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In a recent elaborate judgment ITAT Mumbai relying on the Supreme Court judgment in Munjal Sales Corporation has ruled that interest paid on partner’s capital is an expenditure covered for disallowance on account of expenditure incurred in relation to exempt income under section 14A of Income Tax Act, 1961 read with Rule 8D.

Case Law Details:
ITA No.1562/Mum/2014 AY: 2010-11
M/s Pahilajrai Jaikishin (Appellant) vs. ACIT (Respondent)
Date of Order: 01-02-2016

Case Laws referred:
Munjal Sales Corporation v. CIT (2008) 168 Taxman 43(SC)
CIT v. Walfort Share& Stock Brokers (P) Ltd (2010) 326 ITR-1(SC)
Sh. Vishnu Anant Mahajan v. ACIT in ITA No. 3002/Ahd./2009-Ahmedabad ITAT
Shankar Chemicals Work v. DCIT (2011) 12 taxmann.com 461(Ahd.)

Facts of the Case:
The assessee firm was a partnership firm engaged in the business of manufacturing , trading and export of textile goods. During the course of assessment proceedings u/s 143(3) read with Section 143(2) of the Income Tax Act, 1961 (the Act), it was observed by the assessing officer (AO) that the firm had made investments in mutual funds, shares etc.  and the firm had received the dividend income which was exempt from tax. However, in the Profit & Loss a/c the assessee firm has claimed several expenses including interest expenses but no expenditure had been disallowed by the firm in relation to earning of exempt income in the computation of income. The firm was asked to explain that why disallowance should not be made u/s 14A of the Act read with Rule 8D of Income Tax Rules, 1962. The assessee firm submitted that only expenses debited against earning of exempt income are Rs.18633/- being Securities Transaction Tax (STT) and Rs 1724/- being Portfolio Management Services (PMS) charges paid to portfolio managers , totaling to Rs.20,357/- and as such these expenses do not relate to export business of the assessee firm and the same is clearly disallowable u/s 37(1) of the Act and which may be disallowed .

The assessee firm submitted that interest paid to the partner on their capital u/s. 40(b) of the Act cannot be considered as an expenditure in the hands of assessee firm for the purpose of section 14A. The assessee firm submitted that since, interest paid on capital of partners is only a statutory allowance allowable under the provision of sec. 40(b) of the Act, same cannot be held as an expenditure incurred for earning of an exempt income under the ambit of Section 14A of the Act. The assessee firm submitted that interest paid to partners on capital is not an expenditure but forms part of appropriation account and thus as per principles of accountancy it goes below the line.

The AO rejected the contentions of the assessee firm and made a disallowance of Rs. 1536264/-

Contentions of the assessee firm before ITAT:
The assessee firm submitted that disallowance of the interest paid on partners capital was to be deleted as the same was not covered u/s. 14A of the Act as the issue was squarely covered by the decision of Mumbai Tribunal dated 11.03.2015 in assessee firm’s own case in the immediately preceding assessment year i.e. 2009-10 in ITA No. 6870/Mum/2012. The assessee firm contended that disallowance was deleted by the Mumbai Tribunal to the extent of disallowance u/s 14A of the Act on account of interest paid on capital contributed by the partners on the premise that there is direct relation between the share in the profit of the firm and the interest on capital account, then the said interest cannot be treated as an expenditure to be attributable for earning the dividend income and hence the Tribunal had deleted the addition to the extent of disallowance u/s 14A of the Act on account of interest expenditure which was not on the borrowed fund but on the capital contributed by the partners.

Question before ITAT
Whether treatment of interest paid by the assessee firm to its partners on the capital contributed by the partners, i.e. whether it is an expenditure under the provisions of the Act or part of the profit distributable to Partners being merely appropriation of profits chargeable to tax in the hands of the partners u/s 28(v) of the Act?

Whether it is an ‘expenditure’ as is referred to in Section 14A of the Act incurred and attributable to in relation to earning of an exempt income?

Whether it falls within the definition of Section 36(1)(iii) of the Act being an expenditure or it falls u/s 40(b) of the Act being an statutory allowance claimed by the assessee and therefore does not fall within ambit of ‘expenditure’ as envisaged under Section 14A of the Act ?

Important excerpts from ITAT Judgment:

…. the decision of Hon’ble Supreme Court in the case of Munjal Sales Corporation(supra) is a decision pronounced on 19.02.2008 which is a decision which considered the substantial and major amendment’s to the scheme of taxation of the partnership firm and the partners by the Finance Act,1992 and the Hon’ble Supreme Court has discussed the impact on the taxability of partnership firm and its partners and settled the controversy , brought in by the substantial amendments made by the Finance Act,1992.

The Finance Act, 1992, brought about far-reaching changes in the provisions of the Income-tax Act, 1961 pertaining to taxation of partnership firms. One of the major changes effected was that the remuneration and interest paid to a partner were made allowable deductions in calculation of the firm’s taxable income…

By the amendment introduced by the Finance Act, 1992 effective from April 1, 1993, the distinction between registered and unregistered firms has been removed and section 2(39) and section 2(48) of the Act have been omitted. A firm would be taxed as a separate entity and the share of the partner in the total income of the firm will not be included in calculating his total income, by virtue of section 10(2A) of the Act. Further, subject to section 40(b) of the Act, remuneration and interest paid to a working partner would be deductible from the income of the firm, but would be taxed in the hands of the partners by virtue of section 28(v) of the Act.

The assessee firm has contended that the said interest is nothing but profit of the firm , as the interest to partners is not allowed as deduction under Section 30 to 37 of the Act but u/s 40(b) of the Act and hence interest on capital paid to partner is nothing but statutory allowance and is part of allocable profits to the firm. This argument of the assessee firm is misconceived and fallacious. The Hon’ble Apex Court in the case of Munjal Sales Corporation v. CIT (2008) 168 Taxman 43(SC) has elaborately discussed the provisions of Section 30 to 38 of the Act vis-à-vis Section 40(b) of the Act and has settled the controversy by holding that interest paid to partners is an expenditure whereby claim of deduction u/s 36(1)(iii) of Act is to be firstly established by the taxpayer, and then Section 40(b)(iv) of the Act is not a standalone section but is a corollary section to Section 36(1)(iii) of the Act , restricting the deduction as per provisions of Section 40(b)(iv) of the Act.

… the contentions of the assessee firm that as per decision of Hon’ble Supreme Court in the case of CIT v. Walfort Share and Stock Brokers Private Limited (2010) 192 taxman 211 (SC) interest paid to partner on capital contribution cannot be treated as an ‘expenditure’ being incurred or attributable to earn exempt income u/s 14A of the Act as the said interest is itself not ‘expenditure’ but a ‘statutory allowance’ , cannot be accepted in view of the decision of the Hon’ble Apex Court in Munjal Sales Corporation(supra).

The Ahmedabad Tribunal after elaborately discussing the law in detail , after its amendment by the Finance Act,1992 has held that interest paid to partner on capital is an expenditure covered under the provisions of Section 36(1)(iii) of the Act and is not a statutory allowance u/s 40(b) of the Act and if this expenditure is incurred in relation to or attributable to earning of exempt income as envisaged u/s 14A of the Act, the same shall be allowed as an expense / deduction only against the exempt income earned by the taxpayer u/s 14 A of the Act or in other words shall suffer disallowance u/s 14A of the Act being incurred in relation to earning of an income which does not form part of the total income of the taxpayer.

We are bound by the decision of Hon’ble Supreme Court in the case of Munjal Sales Corporation (supra) and we also fully agree with the decision of Ahmedabad Tribunal in the case of Shankar Chemical Works(supra) . Moreover, under the new scheme of taxation of partnership firm introduced by the Finance Act,1992, the interest paid to the partner on capital has to be claimed as deduction u/s 36(1)(iii) read with Section 40(b) of the Act, from the income of the firm and if after allowing such interest , if the loss results in the hands of the firm, it will be allowed to be carried forward by the firm , while the partner shall be charged to tax for the total interest paid by the firm despite the fact that the firm could not claim the entire deduction due to absence of profits and resultant loss is to be carried forward to be set off against income of the subsequent years . Thus, we hold that interest paid by the assessee firm to the partners on capital contribution is covered as an ‘expenditure’ as envisaged u/s 36(1)(iii) of the Act and the assessee firm has to firstly establish its claim of deduction of interest on capital by satisfying the provisions of Section 36(1)(iii) of the Act and then, Section 40(b) of the Act puts limitation on allowability of interest once it passes the requirements of provisions of Section 36(1)(iii) of the Act and thus , interest paid to partners on capital contribution is not a statutory allowance u/s 40(b) of the Act but is an expenditure u/s 36(1)(iii) of the Act. Thus, if this expenditure is incurred in relation to the income which does not form part of the total income under this Act as envisaged u/s 14A of the Act, the same shall only be allowed as deduction only against the exempt income u/s 14A of the Act or in other words , such interest expenditure on the partner capital shall be disallowed u/s 14A of the Act. Our above discussions will also take care of the contention of the assessee firm that under the presumptive scheme of taxation under Section 44AD and 44AE of the Act, the salary and the interest payable to partner is deducted from the income of the firm computed under 44AD(1) and 44AE(1) of the Act , subject to the conditions and limits specified in clause (b) of section 40 , rather this contention of the assessee support the stand that the salary and interest payable to partners are an ‘expenditure’ covered under Section 30 to 37 of the Act as held by Hon’ble Supreme Court in Munjal Sales Corporation(supra).

Thus, we hold that the interest on partner’s capital to the tune of Rs.12,66,679/- as computed by the AO u/s 14A of the Act read with Rule 8D of the Income Tax Rules, 1962 is an expenditure , which is allowable as an expenditure being incurred by the assessee firm in relation to an income which does not form part of the total income of the assessee firm under the Act , and shall be allowed as deduction from the dividend income from Mutual Funds earned by the assesse firm as envisaged u/s 14A of the Act and shall go to reduce the exempt income earned by the assessee firm from dividend income from Mutual Funds as computed by the AO after applying provisions of Section 14A of the Act read with Rule 8D of Income Tax Rules, 1962 or in other words we uphold the disallowance of interest on partners capital to the tune of Rs 12,66,679/- u/s 14A of the Act read with Rule 8D(2)(ii) of Income Tax Rules,1962.. We further hold that these allowance / deduction of expenditure of Rs.12,66,679/- against the exempt income u/s 14A of the Act or in other disallowance u/s 14A of the Act, will not entitle the partner to claim relief in their individual return of income which shall be chargeable to tax as per the existing and applicable provisions of Section 28(v) of the Act read with Section 2(24)(ve) of the Act after including the afore-said interest income in the hands of the partners.

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Interest paid on Partner’s capital also covered for disallowance u/s 14A and Rule 8D for expenditure incurred in relation to exempt income-ITAT | 04-02-2016 |

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