ITAT MUMBAI BENCH ‘E’: Application of section 40A(2) & 40(B) to firm

ITAT MUMBAI BENCH ‘E’

Syntholab Chemicals & Research

v.

Assistant Commissioner of Income-tax-14(3)

K.C. Singhal, Judicial Member

and Abraham P. George, Accountant Member

IT Appeal No. 5081 (Mum.) of 2006

[Assessment year 2003-04]

April 21, 2008

Section 40A(2), read with section 40(b), of the Income-tax Act, 1961 - Business disallowance - Excessive or unreasonable payments - Whether provisions of section 40A would not have an overriding effect over provisions of section 40(b), rather provisions of section 40(b), being special provisions relating to payment to partners, would prevail over general provisions of section 40A - Held, yes

Section 40(b), read with section 36(1)(iii), of the Income-tax Act, 1961 - Business disallowance – Interest, salary, etc., paid by firm to partner - Assessment year 2003-04 - Whether if condition provided in section 36(1)(iii), i.e., money has been borrowed from partners for purpose of business, is satisfied, interest paid on such money cannot be disallowed except as provided under provisions of section 40(b) - Held, yes - Whether where capital of partners was utilized for purpose of business and, thus, requirement of section 36(1)(iii) stood satisfied and interest paid to partners was in accordance with provisions of section 40(b)(iv), no disallowance could be made of said interest - Held, yes

Facts

During the relevant assessment year, the assessee-firm had paid interest to partners and their family members and claimed deduction of the same. The Assessing Officer noticed that the assessee had paid interest to partners at the rate of 12/18 per cent per annum while interest received on FDR kept by the assessee with the bank was at an average rate of 9 per cent per annum. He, therefore, held that the interest paid to partners was excessive and unreasonable as per the provisions of section 40A(2). He, therefore, worked out interest paid in excess of interest received from fixed deposits and by invoking the provisions of section 40A(2) disallowed the same. On appeal, the Commissioner (Appeals) held that the provisions of section 40 have an overriding effect over the provisions of sections 30 to 38, while the provisions of section 40A had an overriding effect over the entire provisions of the Act, and, thus, the provisions of section 40A would have an overriding effect over section 40 also. He also held that section 40 only restricts the allowance of interest to partners to the limit of interest provided in the section, but section 40A disallows the payment if it is in excess of the market value and since in the instant case the partners of the firm were covered by the provisions of section 40A(2), excessive or unreasonable payment of interest would be disallowable. He, therefore, upheld the order of the Assessing Officer.

On second appeal :

Held

There cannot be any dispute to the legal provision that interest on borrowed fund can be allowed as a deduction only where condition specified in section 36(1)(iii) is satisfied. This legal position would also be applicable to amounts borrowed from the partners by way of capital or otherwise even after amendment to section 40(b) effective from 1-4-1993. The only condition provided in section 36(1)(iii) is that money must be borrowed for the purpose of business. If this condition is satisfied, then no disallowance can be made except as provided under the provisions of section 40(b) which has an overriding effect. Section 40(b) only restricts the allowance up to the limit prescribed in the section. The finding of the Commissioner (Appeals) that section 40A has an overriding effect even over the provisions of section 40(b) and, consequently, the disallowance can be made even when it is found that payment to partners is excessive or unreasonable having regard to the fair market value of goods, services or facilities, could not be accepted inasmuch as both the provisions cover different fields and even otherwise the provisions of section 40(b), being special provisions relating to payment to partners, would prevail over the general provisions of section 40A.

In the instant case, the entire income including the interest on FDR had been assessed as business income by the Assessing Officer. Therefore, it was clear that capital of partners was utilized for the purpose of the business and, consequently, the requirement of section 36(1)(iii) stood satisfied. Further, interest paid to partners was in accordance with the provisions of section 40(b)(iv) and, therefore, no disallowance could have been made.

In the instant case, the disallowance had been made under section 40A(2), which had no application to the instant case. Therefore, the impugned disallowance made by the Assessing Officer and confirmed by the Commissioner (Appeals) was not justified and was liable to be deleted.

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