1990 (2) TMI 1 - SC - Income Tax

Firm - interest paid by partner on funds withdrawn from the firm - held that such interest should be excluded from interest paid to partner before disallowance u/s40(b)

Summary

Issues Involved:
1. Whether, in making a disallowance of the interest paid by a partnership firm to a partner under section 40(b) of the Income-tax Act, 1961, the interest paid by the partner on his borrowings from the firm should be taken into account and deducted, and only the balance disallowed under section 40(b).

Detailed Analysis:

Issue 1: Disallowance of Interest Paid by Partnership Firm to Partner under Section 40(b)

The Supreme Court addressed the question of whether, in making a disallowance of the interest paid by a partnership firm to a partner under section 40(b) of the Income-tax Act, 1961, the interest paid by the partner on his borrowings from the firm should be taken into account and deducted, and only the balance disallowed under section 40(b).

Background and Divergence of Judicial Opinion:
The High Courts have shown a sharp divergence of judicial opinion on this matter. The Allahabad, Andhra Pradesh, Karnataka, Rajasthan, and Punjab & Haryana High Courts have taken the view that only the net amount of interest paid by the firm to the partner is liable to disallowance under section 40(b). Conversely, the Madras High Court in CIT v. O. M. S. S. Sankaralinga Nadar and Co. [1984] 147 ITR 332 has taken a contrary view.

Facts of the Case:
The appellant, a registered firm, paid interest to its partners and also received interest from them on their borrowings. The Income-tax Officer disallowed the entire interest paid to the partners without setting off the interest received from them. The Appellate Assistant Commissioner and the Income-tax Appellate Tribunal allowed the set-off, but the High Court reversed this decision, relying on its earlier pronouncement in Sankaralinga Nadar's case.

Statutory Provisions:
Section 40(b) of the Income-tax Act, 1961, as it stood before the 1984 amendment, disallowed any payment of interest by a firm to a partner. The 1984 amendment introduced Explanation I, which limited the disallowance to the net amount of interest paid by the firm to the partner.

Arguments and Contentions:
- Contention (a): The appellants argued that the scheme of section 40 aims to ascertain the 'real income' of the firm and does not intend to penalize it for non-deductible outgoings. The court, however, rejected this argument, emphasizing the mandatory language of section 40(b) and the need for a strict interpretation.
- Contention (b): The appellants contended that the judicial interpretation of similar provisions in the 1922 Act should apply to section 40(b) of the 1961 Act. The court found this argument inapplicable as the earlier decision did not rest on any special or technical connotation of the word "interest."
- Contention (c): The appellants argued that interest paid to and received from a partner are integral parts of the same transaction and should be treated as such. The court accepted this argument, stating that if the transactions are shown to have the element of mutuality and are referable to the funds of the partnership, the net interest should be considered for disallowance under section 40(b).
- Contention (d): The appellants argued that the 1965 Circular of the Central Board of Direct Taxes, which supported their view, should be binding. The court held that while circulars beneficial to assessees are binding on authorities, they do not bind the Tribunal or the High Court in interpreting the law.
- Contention (e): The appellants argued that the 1984 amendment was a legislative exposition of the existing law. The court found that the express prospective operation of the amendment indicated it was intended as a change in the law rather than a clarification.

Conclusion:
The Supreme Court allowed the appeals, set aside the High Court's orders, and held that the net interest paid by the firm to the partner should be considered for disallowance under section 40(b). The question of law was answered in the affirmative, supporting the appellants' contention that only the net interest should be disallowed. The appeals were allowed without any order as to costs.