2024 (1) TMI 413 - AT - Income Tax

Disallowance of interest u/s. 36(1)(iii) - loan borrowed for the purpose of settling outgoing partners capital account - character of loan borrowed - HELD THAT - Interest paid on capital account of partners partakes the nature of funds borrowed for the purpose of business of the assessee and consequently, interest paid on said capital account needs to be allowed as deduction u/s. 36(1)(iii) of the Act. In so far as interest paid on loan borrowed from Punjab National Bank, the AO has not disputed that the assessee s firm has borrowed Rs. 19 Crs. loan from Punjab National Bank. The said loan has been borrowed for the purpose of business of the assessee s firm, because, the firm was carrying on the business of running hotel called the Hotel President which was owned by the partnership firm which is evident from the financial statement of the assessee for earlier years where the property is in the name of partnership firm and the assessee has claimed depreciation on building. Loan from Punjab National Bank has been borrowed to settle the capital account of retiring partners. As we have already stated in our earlier part of this order, unless the firm settle the outgoing partners capital account, which is nothing but a debt of the firm business cannot be run smoothly, because, the entire business of the assessee is running a hotel. Therefore, in our considered view, any loan borrowed for the purpose of settling outgoing partners capital account which has been treated as debt in the books of accounts of the firm assumes the character of loan borrowed for the purpose of business of the assessee, and consequently, interest paid on borrowed capital account is allowable deduction u/s. 36(1)(iii) of the Act. Sole basis for the AO to disallow interest paid on partners capital account and loan borrowed from Punjab National Bank is on the ground that payment to outgoing partners is nothing but family settlement - AO and CIT(A) were completely erred in coming to the conclusion that reconstitution of partnership firm to retire partners and settle their account cannot be considered as family settlement, because, asset was brought into the books of accounts of the partnership firm. Further, the firm has developed the property and exploited the property for the purpose of running its business. The firm has claimed depreciation on building, on which, the hotel was constructed and managed. Therefore, when the asset was owned by the partnership firm, any settlement out of assets belong to the firm to the outgoing partners, cannot be considered as settlement of family property, just because, the partners were family members. Therefore, it is very clear that retired partners taking a portion of value of firm s assets and thus, just because, the asset has been revalued before reconstitution of partnership firm, cannot be a reason for the AO to treat the settlement of firm properties among partners as settlement of family property. As relying on Narayanappa v. Bhaskara Krishnappa 1966 (1) TMI 75 - SUPREME COURT share of partner in partnership assets means his proportion share in the assets of the firm is net of liabilities. Therefore, when the outgoing partners are taking out their share in the assets of the firm, the Fair Market Value of the assets needs to be ascertained. In the present case, the assessee has revalued the assets to ascertain the Fair Market Value of the assets of the firm before settlement of retiring partner s shares in the proportionate assets of the firm. Therefore, we are of the considered view that the AO and the CIT(A) erred in holding that settlement to partners is a family settlement and the same cannot be considered as settlement of firm assets. We are of the considered view that there is no dispute with regard to the fact that the sole business of the partnership firm is running hotel and said business was owned by the partnership firm. On retirement, the outgoing partners has been paid their proportionate share in the assets of the partnership firm. The firm has borrowed loan from Punjab National Bank and raised fresh capital from incoming partner to settle the debt/capital account of retiring/outgoing partners. The settlement of capital account of outgoing partners becomes debt of partnership firm and discharge of said debt out of borrowed funds assumes the character of loans/funds borrowed for the purpose of business of the assessee. Since, the loan borrowed from the Bank and capital raised from incoming partner is for the purpose of business of the assessee, any interest paid on said loan and capital account is nothing but interest paid on loan borrowed for the purpose of business of the assessee and allowable u/s. 36(1)(iii) - AO and the Ld.CIT(A) without appreciating the relevant facts simply disallowed interest paid on partners capital account and interest paid on loan from Bank. Therefore, we direct the AO to delete the additions made towards disallowance of interest u/s. 36(1)(iii) of the Act. Appeal filed by the assessee is allowed.

Summary

Issues Involved:
1. Disallowance of interest paid to partner Smt. Hameeda Banu.
2. Disallowance of interest paid to Punjab National Bank.
3. Treatment of the transaction as a family settlement versus a business settlement.
4. Adequacy of the opportunity given before passing the impugned order.

Summary:

1. Disallowance of Interest Paid to Partner Smt. Hameeda Banu:
The assessee argued that the interest paid on the capital account of Smt. Hameeda Banu should be allowed as a deduction under Section 36(1)(iii) of the Income Tax Act. The AO disallowed the interest on the grounds that the capital was used to repay the credit balances of outgoing partners, which were artificially created through revaluation of the firm's assets. The CIT(A) upheld this disallowance, terming the transaction a family settlement rather than a business expense.

2. Disallowance of Interest Paid to Punjab National Bank:
The assessee contended that the interest paid on the loan borrowed from Punjab National Bank was for business purposes, specifically to settle the credit balances of retiring partners. The AO disallowed this interest, asserting that the borrowed funds were not utilized for the business but for repaying artificially created liabilities. The CIT(A) confirmed this disallowance, agreeing with the AO's assessment that the transaction was a family settlement.

3. Treatment of the Transaction as a Family Settlement Versus a Business Settlement:
The AO and CIT(A) considered the revaluation of assets and subsequent payments to outgoing partners as a family settlement. They argued that the partnership deed did not detail the payment terms to the outgoing partners, and thus, the transaction was not a business expense. The Tribunal disagreed, stating that the revaluation was necessary to ascertain the fair market value of the assets for settling the outgoing partners' shares. The Tribunal held that the settlement was for business purposes and not merely a family arrangement.

4. Adequacy of the Opportunity Given Before Passing the Impugned Order:
The assessee claimed that there was no proper opportunity given before passing the impugned order, violating the principles of natural justice. The Tribunal did not specifically address this issue in detail but focused on the substantive grounds of disallowance.

Conclusion:
The Tribunal held that the interest paid on the capital account of the partner and the loan borrowed from Punjab National Bank were for business purposes and allowable as deductions under Section 36(1)(iii) of the Income Tax Act. The AO and CIT(A) were directed to delete the additions made towards the disallowance of interest. The appeal filed by the assessee was allowed.