Ganesh Factory vs Commissioner of Income Tax

During the period relevant to the assessment year 1974-75, the asses-see, a partnership concern, paid Rs. 18,000 as salary to three of its partners and during the assessment proceedings claimed deduction thereof as business expenditure. The Income Tax Officer disallowed the deduction as, the payment of salary to the partners was not allowable in view of Section 40(b) of the Income Tax Act, 1961 (hereinafter called "the Act"). The contention of the assessee before the Appellate Assistant Commissioner that the provisions of Section 40A of the Act were applicable and had overriding effect on Section 40(b) did not prevail and the assessee remained unsuccessful. Their further appeal before the Income Tax Appellate Tribunal, Chandigarh, also remained unsuccessful. The Tribunal came to the conclusion that Section 40(b) and Section 40A of the Act operate in different fields and that there was no conflict as was attempted to be made on behalf of the assessee. At the instance of the assessee, the Tribunal has referred the following questions for the opinion of this court:

"1. Whether the Tribunal has been in error in holding that the provisions of sections 40(b) and 40A(2) of the Income Tax Act, 1961, operate in different fields ?

Whether the Tribunal has been right in law in holding that though the Income Tax authorities may restrict or modify a claim of payment of salary to a partner but even such restricted or modified payment is disallowable u/s 40(b) of the Income Tax Act, 1961, and thereby upholding the disallowance of Rs. 18,000 in the appellant''s case in respect of the assessment year 1974-75 ?"

By virtue of Section 40, the amounts detailed in the various Sub-clauses of Clauses (a) to (d) shall not be deducted in computing the income chargeable under the head "Profits and gains of business or profession" notwithstanding anything to the contrary contained in Sections 30 to 39 of the Act. The relevant provisions for our consideration in this section would be clause (b), the relevant portion of which is as follows :

"(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."

By virtue of clause (b), if a firm pays interest, salary, bonus, commission or remuneration to any of the partners of the firm, the same has to be disallowed. Here, we are concerned with payment of salary to partners and by virtue of the aforesaid provision, the salary would be disallowed from the deductions as Section 40, by virtue of the non obstante clause, has an overriding effect over the provisions of sections 30 to 39 under which, possibly, deduction could be allowed.

The argument on behalf of the assessee is that after the enactment of Section 40A with effect from April 1, 1968, it contains a non obstante clause saying that this section shall have effect notwithstanding anything to the contrary contained in any other provision of the Act relating to the computation of income under the heading "Profits and gains of business or profession" and, therefore, Section 40A will have overriding effect even on Section 40 including Clause (b) thereof. Hence, Section 40(b) is not to be considered in the wake of Section 40A.

The argument raised on behalf of the assessee would be correct only to the extent that wherever amounts are covered by Section 40A, to that extent it will override the provisions of Section 40, but where matters which are not dealt with in Section 40A are dealt with in Section 40, in that case, Section 40A will not stand in the way of applying Section 40. Therefore, the crucial point is whether the question of allowing or disallowing salary or part thereof to a partner is covered by Section 40A or not ? For this matter, reference may be made to Section 40A(2)(a), the relevant portion of which is as follows :

"40A(2)(a). Where the assessee incurs any expenditure in respect of which payment has been or is to be made to any person referred to in Clause (b) of this sub-section, and the Income Tax Officer is of the opinion that such expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession of the asses-see or the benefit derived by or accruing to him therefrom, so much of the expenditure as is so considered by him to be excessive or unreasonable shall not be allowed as a deduction."

The aforesaid provision relates to the expenditure in relation to any person referred to in Clause (b) of the sub-section and the expenditure has to be considered in relation to the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession of the assessee or the benefit derived by or accruing to the assessee therefrom. Only so much of the expenses, if paid to a person referred to in Clause (b), are allowable which are found to be not excessive and unreasonable and the excessive or unreasonable portion has to be disallowed Further, we have to consider as to what kind of expenditure is dealt with in Clause (a) of Sub-section (2) of Section 40A of the Act. It has to be in regard to the fair market value of the goods, services or facilities for business purposes. Section 40A(2)(a) came up for consideration before the Karnataka High Court in T.T. Pvt. Ltd. Vs. Income Tax Officer, Company Circle-III, Bangalore, , and Venkataramaiah J., at pages 667 to 570 of the reported judgment, considered the scope of the aforesaid provision in view of Section 40 and gave the following verdict (at p. 568) :

"The goods, services and facilities referred to in Section 40A(2)(a) are those which have a market value and which are commercial in character. Many of the services and facilities referred to above are those which are nowadays provided by independent organisations. They take diverse forms such as packing and forwarding, transport service, advertisement service, warehousing facilities, processing, collection of price, insurance of goods, etc., which involve investment of large finance and employment of number of persons. The cost of post-manufacture operations in some cases will be of the order of 30% of the price paid by the consumers. Marketing and distribution of goods have become important branches of modern industrial and commercial operations which have now become highly standardised."

A reading of the aforesaid quotation shows that payment of salary to a partner of the firm, who may be working whole time for the assessee-firm, would not come within the ambit of services as the services provided u/s 40A are as noticed in the aforesaid quotation and not as an employee, i.e., relationship of master and servant.

Moreover, the Legislature was aware of the meaning of "salary" in contradistinction to the services which may be rendered for carrying on business by a person. Here, in the statement of the case, it is mentioned that total salary of Rs. 18,000 was paid to three of the partners of the firm and the word "salary" is clearly covered by Section 40(b) and does not come within the ambit of Section 40A. Therefore, we are of the opinion that such a matter is not covered by Section 40A and would be covered only u/s 40. Since salary has been paid by the assessee-firm to its partners, the same has to be disallowed by virtue of clause (b) of Section 40 of the Act and the Tribunal and the officers below were right in disallowing the entire salary paid to the partners of the firm.

The Tribunal, in its order, made the observations that by virtue of Section 40A, the Income Tax Officer may restrict or modify a claim of payment of salary to a partner depending upon the extent and nature of his services but in spite of such modified payment, the same has to be disallowed keeping in view the provisions of Section 40(b) of the Act. In this respect, there was some misunderstanding with the Tribunal. If Section 40A applies, then Section 40 would stand excluded but if Section 40A does not apply and the matter is covered by Section 40, then the matter of payment of salary to a partner of the firm has to be decided u/s 40 alone. Otherwise, the Tribunal was right in coming to the conclusion that Section 40(b) and Section 40A of the Act operate in different fields.

Accordingly, both the questions are answered in favour of the Revenue as indicated above. However, there will be no order as to costs.