Commissioner Of Income-Tax v. London Machinery Co.

Satish Chandra, C.J:— This reference relates to the assessment year 1972–73. The assessee is a registered firm, consisting of seven partners. According to the partnership deed, three of them, to wit C.L Barry, I.L Berry and P.K Berry, were stated to be partners acting as kartas of their respective Hindu undivided families. (HUF for short). The HUFs contributed capital, but the partnership deed provided that no interest shall be paid on it unless the partners agreed otherwise. The other four partners entered the firm in their individual capacities.

2. The three karta-partners deposited funds belonging to each of them in their individual capacity in the accounts of the firm. The firm paid to each of them interest amounting to a total of Rs. 20,996 as individuals. The firm claimed deduction of this amount as business expenditure. The ITO disallowed it. This disallowance was upheld on appeal. The assessee took the matter to the Tribunal. The Tribunal considered the matter elaborately, and held that the three kartas were partners in the firm as representing their HUFs. The deposits were made by them from their own personal funds. The firm paid interest to them in their individual capacity and not as representing their HUFs. Since these three persons were partners in a different capacity, that is, as the kartas, the interest paid to them as individuals could not be held to be payment to a partner of the firm. It directed the deletion of the amounts in the assessment of the firm.

3. At the instance of the CIT, the Tribunal has solicited our opinion on the following question of law:

“Whether, on the facts and in the circumstances of the case, s. 40(b) of the I.T Act, 1961, did not apply to the payment of interest to Sri C.L Barry, I.L Berry and P.K Berry?”

4. Section 40(b) reads:

“40. Notwithstanding anything to the contrary in sections 30 to 39, the following amounts shall not be deducted in computing the income chargeable under the head Profits and gains of business or profession—…

(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.”

5. This provision of the 1961 Act is the successor to s. 10(4) of the Act of 1922. The two provisions are identical, with the only difference that in s. 40(b) bonus has also been included. The question then arises who is the partner of a firm.

6. Section 2(23) of the Act of 1961 provides that the expressions “firm”, “partner” and “partnership” have the meanings respectively assigned to them ini the Indian Partnership Act, 1932.

7. Section 4 of the Indian Partnership Act prescribes:

“‘Partnership’ is the relation between persons who have agreed to share the profit of a business carried on by all or any of them acting for all.

8. Persons who have entered into partnership with one another are called individually ‘partners’ and collectively ‘a firm’, and the name under which their business is carried on is called the firm name.

9. It is thus apparent that only “persons” can be partners.

10. Section 3(42) of the General Clauses Act says:

“‘Person’ shall include any company or association or body of individuals whether incorporated or not.”

11. This definition applies when there is nothing repugnant to the subject or context. After examining the position in the Partnership Act, the Privy Council in Senaji Kapurchand v. Pannaji Devichand, AIR 1930 PC 300 held that an association of persons is not a person within the meaning of that expression in the Partnership Act.

12. This view was approved by the Supreme Court in Firm Bhagat Ram Mohanlal v. CEPT, [1956] 29 ITR 521. This was a case of a joint Hindu family. The Supreme Court held (p. 525):

“It is not in dispute that Mohanlal was the karta of the joint family, and that he entered into the partnership on 23rd August, 1940, as such karta. It is well settled that when the karta of a joint Hindu family enters into a partnership with strangers, the members of the family do not ipso facto become partners in that firm. They have no right to take part in its management or to sue for its dissolution. The creditors of the firm would no doubt be entitled to proceed against the joint family assets including the shares of the non-partner coparceners for realisation of their debts. But that is because under the Hindu law, the karta has the right when properly carrying on business to pledge the credit of the joint family to the extent of its assets, and not because the junior members become partners in the business. In short, the liability of the latter arises by reason of their status as coparceners and not by reason of any contract of partnership by them.”

13. Explaining the basis of this principle of law their Lordships further observed (p. 526):

“If members of a coparcenary are to be regarded as having become partners in a firm with strangers, they would also become under the partnership law partners inter se, and it would cut at the very root of the notion of a joint undivided family to hold that with reference to coparce-nery properties the members can at the same time be both coparceners and partners.”

14. In CIT v. Bagyalakshmi & Co., [1965] 55 ITR 660, the Supreme Court had occasion to consider certain basic principles. It was held (p. 664):

“If the distinction between three concepts is borne in mind much of the confusion disappears. A partnership is a creature of contract. Under Hindu law a joint family is one of status and right to partition is one of its incidents. The income-tax law gives the Income-tax Officer a power to assess the income of a person in the manner provided by the Act. Except where there is a specific provision of the Income-tax Act which derogates from any other statutory law or personal law, the provision will have to be considered in the light of the relevant branches of law.”

15. The Supreme Court went on to observe further:

“A contract of partnership has no concern with the obligation of the partners to others in respect of their shares of profits in the partnership. It only regulates the rights and liabilities of the partners. A partner may be the karta of a joint Hindu family, he may be a trustee, he may enter into a sub-partnership with others, he may, under an agreement, express or implied, be the representative of a group of persons, he may be a benamidar for another. In all such cases he occupies a dual position. Qua the partnership, he functions in his personal capacity; qua the third parties, in his representative capacity.”

16. In Agarwal and Co. v. CIT, [1970] 77 ITR 10 the Supreme Court ruled that in order to determine who the partners of a firm are, the deed of partnership has to be looked into. If the document shows that a joint Hindu family enters into a partnership through its karta, in law the position is that only the karta is the partner in the firm. The other members of the joint Hindu family do not ipso facto become partners. Their Lordships reiterated the observation of the Supreme Court in CIT v. Kalu Babu Lal Chand, [1959] 37 ITR 123 that it is now well settled that a HUF cannot as such enter into a contract of partnership with another person or persons. They further observed (p. 15):

“The concept of a Hindu undivided family joining a partnership presents considerable difficulty. A Hindu undivided family is a fleeting body. Its composition changes by births, deaths, marriages and divorces. Such a; partnership is likely to have a precarious existence. The assumption in section 4(3) of the Companies Act, 1913, that a Hindu joint family can be a partner in a partnership appears to be based an erroneous view of the law.”

17. Their Lordships also referred;to the definition of the word “person” occurring in s. 2(9) of the Indian I.T Act, 1922 (which is equivalent to s. 2(31) of the Act of 1961). It was held that this definition cannot be imported into the Partnership Act, the provisions of which alone are rele vant for finding as to who could join as partners. It is only partnerships constituted according to the provisions of the Partnership Act that can be considered as partnerships under the I.T Act. The definition of person in the Act is intended for the purpose of levying income-tax and for other cognate matters.

18. It may be observed that s. 4 which charges income-tax on income uses the word person as the subject-matter of the charge, but s. 40(b) with which we are concerned in the present case, does not use the word “person”. On the other hand, it refers to payment to a partner.

19. In Ram Laxman Sugar Mills v. CIT, [1967] 66 ITR 613, the Supreme Court emphasised that a HUF is undoubtedly a person within the meaning of the Indian I.T Act. It is, however, not a juristic person for all purposes, and cannot enter into an agreement of partnership with either another undivided family or individual. It is open to the manager of a joint Hindu family as representing the family to agree to become a partner with another person. The partnership agreement in that case is between the manager and the other person, and no member of the family, excepting the manager, acquires a right or interest in the partnership. The junior members of the family may make a claim against the manager for treating the income or profits received from the partnership as a joint family asset, but they cannot claim to exercise the rights of partners nor be liable as partners.

20. All these authoritie's bring out the position that when a person in his capacity of karta of a HUF enters into a partnership with others, the karta in his personal capacity alone is the partner. The firm can treat the karta and not the other members of the HUF as its partner.

21. Section 40(b) prohibits any allowance in respect of any payment by way of interest, salary, bonus, commission or remuneration made by the firm to any of its partners. The prohibition is in terms absolute, and makes no distinction in respect of payments of interest, commission, salary, bonus or remuneration. It does not make any distinction in respect of the character of or capacity in which the payment is made to the partner. The payment of salary to a partner on the footing that he is an employee, in addition to being a partner, is not allowable. This was so held by the Madras High Court in A.S.K Rathnaswamy Nadar Firm v. CIT, [1965] 58 ITR 312. It relied on its earlier decision in R.A Goodsir and Co. v. CEPT, [1948] 16 ITR 367.

22. In Girdharilal Ghasiram v. CIT, [1968] 69 ITR 890, the Calcutta High Court disallowed deduction in respect of payment to a partner as salary. It was ruled that it was immaterial as to in which capacity he became partner. The payment to him was as a partner, and that was enough.

23. Payment of salary has been disallowed by this court in CIT v. Ram Laxman Sugar Mills, [1970] 76 ITR 123, by the Delhi High Court in Pannalal Girdharilal v. Commissioner Of Income-Tax, Delhi., [1971] 81 ITR 624, by the Karnataka High Court in N.M Anniah & Co. v. CIT, [1975] 101 ITR 348 and by the Patna High Court in CIT v. Jainarain Jagannath, [1945] 13 ITR 410.

24. Learned counsel appearing for the assessee stressed that the case of salary was distinguishable from payment of interest, because salary is remuneration for personal service rendered by the partner.

25. In the authorities mentioned above this distinction was not countenanced. The Madras High Court specifically disallowed payment to a partner, though stated to be an employee, namely, for personal service rendered by him.

26. CIT v. Veeriah Reddiar, [1969] 73 ITR 162 (Ker), is a case of payment of interest. There, one of the partners of the firm was carrying on independent business. That partner borrowed money in order to supply goods to the assessee-firm. The assessee-firm paid interest on such borrowings. The claim for deduction of the interest so paid was disallowed. The contention that interest was paid to the proprietor of the business and not to the proprietor in his capacity as partner of the assessee-firm was overruled. It was held that interest was paid to the partner, and that there is nothing to indicate that the provision applies only to some categories of interest paid by a firm to a partner.

27. Learned counsel for the assessee invited our attention to Addl. CIT v. Vallamkonda Chinna Balaiah Chetty and Co., [1977] 106 ITR 556 (AP). In that case, the principal point decided was whether the assessee had adopted a subterfuge to evade tax by changing the capital account from the name of the partner to that of the HUF represented by the partner. It was held that the capital was contributed by the family, and so the change was to indicate the real state of affairs. The attention of the Andhra Pradesh High Court was not invited to the various decisions mentioned above, in which it has been held that the character or capacity of the partner in which he received payment was immaterial. The fact that payment was made to him was enough. The observation that interest was paid not to Ramachandraiah as partner but to Ramchandraiah's family which had advanced the amount and so the payment did not come within the mischief of s. 40(b) of the Act, does not, with respect, lay down the correct law. On the other hand, the Andhra Pradesh High Court in CIT v. T. Veeraiah and K. Narasimhulu, [1977] 106 ITR 283, held that the capital contributed by the partner was as a partner, though the funds may have emanated from the joint family. The capital did not cease to have the characteristic of a capital investment by the partner, interest on which is not deductible from the income of the firm under s. 40(b).

28. For the assessee strong reliance was placed upon a Full Bench decision of this court in CIT v. Ram Laxmcm Sugar Mills, [1973] 90 ITR 73 (All). In that case the Government of India appointed four of the partners of the firm as members of the management board under the Essential Supplies (Temporary Powers) Act. Under the direction of the Central Government a sum of Rs. 28,422 was paid to the members of the board. The question was whether this payment was allowable. Mathur Actg. C.J, held that the payment was inadmissible. Section 10(4)(b) of the Act of 1922 does not make any distinction between payments made voluntarily by the firm or otherwise. The persons to whom payment was made were partners. The payment was hence not admissible as a deduction.

T.S Misra, J.:— held that payment to a member of the board of management was not in the capacity of a partner, because a member of the board was not the agent of the other partners of the firm. His acts were not binding on the other partners. The remuneration was not paid by the firm to a partner but to the authorised controller or the member of the board of management.

Gulati, J.:— took a differenf line of reasoning. He held that no payment to a partner even though out of the partnership funds can be said to be a distribution of the profits if the payment has not been made with the mutual consent or in pursuance of the contract of partnership and so the payment made under the directions of the Central Government, not being with the consent of the partners, was not covered by s. 10(4)(b).

29. In our opinion, this decision is not helpful to resolve the controversy in the present case. Here no one says that the payment was made to a person, who was not, in law, the partner at the time when he received the payment. The viewpoint expressed by T.S Misra J. is hence not available. It is not the assessee's case that the payment of interest was not made in pursuance of the contract or with the consent of the partners.

Gulati, J.:— emphasised that the capacity in which a partner receives such payment is not very material. The payment should be in pursuance of the contract express or implied. In the present case, the assessee emphasises the capacity in which the partner received the payment, and not that the payment was not made with the consent, express or implied, of the partners of the firm.

30. The observation of Gulati J. that the distribution of profits between the partners can only be according to the terms of the partnership arrived at between the partners by mutual consent does not help the assessee's case. It is well settled that even where the partnership deed states that a particular person is a partner as representing his HUF, the legal implication is that the person is a partner personally. The other family members are not. The capacity in which he receives the payment, namely, for and on behalf of the family, or for his own beneficial interest, is immaterial. Payment to a person who is a partner is the only criterion for purposes of s. 40(b). If a partner makes deposits in the firm of moneys belonging to his HUF as also deposits moneys belonging to him individually, in fact and in law the partner brings in the money. In both cases, the payment of interest by the firm to such a partner is as a partner, no matter who really has the beneficial interest in such payment.

31. In a case, where the partner brings in money belonging to his HUF, the HUF may claim that the amount received as interest was HUF property in the hands of the karta. But, that is a matter entirely apart. The firm makes payment to a partner. That is enough for applying s. 40(b). It is immaterial who has the beneficial interest in that money be it payment as a salary, remuneration or interest, etc.

32. Two decisions of the Supreme Court bring out this distinction.

33. In V.D Dhanwatey v. CIT, [1968] 68 ITR 365 (SC)., it was held that the remuneration paid by the firm to V, was directly related to the investment in the partnership business from the assets of the family. There was real and sufficient connection between investment from the joint family funds and the remuneration paid to V. The salary paid to V by the firm was, therefore, assessable as the income of the HUF.

34. On the other hand, in CIT v. Gumnath V. Dhakappa, [1969] 72 ITR 192, the Supreme Court held that in the absence of a finding that the salary received by the managing partner (who was also the karta of his HUF) was directly related to any asset of the family being utilised in the firm, the payment of salary to him could not be treated as the income of the HUF.

35. The question as to whether payment made to a partner is assessable as his own income or as the income of the HUF, of which he is the karta, depends on different considerations. It has no reflection or effect on the applicability of s. 40(b), which covers payments made by the firm to its partners. Section 40(b) is not concerned with, and hence cannot be affected by, the consequential assessment of the payment made by the firm either in the hands of the karta individually or of his HUF.

36. It was stressed on behalf of the assessee that this view will lead to double taxation. That is not an unheard of proposition in income-tax matters. The amounts paid by the firm to a partner as salary or interest, etc., are disallowed on the ground that they are illegal distribution of the profits of the firm. Many kinds of expenses, though actually incurred, are disallowed as inadmissible deduction. Such amounts are taxed in the hands of the firm, though they are also assessed in the hands of the recipient of such payments on the ground that they constitute the latter's income. Section 167 of the I.T Act deals with representative-assessees, and provides that the ITO has the same remedy against the representative-assessee as well as against the beneficiary direct. This provision, to which our attention was invited by learned counsel for the assessee, has no bearing on the question, which we have to resolve.

37. The Tribunal laid emphasis on the method of computing a partner's share in the income of the firm given in s. 67 of-the Act. We do not see how that helps. As already seen, the Supreme Court has laid down that the arnounts paid to a partner are liable to be assessed in the hands of the partnelr individually or the HUF, of which he is the representative, depending on the finding whether there was a direct connection between the contribution of the HUF and the payment. In case the HUF is found to be the real and substantial cause for the payments, such payments cannot obviously be assessed in the hands of the partner in his individual assessment. The difficulty that may be experienced by the partner who received the payment in relation to his own assessment cannot, in our opinion, confuse the clear language of s. 40(b).

38. In our view, the interest paid by the firm to the partners either on the amounts brought by them from their respective HUF funds, or brought from their own individual funds is in either case payment of interest to the partners. Both these kinds of payments are within the purview of s. 40(b), and are inadmissible as a deduction in the assessment of the firm. The question of law referred for our opinion, namely:

“Whether, on the facts and in the circumstances of the case, s. 40(b) of the I.T Act, 1961, did not apply to the payment of interest to Sri C.L Berry, I.L Berry and P.K Berry?”

is answered in the negative, in favour of the department and against the assessee.

39. The Commissioner would be entitled to costs which are assessed at Rs. 200.