Clause (b) of Section 40 of the Income Tax Act specifies one of the amounts which shall not be deducted in computing the income chargeable under the head "Profits and gains of business or profession". As it stood at the relevant time, It read thus:
"40 Notwithstanding anything to the
contrary in sections 30 to 39, the
following amounts shall not be
deducted in computing the income
chargeable under the head ‘Profit
and gains of business or
profession’,-
(b) in the case of any firm, any
payment of interest, salary, bonus,
commission or remuneration made by
the firm to any partner of the
firm.
Explanation 1: Where interest is
paid by a firm to any partner of
the firm who has also paid interest
to the firm, the amount of interest
to be disallowed under this clause
shall be limited to the amount by
which the payment of interest by
the firm to the partner exceeds the
payment of interest by the partner
to the firm.
Explanation 2: Where an individual
is a partner in a firm on behalf,
or for the benefit, of any other
person [such partner and the other
person being hereinafter referred
to as ‘partner in a representative
capacity’ and person so
represented’ respectively],-
(i) interest paid by the firm to
such individual or by such
individual to the firm otherwise
than as partner in a representative
capacity, shall not be taken into
account for the purposes of this
clause;
(ii) Interest paid by the firm to
such individual or by the firm to
the firm as partner in a
representative capacity and
interest paid by the firm to the
person so represented or by the
person so represented to the firm,
shall be taken into account for the
purposes of this clause.
Explanation 3: Where an individual
is a partner in a firm otherwise
than as partner in a representative
capacity, interest paid by the firm
to such individual shall not be
taken into account for the purposes
of this clause, if such interest is
received by him on behalf, or for
the benefit, of any other person."
The first and the main question arising herein is whether interest paid to a partner on the amounts deposited by him individual deposited by him in individual capacity is hit by clause (b) where the partner is a partner not in his individual capacity but as representing a Hindu Undivided Family [H.U.F.] The question which was referred by the Tribunal for the opinion of the High Court in this behalf read:
"Whether the Tribunal was correct
in allowing the assessee’s claim
for interest paid on the credit
balance in the individual account
of Sri Rajendra Kumar ?"
The assessee, Brij Mohan Das Laxman Das, is a registered partnership firm having three partners. One of them is Rajendra Kumar. He was a partner as the Karta of and representing his H.U.F. The partnership firm maintained two accounts in the name of Rajender Kumar, a capital account and a deposit account. The share of profit of Rajendra Kumar was credited to the capital account while the interest paid to him on the deposits made by him was credited to his deposit account. In other words, the deposits were said to have been made by Rajendra kumar in his individual capacity and accordingly interest was paid to him in his individual capacity. Rajendra Kumar was assessed in the status of individual and also in the status of H.U.F. For the Assessment Year 1974-75, the Income Tax Officer called upon the assessee herein to show cause why the interest amount in a sum of Rs.7,923/- paid to Rajendra Kumar be not added back to the income of the partnership firm since it was a payment made to a partner. The appellant-assessee contended that since the amount was paid to Rajendra Kumar in his individual capacity and not in his capacity as a partner, the said payment cannot be disallowed under clause (b) of Section 40. This pals was rejected by the Income Tax Officer and his view was affirmed in appeal by the Appellate Assistant Commissioner. On further appeal, however, the Tribunal agreed with the assessee and deleted the said addition.
On reference, the High Court held following its earlier decision in Commissioner of Income Tax v. London Machinery Company [(1979) 117 I.T.R. 111] that the amount was rightly disallowed by the Income Tax Officer and that the Tribunal was not right in allowing the assessee’s appeal. The High Court has, however, certified the case under Section 261.
It may be mentioned that Explanations 1,2 and 3 to the above clause were added by the Taxation Laws [Amendment] Act, 1984 with effect from April 1, 1985. Explanation expressly that where an individual is a firm on behalf of or for the benefit of any other person, any interest paid by the firm to such individual otherwise then as partner in representative capacity, shall not be taken into account for the purpose of clause (b). It is, therefor, clear that with effect from April 1, 1985, the question of the nature involved herein would not arise. Where a person is a partner in a representative capacity, i.e., as representing H.U.F., any interest paid to him in him individual capacity will not be hit by clause (b) The only question is what is the position earlier to April 1, 1985 - which is the case here. Prior to the introduction of the said Explanation, there was a conflict of opinion amount the several High Courts in the Country, the majority of High Courts taking the view in favour of the assessee and a few High Counts taking the contrary view. There was no decision of the Supreme Court on this question. The Taxation Laws [Amendment] Act which introduced the said Explanation does not say that the said Explanation shall have effect retrospectively. The question is whether the said Explanation is merely declaratory and clarificatory in nature, in which case it will govern the previous assessment years as well or whether is a substantial provision having effect only prospectively.
In Gajanand Poonam Chand v. Commissioner of Income Tax [Tax [(1984) 174 I.T.R.346], the Rajasthan High Court has taken the view that the said Explanation is merely declaratory in mature and that, therefore, even for the assessment years prior to April 1, 1985 the position of law should be understood to be the same. In support of this proposition, the High Court relied upon the fact that ordinarily the purpose of an Explanation is to clarify that which is already and not to introduce something new. The High Court opined that the Explanation was inserted by the Parliament with a view to settle the controversy as to the meaning and effect of the said clause among the several High Courts and that the Explanation puts a seal of approval on the view taken by the majority of the High Courts. The High Court also referred to the definition of "person " in clause (31) of Section 2. It pointed out that the definition shows clearly that an individual, a H.U.F. and a firm are distinct persons/entities for the purpose of the Income Tax Act. The High Court, therefore, concluded that since an individual and a H.U.F. are two distinct entities for the purpose of the Act, clause (b) of Section 40 has on application where the interest is paid to the partner on deposits made by him with the firm in his individual capacity where such person is a partner not in his individual capacity but as representing a H.U.F. Sri G.C. Sharma, learned but as representing a H.U.F. Sri G.C. Sharma, learned counsel for the appellant-assessee, strongly relies upon this decision and commends it for our acceptance. Learned counsel points out that even before the enactment of Taxation Laws (Amendment) Act, 1984 (which inserted Explanation 2 aforesaid), a majority of the High Courts in the country had taken the same view though a few High Courts have no doubt taken a contrary view. Looked at from any angle, Sri Sharma says, the issue must be answered in favour of the assessee.
Clause (b) of Section 40 is based upon and is a recognition of the basic nature of relationship between a firm and its partner. In Commissioner of Income Tax v Chidambaram Pillai [(1977) 106 I.T.R.292], this Court observed:
"Here the first thing that we must
grasp is that a firm is not a legal
person even though it has some
attributes of personality.
Partnership is a certain relation
between persons, the product of
agreement to share the profits of a
business. ‘Firm’ is a collective
noun, a compendious expression to
income-tax law, a firm is a unit of
assessment, by special provisions,
but is not a full person which
leads to the next step that since a
contract of employment requires two
distinct persons viz. the employer
and the employee, there cannot be a
a contract of the service, in
strict law, between a firm and one
of its partners. So that any
agreement for remuneration of a
partner for taking part in the
conduct of the business must be
regarded as portion of the profits
being made as a reward for the
human capital brought in. Section
13 of the Partnership Act brings
into focus this basis of
partnership business."
This Court also quoted with approval the passage from Lindley on the Law of Partnership to the effect: "In point of law, a partner may be the debtor or the creditor of his co-partners, but he cannot be either debtor or creditor of the firm of which he is himself a member, nor can he be employer." The provisions in Chapters III and IV of the Partnership Act amply define and delineate the duties, obligations and rights of the partners vis-a-vis the firm. The question yet remains where an individual is a partner in one capacity, e.g., as a representative of another person, can he have no other capacity vis-a-vis the firm. To be more, precise, does the above position of law preclude an individual, who is a partner representing a H.U.F., from depositing his personal funds with the partnership and receiving interest thereon? Explanation 2 says in clear terms that there is no such bar. This is the legislative recognition of the theory of different capacities an individual may hold- no doubt confined to clause (b) of Section 40. Once this is so, we see no reason to hold that this theory of different capacities is not valid or available for the period anterior to April 1, 1985. Accordingly, we hold that even for the period anterior to April 1, 1985, any interest paid to a partner, who is a partner representing his H.U.F., on the deposit of his personal/individual funds, does not fall within the mischief of clause (b) of Section 40. In this view of the matter, we agree with the view taken by the Rajasthan High Court in Gajanand Poonam Chand that Explanation 2, in the context of clause (b) of Section 40, is declaratory in nature. Accordingly, we allow this appeal, set aside the judgment of the High Court and answer the question referred under Section 256 in the affirmative, i.e., in favour of the assessee and against the Revenue. No costs.