Section 40(b) of Income Tax Act, 1961 provides certain limitations on the deductions of expenses allowed to assessees being partnership firms regarding the remuneration and interest payable to its partners.
The deductions on salary and interest paid to partners should not exceed the limits stated in section 40(b) and are available only on fulfillment of some conditions stated therein.
Conditions for availing deduction under Section 40(b):
The following conditions have to be satisfied for availing any deduction in connection with the salary or interest paid to a partner by a partnership firm.
1. Partner must be a working partner: The partners, who are to be paid with the salary, remuneration, interest, etc., by the firm, must be working partners and not the silent ones.
“Working partner” refers to a partner who is actively associated with the business of the partnership firm and is not a partner who only enjoys the profits of the business.
If a partner is not a working partner then salary paid to him will not be eligible for deduction under section 40(b) of the Act. Explanation 4 to section 40(b) provides such a condition.
2. Remuneration must be stated in the Partnership Deed: According to section 40(b) only that salary or interest payable to working partners will be allowed as deduction which is mentioned in the partnership deed. If the partnership deed does not have such provisions, the deductions may be disallowed.
3. Quantity of remuneration must be stated: CBDT in its circular no. 739 published on 25.03.1996 have stated that no deduction under section 40(b) (v) will be allowed unless the partnership deed specifies the amount of remuneration payable to a partner. Thus amount of remuneration is required to be mentioned in the partnership deed to avoid any disallowance under section 40(b) of the Act.
It is often seen that a partnership deed contains clauses like “The partners have agreed that the remuneration will be the amount allowable under the provisions of section 40(b)(v) of the Act and the amount of remuneration will be such as may be agreed upon by the partners.” If a partnership deed contains such a clause, then remuneration may be disallowed according to section 40(b).
In the case of Commissioner of Income Tax vs. M/s. Anil Hardware Store (2010) 323 ITR 368 (HP), the remuneration clause in partnership deed was present and it was contended by the revenue that for profits up to Rs.75, 000/-, even in the partnership deed, the word “up to Rs.50, 000” have been used, however deduction was allowed.
4. Remuneration relating to any period prior to the date of deed not to be allowed: According to section 40(b) (iii) the remuneration will be allowed only for that period where from the partnership deed specifies such remuneration.
Illustration: If a Partnership deed is executed on 01.04.2012 which do not authorize payment of remuneration to the partners and the deed is amended thereafter by another deed to provide for such authorization on 01.04.2014, then deduction for remuneration will not be allowed for the time period between 01.04.2012 to 01.04.2014 since that period is not authorized by the deed.
5. Remuneration more than the limit is not allowed: When the amount of remuneration is more than the limit stated in section 40(b), any payment to any working partner, which is authorized by the partnership deed, will be disallowed.
6. Any interest which is more than 12% to be disallowed: As per Section 40(b) (iv) of the Act, any payment of interest to any partner is authorized by the partnership deed but is more than the amount calculated at the rate of 12% simple interest per year shall not be allowed.
Thus payment of interest to any working partner is allowed only up to 12% per annum as deduction under section 40(b). Even if the partnership deed provides payment of a higher rate of interest, the excess interest will not be allowed. The interest is allowable only up to 12% in case of the working partners as per explanation to section 40(b).
If an individual is a partner in a firm on behalf of any other person, the interest paid by the firm to such person who acts in a representative capacity, shall not be considered for section 40(b).However, the interest paid by the firm to such person so represented shall be considered, if such interest is received by him for the benefit of such other person.
