Section 40(b) in Detail: Remuneration & Interest to Partners by Firm

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October 17, 2012Income TaxNo comments

Section 40(b): Payment of Interest, Salary, Bonus, Commission or Remuneration made by Firm to its Partners.

Section 40(b) laid down the rules for the allowance of payment made by the firm to its partners as salary, remuneration, bonus, commission and interest. The deductions regarding salary to partners and any payment of interest to partners should not exceed the monetary limits specified u/s 40(b) and are deductible subject to the fulfillment of conditions mentioned therein.

1. Partner to be paid must be a working partner: The partners of a partnership firm whose accounts are to be credited with the salary, remuneration, commission, bonus or by whatever name called, by the firm, must be working partners and not the silent partners. Working partner in general terms means the partner who is actively engaged in the business of the partnership firm and is not a partner for merely enjoying the profits/benefits of the partnership business. If a partner is not a working partner then remuneration to such partner will not be eligible for deduction as per section 40(b) of Income Tax Act 1961. Explanation 4 to section 40(b) provides meaning of working partner as an individual who is actively engaged in conducting the affairs of the business or profession of the firm of which he is a partner.

2. Remuneration or interest must be authorized by the Partnership Deed: As per section 40(b) only that salary, remuneration, bonus, commission etc payable to working partners or any payment of interest payable to any partner will be allowed as deduction only if it is authorized by the partnership deed. If the partnership deed doesn’t contain such provisions then the such deductions may be disallowed if the same is claimed by the partnership firm.

Quantification of remuneration is must: CBDT in its circular no. 739 dt 25/03/1996 have clarified that no deduction under section 40(b)(v) will be admissible unless the partnership deed either specifies the amount of remuneration payable to each individual working partner or lays down the manner of quantifying such remuneration.

Thus amount of remuneration is required to be specified in the partnership deed for it to be considered as authorized by the partnership deed and to avoid any disallowance u/s 40(b).

3. No Remuneration to be allowed which relates to any period falling prior to the date of such partnership deed: As per section 40(b)(iii) the remuneration will be allowed as deduction only for that period onwards where from the partnership deed authorizes such remuneration. Thus if a Partnership deed is executed on 01-04-2010 which doesn’t authorizes payment of remuneration to the partners and subsequently the deed is amended by a subordinate partnership deed to provide for such authorization on 01-04-2011 then remuneration to partners will not be allowed for period between 01-04-2010 to 01-04-2011 since during that period it is not authorized by the deed.

4. No Retrospective Effect for Remuneration: If the original partnership deed fails to provide the quantum of remuneration than no remuneration will be allowed to be deducted even if the deed is amended to provide remuneration for earlier time. Example- Partners entered into a partnership agreement on 01-04-2010 and no salary was provided in the deed, on 31-01-2011, the partners entered into an agreement to amend the original deed with retrospective effect from 01-04-2010 to provide salary to each partner. Now the allowance will be only for the month starting from 01-02-2011 to 31-03-2011, not for the period 01-04-2010 to 31-01-2011.

5. Remuneration exceeding the limit prescribed u/s 40(b) to be disallowed: As per section 40(b)(v) any payment of remuneration to any partner who is a working partner, which is authorized by, and is in accordance with, the terms of the partnership deed and relates to any period falling after the date of such partnership deed in so far as the amount of such payment to all the partners during the previous year exceeds the aggregate amount computed as hereunder will be disallowed:

 


(a) on the first Rs. 3,00,000 of the book-profit or in case of a loss
Rs. 1,50,000 or at the rate of 90 per cent. of the book-profit, whichever is more;
(b) on the balance of the book-profit
at the rate of 60 per cent.

Explanation 3 to section 40(b) defines “book-profit” as to mean the net profit, as shown in the profit and loss account for the relevant previous year, computed in the manner laid down in section 28 to 44D as increased by the aggregate amount of the remuneration paid or payable to all the partners of the firm if such amount has been deducted while computing the net profit.

6. Any interest to any partner exceeding 12% disallowed: As per Section 40(b)(iv) any payment of interest to any partner which is authorized by, and is in accordance with, the terms of the partnership deed and relates to any period falling after the date of such partnership deed in so far as such amount exceeds the amount calculated at the rate of 12[twelve] per cent simple interest per annum shall be disallowed. Thus payment of any simple interest to any partner is allowed only to the extent of 12% per annum as deduction as per section 40(b). Even if the partnership deed authorizes any payment of higher rate of interest than 12% to any partner, the excess of interest will not be deducted.

It is here to be noted that where remuneration/salary etc is allowable only to the working partners as per section 40(b)(iii) but payment of interest not exceeding 12% per annum is allowable to any partner whether working or not, since the word any partner is used in 40(b)(iv).

7. Representative Capacity: As per explanation 1 to section 40(b) where an individual is a partner in a firm on behalf, or for the benefit, of any other person(i.e Partner in a representative capacity), interest paid by the firm to such individual otherwise than as partner in a representative capacity, shall not be taken into account for the purposes of section 40(b);

But interest paid by the firm to such individual as partner in a representative capacity and interest paid by the firm to the person so represented shall be taken into account for the purposes of this clause.

Explanation 2 to section 40(b) further provides that where an individual is a partner in a firm otherwise than as partner in a representative capacity, interest paid by the firm to such individual shall not be taken into account for the purposes of this clause, if such interest is received by him on behalf, or for the benefit, of any other person.

Notes:

1. If a firm pays interest to a partner and the partner pays interest to the firm on his drawings, then the interest shall be netted off. The interest received by the firm from the partners on their drawings is taxable in the hands of the firm as income under the head Profits & Gains of Business or Profession. The interest paid by the firm to the partners is allowed as per section 40(b).

2. Interest paid by the firm to its partners on their fixed capital account, current account and loan account is allowable as deduction to the firm provided the partnership deed specifically authorizes the payment of interest on fixed capital account, current capital account and loan account. If the partnership deed authorizes the payment of interest on fixed capital account only, then interest on current capital account and loan account shall not be allowed as deduction to the firm.

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