Commissioner of Income Tax vs M.L. Trading and Co.

The Income Tax Appellate Tribunal has referred the following questions of law for decision by this court :

"Whether, on the facts and in the circumstances of the case, and on a proper construction of Section 40(b) of the Income Tax Act, 1961, the total amount of interest of Rs. 36,771 paid by the assessee-firm to its partners was not rightly disallowed by the Income Tax Officer while computing the total income of the assessee ?"

From the statement of the case, it appears that the assessee is a firm consisting of four partners. In the relevant year, the assessee paid Rs. 36,771 as interest to its partners and had also received an amount of Rs. 78,239 as interest from the partners. It was contended before the Income Tax Officer that only the net amount of interest paid to any partner could be disallowed in view of the decision of the Allahabad High Court in the case of Sri Ram Mahadeo Prasad Vs. Commr. of Income Tax, United Provinces, Lucknow, . The Income Tax Officer rejected the contention of the assessee and disallowed the entire amount paid to the partners u/s 40(b) of the Act. On appeal being preferred, the Appellate Assistant Commissioner confirmed the order of the Incomes-tax Officer. On further appeal, the Tribunal has held that only the net amount paid to any partner has to be considered for the purposes of Section 40(b) of the Act. In taking this view, the learned Tribunal granted relief on the aforesaid decision of the Allahabad High Court.

Shri Choudhuri, appearing for the Department, has urged that in the face of the language of Section 40(b) of the Act, there can be no manner of doubt that the entire amount of interest paid by the firm to the partners cannot be allowed to be deducted from the total income of the firm. If we adopt a strict literal interpretation of the aforesaid section, the contention of Shri Choudhuri may be right. But then it has been the consistent view of different High Courts of the country which includes the decision rendered in Commissioner of Income Tax Vs. Kailash Motors, and Commissioner of Income Tax Vs. Motilal Ramjiwan and Company, that it is only the net amount of interest payable to a particular partner after adjusting the interest paid by him to the firm which shall fall within the net of Section 40(b) of the Act. Indeed, an Explanation was added to Section 40(b) by the Taxation Laws (Amendment) Act, 1984, made effective from April 1, 1985, which reads as below :

"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."

It seems that the Explanation was inserted keeping in view the pronouncements of different High Courts of the country relating to the interpretation of Section 40(b) of the Act. It also seems quite logical and reasonable that it should be only the net interest which has been paid by the firm to the specified partner that should be disallowed u/s 40(b) of the Act. It does not stand to reason that while the interest paid by the partners and received by the firm would be added as the income of the firm, at the same time, the interest paid by the firm to the same partner who had paid interest to the firm would be disallowed.

We, accordingly, answer the question in the affirmative and in favour of the asessee. We, however, make it clear that the interest paid by the firm shall be deducted after taking into account the interest paid by the partners individually. To make it clear, we state that each partner''s account shall be examined separately and deduction shall be confined accordingly.