2016 (10) TMI 56 - AT - Income Tax

Addition u/s 14A - source of funds for investment made in mutual funds - interest paid to its partners - when loan taken from the partners would be held as own funds or borrowed funds for the purpose of Section 14A - since, interest on capital is taxable in hands of partners and disallowance will lead to double taxation in hands of partner as well as firm. - Held that - It is clear from the above that firm and partners of the firm are not separate person under Partnership Act although separate unit of assessment for tax purposes. There cannot therefore be a relationship inferred between partner and firm as that of lender of funds (capital) and borrowal of capital from the partners, hence section 36(1)(iii) is not applicable at all. Section 40(b) is the only section governing deduction towards interest to partners. In the light of what is already noted above that firm and partners not being two separate persons, the question of borrowing capital by the firm from its partners does not arise at all and, therefore, section 36(1)(iii) is not at all applicable for the purposes of computation of interest to partners under section 40(b) of the Act. To put it differently, in view of section 40(b) of the Act, the Assessing Officer purportedly has no jurisdiction to apply the test laid down under section 36 of the Act to find out whether the capital was borrowed for the purposes of business or not. Thus, the question of allowability or otherwise of deduction does not arise except for S. 40(b) of the Act. As per the scheme of the Act, the interest paid by the firm and claimed as deduction is simultaneously susceptible to tax in the hands of its respective partners in the same manner. In the same vain, the firm is merely a compendium of its partners and its partners do not have separate legal personalities under the basic law as discussed. The interest paid to partners and simultaneously getting subjected to tax in the hands of its partners is merely in the nature of contra items in the hands of the firms and partners. Consequently interest paid to its partners cannot be treated at par with the other interest payable to outside parties. Thus, in substance, the revenue is not adversely affected at all by the claim of interest on capital employed with the firm by the partnership firm and partners put together. Thus, capital diverted in the mutual funds to generate alleged tax free income does not lead to any loss in revenue by this action of the assessee. In view of the inherent mutuality, when the partnership firm and its partners are seen holistically and in a combined manner with costs towards interest eliminated in contra, the investment in mutual funds generating tax free income bears the characteristic of and attributable to its own capital where no disallowance under S. 14A read with Rule 8D is warranted. Consequently, the plea of the assessee is merited in so far as interest attributable to partners. However, the interest payable to parties other than partners, in our view, would be subjected to provisions of Rule 8D(2)(ii) of the Rules. Similarly, in the absence of any specific plea from assessee towards disallowance under Rule 8D(3), we hold it sustainable in view of express mandate of law. The matter is accordingly remanded back to the file of the Assessing Officer for re-computation of disallowance under Rule 8D r.w.s. 14A of the Act in terms of our opinion expressed hereinabove.

Issues Involved:
1. Invocation of section 14A of the Income-tax Act, 1961.
2. Disallowance of interest and other common expenses attributable to tax-free dividend income.
3. Nature of interest on partner’s capital as an expenditure.
4. Double taxation concerns due to disallowance of interest on partner’s capital.

Detailed Analysis:

1. Invocation of section 14A of the Income-tax Act, 1961:
The Assessing Officer invoked section 14A to disallow expenses related to earning tax-free dividend income from mutual funds. The assessee argued that the interest on partner’s capital should not be considered an expenditure under section 14A, as it is a statutory allowance under section 40(b) of the Act. The CIT(A) upheld the Assessing Officer's decision, noting that the interest on partner’s capital, which was used for tax-free investments, should be disallowed under section 14A.

2. Disallowance of interest and other common expenses attributable to tax-free dividend income:
The Assessing Officer observed that the assessee had invested in mutual funds using interest-bearing funds, including partner’s capital, and disallowed a proportionate amount of interest and common administrative expenses under Rule 8D of the Income Tax Rules. The CIT(A) confirmed this disallowance, stating that expenses related to tax-free income must be disallowed under section 14A.

3. Nature of interest on partner’s capital as an expenditure:
The assessee contended that interest on partner’s capital is not an expenditure but a statutory allowance under section 40(b), similar to depreciation on business assets. The Tribunal noted that interest on partner’s capital is not treated as an allowable business expenditure except under section 40(b). The Tribunal referred to the Supreme Court's decision in CIT vs. R.M. Chidambaram Pillai, which held that salary and interest paid to partners represent a special share of profits and are taxable as business income.

4. Double taxation concerns due to disallowance of interest on partner’s capital:
The assessee argued that disallowing interest on partner’s capital would lead to double taxation, as the interest is already taxed in the hands of the partners. The Tribunal acknowledged this concern, noting that the interest paid to partners and taxed in their hands is merely a contra item in the hands of the firm and partners. The Tribunal concluded that interest on partner’s capital should not be disallowed under section 14A, as it does not adversely affect revenue when viewed holistically with the partners.

Conclusion:
The Tribunal held that interest attributable to partners should not be disallowed under section 14A, but interest payable to parties other than partners would be subject to Rule 8D(2)(ii). The Tribunal remanded the matter back to the Assessing Officer for re-computation of disallowance under Rule 8D r.w.s. 14A. The appeal of the assessee was partly allowed.

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