“RESTRUCTURING THE TAXATION OF FIRMS

49. Under the existing provisions of the Income-tax Act, the tax liability of the firm and partners depends upon whether the firm is granted registration under the Income-tax Act or not. In the case of a registered firm, the firm is assessed to income tax at special rates and the partners are assessed on their share income from the firm at the normal rates. However, the tax payable by the firm is allowed as a deduction before the apportionment of profits. The unregistered firm is taxed at the rates applicable to individuals, with the share income included in the hands of the partners for rate purposes only. This procedure results in complexities in the assessment of firm and partners apart from double taxation of the same income.

With a view to avoiding the above criticism, a new scheme of income tax assessment of firms is proposed. The salient features of the proposed scheme is as under:

(a) the firm will be taxed as a separate entity. There will be no distinction between registered and unregistered firms;
(b) the share of the partner in the income of the firm will not be included in computing his total income;
(c) any salary, bonus, commission, remuneration, by whatever name called, which is due to received by a partner will be allowed as a deduction subject to certain restrictions; …”. (Emphasis supplied)

Nature of income in the hands of the partner

A partner may receive “share in profits”, in various forms. It could be:

• Share in profit
• Remuneration
• Interest
• Other payments

Hon'ble Supreme Court considered the nature of share of profit which a partner gets from the firm in case of CIT vs. R.M. Chidambaram Pillai (1977) 106 ITR 292. It held that payment of salary to a partner represents a special share of profits and it retains the same character that of the income of the firm.

Hence, basically, interest, remuneration and share profit from firm, all are business income but law only provides that what is deductible in case of the firm is taxable in the hand of partners.

Exemption ?!?

The Finance Act, 1992, while amending the scheme of taxation of firm and partners, inserted sub-section (2A) in section 10, which provides: “In computing the total income of a previous year of any person, any income falling within any of the following clauses shall not be included – …”, to provide that in case of Partner of a firm assessed as such, his share in the total income of the firm assessed as such shall not be included in his total income.

Section 10(2 A) of the Act reads as follows:

“In computing the total income of the previous year of any person, any income falling within any of the following clauses shall not be included –

(2A) in the case of a person being a partner of firm which is separately assessed as such, his share in the total income of the firm”. (Emphasis supplied)

It may be noted from the provision that the reason for exclusion of the share in profit is spelt out by the Legislature in the provision itself. Such exclusion operates only in a case where the share in profits is derived from a firm, which is assessed as such.

Thus, it may be noted that:

• The entire profits of the firm (which is not a legal entity but separately assessed for the purposes of tax) are taxed in the hands of the firm.

• Only that share of profit, which suffers tax in the hands of the firm, is excluded in computing total income, so as to avoid double taxation of the same income.

• In other words, unlike the other exemption provisions, the provisions of sub-section (2A) of section 10 seek to avoid double taxation and it does not provide for exemption implying no tax on such income.

As such, there was no necessity of such a provision inasmuch as it is a clear position that the same income cannot be assessed twice. As may be noted, even the Memorandum states that to avoid double taxation, the new scheme of taxation has been envisaged.

Unless a clear intention to do so is spelt out by the Legislature, once the profits are chargeable in the hands of the firm, on what basis the same could be again charged in the hands of its partners is not clear.

Prior to the amendment, to illustrate, section 182 permitted inclusion of share of a partner in the firm for the purposes of assessment to tax and section 67 provided the method of allocation. The said provisions have been omitted.

In the circumstances, it seems, the provision is only by way of clarification and basically, it seems, provides for the manner of quantification of share of profits not includible in the hands of a partner of a firm assessed as such.

A receipt may not be income at all and yet it may be included in the express exemption, like, section 10, out of abundant caution. In the context, the following observations, at Page 439, The Law and Practice of Income-tax” (Ninth Edition) by Kanga, Palkhivala and Vyas, may be noted (reproduced below):

“A receipt may not be `income’ at all within the proper connotation of that term and yet may come within the express exemption in this section, due to the over-anxiety of the draftsman to make the fact of non-taxability clear beyond possibility of doubt1.
It may thus be noted that:

• In case of a firm, its income is either taxed in the hands of the firm or the partners.
• In the hands of the partners, it is not included to avoid double taxation.
• It is not a case where the income does not suffer any tax at all.
• In fact, it is a case where the income does suffer tax, either in the hands of the firm or the partners.

Allowability of expenses in case of partners

Needless to say that any expenditure incurred by a partner for the purposes of discharging his duties as a partner in the course of carrying on of the business of the firm is allowable2 in computing his income, subject to fulfilment of the necessary conditions. Accordingly, for the present purpose, it is not necessary to go into the details thereof.

Section 14A

It is analysed in other articles. For the present purpose, one needs to note the language of the provision and the objective of inserting the provision.

The provision reads as follows:

“(1) For the purposes of computing the total income … no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income which does not form part of the total income under this Act”.

Broadly stated, it applies where expenditure is in relation to exempt income.

The objective behind the introduction of the section, as explained in the Memorandum explaining the provisions of the Finance Bill, 2001 as well as in the Explanatory Circular issued by the Board3 is as follows:

“Certain incomes are not includible while computing the total income as these are exempt under various provisions of the Act. There have been cases where deductions have been claimed in respect of such exempt income. This in effect means that the tax incentive given by way of exemptions to certain categories of income is being used to reduce also the tax payable on the non-exempt income by debiting the expenses incurred to earn the exempt income against taxable income. This is against the basic principles of taxation whereby only the net income, i.e., gross income minus the expenditure, is taxed. On the same analogy, the exemption is also in respect of the net income. Expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income.” (Emphasis supplied)

It may be noted from the provisions as well as the Explanation issued by the authorities that:

• The objective of the provision is not to allow expenditure relating to exempt income against taxable income.

• The expenditure must relate to the income that does not form part of total income. In other words, the expenditure must relate to the income that does not suffer any tax.

• Thus, there must be a direct nexus between the expenditure incurred and the income, which does not form part of the total income.

• Only such expenditure can be disallowed, in terms of the objective of the provision, which pertains to the exempt income. In other words, the objective is to allow expenditure not relating to non-taxable income.

Income from firm, whether exempt

It may be noted from the above discussion that “share in profits of firm”, as such, does form part of total income of the firm; but, not of a Partner.

For the purpose, the Legislature has given a reason, namely, to avoid double taxation.

Accordingly, it cannot be said that the share in profits of firm does not form part of total income or does not suffer tax.

The income, per se, is taxed at the option of the Legislature in the hands of the firm. The other income, like, interest and remuneration also represents share in profits, is taxed in the hands of the partners. Further, the Act also contains provisions to the effect that where the tax liability cannot be recovered from the firm, it can be recovered from the partners and all the partners are jointly and severally liable to discharge the liability. Also, when the share in profits is allocated among the partners, it is after-tax. Thus, the partners suffer the tax paid by the firm.

In terms of the objective of the amendment, it cannot be said that the expenditure pertains to an item of income, which does not suffer any tax at all, and the expenditure is claimed as allowable in computing other income, so as to reduce the effective burden of tax.

Whether disallowance can be made

For the aforesaid reasons, it is submitted that the expenditure incurred by a partner cannot be disallowed under section 14A of the Act.

The above view and some of the reasoning are also supported by the decision of Hon'ble Tribunal in Hitesh D. Gajaria vs. ACIT 11(2), I.T.A. No. 993/Mum/2007 (A.Y.2003-04), and, the following observations need to be noted:

4. We have considered the arguments of the parties and perused the material placed before us. We find that similar issue was considered by ‘C’ Bench of the Mumbai Tribunal vide order dated 26th February, 2007 in the case of Shri Sudhir Kapadia vs. ITO in ITA No.7888/M/03 and the Tribunal dealt with the issue in the following manner.

“4. ITAT, Mumbai bench `J’ in the case of Sudhir Dattaram Patil vs. DCIT 2 SOT 678 (Mum) has considered the question …. The Tribunal held that the salary from the firm in which the assessee is a partner is in the nature of business income u/s. 28(v) and therefore, interest paid by the partner on money borrowed for contributing capital has to be allowed as deduction in the hands of the assessee. In respect of the nature of the share in the profits of a firm, in the hands of the partner, the Supreme Court has considered the issue in the case of CIT, Madras vs. R.M. Chidambaram Pillai 106 ITR 292 the court was examining the nature of share of profits received by a partner. The court held that a firm is not a legal person even though it has some attributes of personally. In Income Tax law a firm is a unit of assessment, by special provisions, but is not a full person. Since a contract of employment requires two distinct persons, the employer and the employee, there cannot be a contract of service, in strict law between a firm and one of its partners. Payment of salary to a partner represents a special share of the profits. Salary paid to a partner retains the same character of the income of the firm. …

5. … we find that the claim made by the assessee is acceptable in law. The Supreme Court … has held that salary paid to a partner retains the same character as income of the firm. This leads us to the next step; i.e., the share of profits received by the partner from the firm retains the same character of the income of the firm; i.e., the share income retains the character of business income. The said business income is exempt from the levy of tax only in the hands of the assessee, but it is taxable in the hands of the firm. The assessee partner gets its share of profit from the firm after firm has been subjected to tax in its hands. Therefore, it is not possible to hold the view that the share income in the hands of a partner is all together tax free on the other hand the share is tax suffered income in the hands of the firm. Therefore, sec. 14A is not applicable in that case. The share income of the firm is exempt from the tax u/s.10(2A) not in the absolute sense. It is only to avoid double taxation, once in the hands of the firm and secondly in the hands of the partner. Therefore we find that the provisions of section 14A would not apply to the assessee / partner and it is not necessary for the Assessing Authority to disallow the proportionate expenditure from the claim of the assessee. …”

We find that the issue is also covered in favour of the assessee by the decision of “E” Bench of the Tribunal in the case of Shri Bharat S. Raut in ITA No. 9212/Mum/2004 and CO No. 212/Mum/2005 vide order dated 25th June, 2008. Thus, respectfully following the precedent we delete the disallowance.”

Having dealt with the principles, one may now consider the specific situations.

Where interest is paid and received and direct nexus can be established between the borrowing and investment in firm, it cannot be said that the interest paid is in relation to income that does not form part of total income. Accordingly, it appears, it cannot be disallowed. In any case, having regard to the above view as well as the decision of the Tribunal, it cannot be disallowed.

Where partner receives remuneration and pays interest and the nexus between the borrowing and investment in firm can be established, it appears, it cannot be disallowed, having regard to the above view as well as the decision of the Tribunal.

Where partner receives interest and/or remuneration and incurs expenditure and the nexus between the expenditure incurred and carrying on of business in partnership can be established, it cannot be disallowed under section 14A of the Act, having regard to the above view as well as the decision of the Tribunal.

 

Article  by  CA. Pradeep S. Shah