C. Bhaskaran Nair vs Commissioner of Income Tax

K.A. Nayar, J.—As directed by this court, the Commissioner of Income Tax, Trivandrum, referred the following questions of law said to arise from the order of the Income Tax Appellate Tribunal, Cochin Bench, in I. T. A. No. 126 (Coch.)/1981 relating to the assessment year 1979-80 :

"(1) Whether, on the facts and in the circumstances of the case, the assessee is entitled to deduct the amount of interest paid by him to the firm from the total income of the assessee ?

(2) Whether, on the facts and in the circumstances of the case, the assessee was entitled to claim deduction of the amount of interest paid on the amount debited in his account towards the price of share purchased from T. Sumathy Amma and Prabhakaran Nair ?

(3) Whether, on the facts and in the circumstances of the case, the Tribunal is right in law in holding that Section 67(3) is the only section which applies to interest paid by a partner to the firm ?

(4) Whether, on the facts and in the circumstances of the case, the Tribunal is right in law in holding that the provisions of Section 37 would not apply to the particular case ?

(5) Whether, on the facts and in the circumstances of the case, the Tribunal was right in law and facts in treating the portion of the share received by him from the firm as the assessee''s real income ?"

The assessee is a partner of two firms, namely, South Indian Timber Industries, Kudamaloor and Kumaranalloor Tile Works, Kottayam. The previous year ended on March 31, 1978, relevant to the assessment year 1979-80. The assessee claimed interest paid by him to the firms on the overdrawn amounts from the firm as an allowable deduction. According to the assessee, the partnership deeds of the two firms stipulated payment of interest at 9% per annum on the debit balances. The interest paid was treated as income of the firms. The amount of interest paid to South Indian Timber Industries was Rs. 26,408 and to Kumaranalloor Tile Works was Rs. 103. Therefore, the assessee claimed these amounts of interest as expenditure allowable in the computation of his share incomes from the two firms. The Income Tax Officer disallowed the claim as he found that the interest amount is not incurred for earning his share income. The Income Tax Officer relied on the decision in CHHOTALAL KESHAVRAM Vs. COMMISIONER OF Income Tax, M. P., . The assessee filed an appeal and the Appellate Assistant Commissioner upheld the action of the Income Tax Officer. In the course of the discussion, the appellant''s representative has agreed before the Appellate Assistant Commissioner that the interest paid to the firms is not for earning profit and that it is as per the agreement in the partnership clause that the interest is paid by the assessee in respect of over-drawals. The Appellate Assistant Commissioner, therefore, held that such interest is not deductible in computing the income of the assessee from business share income from the firms. The Appellate Assistant Commissioner also relied on the above decision, namely, CHHOTALAL KESHAVRAM Vs. COMMISIONER OF Income Tax, M. P., . The assessee took up the matter in second appeal before the Tribunal. The Tribunal also dismissed the appeal. The Tribunal found that, under the relevant clauses of the partnership deeds of the two firms, the assessee was liable to pay interest at 9% per annum on the debit balances. Such interest has been treated as the income of the firms. The Tribunal also noted that the debit balance arose on account of the heavy losses incurred by the firm and such losses have been debited to the accounts of the partners. It was contended before the Tribunal on behalf of the assessee that the share income of the partner in a firm is income to be assessed under the head "Business". Therefore, the interest payment has to be allowed u/s 37 of the Income Tax Act. The contention of the Revenue was that the only deduction that is permissible against the share income of the partner is u/s 67(3) of the Act. The Tribunal distinguished the decisions in Commissioner of Income Tax, Bihar Vs. Ramniklal Kothari, and Commissioner of Income Tax Vs. Sohan Lal Nayyar, and held that the case of the assessee was directly covered by the decision of the High Court of Andhra Pradesh in Commissioner of Income Tax Vs. Smt. Allareddy Sudarsanamma and Others, . The Tribunal further held that the decision of the Madras High Court in M.S.P. Raja and Another Vs. Commissioner of Income Tax, relied on by the Department laid down that as far as the payment of interest by a partner is concerned, it is governed only by the provisions of Section 36(1)(iii) of the Act. In that view of the matter, the Tribunal held that Section 37 of the Act would not apply. The Tribunal further observed that the interest payment in question could not be considered to be interest paid on capital borrowed as it was only interest on the debit balance of the partner and such debit balance has arisen on account of the losses sustained by the firm. The Tribunal dismissed the appeal on the aforesaid reasoning. It is thereafter that the Tribunal has referred the above questions of law at the instance of the assessee.

Heard counsel.

Question No. 2 mentioned hereinbefore relates to the claim for deduction of the amount of interest paid towards the price of the share purchased from T. Sumathy Amma and Prabhakaran Nair. The said question does not arise from the decision of the Appellate Tribunal and, therefore, we refuse to answer the said question.

Questions Nos. 1, 3, 4 and 5 relate to the claim for deduction of interest paid by the assessee to the two firms in accordance with the partnership agreement in respect of the overdrawals by the assessee. Counsel for the assessee referred to Sections 67(3) and 36(1)(iii) of the Income Tax Act and also relied on the decisions in Commissioner of Income Tax, Bihar Vs. Ramniklal Kothari, , Commissioner of Income Tax Vs. Sohan Lal Nayyar, and Rahim Khatoon Vs. Commissioner of Income Tax, . Counsel for the Revenue referred to the decisions in Commissioner of Income Tax Vs. Smt. Allareddy Sudarsanamma and Others, , M.S.P. Raja and Another Vs. Commissioner of Income Tax, , CHHOTALAL KESHAVRAM Vs. COMMISIONER OF Income Tax, M. P., and also a passage in Kanga and Palkhivala on Income Tax, 7th Edition, Volume 1, at page 353.

The assessment of registered firms is governed by Section 182 of the Income Tax Act It says that, in the case of a registered firm, after assessing the total income of the firm, the Income Tax payable by the firm itself shall be determined and the share of each partner in the income of the firm shall be included in his total income and assessed to tax accordingly. The section provides for assessment of the firm as a separate entity and also assessment of the share income of each partner. Section 67 of the Act provides the method of computing a partner''s share in the income of the firm. Sub-section (3) of Section 67 provides that any interest paid by a partner on capital borrowed by him for the purposes of investment in the firm shall, in computing his income chargeable under the head "Profits and gains of business or profession" in respect of his share in the income of the firm, be deducted from the share. There was no provision similar to Sub-section (3) in the 1922 Act. Since the share income of the partner has to be charged as profits and gains of the profession, the deduction permissible u/s 28 and other provisions of the Act are made applicable for assessment of the partner in respect of his share and other income. Section 29 of the Act provides that the income referred to in Section 28 shall be computed in accordance with the provisions contained in Sections 30 - 43 of the Act. Section 36(1) provides for deductions that may be allowed in computing the income from profits and gains of business and/or profession, and Section 36(1)(iii) says that the amount of the interest paid in respect of capital borrowed for the purposes of the business or profession is an allowable deduction. It is in this context that counsel for the assessee submitted that the interest paid to the firms is an allowable deduction u/s 36(1)(iii) of the Act. Admittedly, Section 36(1)(iii) will apply only if the amount of interest is paid in respect of capital borrowed for the purpose of the business or profession. In this case, the Income Tax Officer found that the interest paid to the firms was for overdrawal from the firms. Before the Appellate Assistant Commissioner, it was agreed by the assessee''s representative that the interest paid is not for earning profit. The Tribunal also found that the interest payment is not for capital borrowed as the interest payment is only on the debit balance of the partner and such debit balance arose on account of the loss sustained by the firms. Therefore, Section 36(1)(iii) cannot have any application to the case.

The next question is whether Section 67(3) of the Act will apply. Section 67(3) also will not apply to this case as the section says that any interest paid by a partner on capital borrowed by him for the purposes of investment in the firm shall be deducted from the share in computing his income chargeable under the head "Profits and gains of business or profession".

The only other section that is pressed into service is Section 37 which is the residuary section providing for deduction of any expenditure not being expenditure of the nature described in Sections 30 - 36 and Section 80VV and not being in the nature of capital expenditure or personal expenses of the assessee laid out or expended wholly and exclusively for the purposes of the business or profession. Such an expenditure is an allowable deduction under the head "Profits and gains of business or profession". A partner may be entitled to claim deduction from his share of the profit in respect of the amount expended wholly and exclusively for the purpose of earning his share of profits such as interest paid by him on monies borrowed for investment in the firm. Section 67(3) which provides for deduction of any interest paid by a partner on the capital borrowed by him for the purpose of investment in the firm is not exhaustive nor does it provide that no other deduction shall be allowed in respect of such share income. There is nothing which precludes the application of Section 37 to the case of a partner''s share. But Section 37(1) will apply only to amounts spent by him exclusively to earn his share of the firm. On the facts of this case, especially when it is agreed that the interest payment is not for earning profit, there is no scope for applying Section 37 as well.

Counsel for the assessee referred to Commissioner of Income Tax, Bihar Vs. Ramniklal Kothari, , In that case, the assessee carried on business as partner in different firms and received income from different registered firms as his share of profits. In the individual assessment of the partner, the assessee claimed certain deductions including the interest paid by him. The Tribunal found that the share of profits received by the assessee from the firms was taxable as business income and appropriate deductions admissible u/s 10(2) of the Indian Income Tax Act, 1922, were allowable in computing the taxable income of the assessee. The question thereafter referred to the High Court of Patna was whether the expenses incurred by the assessee (who was not carrying on any independent business of his own), in earning income from various firms in which he was a partner, are allowable in law as deductions. The High Court answered the question in favour of the assessee and thereafter the question came up before the Supreme Court by way of special leave. The Supreme Court held that the receipt by the partner is business income for the purpose of Section 10(1), and being business income, expenditure necessary for the purpose of earning that income and appropriate allowances are deductible therefrom in determining the taxable income of the partner. It was open to the partner to claim a deduction provided he satisfies the taxing authority that such deduction represents necessary expenditure, the expenditure being incurred in order to enable him to earn the profits which are being subjected to tax. After referring to Basantlal Gupta Vs. Commissioner of Income Tax, Madras, , the Supreme Court held (at p. 60) :

"An allowance u/s 10(2) will be permissible in proper cases even after the share has been ascertained if the expenditure sought to be deducted was incurred by the partner solely and exclusively for the purpose of earning his share in the income of the firm."

This case has no application to the facts of this case. The decision was rendered with respect to the provisions contained in the 1922 Act.

The next decision referred to by counsel on behalf of the assessee is Commissioner of Income Tax Vs. Sohan Lal Nayyar, . In that case, under an agreement, the assessee agreed to pay half per cent. out of his own commission to one Laxmi Narain if the sales reached Rs. 15 lakhs per year, but no commission was payable to him if the above target of sales fell short by more than 10%, During the previous year relevant to the assessment year 1961-62, the assessee paid a sum of Rs. 7,568 to Laxmi Narain under the agreement dated April 1, 1960, and the assessee claimed deduction of this amount in computing his own share of income from the firm. The question in that case was whether the said sum of Rs. 7,568 constituted a proper deduction from the assessee''s share income from the firm in which the assessee is a partner, The High Court of Delhi referred to Section 67(3) and observed that there was nothing in Section 67(3) to indicate that that provision was exhaustive and that deductions other than those mentioned therein could not be allowed to a partner and that if a deduction was admissible in respect of a partner''s share in the income of the firm u/s 37 of the Act, it would have to be allowed even though it may not fall within the ambit of Section 67(3) of the Act. The assessee in that case claimed allowance of the amount as an expenditure laid out wholly and exclusively for the purpose of his business. This case also will not help the assessee in his case as, on the facts of the case, the deduction cannot come either u/s 67 or u/s 37 of the Act.

The next case referred to by counsel for the assessee is Rahim Khatoon Vs. Commissioner of Income Tax, . In that case, a theatre was taken by seven individuals on lease and thereafter the seven individuals formed a partnership to run the theatre. Interest on the balance amount paid to the lessor of the theatre by one of the partners was claimed as a deduction from the share income of the partner who paid the amount to the lessor. The High Court of Andhra Pradesh considered the application of Section 67 of the Act and observed that Sub-section (3) enjoins that any interest paid by a partner on capital borrowed by him for the purpose of investment in the firm shall, in computing his income chargeable under the head "Profits and gains of business or profession" in respect of his share in the income of the firm, be deducted from the share. In the case of individuals who are partners of a firm, the analogous provision is found in Section 36(1)(iii) of the Act. Since there was no borrowing of money by the assessee for the purpose of investing the same in the partnership business, on the language of Section 67(3), it was found that the interest payment is not entitled to be deducted. But the court further observed that Section 67(3) is not exhaustive. u/s 37(1) of the Act the expenditure incurred by the assessee by way of payment of interest on the unpaid purchase money is an allowable deduction as the expenditure was incurred wholly and exclusively for the purpose of business and it did not fall within the ambit of Sections 30 - 36. This decision also will not help the assessee''s case here as the interest paid by the assessee was not for the purpose of the business nor was it for the purpose of investment in the firm.

Counsel for the Revenue referred to the decision in Commissioner of Income Tax Vs. Smt. Allareddy Sudarsanamma and Others, . In that case, three assessees were partners in a firm, having one-third share each. They individually withdrew substantial amounts from the firm for personal expenses. They had to pay interest to the firm in respect of their drawings, The question was whether the partners are entitled to deduct the amount of interest paid by them to the firm from their share income. It was held in that case that the assessees are not entitled to deduct the interest amount. The doctrine of real profits was also considered in that case, The High Court of Andhra Pradesh observed (p. 767) :

"Where the partner draws the funds belonging to the firm for meeting his personal expenses, he would be liable to pay interest thereon if the terms of the deed of partnership specifically provide for it. In the instant case, the partnership deed makes the partners liable to pay interest at 12% on the withdrawals made by them for personal expenses from the funds of the firm, although no interest was payable by the firm to the individual partners on their capital investments. In fact, all the three assessees have paid the sums which are now sought to be deducted from the computation of the taxable income towards interest to the firm. The firm''s accounts disclose these amounts being received by it as interest on the amounts withdrawn by the partners. These amounts are, undoubtedly, not only book profits but must be held to be commercial and real profits actually received by the firm in the year of account. These sums have been shown in computing the profits of the firm and they have in fact been assessed to tax in the hands of the firm as per the provisions of Section 182. After the ascertainment of the taxable profits of the firm, the allocation of the respective shares of the three partners, in the instant case, have been made. The share incomes received by the assessees have to be clubbed with their individual incomes received from other sources in order to arrive at the taxable profits received by or accrued to them in the year of account. The transaction relating to the payment of interest by the partners to the firm on the borrowals or withdrawals of amounts belonging to the firm, whether looking at the substance or the form, is undoubtedly, a commercial or business transaction which actually earned profits to the firm."

This decision indicates that the interest paid by the partner to the firm in respect of the overdrawals is not an allowable deduction in the individual assessment of the income of the partner.

The next decision referred to is M.S.P. Raja and Another Vs. Commissioner of Income Tax, . In that case, the partner withdrew monies from the firm and invested the same in another firm having agricultural income not liable to Income Tax. The interest paid by the partner to the firm was claimed as deduction u/s 36(1)(iii) of the Act, The High Court of Madras held (p. 310) :

"Section 67 deals with the method of computing a partner''s share in the income of the firm. Sub-clause (3) thereof provides for the deduction of interest paid on capital borrowed for the purpose of investment in the firm. As a specific provision has been made u/s 67(3) with reference to the claim for deduction of interest from the share of income, it would follow that Section 36(1)(iii), which is in the nature of a general provision relating to all businesses, would have no application. Section 67(3) provides for the deduction of any interest paid by the partner on capital borrowed by him for the purpose of investment in the firm. It proceeds, on the basis that in computing the income chargeable on the profits and gains of business or profession, which the share income would come under, interest paid could be deducted from the share. There must be some share income in order to justify the assessee''s claim for deduction u/s 67(3). When there is none, it is not possible to accept the claim for deduction under that provision. When the claim for deduction under this provision is negatived, it is not possible to fall back u/s 36(1)(iii) for consideration of the same claim as, as pointed out already, in the case of interest payable by a partner for investment in a firm, the claim has to be considered only u/s 67(3) and not under any other provision. In this view also, the claim u/s 36(1)(iii) has to be negatived."

This case also supports the contention of the Revenue that interest paid by the assessee on the amount overdrawn from the partnership is not an allowable deduction.

The next decision referred to by counsel for the Revenue is in CHHOTALAL KESHAVRAM Vs. COMMISIONER OF Income Tax, M. P., . The question in that case was whether interest paid by the partners to their firm on their outstanding debit balances in the books of the firm is an allowable deduction from share of profits of the partners. The court held that the interest debited to the two partners having been transferred to the interest account and the resultant sum having gone into the profit and, loss account, the amounts are commercial and real profits actually received by the firm in the years of account. But as Section 67(3) of the Act exempts only the interest paid by the partner on capital borrowed by him for the purpose of investment in the firm in computing the partner''s income chargeable under the head "Profits and gains of business or profession", the interest paid by the partner will not be allowed as a deduction. The High Court of Madhya Pradesh held thus (p. 356) :

"Section 67(3) has obviously no application to a case where a partner claims a deduction in respect of interest paid by him to the firm."

This case also applies to the facts of the present case.

From the decisions above-cited, it will be clear that when a partner borrows capital for investment in the firm, interest paid thereon can be deducted from his share of income from the firm in computing his income chargeable under the head "Profits and gains of business or profession". All that Section 67(3) requires is that the partner should have borrowed the money for the purpose of investment in the firm as capital or as loan. But Section 67(3) is not exhaustive. Any deduction otherwise allowable u/s 37(1) will have to be allowed even though such deduction will not fall within the ambit of Section 67(3). But, in the case of interest payable by a partner for investment in a firm, the claim will have to be considered u/s 67(3). When a claim for deduction under that section is negatived, it is not possible to fall back upon Section 36(1)(iii) for consideration of the same as a deduction.

In the light of the above discussion, question No. 1 is answered in the negative, that is in favour of the Revenue and against the assessee. We have already stated that question No. 2 does not arise out of the order of the Tribunal, and, therefore, we refuse to answer the same. Our answer to question No. 3, on the facts of this case, is in the affirmative, that is in favour of the Revenue and against the assessee. Question No. 4 is answered in the affirmative, that is in favour of the Revenue and against the assessee. Question No. 5 is also answered in the affirmative, that is in favour of the Revenue and against the assessee.

A copy of this judgment under the signature of the Registrar and the seal of the High Court will be forwarded to the Income Tax Appellate Tribunal, Cochin Bench.