1997 (3) TMI 10 - SC - Income Tax

Interest paid by the firm to a partner (as kartha of HUF) in his individual capacity - assessee s claim to the benefit of clause (b) of section 40 has been wrongly disallowed

Summary

Issues:
Interpretation of section 40(b) of the Income-tax Act, 1961 regarding disallowance of interest paid to partners in a firm.

Analysis:
The case involved the interpretation of section 40(b) of the Income-tax Act, 1961, specifically focusing on the disallowance of interest paid to partners in a firm. The assessee-firm contended that the interest paid to partners in their individual capacity should not be included while computing the income chargeable under the head "Profits and gains of business or profession." The firm maintained separate ledger accounts for partners, distinguishing between individual loans and Hindu undivided family investments. Despite the claim, the Income-tax Officer disallowed the claim under section 40(b) and included the interest paid in the firm's income.

The matter was taken to the Appellate Assistant Commissioner and then to the Income-tax Appellate Tribunal, which upheld the Income-tax Officer's decision. Due to conflicting views among High Courts on the application of section 40(b), the issue was referred to the Supreme Court for clarification.

In a previous case, Brij Mohan Das Laxman Das v. CIT, the Supreme Court had considered a similar issue. The court highlighted the amendment to section 40 by the Taxation Laws (Amendment) Act, 1984, which added Explanation 2 clarifying the treatment of interest paid to partners. The court emphasized that a firm and its partners have distinct legal identities, and a partner cannot be a debtor or creditor of the firm. The court concluded that even before the 1984 amendment, interest paid to a partner representing a Hindu undivided family on personal funds deposited with the firm does not fall under section 40(b).

Citing the above precedent, the Supreme Court in the present case ruled in favor of the assessee, holding that interest paid to partners in their individual capacity, specifically when representing a Hindu undivided family, is not subject to disallowance under section 40(b). The court emphasized the distinct legal entities of partners and firms, and the legislative intent behind Explanation 2 to clarify the treatment of such transactions. Consequently, the court answered the referred question in favor of the assessee, with no order as to costs.