The Chief Justice and Ramesam, J. — This case has been referred to us under Sect. 66 (3) in pursuance of an order of this Court requiring the Commissioner of Income-tax to state a case and refer it.
The facts of the case are as follows: According to a deed of partnership dated 29th July, 1921, Ex. A, A. L. S. P. P. Subramanian Chettiar and A. R. S. S. P. Subramanian Chettiar entered into a partnership according to the terms of which the former contributed Rs. 15, 750 as his ¾ share of the capital and the latter contributed Rs. 5,250 being ¼ share of the capital, the initial capital agreed being Rs. 21,000 and they were to share the profit and loss in the ratio of 3 to 1. The document also contemplates that, if necessary, further sums may be contributed by either party towards the additional capital of the business and that interest should be charged on it. The Commissioner has found that the senior partner advanced a sum of Rs. 4,01,251 as additional capital in parts at various times and that the junior contributed comparatively a very small sum. The amount of interest on the senior partner's advances comes to Rs. 40,757 and the interest on the junior partner's advances to Rs. 78. It is now claimed on behalf of the partnership that the total of these two amounts of interest paid to the partners for sums advanced by them should be deducted in estimating the amount on which the partnership should be assessed for income-tax under Sect. 10 (2) (iii). The Assistant Commissioner held that the whole of the additional sums advanced by the partners must be regarded really as the capital of the firm. On appeal the Commissioner in his order conceded that a partner may sometimes occupy a dual capacity, that is, he may lend a definite sum of money to the firm on a formal document in which case it would be regarded as a loan; but in the present case the sums advanced by the partners cannot be regarded as loans but as ‘Surplus capital.’ The question to be decided by us is whether the sums advanced by the partners should be regarded as “capital borrowed for the purposes of the business” within the meaning of Sect. 10 (2) (iii). In the argument before us the learned vakil who appeared for the Commissioner admitted that the sums advanced by the partners where capital, but he denied that it is capital “borrowed.” The proposition of law for which he contended is that though a partner may make a loan to the partnership he cannot lend capital to the partnership and that additional capital required for the purposes of the partnership can be borrowed only from outsiders, in other words, though capital may be borrowed from outsiders, capital cannot be borrowed from a partner. He cited no authority for this proposition. The sub-clause itself does not contain any limitation as to the person from whom capital is to be borrowed. Once it is conceded that a partner can lend money just like any other third person it is difficult to see why he cannot lend capital also. Whether the money lent is capital or a mere loan really depends on the use to which it is put and not on the person from whom it was borrowed. If it is used for purposes similar to those for which initial capital is used, then it is capital in the hands of the partners by reason of the use which it is put to, though it was money borrowed from the partners. It is not the character of the lender that determines whether the sum borrowed is capital or not. The Commissioner seems to think that, if a sum of money is deposited with the partnership temporarily for reasons unconnected with the business, it is a loan, but if it is invested for a much longer time than the business required it, the initial capital being insufficient, then it becomes surplus capital and not a loan. We are not able to follow these distinctions of the Commissioner. All sums lent to the partnership are loans whoever the parties and whatever the purpose for which they are lent. After being borrowed, if they are used like capital, they become borrowed capital, and, if they are not so used, they continue to be mere loans, the expenditure not being in the nature of capital expenditure (vide Cl. 9 of the same sub-section). In the present case the Commissioner himself found that it was capital and there is no doubt also that it was borrowed from the partners. That being so, we are of opinion that Sect. 10 (2) (iii) applies.
It is said that there is a finding of fact by the Commissioner that the sums in question in this case are not capital borrowed within the meaning of the clause in question. The so-called finding of fact is really based upon certain facts pure and simple as to which there is no dispute and which are accepted on all hands plus certain supposed legal principles on which the Commissioner relies but for which there is really no authority. Wherever a sum is borrowed and it is afterwards used for capital expenditure it is not open to the Commissioner to find that it is not borrowed capital as there is no such principle of law as is contended before us on behalf of the Commissioner. It is also said that there is a finding that the initial capital was nominal and from the beginning additional capital was intended. Here again there is no dispute about the facts. The initial capital consisting of two amounts which the parties were bound to contribute, is known. So far as additional or surplus capital is concerned no partner is bound to advance any particular sum. All that the deed provides is that if a partner chooses to advance certain sums he will be entitled to interest, but he is not compellable to do so. It is clear therefore that what is called surplus capital has different characteristics from the initial capital and it is not open to ignore this difference. The fact that a large business was contemplated for which the small initial capital would not be enough and additional capital would therefore be required has really no bearing on the legal aspect of the question, additional capital having different incidents from initial capital. Moreover, however high may be the proportion one partner may contribute in the form of additional capital relatively to the other partner it will have no bearing on the proportion in which the profits are to be taken. This again shows that it is not open to regard additional capital as really initial capital. The Commissioner's finding being based on misconceptions of law cannot be accepted as findings of fact binding upon us.
The only other question is whether interest paid on the sums advanced can be said to be in any way dependent on the earning of profits. It is clear that the clause
“Where the payment of interest thereon is not in any way dependent on the earning of profits”
relates to the payability of interest, that is, the clause excludes cases where interest is payable in some manner dependent on the earning of profits. If interest is payable, whether profits are earned or not the clause applies. The learned vakil for the Commissioner argued that the scheme of the Act showed that wherever profits are earned, they were intended to be wholly assessed and the construction we are placing on this clause is inconsistent with the scheme of the Act. There is no such general scheme in the Act. In this respect the law in India seems to be different from that in England and the English cases mentioned by the learned vakil for the Commissioner have really no bearing on the construction of the Indian Act and need not be referred to. It is hardly necessary to observe that, when interest is deducted from the earnings under this clause by the partnership as its expenditure, it is really profit earned by the individual partner who takes the interest and it will be added to his income in assessing him individually. The actual rate of assessment and to what extent the State is profited or loses by the change in the assessee depends really on the actual income of the individual partner for the particular year and in the case where he has lost in his trade in any year the transfer of the amount as his income may merely reduce his losses and may not result in any assessment. But these are all accidental circumstances which may vary year after year. One year the State may lose and another year the partnership may lose. Gain or loss to the State is really irrelevant for our purpose.
There is one further observation to be made. It is only where interest is paid that the deduction contemplated by Sect. 10 (2) (iii) is permissible. Payment need not be actually in cash but may be by adjustment of accounts; but in whatever manner it is done it must be a real out-going. In the present case the Commissioner has found that interest has been paid as the question referred to us shows. There may be cases where no interest has yet been paid but may be due only. In such a case the partnership cannot ask for deduction of interest merely on the ground that it is due. Therefore no question arises before us on this aspect of the matter.
We therefore answer the question referred to us as follows:—
Where a partner as partner lends money beyond the initial capital to the partnership at an agreed rate of interest and the money is used for capital expenditure, the interest paid by the partnership to him in the year of assessment must be deducted in computing the profits or game of the partnership within the meaning of Sect. 10 (2) (iii).
Costs Rs. 500 will be paid by the Commissioner of Income-tax to the assessees.
The above judgment represents the joint view of Ramesam, J., and myself and was drafted by him after full discussion between us.
R. C. No. 22 of 1926.—This is governed by our opinion in the other case.
Costs Rs. 100 will be paid by the Commissioner of Income-tax to the assessees.
Wallace, J.—I agree with the statement of the law applicable to this case as expounded by my learned brothers, the case being one where, on the facts found, there was a genuine borrowing of capital at the prevailing market rate of interest. I only wish to guard myself against the supposition that in other cases it will not fall to be decided as a point of fact whether the alleged borrowing of capital was not a genuine loan but a mere device to evade the Act. To take an extreme case: Where two partners agree on a nominal capital and then each lends additional capital at a fancy rate of interest calculated so high or with so little relation to the market rate, as to be obviously designed to absorb all probable profits, and thus enable them to submit a nil profits return, it would surely be open to the Commissioner to find that there was no genuine borrowing of capital. I agree that the present case falls under Sect. 10 (2) (iii) of the Indian Income-tax Act.
Beasley, J.—I agree and make the same reservation as Wallace, J.
Thiruvenkatachariar, J.—The answer to the question referred to the Full Bench depends upon the meaning which should be ascribed to the expression capital borrowed for the purposes of the business' in Sect. 10, Cl. 2 (iii) of the Indian Income-tax Act. It was argued by the learned vakil for the Commissioner that any sum of money which a partner puts into the business of a firm for being used as capital cannot be treated as a loan from him to the partnership, even though the firm purports to borrow the amount from him as a loan; in other words a firm cannot legally borrow its capital from its partners. This proposition would be quite correct if by ‘capital’ is meant the sum which a partner contributes under the agreement of partnership for the purpose of commencing or carrying on the business and which is intended to be risked by him in the business. That is the true sense of the word ‘capital’ and so far as the contribution made by a partner relates only to capital so understood, he is not a creditor of the firm. He has no right to sue the firm for the recovery of such contributions or advances and he can only get back his capital on the dissolution of the firm, out of any surplus assets which may remain after meeting all its liabilities. But in the clause we have to construe, the word ‘capital’ appears to be used not in the sense of a partner's contribution as capital which as pointed out cannot be treated as borrowed capital but as meaning sums borrowed for capital expenditure. Such a borrowing by a firm whether from an outsider or from one of its partners cannot have the effect of increasing the capital of the firm. As observed in Lindley on Partnership:
“If a firm borrows money so as to be itself liable for it to the lender, the capital of the firm is no more increased than is the capital of an ordinary individual increased by his getting into debt.”
So it is the advances made by a partner to a firm over and above the amount which he has agreed to subscribe towards the capital of that business, Cannot be treated as an increase of his capital but as a loan made by him and if such advances are made for being used for the same purposes for which the original capital was intended to be used, they will be capital borrowed for the purpose of business within the meaning of Sect. 10, Cl. 2 (iii), and, if the other requirements of that clause are satisfied, the payment of interest on such borrowings should be deducted from the profits of the business. It is a question of fact in each case whether the further advance made by a partner over and above the capital agreed to be put in by him is really a loan by him to the partnership or an increase of his capital in the business made with the consent of the other partners. So far as the present case is concerned, the question referred treats the advances in question as loans made by the partner to the firm for being utilised as capital and there seems to be no valid ground for questioning that fact. I therefore agree that the question should be answered in the affirmative.
N.R.RReference answered.