SUWALAL ANANDILAL JAIN vs COMMISSIONER OF INCOME TAX.

K. VENKATASWAMI, J. :

The question that has been referred to this Court under s. 257 of the IT Act, 1961 (hereinafter called "the Act"), reads as follows :

"Whether, on the facts and circumstances of the case, the assessees claim to the benefit of cl. (b) of s. 40 of the IT Act, 1961, has been rightly disallowed ?"

The assessment year in question is 1976-77. The case of the assessee-firm was that Shanti Kumar Jain, Ashok Kumar Jain, Raj Kumar Jain and Niranjan were partners in the firm in their capacity as Karta of the respective HUF. They have advanced monies to the assessee-firm in their individual capacity. The assessee-firm paid interest to them on the investments made in their respective individual capacity. It is the further case of the assessee-firm that it has maintained two separate ledger accounts of the partners, one of individual as loan creditor and another of Karta of HUF as partners in the firm. The sources of the money, according to the assessee, are quite separate. The assessee-firm claimed that the interest paid to them shall not be included while computing the income chargeable under the head "Profits and gains of business or profession". Notwithstanding such claim, the ITO applied s. 40(b) of the Act and completed the assessment by order dt. 29th January, 1978. The result was that the interest paid to the partners in the circumstances stated above was included under the head "Profits and gains of business or profession".

On appeal to the AAC the assessment was confirmed by an appellate order dt. 27th August, 1980. Still aggrieved, the assessee-firm preferred further appeal to the Tribunal. The Tribunal, relying upon an unreported decision of the Patna High Court in Tax Case No. 83-84 of 1971 in the case of Makhan Lal Harnarayan vs. CIT, confirmed the view taken by the ITO and upheld by the AAC. In view of the divergence of views among the High Courts on the application of s. 40(b) of the Act, the issue has been referred to this Court.

We have heard counsel on both sides.

Under identical circumstances, this Court in M/s Brij Mohan Das Laxman Das vs. Commissioner of Income Tax, Amritsar (JT 1997 (1) SC 155) had occasion to consider an identical issue.

Jeevan Reddy J., speaking for the Bench, after noticing the subsequent amendment to s. 40 by Taxation Laws (Amendment) Act, 1984, under which Expln. 2, inter alia, has been added, has observed as follows :

"In Gajanand Poonam Chand vs. Commissioner of Income Tax (1984 174 I.T.R.346) the Rajasthan High Court has taken the view that the said Explanation is merely declaratory in nature and that, therefore even for the assessment years prior to 1st April, 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 enacted and not to introduce something new. The High Court opined that the Explanation was inserted by 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 cl. (31) of s. 2. It pointed out that the definition shows clearly that an individual, an HUF and a firm are distinct persons/entities for the purpose of the IT Act. The High Court therefore, concluded that since an individual and an HUF are two distinct entities for the purpose of the Act, cl. (b) of s. 40 has no 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 an HUF. 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 the Taxation Laws (Amendment) Act, 1984 (which inserted Expln. 2 aforesaid), a majority of the High Court 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 s. 40 is based upon and is a recognition of the basis nature of the relationship between a firm and its partner. In Commissioner of Income Tax vs. 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 designate an entity, not a person. In 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 contract of 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 a portion of the profits being made over as a reward for the human capital brought in s. 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 employed by his firm, for, a man cannot be his own 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 an HUF from depositing his personal funds with the partnership and receiving interest thereon ? Expln. 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 cl. (b) of s. 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 1st April, 1985. Accordingly, we hold that even for the period anterior to 1st April, 1985, any interest paid to a partner, who is a partner representing his HUF, on the deposit of his personal/individual funds, does not fall within the mischief of cl. (b) of s. 40. In this view of the matter, we agree with the view taken by the Rajasthan High Court in Gajanand Poonam Chand and Bros. case (supra) that Expln. 2, in the context of cl. (b) of s. 40, is declaratory in nature. Accordingly, we allow this appeal, set aside the judgment of the High Court and answer the question referred under s. 256 in the affirmative, i.e., in favour of the assessee and against the Revenue."

In view of the above pronouncement of this Court, we do not think that this question requires any further elucidation. Accordingly, the question is answered in favour of the assessee and against the Revenue. There will be no order as to costs.