Facts of the Case

The present appeal and reference arose from orders passed by the Income Tax Appellate Tribunal (ITAT) relating to different assessment years concerning M/s Kishori Lal & Sons. The dispute centered around the allowability of salary paid by the firm to persons who were partners in their individual names but were representing their respective Hindu Undivided Families (HUFs).

For Assessment Year 1988-89, an amount of ₹1,86,626 was paid as salary to a person representing an HUF. The Assessing Officer disallowed the expenditure under Section 40(b) of the Income-tax Act, 1961. The Commissioner of Income Tax (Appeals) deleted the addition, and the ITAT upheld the deletion.

Similarly, for Assessment Year 1990-91, additions were deleted by the CIT(A) and ITAT relating to salary paid to partners representing HUFs and notional interest on advances made to partners. The Revenue challenged these findings before the Delhi High Court.

 

Issues Involved

ITR No. 31/1999

  1. Whether the ITAT was correct in law in allowing relief to the assessee firm regarding salary paid in view of Section 40(b) of the Income-tax Act, 1961?
  2. Whether the Tribunal committed an error in applying the decision of the Andhra Pradesh High Court instead of the jurisdictional Delhi High Court decision?

ITA No. 172/2001

  1. Whether the CIT(A) and ITAT erred in deleting the addition representing disallowance under Section 40(b) of salary paid to partners who had joined the firm as partners representing their respective HUFs?
  2. Whether the CIT(A) and ITAT erred in deleting the addition relating to notional interest on borrowed funds allegedly diverted as interest-free advances to partners?

 

Petitioner’s Arguments (Revenue)

The Revenue contended that salary paid to a partner representing an HUF was covered by the prohibition contained in Section 40(b) of the Income-tax Act, 1961.

It was argued that irrespective of whether a partner represented an HUF, the payment was ultimately made to a partner of the firm and therefore could not be allowed as a deductible business expenditure.

The Revenue relied upon the legal interpretation subsequently affirmed by the Supreme Court regarding the scope and applicability of Section 40(b).

 

Respondent’s Arguments (Assessee)

The assessee contended that the salary was paid to an individual who represented an HUF and therefore such payment should not be treated as payment to a partner in the capacity contemplated under Section 40(b).

The assessee relied upon judicial precedents supporting the proposition that where a partner participates in a representative capacity on behalf of an HUF, payments made to such person may not attract the disallowance provisions of Section 40(b).

 

Court Order / Findings

The Delhi High Court noted that the Supreme Court in Rashik Lal & Co. vs Commissioner of Income Tax (229 ITR 458) had clarified the legal position regarding payments made to partners representing HUFs.

The Supreme Court had held that although an HUF cannot itself become a partner in a partnership firm, the individual who joins the partnership remains the partner in the eyes of law. Consequently, payments made by the firm to such partner fall within the scope of Section 40(b).

Applying the ratio of the Supreme Court decision, the Delhi High Court held:

  • Salary paid to a partner representing an HUF attracts Section 40(b).
  • The distinction between commission and salary is irrelevant for the purpose of Section 40(b), as the provision covers both categories.
  • The question relating to salary paid to partners representing HUFs was answered in favour of the Revenue and against the assessee.
  • Since Question No. 1 was decided in favour of the Revenue, the second question in ITR No. 31/1999 became redundant and was returned unanswered.
  • Regarding notional interest, the Court observed that no actual interest had been charged and therefore the question did not require any answer in the context of notional interest.

 

Important Clarification

Principle Laid Down

  1. An HUF cannot become a partner in a partnership firm because a partnership is an association of individuals.
  2. Even if a person joins a firm on behalf of an HUF, the individual alone is recognized as the partner in law.
  3. Salary, commission, bonus, remuneration or similar payments made by the firm to such partner are hit by Section 40(b) and are liable for disallowance.
  4. The Supreme Court decision in Rashik Lal & Co. v. CIT (229 ITR 458) governs such situations and settles the legal position.
  5. No addition can ordinarily be sustained merely on the basis of hypothetical or notional interest where no actual interest is charged.

 

Sections Involved

  • Section 40(b), Income-tax Act, 1961 – Disallowance of salary, commission, bonus, remuneration and interest paid by a firm to its partners.
  • Partnership Law Principles relating to HUF Representation in Firms.


Link to Download the Order

https://delhihighcourt.nic.in/app/case_number_pdf/2004:DHC:12930-DB/BCP14122004ITA1722001_112410.pdf

 

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