Bibek Mohanty, AR for the Assessee. Subhendu Dutta, DR for the Revenue.

Both the appeals filed by the assessee are against the order of the CIT(A)-2, Bhubaneswar dated 20.9.2018 for the assessment year 2015-16 and dated 27.6.2019 for the assessment year 2016-17, in the matter of assessment u/s.143(3)/147 of the Income tax Act, 1961 (in short ‘the Act’).

2. The only issue involved in both the appeals is that as to whether the interest on partners’ capital can be treated as exempt for the purpose of making disallowance u/s. 14A of the Income Tax Act, 1961 by invoking the Rule 8D of I.T.Rules, 1962 of Rs.14,00,616/- for the assessment year 2015- 16 and Rs.20,82,640/- for the assessment year 2016-17.

3. Since facts are identical, for the sake of convenience and brevity, we discuss the facts for the assessment year 2015-16 and the decision will apply mutatis mutandis to the assessment year 2016-17.

4. Facts of the case are that during the course of assessment proceedings, the Assessing Officer noticed from the profit and loss account that the assessee firm has shown gross receipts from production of TV programme at Rs.2,59,41,372/- and other income at Rs.53,46,605/-. Out of such business income, the assessee has claimed interest expenses to the tune of Rs.29,09,769/- in the profit and loss account on partners’ capital. The AO also noticed that the assessee has purchased mutual fund to the tune of Rs.1,42,00,000/- during the relevant assessment year, which is the ancillary activities of the assessee firm. The assessee has not availed any secured loan or other loan for the business activities except an unsecured loan of Rs.4,24,371/-. The major portion of partner’s capital account is invested by the assessee in acquiring of mutual funds and other share transaction, which does not form part of the total income. Further, the assessee has shown dividend income and other long term capital gain to the tune of Rs.32,30,.069/-,in the return of income as exempted income which does not form part of the total income. From the above, the AO observed that the interest paid on partners’ capital account has been invested in acquiring mutual funds, which is not allowable as expenditure in the hands of the assessee firm. In view of above, the AO computed the disallowance u/s.14A read with Rule 8D of the Rules at Rs.14,00,616/- being proportionate amount of expenditure towards interest in relation to income which does not form part of the total income and disallowed the same, which was upheld in the firm appeal.

5. Ld Authorised Representative of the assessee placing reliance on the decision of Hon’ble Gujarat High Court in the case of Pr. CIT vs CIMS Hospital Pvt Ltd., (2020) 4 NYPCTR 244 (Guj) submitted that the Assessing Officer can apply Rule 8D of the I.T.Rules if the having regard to the accounts of the assessee is not satisfied with the correctness of the claim made by the assessee in respect of such expenditure in relation to the exempted income. Further placing reliance on the decision of Hon’ble Bombay High Court in the case of PCIT vs BSE Ltd., (2019) 3 NYPCTR 874 (Bom), ld A.R. submitted that non-satisfaction as recorded by the AO for rejecting the sou moto disallowances claimed by the assessee is not done as required under section 14A(2) of the Act. He further explained that the AO must first record a conclusion that having regard to the accounts of the assessee, he is not satisfied with the disallowances offered by the assessee in terms of section 14(2) of the Act. It only on being dissatisfied with the above, Rule 8D of the I.T.Rules can be invoked to compute the disallowance. He further relied on the decision of Hon’ble Gujarat High Court in the case of Pr. CIT vs Aditya Medisales Ltd., (2020) 4 NYPCTR 245 (Guj) to submit that no disallowance towards expenses could be made under Rule 8D(2)(ii) as there was sufficient own fund was available with the assessee. Ld A.R. further submitted that no capital was introduced for investment purposes and, therefore, no disallowance should have been made in the case of the assessee.

6. Ld A.R of the assessee further relied on the decision of ITAT Pune in the case of Quality Industries vs JCIT, 161 ITD 217(Pune) to submit that the issue is covered in favour of the assessee. He also submitted that the decision of the ITAT Pune in the case of Quality Industries (supra) has been followed by ITAT Jaipur Bench in the case of M/s. ASK Partners vs ACIT in ITGA No.187/JP/2017 for A.Y. 2013-14 order dated 31.12.2018 holding that payment of interest to the partners’ towards the use of the partner’s capital as per the provisions of partnership deed is held not subject to disallowance under section 14A r.w. Rule 8D(ii) of the Act. Ld A.R. submitted that the assessee has not incurred any expenditure in relation to exempt income.

Therefore, it was his prayer that the orders of the lower authorities be dismissed by allowing the appeals of the assessee.

7. On the other hand, ld D.R. dutifully supported the orders of lower authorities.

8. We have heard the rival submissions and perused the relevant materials placed on the record of the Tribunal. The assessee is claiming that there are no borrowed funds and no expenditure can be directly attributed to earn the exempt income and the Assessing Officer has not recorded his satisfaction for not accepting the assessee’s claim. In support of its claim, the assessee has relied on the decision of ITAT Pune in the case of Quality Industries(supra), wherein, on similar situation, it is held that payment of interest to the partners by the assessee firm as per the provisions of the partnership deed is not an expenditure which is subject to the provision of section 14A of the Act. The relevant observations of the Tribunal are as follows:

“ 10. We have carefully considered the rival submissions. The pre-dominant question that arises for our consideration is whether payment of interest to the partners by the partnership firm toward use of partner’s capital is in the nature of ‘expenditure’ or not for the purposes of section 14A of the Act and consequently, whether interest on partners capital is amenable to section 14A or not in the hands of partnership firm.

11. In order to adjudicate this legal issue, we need to appreciate the nuances of the scheme of the taxation. We note that prior to amendment of taxation laws from AY 1993-94, the interest charged on partners capital was not allowed in the hands of partnership firm while it was simultaneously taxable in the hands of respective partners. An amendment was inter alia brought in by the Finance Act 1992 in section 40(b) to enable the firm to claim deduction of interest outgo payable to partners on their respective capital subject to some upper limits. Hence, as per the present scheme of taxation, the interest payment on partners capital in essence is not treated as allowable business expenditure except for the deduction available under S. 40(b) of the Act.

11.1. Ostensibly, with effect from assessment year 1993-94, partnership firms complying with the statutory requirements and assessed as such are allowed deduction in respect of interest to partners subject to the limits and conditions specified in section 40(b) of the Act. In turn, these items will be taxed in the hands of the partners as business income under s. 28(v).Share of partners in the income of the firm is exempt from tax under section 10(2A). Thus, the share of income from firm is on a different footing than the interest income which is taxable under the business income.

11.2 Similarly, we note that interest and salary received by the partners are treated on a different footing by the Act and not in its ordinary sense of term. The Section 28(v) treats the passive income accrued by way of interest as also salary received by a partner of the firm as a ‘business receipt’ unlike different treatments given to similar receipts in the hands of entities other than partners. In this context, we also note that under proviso to section 28(v), the disallowance of such interest is only in reference to section 40(b) and not section 36 or S. 37. This also gives a clue that deduction towards interest is regulated only under section 40(b) and the deduction of such interest to partners is out of the purview of s. 36 or 37 of the Act. Notably, there has been no amendment in the general law provided under Partnership Act 1932. The amendment to section 40(b) as referred here in above has only altered the mode of taxation. Needless to say, the Partnership firm is not a separate legal entity under the Partnership Act. It is not within the purview of the Income-tax Act to change or alter the basic law governing partnership. Interest or salary paid to partners remains distribution of business income.

11.3 Relevant here to refer to decision of Hon’ble Supreme Court in the case of CIT vs. R.M. Chimbaram Pillai (1977) 106 ITR 292(SC) relied upon by the Assessee.

Supreme Court has held in the case of R.M. Chidambaram Pillai, etc. (supra) held that:

"A firm is not a legal person, even though it has some attributes of personality. In Income-tax law, a firm is a unit of assessment, by special provisions, but it is not a full person. Since a contract of employment requires two distinct persons, viz., the employer and the employee, there cannot be a contract of service, in strict law, between a firm and one of its partners. Payment of salary to a partner represents a special share of the profits. Salary paid to a partner retains the same character of the income of the firm.

Held accordingly, the salary paid to a partner by a firm which grows and sells tea, is exempt from tax, under rule 24 of the Indian Income- tax Rules, 1922, to the extent of 60 per cent thereof, representing agricultural income and is liable to tax only to the extent of 40 per cent."

Supreme Court has also held in the case of CIT vs. Ramniklal Kothari (1969) 74 ITR 57 (SC) that the business of the firm is business of the partners of the firm and, hence, salary, interest and profits received by the partner from the firm is business income and, therefore, expenses incurred by the partners for the purpose of earning this income from the firm are admissible as deduction from such share income from the firm in which he is partner.

Thus, the ‘partnership firm’ and partners have been collectively seen and the distinction between the two was blurred in the judicial precedents even for taxation purposes.

11.4 Section 4 of the Indian Partnership Act 1932 defines the terms partnership, partner, firm and firm name as under :

“Partnership" is the relation between persons, who have agreed to share the profits of a business, carried on by all or any of the partners acting for all. Persons who have entered into partnership with one another are called individually ‘Partners’ and collectively a ‘firm’ and the name under which their business is carried on is called the ‘firm name”. Thus, it is clear from the above that firm and partners of the firm are not separate person under Partnership Act although separate unit of assessment for tax purposes. There cannot therefore be a relationship inferred between partner and firm as that of lender of funds (capital) and borrowal of capital from the partners, hence section 36(1)(iii) is not applicable at all. Section 40(b) is the only section governing deduction towards interest to partners. In the light of what is already noted above that firm and partners not being two separate persons, the question of borrowing capital by the firm from its partners does not arise at all and, therefore, section 36(1)(iii) is not at all applicable for the purposes of computation of interest to partners under section 40(b) of the Act. To put it differently, in view of section 40(b) of the Act, the Assessing Officer purportedly has no jurisdiction to apply the test laid down under section 36 of the Act to find out whether the capital was borrowed for the purposes of business or not. Thus, the question of allowability or otherwise of deduction does not arise except for S. 40(b) of the Act.

11.5 As noted, as per the scheme of the Act, the interest paid by the firm and claimed as deduction is simultaneously susceptible to tax in the hands of its respective partners in the same manner. In the same vain, the firm is merely a compendium of its partners and its partners do not have separate legal personalities under the basic law as discussed. The interest paid to partners and simultaneously getting subjected to tax in the hands of its partners is merely in the nature of contra items in the hands of the firms and partners. Consequently interest paid to its partners cannot be treated at par with the other interest payable to outside parties. Thus, in substance, the revenue is not adversely affected at all by the claim of interest on capital employed with the firm by the partnership firm and partners put together. Thus, capital diverted in the mutual funds to generate alleged tax free income does not lead to any loss in revenue by this action of the assessee. In view of the inherent mutuality, when the partnership firm and its partners are seen holistically and in a combined manner with costs towards interest eliminated in contra, the investment in mutual funds generating tax free income bears the characteristic of and attributable to its own capital where no disallowance under S. 14A read with Rule 8D is warranted. Consequently, the plea of the assessee is merited in so far as interest attributable to partners. However, the interest payable to parties other than partners, in our view, would be subjected to provisions of Rule 8D(2)(ii) of the Rules. Similarly, in the absence of any specific plea from assessee towards disallowance under Rule 8D(3), we hold it sustainable in view of express mandate of law. The matter is accordingly remanded back to the file of the Assessing Officer for re- computation of disallowance under Rule 8D r.w.s. 14A of the Act in terms of our opinion expressed here in above.”

9. Respectfully following the decision of ITAT Pune in the case of Quality Industries (supra), we hold that payment of interest to the partners towards the use of the partner’s capital as per the provisions of partnership deed is held not subject to disallowance under section 14A read with Rule 8D(ii) of the Act. We are also of the view that interest is simultaneously be subjected to tax in the hands of its partners is merely in the nature of contract items in the hands of the firms-partners. Therefore, the investment in Mutual funds by the assessee generating tax free income bears the characteristic of and is attributable to its capital where, no disallowance u/s.14A r.w Rule 8D(ii) is warranted. However, in respect of disallowance u/r 8D(iii), no specific ground or plea has been taken by the ld A.R. on behalf of the assessee, therefore, we hold it sustainable in view of express mandate of law. At this stage, keeping in view the facts related to the remaining issue of mandatory disallowance u/s.14A r.w. Rule 8D(2)(iii),we are consistently following the view expressed by this Bench in the case of NALCO vs ACIT, Corporate Circle in ITA Nos.106 & 110/CTK/2018 order dated 23.9.2019, wherein, it was held thus :

“11. Invoking the provisions of Section 14A r.w.Rule 8D, the AO has made the disallowance of Rs.6,82,43,072/- by observing that the disallowance suo-moto made by the assessee is very less compared to the administrative and employee cost devoted to earn the exempt income. In appeal, the CIT(A) has confirmed the disallowance as there may not be any direct expense and that the assessee has not made any interest payments related to earning of exempted dividends and accordingly, the only way disallowance can be computed proportionately as per Rule 8D(2)(iii) of I.T.Rules.

12. Ld. AR before us submitted that the assessee has already added the sum of Rs.82,378/- in the computation of income with the (return of income) u/s.14A of the Act in respect of expenses incurred relating to its exempted income and Rule 8D is not applicable. Ld. AR further submitted that this issue has been decided by the Tribunal in ITA No.211/CTK/2016 along with other connected appeals, order dated ITA Nos.106&110/CTK/2018 CO No.30/CTK/2018 12 29.06.2018 for the assessment year 2013-2014. On the other hand, ld. DR relied on the order of AO.

13. We find that this issue has been decided by the Tribunal in assessee’s own case for the assessment year 2010-2011 in ITA No.211/CTK/2016 along with other connected appeals, order dated 29.06.2018 for the assessment year 2013-2014, wherein the Tribunal relying its earlier order dated 27.04.2018, passed in ITA No.352/CTK/2016 for the assessment year 2010-2011 along with other connected appeals has observed as under :-

22. From the above judicial decisions, we find that the Tribunal has restored the disputed issue to the file of AO for re-examination and reverification and apply the provisions of Section 14A r.w.rule 8D and in the instant case, the issue being similar, we find that the AO has not complied with the mandatory requirement of Section 14A (2) of the Act read with Rule 8D (1) (a) of the Rules and we respectfully follow the above judicial decision of the Tribunal and remit the disputed issue to the file of AO for re-examination and verification and to decide the issue on merits after complying the mandatory requirement of the provisions of Section 14A of the Act and this ground of appeal is allowed for statistical purposes.

14. From the orders both the authorities below, we observe that the assessee is earning income under different heads, as mentioned above. During the year, the assessee has received dividend of Rs.110,068,076/- and claimed such income as exempt income. The assessee has only made disallowance at Rs.1,20,828/- u/s.14A to earn the exempt income. The Assessing Officer has applied section 14A read with Rule 8D and disallowed the expenditure as per formula provided under rule 8D. The assessee is stated to have made no fresh investments out of borrowed funds. The Assessing Officer appears to have calculated the disallowance as per Rule 8D(2)(iii) observing that administrative expenses cannot be denied to earn exempt income. We, however, find that the Assessing Officer has considered average total investment appearing on the first day and last day of the financial year, which in our opinion is not justified. These investments may also include such investments from which no exempt income would have been earned by the assessee. As is clear from the Rule itself, the average of only such investments have to be taken into account, which yielded the income not forming part of the total income. Therefore, the AO was required to work out the average of such investment, the income from which did not form part of the total income instead of total value of investment. For this view, our stand is fortified by the decision of Special Bench in the case of ACIT vs. Vireet Investment (P) Ltd., (2017) 82 Taxman.com 415 (Delhi Trib.)(SB). None of the parties before us, however, have laid any details to examine as to which of the investments have yielded such income which did not form part of the total income. We, therefore, restore the matter back to the file of the Assessing Officer for calculating the disallowance u/s. 14A read with Rule 8D afresh, in the light of observations made in the body of this order above. Accordingly, ground No.4 is allowed for statistical purposes. “

In the present case also, none of the parties before us, have submitted any details to examine as to which of the investment yield such exempt income which did not form part of total income. We, therefore, restore the issue to the file of the AO for limited purpose i.e. for calculation of the disallowance u/s.14A r.w. Rule 8D(2)(iii) of the Rules, in the light of our conclusions recorded hereinabove.

10. Thus, the issue is restored to the file of the AO for recomputation of disallowance u/s.14A of the Act r.w. Rule 8D(2)(iii) in terms of our directions given hereinabove and the appeal for assessment year 2015-16 is partly allowed for statistical purposes.

11. Since facts and issue involved in the appeal for assessment year 2016-17 are identical, therefore, in line with our decision for the assessment year 2015-16, addition made u/s.14A of the Act is partly deleted and disallowance u/s.14A r.w. 8D(2)(iii) is restored to the file of the AO, hence,in the same line as has been restored for limited purposes. Hence, appeal for assessment year 2016-17 is partly allowed for statistical purposes.

12. In the result, appeals of the assessee are partly allowed.

Order pronounced on 21/10/2020.

SD/- SD/-

(Laxmi Prasad Sahu) (Chandra Mohan Garg)

ACCOUNTANT MEMBER JUDICIAL MEMBER

Cuttack; Dated 21 /10/2020