My firm pays interest on partners' capital. Is the s.40(b)(iv) ceiling the only test the AO can apply?
No — both tests apply, in that order. A firm must first bring the interest within s.36(1)(iii) and then keep within the ceiling in s.40(b)(iv), because ss.30 to 38 grant the deduction while s.40 operates as a limitation on them. Whether the partners' capital was in the nature of a loan makes no difference to that analysis.
Decided by the Supreme Court (S.H. Kapadia J and B. Sudershan Reddy J) on 2008-02-19, reported as (2008) 298 ITR 298 (SC); 168 Taxman 43 (SC); 215 CTR 105 (SC); Civil Appeal Nos. 1378 to 1382 of 2008. It bears on section 36(1)(iii), section 40(b)(iv), section 40(b) of the Income Tax Act 1961, in Deductions & Disallowances matters.
It settles the structure of the argument when a firm's interest to partners is disputed, so you know which limb the officer is actually on. The decision also carries two points that decide most of these disputes on facts: where the firm has sufficient profits and own funds, its case that interest-free loans to sister concerns came out of those funds has to be accepted; and where loans given in an earlier year were accepted as given for business purposes, the interest cannot be disallowed in a later year.
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The assessee was a firm. In August and September 1991 it granted interest-free advances to sister concerns, which the department disallowed on the footing that they came not from the firm's own funds but from interest-bearing loans taken from third parties. For assessment years 1992-93 and 1993-94 the Tribunal deleted the disallowance, holding the advances were made from the firm's own funds and for business purposes, and the department accepted those orders. The advances were repaid year by year and were finally repaid in assessment year 1997-98. During assessment year 1995-96 a further interest-free loan of Rs 5 lakhs was advanced, in a year in which the firm's opening balance was Rs 1.91 crores. For assessment years 1994-95 to 1997-98 the Tribunal took the contrary view because of the change made by the Finance Act 1992, and the Punjab and Haryana High Court upheld the disallowance, relying on its own judgment in CIT v. Abhishek Industries Ltd. The assessment years before the Supreme Court were 1993-94 to 1997-98.
The appeals were allowed and the High Court judgments set aside, with no order as to costs (para 19). Section 40 is not a stand-alone section: it begins with a non obstante clause and operates as a limitation on the deductions in ss.30 to 38, so a firm must first establish its right to a deduction under one of ss.30 to 38 - here s.36(1)(iii) - and then show it is not disentitled by s.40(b)(iv) (paras 14-15). The assessee's argument that partner's capital is not a loan, so that only s.40(b)(iv) applied, was conceptually accepted but held not to displace that scheme (para 15). On the facts the assessee nonetheless succeeded: the loans made in August and September 1991 continued until assessment year 1997-98, had already been found to be for business purposes, and the interest paid did not exceed the 18/12 per cent limit, so the deduction was allowable (para 16). The Tribunal's finding that there was nothing to show the Rs 5 lakh loan in 1995-96 came from the firm's own funds was erroneous, because the opening balance of Rs 1.91 crores was more than sufficient to cover it (para 17).
Before the Finance Act 1992 interest paid by a firm to a partner was a business disallowance and had to be added back. After that Act it became deductible up to the 18/12 per cent limit in s.40(b)(iv). Because s.40 opens 'Notwithstanding anything to the contrary in sections 30 to 38', an expenditure may fall within ss.30 to 38 and still lose the deduction under s.40; s.36(1) sits under the heading 'Other deductions' while s.40 sits under 'Amounts not deductible', so ss.30 to 38 are deductions and s.40 is a limitation on them (para 14). Reading Chapter IV-D as a whole, ss.28 to 43C deal with business income, ss.30 to 38 with deductions and ss.40A and 43B with business disallowances; s.40(b)(iv) was enacted not only to avoid double taxation but to bring different assessees on par, and both s.36(1)(iii) and s.40(b)(iv) deal with interest paid by a firm, so every assessee claiming under ss.30 to 38 must also show it is not disentitled under s.40. Section 40 is a corollary to ss.30 to 38 and not a stand-alone section (para 15). On the facts, since the Tribunal had already found for 1992-93 and 1993-94 that the loans were from the firm's own funds and for business purposes, and those advances simply ran on until 1997-98, the change of law brought about by the Finance Act 1992 did not justify disallowance in the later years (para 16).
In our view, section 40 is a corollary to sections 30 to 38 and, therefore, section 40 is not a stand-alone section.
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Handle my notice → Ask a CA on WhatsAppNo — both tests apply, in that order. A firm must first bring the interest within s.36(1)(iii) and then keep within the ceiling in s.40(b)(iv), because ss.30 to 38 grant the deduction while s.40 operates as a limitation on them. Whether the partners' capital was in the nature of a loan makes no difference to that analysis. This was decided by the Supreme Court (S.H. Kapadia J and B. Sudershan Reddy J) and bears on section 36(1)(iii), section 40(b)(iv), section 40(b) of the Income Tax Act 1961. It is reported as (2008) 298 ITR 298 (SC); 168 Taxman 43 (SC); 215 CTR 105 (SC); Civil Appeal Nos. 1378 to 1382 of 2008. It settles the structure of the argument when a firm's interest to partners is disputed, so you know which limb the officer is actually on. The decision also carries two points that decide most of these disputes on facts: where the firm has sufficient profits and own funds, its case that interest-free loans to sister concerns came out of those funds has to be accepted; and where loans given in an earlier year were accepted as given for business purposes, the interest cannot be disallowed in a later year. If it applies to you, the first step is this: Answer the two stages separately in the reply — entitlement under s.36(1)(iii) first, then compliance with the s.40(b)(iv) rate ceiling — rather than treating the ceiling as the whole question.
The assessee was a firm. In August and September 1991 it granted interest-free advances to sister concerns, which the department disallowed on the footing that they came not from the firm's own funds but from interest-bearing loans taken from third parties. For assessment years 1992-93 and 1993-94 the Tribunal deleted the disallowance, holding the advances were made from the firm's own funds and for business purposes, and the department accepted those orders. The advances were repaid year by year and were finally repaid in assessment year 1997-98. During assessment year 1995-96 a further interest-free loan of Rs 5 lakhs was advanced, in a year in which the firm's opening balance was Rs 1.91 crores. For assessment years 1994-95 to 1997-98 the Tribunal took the contrary view because of the change made by the Finance Act 1992, and the Punjab and Haryana High Court upheld the disallowance, relying on its own judgment in CIT v. Abhishek Industries Ltd. The assessment years before the Supreme Court were 1993-94 to 1997-98. The matter was decided on 2008-02-19 by the Supreme Court (S.H. Kapadia J and B. Sudershan Reddy J). On those facts the Supreme Court held as follows. The appeals were allowed and the High Court judgments set aside, with no order as to costs (para 19). Section 40 is not a stand-alone section: it begins with a non obstante clause and operates as a limitation on the deductions in ss.30 to 38, so a firm must first establish its right to a deduction under one of ss.30 to 38 - here s.36(1)(iii) - and then show it is not disentitled by s.40(b)(iv) (paras 14-15). The assessee's argument that partner's capital is not a loan, so that only s.40(b)(iv) applied, was conceptually accepted but held not to displace that scheme (para 15). On the facts the assessee nonetheless succeeded: the loans made in August and September 1991 continued until assessment year 1997-98, had already been found to be for business purposes, and the interest paid did not exceed the 18/12 per cent limit, so the deduction was allowable (para 16). The Tribunal's finding that there was nothing to show the Rs 5 lakh loan in 1995-96 came from the firm's own funds was erroneous, because the opening balance of Rs 1.91 crores was more than sufficient to cover it (para 17).
Before the Finance Act 1992 interest paid by a firm to a partner was a business disallowance and had to be added back. After that Act it became deductible up to the 18/12 per cent limit in s.40(b)(iv). Because s.40 opens 'Notwithstanding anything to the contrary in sections 30 to 38', an expenditure may fall within ss.30 to 38 and still lose the deduction under s.40; s.36(1) sits under the heading 'Other deductions' while s.40 sits under 'Amounts not deductible', so ss.30 to 38 are deductions and s.40 is a limitation on them (para 14). Reading Chapter IV-D as a whole, ss.28 to 43C deal with business income, ss.30 to 38 with deductions and ss.40A and 43B with business disallowances; s.40(b)(iv) was enacted not only to avoid double taxation but to bring different assessees on par, and both s.36(1)(iii) and s.40(b)(iv) deal with interest paid by a firm, so every assessee claiming under ss.30 to 38 must also show it is not disentitled under s.40. Section 40 is a corollary to ss.30 to 38 and not a stand-alone section (para 15). On the facts, since the Tribunal had already found for 1992-93 and 1993-94 that the loans were from the firm's own funds and for business purposes, and those advances simply ran on until 1997-98, the change of law brought about by the Finance Act 1992 did not justify disallowance in the later years (para 16). In the words reproduced by the source cited on this page: "In our view, section 40 is a corollary to sections 30 to 38 and, therefore, section 40 is not a stand-alone section." The decision followed or applied CIT v. Abhishek Industries Ltd. [2006] 286 ITR 1 / 156 Taxman 257 (P&H) - impliedly overruled; Munjal Sales Corp. v. CIT [2008] 298 ITR 288 (P&H) - reversed; CIT v. Munjal Sales Corpn. [2008] 298 ITR 294 (P&H) - reversed.
It was decided by the Supreme Court on 2008-02-19 and is reported as (2008) 298 ITR 298 (SC); 168 Taxman 43 (SC); 215 CTR 105 (SC); Civil Appeal Nos. 1378 to 1382 of 2008. Binding on every court and authority in India. A Supreme Court decision binds every assessing officer, every Commissioner (Appeals), every bench of the Income Tax Appellate Tribunal and every High Court in India. An officer who declines to follow it is acting contrary to law, and that refusal is itself a ground of appeal. On section 36(1)(iii), section 40(b)(iv), section 40(b), the practical question is whether the facts of your own notice match the facts of this case closely enough for the same rule to apply.
It helps the taxpayer. The appeals were allowed and the High Court judgments set aside, with no order as to costs (para 19). Section 40 is not a stand-alone section: it begins with a non obstante clause and operates as a limitation on the deductions in ss.30 to 38, so a firm must first establish its right to a deduction under one of ss.30 to 38 - here s.36(1)(iii) - and then show it is not disentitled by s.40(b)(iv) (paras 14-15). The assessee's argument that partner's capital is not a loan, so that only s.40(b)(iv) applied, was conceptually accepted but held not to displace that scheme (para 15). On the facts the assessee nonetheless succeeded: the loans made in August and September 1991 continued until assessment year 1997-98, had already been found to be for business purposes, and the interest paid did not exceed the 18/12 per cent limit, so the deduction was allowable (para 16). The Tribunal's finding that there was nothing to show the Rs 5 lakh loan in 1995-96 came from the firm's own funds was erroneous, because the opening balance of Rs 1.91 crores was more than sufficient to cover it (para 17). It arises in Deductions & Disallowances matters, on section 36(1)(iii), section 40(b)(iv), section 40(b) of the Income Tax Act 1961, and was decided by S.H. Kapadia J and B. Sudershan Reddy J. Before relying on it, read the source linked on this page and check whether it has since been distinguished, overruled or overtaken by an amendment to the Income Tax Act. In practice the steps that follow from it are these. Put the profits and own funds of the firm on record alongside the interest-free advances, since sufficiency of own funds is what carried the assessee here. Pull the assessment record for the year the loan was first given; if it was accepted then as for business purposes, say so and rely on that acceptance for the year under dispute. Do not argue about whether the partners' capital was really a loan, which the Court treated as irrelevant.
Validity check could not be completed. The judgment's own case review records that it impliedly overruled CIT v. Abhishek Industries Ltd. [2006] 286 ITR 1 / 156 Taxman 257 (P&H) and reversed the two Punjab and Haryana High Court judgments below, reported at [2008] 298 ITR 288 and 298 ITR 294. No later decision applying, following or affirming it has been identified, and the judgment carries no citator entry recording later treatment, so its current standing is left unverified rather than asserted. Nothing overruling or doubting it was found either. Two related points rest on secondary commentary that has not been re-checked and should be confirmed before being relied on: the present rate ceiling in s.40(b)(iv), and the state of the main clause of s.36(1)(iii) after later Finance Acts. No source could be cited for that finding. Checking whether an authority still stands matters as much as knowing what it held: a decision may be overruled on one point and survive on another, or the provision it interprets may have been amended since. Read the source and the editor's note on this page before relying on it in a reply to an Assessing Officer or in an appeal.
On the law the Revenue won and the assessee lost: the Court expressly accepted the Additional Solicitor General's submission that s.40 limits ss.30 to 38, and said so at para 18, adding that the assessee succeeded 'on the peculiar facts of this case'. Cite it for the two-stage framework, not for a taxpayer-friendly reading of s.40(b)(iv). The decision also impliedly overruled the Punjab and Haryana High Court's judgment in CIT v. Abhishek Industries Ltd., which had been the basis of the disallowance below. This library shows the verification state of every entry openly. This entry has not yet been read in full by a chartered accountant. The summary reflects the sources listed on this page. Read the source before you rely on it in a reply to an Assessing Officer or in an appeal before the Commissioner (Appeals) or the Income Tax Appellate Tribunal.
The appeals were allowed and the High Court judgments set aside, with no order as to costs (para 19). Section 40 is not a stand-alone section: it begins with a non obstante clause and operates as a limitation on the deductions in ss.30 to 38, so a firm must first establish its right to a deduction under one of ss.30 to 38 - here s.36(1)(iii) - and then show it is not disentitled by s.40(b)(iv) (paras 14-15). The assessee's argument that partner's capital is not a loan, so that only s.40(b)(iv) applied, was conceptually accepted but held not to displace that scheme (para 15). On the facts the assessee nonetheless succeeded: the loans made in August and September 1991 continued until assessment year 1997-98, had already been found to be for business purposes, and the interest paid did not exceed the 18/12 per cent limit, so the deduction was allowable (para 16). The Tribunal's finding that there was nothing to show the Rs 5 lakh loan in 1995-96 came from the firm's own funds was erroneous, because the opening balance of Rs 1.91 crores was more than sufficient to cover it (para 17).
Every entry in this library links to where it was found, so you can check it yourself rather than take our word for it.
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I have my own funds and borrowings. Can the AO assume the interest-free advance came out of the loan?