2023 (6) TMI 1110 - AT - Income Tax

Interest on capital paid to the partner - payment of interest by the two partnership firms towards use of partners capital - Expenditure incurred on account of commercial expediency or not? - whether is in the nature of expenditure or not for the purpose of section 36(1)(iii) read with section 40(b) or whether interest payment is allowable under the provisions of the Income Tax Act? - As argued if at all any disallowance has to be made in the hands of the firm, the same cannot be taxed in the hands of concerned partners - HELD THAT - When the partnership firm and its partners are seen holistically and in combined manner, the payment of interest to partners and its allowability in the hands of the partners does not lead to deriving of any additional advantage by a firm since the same interest is taxable in the hands of the partners simultaneously. Being so, in our opinion, the interest payment to partners by these firms to be allowed as a deduction while computing the income of these firms. However, the same shall be limited to the extent of allowability u/s 40(b) of the Act. in the present case, in the assessment years 2011-12, 2012-13, 2016-17 and 2017-18 has been allowed. The same cannot be questioned in the assessment years 2013-14 to 2015-16. Similarly, in the case of M/s. Century Silicon City it has been allowed in the assessment years 2012-13, 2016-17 2017-18. Hence, it cannot be questioned in the assessment years 2013-14 to 2015-16 and the revenue cannot be allowed to take different view in different assessment year as the judicial discipline requires consistency in these proceedings. On this count also, this disallowance is not justified. From the proviso to section 28 (v) of the Act, it is seen that if there is any disallowance of interest in the hands of the firm due to clause (b) of section 40, income in the hands of the partner has to be adjusted to the extent of the amount not so allowed to be deducted in the hands of the firm. Hence, it is seen that the operation of the proviso to section 28(v) of the Act will come into play only if there is some disallowance in the hands of the firm under clause (b) of section 40 of the Act. In our opinion, the argument of the ld. A.R. is justified. Therefore, on this count we are of the opinion that since the amount has been taxed in the hands of partners u/s 28(v) of the Act same to be allowed in the hands of the assessee u/s 40(b) of the Act, otherwise it amounts to double taxation. In the present case, it is not the case of either of the parties interest payment is not exceeding the limit provided in section 40(b) - Hence, we direct the AO to allow the deduction to the extent of limit prescribed in section 40(b) of the Act. It is needless to mention herein that what is allowed in the hands of these assessees u/s 40(b)(iv) of the Act as a deduction, same to be taxed in the hands of the respective partners u/s 28(v) of the Act. In view of the above, we allow the grounds of appeals raised by both the assessees.

Summary

Issues Involved:
1. Disallowance of interest on capital paid to partners.
2. Applicability of sections 36(1)(iii), 37, and 40(b) of the Income Tax Act.
3. Legitimacy of the revaluation of assets and its impact on tax liability.
4. Allegation of the use of a colourable device to evade taxes.

Summary:

1. Disallowance of Interest on Capital Paid to Partners:
The appeals concern the disallowance of Rs. 4,80,00,000/- on account of interest on capital paid to partners. The assessees argued that the interest payment was for business purposes and commercially expedient. The Assessing Officer (AO) and CIT(A) disallowed the interest, stating it was not incurred wholly and exclusively for business purposes and was a colourable device to transfer money and reduce tax liability.

2. Applicability of Sections 36(1)(iii), 37, and 40(b) of the Income Tax Act:
The AO and CIT(A) held that the interest expenditure was not allowable under section 37(1) or section 36(1)(iii). The CIT(A) clarified that the admissibility of interest paid to partners is governed by section 40(b)(iv) and not by sections 36(1)(iii) or 37. The Supreme Court in Munjal Sales Corporation Vs CIT (2008) stated that section 40(b)(iv) places limitations on deductions under sections 30 to 38, and the assessee must establish entitlement under section 36(1)(iii) and not be disentitled under section 40(b)(iv).

3. Legitimacy of the Revaluation of Assets and Its Impact on Tax Liability:
The CIT(A) found that the revaluation of assets and transfer of Rs. 40 Crore to retiring partners was a colourable device to transfer money from M/s Century Real Estate Holdings Pvt Ltd to its Directors, avoiding Dividend Distribution Tax and reducing tax liability in the hands of the firm. The revaluation lacked economic rationale and was not in accordance with accounting principles for all partners.

4. Allegation of the Use of a Colourable Device to Evade Taxes:
The CIT(A) and AO concluded that the transaction was a colourable device to evade taxes, citing the Supreme Court's decision in Mc Dowell and Company Ltd Vs CTO (1985), which condemned tax avoidance through dubious methods. The CIT(A) emphasized the moral obligation to pay taxes honestly and the role of courts in exposing tax avoidance schemes.

Judgment:
The Tribunal allowed the appeals, directing the AO to allow the deduction of interest paid to partners under section 40(b) to the extent of the prescribed limit and to tax the same in the hands of the partners under section 28(v). The Tribunal emphasized consistency in judicial proceedings, noting that similar deductions were allowed in other assessment years. The Tribunal rejected the application of the Shankar Chemicals Works case, as it was not relevant to the facts of the present case. The appeals were allowed, and the order was pronounced on 10th Mar, 2023.