Madras High Court
Commissioner Of Income Tax vs Indian Fireworks Industries on 20 April, 1995
JUDGMENT S.M. Ali Mohamed, J.
1. Pursuant to the direction of this Court in TCP Nos. 514 and 515 of 1980, dt. 23rd Feb., 1981, the Tribunal, Madras Branch 'C', has drawn up the statement of cases and has referred the following question of law for the opinion of this Court, under s. 256(2) of the IT Act, 1961 (hereinafter referred to as "the Act") :
"Whether, on the facts and in the circumstances of the case, the Tribunal was correct in law in holding that when a partner receives as well as pays interest to a partnership-firm, the disallowance of interest to be made under s. 40(b) of the IT Act, 1961, should be the net interest only and not gross interest ?"
2. The relevant facts of the case are as follows :
The assessee, the Indian Fireworks Industries, Sivakasi, is a registered partnership under the Indian Partnership Act, 1932. The reference relates to the asst. yrs. 1975-76 and 1976-77. In making the assessments, the ITO disallowed the gross interests paid to the partners by the assessee-firm of Rs. 54,775 and Rs. 61,827, respectively, under s. 40(b) of the IT Act, 1961, rejecting the assessee's plea that when a partner receives as well as pays interest to the firm only the net interest should be disallowed under s. 40(b) of the Act. The assessee preferred an appeal to the AAC. The AAC allowed the appeal of the assessee holding that only the net interest paid by the partner should be disallowed under s. 40(b) of the Act. On further appeal preferred by the Revenue, the Tribunal concurred with the view of the AAC that only the net interest paid by the party should be disallowed under s. 40(b) of the Act, following the decision of the Tribunal in the case of another assessee in ITA No. 1237/Mad of 1977-78, dt. 5th Aug., 1978.
3. Mrs. Aparna Nandakumar, learned counsel appearing on behalf of the Revenue, strenuously urged that the Tribunal erred in law in holding that only the net interest paid by the partner should be disallowed under s. 40(b) of the Act and submitted that the entire gross interest should be disallowed under s. 40(b) of the Act. In this connection, Mrs. Aparna Nandakumar, referred to a decision of this Court in CIT vs. O. M. S. S. Sankaralinga Nadar & Co. and submitted that the entire gross interest paid by the firm to its partner is liable to be disallowed under s. 40(b) of the Act. However, she was fair in her submission that the opinion of this Court expressed in CIT vs. O. M. S. S. Sankaralinga Nadar & Co. (supra) has been overruled by the Supreme Court in Keshavji Ravji & Co. vs. CIT (1990) 183 ITR (SC) 1. No one appeared on behalf of the assessee-respondent. Before the above ruling of the Supreme Court, there was a sharp divergence of legal opinion in the various High Court of this country. In Sri Ram Mahadeo Prasad vs. CIT (1953) 24 ITR 176 (All), CIT vs. Kailash Motors , CIT vs. T. V. Ramanaiah & Sons , CIT vs. Kothari & Co. (1987) 165 ITR 594 (Kar), CIT vs. Motilal Ramjiwan & Co. , CIT vs. Precision Steel & Engg. Works , the High Courts have taken the view that, where a firm pays interest to its partner and the partner also pays interest to the firm, only the net amount of interest paid by the firm to the partner is liable to disallowance under s. 40(b) of the Act. However, in CIT vs. O. M. S. S. Sankaralinga Nadar & Co. (supra), the High Court of Madras has taken a contrary view.
4. The statutory provision under s. 40(b) of the Act reads as follows :
"40. Notwithstanding anything to the contrary in ss. 30 to 39, the following amounts shall not be deducted in computing the income chargeable under the head 'Profits and gains of business or profession'.... (b) in the case of any firm, any payment of interest, salary, bonus, commission or remuneration made by the firm to any partner of the firm....."
By the Taxation Laws (Amendment) Act, 1984, several amendments were introduced in the body of s. 40. One of them was the introduction of Expln. 1 in cl. (b) of s. 40. That Explanation reads :
"Explanation 1 - Where interest is paid by a firm to any partner of the firm who has also paid interest to the firm, the amount of interest to be disallowed under this clause shall be limited to the amount by which the payment of interest by the firm to the partner exceeds the payment of interest by the partner to the firm." Interpreting s. 40 of the Act, the Supreme Court has observed as follows :
"Sec. 40 imposes a restriction on the deductibility of certain outgoings and expenses which are, otherwise, enabled under ss. 30 to 39 of the Act and constitutes an exception to these sections. Clause (b) of s. 40 is analogous, with some enlargement, to s. 10(4)(b) of the predecessor Act of 1922. The prohibition in s. 40 against the deductibility of certain outgoings is in mandatory terms. It is this aspect that has loomed large in the reasoning supporting the view accepted by the Madras High Court in Sankaralinga Nadar's case and emphasised by learned counsel for the Revenue. The reasoning of the Madras High Court in that case and of the Andhra Pradesh High Court in CIT vs. T. V. Ramanaiah & Sons (supra), illustrate the rival points of view. The Madras High Court held : 'The collocation of the words shows that what is disallowed in the matter of payment of interest cannot be the net interest, but can only be interest paid with reference to a given account relating to payment of interest by the firm to the partner. This is because the subject of disallowance in the matter of payment of interest appears in s. 40(b) cheek by jowl with salary, bonus, commission or remuneration made by the firm to the partner. There cannot be any net salary or net bonus or net remuneration in matters of disallowance. They can only be salary, as such, or bonus, as such, or commission, as such, or remuneration as such which are the subject of disallowance. In like manner, when the section speaks of payment of interest by the firm to a partner as the subject of disallowance, it can only be payment of "gross" interest in the particular account in which interest is payable. Salary, bonus, commission or remuneration do not have what may be characterised as a two-way traffic..... In the earlier of the cases, the Allahabad High Court endorsed the Tribunal's decision to disallow only the net interest. The Court did so, not on a construction of the words of the section, but on equitable grounds of "fairness".....' The Andhra Pradesh High Court, however, taking the contrary view relied on what it considered the Revenue's own understanding of the legal position as made manifest in the Board's circular that the 'real purpose of s. 40(b) of the Act was to add back only the net amount of interest and not the gross amount'. On the interpretation of s. 40(b), the High Court in Ramanaiah's case said :
'.... As a matter of interpretation of s. 40(b) of the Act, we find that there is nothing in the provision which expressly states that the amount to be added back is either gross or net. The provision requires that "any payment of interest" by a partnership-firm to a partner shall not be deducted in computing the income of the partnership firm. For the purpose of finding out the amount paid by way of interest, it is necessary for the ITO to find out the amount of interest paid by the partnership firm to the partner and also see if the same partner paid any interest to the partnership-firm and ascertain the amount of interest effectively paid by the partnership firm to the partner'....."
Expln. 1 in cl. (b) s. 40 was introduced in the Act by the Taxation Laws (Amendment) Act, 1984. As the assessment in the instant cases relates to the asst. yrs. 1975-76 and 1976-77, the Expln. 1 in cl. (b) of s. 40 inserted by the Taxation Laws (Amendment) Act, 1984, may not be strictly applied for the same. With regard to the Explanation, the Supreme Court in Keshavji Ravji & Co. vs. CIT (1990) 183 ITR 1 (SC) observed as follows :
"It is also true that an Explanation....... be introduced by way of abundant caution in order to clear any mental cob-weds surrounding the meaning of a statutory provision spun by interpretative errors and to place what the legislature considers to be the true meaning beyond any controversy or doubt. Hypothetically, that such can be the possible purpose of an 'Explanation' cannot be doubted. But the question is whether, in the present case, Expln. 1 inserted into s. 40(b) in the year 1984 has had that effect.
The 'Notes on Clauses' appended to the Taxation Laws (Amendment) Bill, 1984, say that cl. 10 which seeks to amend s. 40 will take effect from 1st April, 1985, and will, accordingly, apply in relation to the asst. yr. 1985-86 and subsequent years. The express prospective operation and effectuation of the 'Explanation' might, perhaps, be a factor necessarily detracting from any evincement of the intent on the part of the legislature that the Explanation was intended more as a legislative exposition or clarification of the existing law than as a change in the law as it then obtained."
After considering the various contentions made by learned counsel for the assessee, the Supreme Court observes as follows :
"It appears to us that, if, in substance, the interest paid by the firm to a partner and the interest, in turn, received from the partner are mere expressions of the applications of the funds or profits of the partnership and which, having regard to the community of interest of the partners, are mere variations of the method of adjustment of the profits, there should be no impediment in treating them as part of the same transaction if, otherwise, in general law, they admit of being so treated. The provisions of s. 40(b) do not exclude or prohibit such an approach. If, instead of the transactions being reflected in two separate or distinct accounts in the books of the partnership, they were in one account, the quantum of interest paid by the firm to the partner would, to the extent of the drawings of the partner, stand attenuated. The mere fact that the transactions are split into or spread over two or more accounts should not, by itself, make any difference if, otherwise, the substance of the transaction is the same. One of the relevant tests would be to see whether the funds on which interest is paid or received partake of the same character. A broad analogy, though in itself may not be conclusive, is furnished by the idea of 'mutual dealings' and the principle of set-off statutorily recognised in bankruptcy proceedings under s. 46 of the Provincial Insolvency Act and attracted also to proceedings for winding up of companies by virtue of s. 529 of the Companies Act, 1956, where the 'mutual credit' clause steps in to avoid the injustice, which would otherwise arise, of compelling a creditor to pay the official assignee the full amount of the debt due from him to the insolvent, while the creditor would, perhaps, receive only a small dividend on the debt due from the insolvent to him under a pari passu payment. This principle was recognised by this Court in Official Liquidator vs. Smt. Lakshmikutty (1971) 2 SCR 349. The set-off in this case is, no doubt, the result of a statutory provision. In the case of partners, the special legal incidents of their relationship would substitute for the statutory provision and govern the situation. Indeed, even the idea of a set-off itself, which presupposes a duality of entities, may be out of place in the very nature of the relationship between a firm and its partners where the former is a mere compendious reference to the latter. But even to the extent the income-tax law which identifies the firm as a distinct entity and unit of assessment goes, the idea of set-off may be invoked in view of the mutuality implicit in the putative duality inherent in deeming the firm as a distinct entity under the Act for certain purposes. The fiction may have to be pushed to its logical conclusion.
The decision of the Madras High Court in Sankaralinga Nadar's case , speaks of income-tax and equity being strangers. To say that a Court could not resort to the so-called 'equitable construction' of a taxing statute is not to say that, where a strict literal construction leads to a result not intended to subserve the object of the legislation, another construction, permissible in the context, should not be adopted. In CIT vs. J. H. Gotla , this Court said :
'..... we should find out the intention from the language used by the legislature and if strict literal construction leads to an absurd result, i.e., a result not intended to be subserved by the object of the legislation found in the manner indicated before, then if another construction is possible apart from the strict literal construction, then that construction should be preferred to the strict literal construction. Though equity and taxation are often strangers, attempts should be made that these do not remain always so and if a construction results in equity rather than in injustice, then such construction should be preferred to the literal construction. Furthermore, in the instant case, we are dealing with an artificial liability created for counteracting the effect only of attempts by the assessee to reduce tax liability by transfer......' In this respect, taxing statutes are not different from other statutes. In Attorney-General vs. Carlton Bank (1899) 2 QB 158, Lord Russel of Killowen, C. J. said :
'I see no reason why special canons of construction should be applied to any Act of Parliament, and I know of no authority for saying that a taxing Act is to be construed differently from any other Act. The duty of the Court is, in my opinion, in all cases the same, whether the Act to be construed relates to taxation or to any other subject, viz., to give effect to the intention of the legislature...' In our opinion, where two or more transactions on which interest is paid to or received from the partner by the firm are shown to have the element of mutuality and are referable to the funds of the partnership as such, there is no reason why s. 40(b) should be so construed as to exclude in quantifying the interest on the basis of such mutuality. In such circumstances, the interest, if any, paid to a partner by the firm in excess of what is received from the partner could alone be excluded from deduction under s. 40(b)."
4. Accordingly, the Supreme Court accepted the opinion of the Allahabad High Court, Andhra Pradesh High Court, Karnataka High Court, Rajasthan High Court and the Punjab & Haryana High Court to the effect that where a firm pays interest to its partner and the partner also pays interest to the firm, only the net amount of interest paid by the firm to the partner is liable to disallowance under s. 40(b) of the Act and rejected the opinion of this Court expressed in CIT vs. O. M. S. S. Sankaralinga Nadar's & Co. (supra). The ruling of this Court in Sankaralinga Nadar's case (supra) was given on 7th Dec., 1982, while the orders of the Tribunal in the instant cases are dt. 5th Aug., 1978, and 14th Dec., 1978, respectively, before the decision of this Court in Sankaralinga Nadar's case (supra). The Tribunal followed the decision of the Allahabad High Court and the Board's circular and held that the net interest received from the partner should be disallowed under s. 40(b) of the Act. We find no error of law in the above view expressed by the Tribunal, in view of the above ruling of the Supreme Court. We answer the question referred to us in the two cases of reference, in the affirmative against the Revenue and in favour of the assessee. There shall be no order as to costs.