record of the proceedings called for by him. If there are no materials on record on the basis of which it can be said that the Commissioner acting in a reasonable manner could have come to such a conclusion, the very initiation of proceedings by him will be illegal and without jurisdiction. The Commissioner cannot initiate proceedings with a view to starting fishing and roving enquiries in matters or orders which are already concluded. Such action will be against the well-accepted policy of law that there must be a point of finality in all legal proceedings, that stale issues should not be reactivated beyond a particular stage and that lapse of time must induce repose in and set at rest judicial and quasi-judicial controversies as it must in other spheres of human activity.

The ITAT opined that the decision of the Bombay High Court was applicable to the facts of the present case and held that orders u/s.263 of the Act cannot be sustained as the conditions for exercise of jurisdiction under the said provisions were absent.

Decision/ Conclusion/Held:
The impugned orders u/s.263 were quashed and the appeals were allowed.

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