Calcutta High Court
Commissioner Of Income-Tax vs Mohanlal Bhagwati Prosad on 26 November, 1991
Equivalent citations: [1993]204ITR234(CAL)
JUDGMENT Ajit Kumar Sengupta, J.
1. In this reference under Section 256(2) of the Income-tax Act, 1961 (for short, "the Act"), for the assessment year 1984-85, the following questions of law have been referred to this court:
"1. Whether, on the facts and in the circumstances of the case, the Tribunal was justified in law in holding that the interest paid by the firm to its partners cannot be disallowed under Section 40(b) of the Income-tax Act, 1961, as the partners were representing their Hindu undivided family in the firm and the interest were paid to them in their individual capacity ?
2. Whether, having regard to the fact that the three Explanations inserted by the Taxation Laws (Amendment) Act, 1984, were with effect from April 1, 1985, the Tribunal was justified in law in holding that they were only clarificatory in nature and must govern assessments prior to the assessment year 1985-86 and in that view directing to delete the add back of interest paid to the partners in their individual, capacity as they represented their Hindu undivided family in the firm ?"
2. Briefly stated, the facts are that the assessee, in its return for the assessment year 1984-85, for which the relevant previous year ended on October 15, 1983, claimed deduction in respect of interest amounting to Rs. 2,720 and Rs. 17,605 paid to Shri B.P. Kedia and Shri K.P. Kedia, respectively. The said persons were partners of the assessee-firm as kartas of their respective Hindu undivided families (for short, "the HUF"). The interest was claimed to be paid to the said persons in their individual capacity and not as kartas of the Hindu undivided families. It was claimed that the provisions of Section 40(b) of the Act were not applicable to the said interest. The Assessing Officer rejected this contention. He was of the view that the Hindu undivided family as such could not be a partner and the said two partners were really partners in their individual capacity qua the other partners and they were accountable to their respective Hindu undivided families for the share income from the firm. He applied the provisions of Section 40(b) and disallowed the said interest.
3. The assessee challenged the above disallowance in appeal before the Commissioner of Income-tax (Appeals) and contended that interest paid to Shri B.P. Kedia and Shri K.P. Kedia could not be disallowed under Section 40(b) as interest was paid to them as individuals, whereas they were partners in the assessee-firm as kartas of the respective Hindu undivided families. The assessee further relied upon Explanation 2 to Section 40(b) inserted with effect from April 1, 1985.
4. The Commissioner of Income-tax (Appeals) did not agree with the above submissions and confirmed the action of the Income-tax Officer. While doing so, he relied upon the decision of the Allahabad High Court in CIT v. London Machinery Co, [1979] 117 ITR 111 and on the decision of this court in Giridharilal Ghasiram v. CAT [1968] 69 ITR 890.
5. Being aggrieved, the assessee challenged the above order in appeal before the Appellate Tribunal. It was contended on behalf of the assessee that the kartas of the Hindu undivided families, in their representative capacities, could be partners in a firm as was clear from the Explanation introduced to Section 40(b) with effect from April 1, 1985. The said Explanation was claimed to be of clarificatory nature.
6. The Tribunal accepted the above contention of the assessee and held that the amendment introduced with effect from April 1, 1985, was of clarificatory nature and was applicable even to the assessment year 1984-85. The Tribunal relied upon the decision of the Andhra Pradesh High Court in the case of N. T. R. Estate v. CIT [1986] 157 ITR 285. Accordingly, the Tribunal allowed the appeal of the assessee.
7. In the present case, there is no dispute that the two partners, namely, Shri B.P. Kedia and Shri K.P. Kedia, represented their respective Hindu undivided families and were partners of the assessee-firm in their capacity as kartas of their respective Hindu undivided families. In his order under Section 185(1)(a) of the Act granting registration to the assessee-firm, the Income-tax Officer has taken due note of the aforesaid factual position. The said two persons, in their capacity as kartas of their respective Hindu undivided families, in which capacity they were partners, had advanced loans to the assessee-firm on which they were paid interest. Such interest amounted to Rs. 87,246 in one case and Rs. 48,426 in the other. The said two persons had also advanced loans to the assessee-firm in their individual capacity on which they were paid interest amounting to Rs. 2,720 and Rs. 17,605, respectively. It is evident from the assessment order and the allocation of income made by the Income-tax Officer that the loans advanced by the said two persons in their individual capacity and the interest paid thereon were accounted for separately in the books of the assessee-firm. In other words, in the books of the assessee firm, there were two separate accounts--one in respect of the partner representing his Hindu undivided family and the other in respect of the loan advanced by him in his individual capacity, and the interest payable on the respective loans was separately calculated and credited to the respective accounts. The assessee's claim as to the inapplicability of Section 40(b) was restricted to the interest credited to the individual loan accounts only, namely, the sums of Rs. 2,720 and Rs. 17,605. The assessee did not dispute that the interest of Rs. 87,246 and Rs. 48,426 paid to the partners representing their respective Hindu undivided families was to be disallowed under Section 40(b). The only issue which therefore arises for consideration is as to whether the interest paid to the said two persons amounting to Rs. 2,720 and Rs. 17,605, respectively, in their individual capacity is subject to the disallowance under Section 40(b).
8. Section 40(b) reads as follows :
"40. Notwithstanding anything to the contrary in Sections 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."
9. However, there is a divergence of judicial opinion on the interpretation of Section 40(b). Some courts have held that, for the purposes of Section 40(b), no distinction could be made with respect to the capacity in which a person was partner and that interest paid to a person in his individual loan account would also be disallowed under Section 40(b) notwithstanding that he was a partner in a representative character as karta of his Hindu undivided family. Other courts have held to the contrary.
10. By the Taxation Laws (Amendment) Act, 1984 (for short, "the said Amendment Act"), three Explanations were inserted under Clause (b) of Section 40. Explanation 2, which is material for the purposes of the present case, reads as under :
"Explanation 2.--Where an individual is a partner in a firm on behalf, or for the benefit, of any other person (such partner and the other person being hereinafter referred to as 'partner in a representative capacity' and 'person so represented', respectively),--
(i) interest paid by the firm to such individual or by such individual to the firm otherwise than as partner in a representative capacity, shall not be taken into account for the purposes of this clause ;
(ii) interest paid by the firm to such individual or by such individual to the firm as partner in a representative capacity and interest paid by the firm to the person so represented or by the person so represented to the firm, shall be taken into account for the purposes of this clause."
11. The said Explanation 2 was inserted with effect from April 1, 1985. However, the Central Board of Direct Taxes, in a circular explaining the salient features of the said Amendment Act (see [1984] 149 ITR (St.) 127), stated as follows :
"(2) A number of amendments have been made to bring out the legislative intention more clearly so that further controversy and litigation regarding the true intent and purport of these provisions is avoided. To illustrate : . . . .
(b) It has also been clarified that where a person is a partner in his representative capacity, interest paid to him in his individual capacity will not be disallowed under the abovementioned provision and vice versa."
12. It is thus evident that the insertion of Explanation 2 to Section 40(b) has been expressly stated to be clarificatory in nature for bringing out the legislative intention more clearly so that further controversy and litigation regarding the true intent and purport of the said provision was avoided.
13. This court in the case of Girdharilal Ghasiram v. CIT [1968] 69 ITR 890, considered a case of payment of salary made by a firm to its partner in the context of the provisions of Section 10(4)(b) of the Indian Income-tax Act, 1922. In that case, a karta of a Hindu undivided family who was receiving a salary for services rendered to a firm became a partner of the firm and the firm continued to pay salary to him as before. It was held that the remuneration paid to the karta could not be claimed as a deduction as he was serving the firm for remuneration in his capacity as partner.
14. The Allahabad High Court in the case of CIT v. London Machinery Co. [1979] 117 ITR 111, held that Section 40(b) would apply to the payment of interest to partners who were partners in their capacity as kartas of their Hindu undivided families and had deposited their individual money in the firm. It was held that the capacity in which the partner received the payment, namely, for and on behalf of the family or for his own benefit and interest was immaterial. This decision was based on the position under the partnership law that a Hindu undivided family cannot become a partner of a firm, the firm only recognising the karta as a partner and that the members of the Hindu undivided family do not become partners and have no say in the affairs of the firm notwithstanding that the karta is a partner.
15. The Andhra Pradesh High Court in the case of Terla Veeraiah v. CIT [1979] 120 ITR 502, held that Section 40(b) had no application to interest credited to the individual account of a person though he was a partner in his representative capacity as karta of his Hindu undivided family.
16. The Madras High Court in the case of Dwarkadas Rameshwar Goenha v. CIT [1981] 127 ITR 397, agreeing with the Allahabad High Court, held that interest paid by a firm to a partner representing his Hindu undivided family in respect of a loan advanced by him in his individual capacity attracted disallowance under Section 40(b). The same view was taken by the Delhi High Court in the case of Sanghi Motors v. CIT [1982] 135 ITR 359.
17. In the case of Venkatesh Emporium v. CIT [1982] 137 ITR 593, the Madras High Court dealt with a case of payment of interest to a Hindu undivided family where its karta was a partner in the firm in his individual capacity. It was held that disallowance of interest paid by the firm to the Hindu undivided family by invoking Section 40(b) of the Act was not justified. The earlier decision in the case of Dwarkadas Rameshwar Goenka v. CIT [1981] 127 ITR 597 (Mad) was distinguished and explained as a decision turning on its own facts.
18. The Bombay High Court in the case of CIT v. Pannalal Hiralal and Co. [1984] 146 ITR 549 held that, if a Hindu undivided family through its manager is a partner of the firm, then for the purposes of the Income-tax Act, the interest received will be income of the Hindu undivided family; while, if any coparcener including the manager has advanced a personal loan, the interest paid in respect of the personal loan cannot be treated as interest paid to the Hindu undivided family which is a partner through the manager. V was a partner in the assessee-firm in his capacity as a representative of his Hindu undivided family. The interest received by him was not in his capacity as a representative of his Hindu undivided family but in his capacity as an individual. Therefore, the interest paid to V in his individual capacity would not be payment made to a partner so as to attract the provisions of Section 40(b).
19. The question came up for consideration before a Full Bench of the Gujarat High Court in the case of Chhotalal and Co, v. CIT [1984] 150 ITR 276. At pages 283 to 286, the court held as follows :
"The position, therefore, is well-settled that there is no impediment in a Hindu undivided family becoming a partner of a firm through its representative. Such a partnership will not be invalid or against law, but partnership being a relationship between persons who have agreed to share the profits of a business carried on by all or any of them acting for all and the relationship of partnership being one that arises from a contract, the persons who come together in the partnership will be recognised as between them as partners. In a case where one of the partners represents a Hindu undivided family or is a trustee of a trust, the members of the family or the beneficiaries in the trust, as the case may be, cannot exercise rights which their representative can exercise as against the other partners. They cannot sue on behalf of the firm for settlement of accounts and cannot exercise any rights as against the other partners as if they are themselves the partners in the partnership firm. This is not to say that they have no rights at all arising from the fact that the partner is their representative. They can make their representative accountable to them. They can seek to enforce his obligations and the representative will be bound to observe all obligations which law casts on him as such representative. Where one of the partners is really a representative of others, third parties are not barred from dealing with him in his representative capacity, for, they are not parties to the contract of partnership. The Revenue is in no way precluded from dealing with the partner as a representative if, he is one such, as for instance, where he is a 'karta' of a Hindu undivided family. The income derived by him as a partner would really be income of the Hindu undivided family and really derived by the Hindu undivided family. Of course, when the Income-tax Officer has granted registration to the firm, the firm has to be assessed and the next logical step is to assess the partners taking into account also the income of the partners derived from the firm. In doing so, if the partner is receiving income on behalf of a trust, it is the trust that has to be assessed on that part of the income, or, in other words, he is to be assessed as a trustee and not in his individual capacity. If it is a Hindu undivided family on behalf of which he receives the income, the partner being its representative, it is the income of the family which is ultimately to be assessed. ...
The Revenue is not precluded from looking into the real character of the partner and the capacity in which he represents himself in the partnership firm. If that be so, for the purpose of Section 40(b), the Income-tax Act, 1961, is the Revenue to take note of the representative character of the assessee and make disallowance falling within the section in accordance therewith ? That is the question which we are really called upon to answer here.
What is said for the Revenue is that while the Revenue may take note of the fact that Shri C.S. Virani really represents a Hindu undivided family when it makes the individual assessment on the Hindu undivided family of which he is a representative, that will have no bearing when the Revenue seeks to assess the firm to its tax. At that stage, it is said, the real character of Shri C.S. Virani does not call for consideration and he need be treated only as a partner and if so treated, whatever is paid as interest to Shri C.S. Virani irrespective of the character in which such payment is made is to be disallowed on account of Section 40(b) of the Act. This approach would assume that, so far as the Revenue is concerned, the Revenue cannot take note of the capacity in which a person happens to be a partner of a firm. Such an approach is unsustainable in law, for whatever may be the obligations as between the partners, arising out of a contract, so far as the Revenue is concerned, it is the real character of the partner who is assessed that would be relevant for assessment purpose. If Shri C.S. Virani is a partner as representing a Hindu undivided family, at all times the Revenue can only treat him as representing the Hindu undivided family, whatever may be the rights of the other partners in the firm as against him. If so, when Shri C.S. Virani as representing the Hindu undivided family has advanced funds of the Hindu undivided family to the firm and interest thereon is paid to the Hindu undivided family, it is interest paid to Shri C.S. Virani, the partner. If he advances amounts from his individual account when he is a partner as representative only of the Hindu undivided family, the interest is not paid to him qua partner but as a stranger.
We should point out an anomaly if a different view is taken. Supposing a stranger advances a substantial sum of money to a firm on interest and the interest is being paid by the firm to that stranger, such interest payments could be deductible as revenue expenditure under Section 37. If by some fortuitous circumstances, such stranger becomes a trustee of a trust, the previous trustee of which was a partner of that firm, can it, for that reason, be said that the interest which had to be paid to him as was done earlier, not as trustee but on his own individual account, should no longer be an item of expenditure to be deducted ? We see neither reason nor logic in such an approach. If the income-tax authorities are to act on the basis of real facts and not on any assumptions, then, for the purpose of Section 40(b), they will have to consider the Hindu undivided family as represented by Shri C.S. Virani as the partner and if that is so, what is paid to Shri C.S. Virani as representing Hindu undivided family by way of interest will alone fall within the section."
20. The Karnataka High Court in the case of CIT v. Khoday Eswarsa and Sons [1985] 152 ITR 423, held that the dual capacity in which a person may be acting was immaterial for the purposes of making the disallowance under Section 40(b).
21. The question again arose for consideration by the Andhra Pradesh High Court in the case of N. T. R. Estate v. CIT [1986] 157 ITR 285. In that case, the court also considered the effect of the introduction of Explanation 2 in Section 40(b). At pages 289 and 290 of the Reports, the court held as follows :
"It is true that there is a conflict of judicial opinion on this aspect (vide judgments of the Karnataka, Allahabad and Delhi High Courts above referred to on which reliance was placed by the learned standing counsel for the Revenue). We do not think that any case is made out for reconsideration of the judgments of this court in Addl. CIT v. Vallamkonda Chinna Balaiah Chetty and Co. and Terla Veeraiah v. CIT [1979] 120 ITR 502 (AP) for two reasons : firstly, the view taken by this court finds support in the judgments of the Gujarat High Court and Madras High Court above referred to ; and, secondly, the principle enunciated by this court is now statutorily recognised by the Taxation Laws (Amendment) Act of 1984, which will be effective from the assessment year 1985-86. By Section 10 of the above Amendment Act, three Explanations were inserted. Explanations 2 and 3 deal with the matter under consideration. The effect of these Explanations is : (a) if a person is a partner in a firm in a representative capacity and if such partner lends to the partnership monies belonging to him individually, then the interest paid to such partner on the monies lent by him is not liable to be added back under Section 40(b) of the Act ; and (b) similarly, if a person is a partner in his individual capacity and if such partner lends to the partnership monies belonging to the Hindu joint family, of which he is the 'karta', then the interest paid on the monies lent by the joint family is not liable to be added back under Section 40(b) of the Act. The above amendment to the statute is clear acceptance of the views expressed by this court, the Gujarat High Court and the Madras High Court in the decisions above referred to. It is true that Explanations 2 and 3 inserted by the Taxation Laws (Amendment) Act of 1984 will be effective from the assessment year 1985-86. It is well to bear in mind that in the Statement of Objects and Reasons introducing the Taxation Laws (Amendment) Bill, 1984, it has been specifically mentioned that the amendments introduced in the Bill are intended mainly to streamline procedures in the interest of better work management, avoid inconvenience to taxpayers, reduce litigation, remove certain anomalies in and rationalise some of the provisions of these enactments and counteract tax avoidance and tax evasion. We consider that the present amendment to Section 40(b) of the Act through Explanations 2 and 3 above referred to is to avoid inconvenience to taxpayers, reduce litigation and in that view, the spirit of Explanations 2 and 3 introduced by the Taxation Laws (Amendment) Bill, 1984, should be followed with respect to the preceding assessment years also in order to avoid unnecessary litigation. It cannot be gainsaid that the Legislature was fully aware of the conflict of judicial opinion in this matter among the various High Courts in the country and the present amendment, to Section 40(b) through Explanations 2 and 3 is brought about to set at rest the controversy. We see no reason to hold that the principle statutorily recognised by Explanations 2 and 3, following the decisions of some High Courts, is good only from the assessment year 1985-86 and ceased to be so for the preceding assessment years. In our opinion, Explanations 2 and 3 are merely clarificatory in character and must, therefore, govern the assessments prior to the assessment year 1985-86 also.
In this view of the matter, we consider that the interest paid by the assessee-firm to its partners on monies lent by them in their individual capacity is not liable to be disallowed under Section 40(b) of the Act, inasmuch as the partners were acting in a representative capacity so far as the partnership interest is concerned."
22. The Madhya Pradesh High Court in the case of Balchand Hashmatrai and Co. v. CIT [1986] 161 ITR 121 also considered the effect of the insertion of Explanation 2 in Section 40(b). That was a case relating to the assessment year 1976-77, It was held that the provisions of Explanations 2 and 3 of Section 40(b) of the Income-tax Act, 1961, and the circular make it clear that disallowance of interest paid by a firm can be made under Section 40(b) only if the interest is paid by the firm to the partner in his capacity as partner, No disallowance can be made under Section 40(b) if the interest is paid by the firm to the partners in a capacity other than the capacity of a partner. Where a member of a Hindu undivided family is a partner in his individual capacity, interest paid to him as a representative of the Hindu undivided family cannot be disallowed. Though Explanations 2 and 3 were inserted with effect from April 1, 1985, they point out the effect of interest paid in such cases.
23. The Patna High Court in the case of Chandmul Rajgarhia v. CIT [1987] 164 ITR 486, agreeing with the Allahabad and Delhi High Courts and dissenting from the Gujarat, Bombay and Andhra Pradesh High Courts, held that interest paid to a partner, in whatever capacity it was paid to him, could not be allowed as a deduction under Section 40(b).
24. The question again came up for consideration before a Full Bench of the Madhya Pradesh High Court in the case of CIT v. Narbharam Popatbhai and Sons [1987] 166 ITR 534, In the said decision, the effect of insertion of Explanation 2 in Section 40(b) was also considered and the amendment was held to be clarificatory. The Full Bench approved the Division Bench judgment of the Madhya Pradesh High Court in the case of Balchand Hashmatrai and Co. v. CIT [1986] 161 ITR .121 and agreed with the view expressed by the Gujarat, Bombay and Andhra Pradesh High Courts and by the Madras High Court in its later decision in the case of Venkatesh Emporium v. CIT [1982] 137 ITR 593. The view expressed by the Allahabad, Delhi and Karnataka High Courts and in the earlier decision of the Madras High Court in Dwarkadas Rameshwar Goenka v. CIT [1981] 127 ITR 397 was expressly dissented from.
25. The Rajasthan High Court in the case of Gajanand Poonam Chand and Sons v. CIT [1988] 174 ITR 346 at pages 350 and 351 of the Reports held as follows :
"It would be useful to refer to the definition of 'person' given in Section 2(31) of the Act. This is an inclusive definition and it clearly shows that an 'individual', a 'Hindu undivided family' and a 'firm1 are to be treated as distinct persons or entities for the purposes of the Income-tax Act. In this scheme of things, it is obvious that under the provisions of the Income-tax Act, there is no inconsistency in treating an individual as a person distinct from the same individual representing the Hindu undivided family as its karta for the purposes of partnership in a firm. The question, therefore, is whether, in such a situation, for the purpose of Section 40(b), the distinction between the two personalities of an individual, which is clearly recognised by the provisions of the Income-tax Act is to be treated as obliterated. We do not find anything in Section 40(b) requiring obliteration of the distinction between these two personalities of an individual in order to hold that merely because an individual is also in his representative capacity as karta of a Hindu undivided family, a partner of the assessee-firm, the interest paid to him in his distinct individual account must be disallowed under Section 40(b).
It appears to us that the Legislature inserted Explanation 2 in Section 40(b) with effect from April 1, 1985, to settle the controversy on account of divergence of opinion among the High Courts on this point, there being no authoritative pronouncement of the Supreme Court. In this view of the matter, we are inclined to hold that Explanation 2 is merely declaratory of the existing law as contained in Clause (b) of Section 40 intended to remove the doubt raised on account of conflicting High Court decisions ; and it is not a new enacting provision carving out an exception from the general rule contained in Clause (b). The ordinary purpose of an Explanation is to clarify that which is already enacted and not to enact something new. No doubt, the Explanation sometimes may be a distinct enacting provision itself. However, it would then not be performing its ordinary or normal function of an Explanation. We are of the view that the function of Explanation 2 inserted in Clause (b) with effect from April 1, 1985, is its normal function of explaining that which is already contained in Clause (b). . . .
Insertion of Explanation 2 along with Explanation 3 without any amendment being made simultaneously in Clause (b) of Section 40 or the definition of 'person' in Section 2(31) of the Act reinforces our conclusion that under the Income-tax Act, an individual representing the Hindu undivided family has a personality distinct from his capacity as a mere individual. It is with the different facets of personality of an individual under the Income-tax Act with which we are concerned."
26. The Rajasthan High Court agreed with the views expressed by the Andhra Pradesh, Bombay, Gujarat and Madhya Pradesh High Courts and by the Madras High Court in its later decision in the case of Venkatesh Emporium v. CIT [1982] 137 ITR 593 and dissented from the Patna, Allahabad and Karnataka High Courts.
27. A Full Bench of the Allahabad High Court, in the case of CIT v. Nitro Phosphetic Fertilizer [1988] 174 ITR 269, by a majority decision, held that Explanation 2 to Section 40(b) did not have retrospective effect. The various decisions rendered by different High Courts were noticed. The earlier decision of the Allahabad High Court in CIT v. London Machinery Co. [1979] 117 ITR 111 was approved. The majority agreed with the view expressed by the Delhi, Karnataka and Patna High Courts and the earlier view of the Madras High Court in Dwarkadas Rameshwar Goenka v. CIT [1981] 127 ITR 397 and dissented from the Gujarat, Madhya Pradesh, Bombay and Andhra Pradesh High Courts and the later decision of the Madras High Court in the case of Venkatesh Emporium v. CIT [1982] 137 ITR 593.
28. The Punjab and Haryana High Court also considered the effect of insertion of Explanation 2 in Section 40(b) in the case of Hindustan Steel Forgings v. CIT [1989] 179 ITR 280. Relying upon the circular issued by the Central Board of Direct Taxes ([1984] 149 ITR (St.) 127), it was held that the amendment was a clarificatory one and had retrospective effect. It was held that the clarification which had been brought about by the amendment should be read as if the unamended provision was also to be read in the same way. The Punjab and Haryana High Court agreed with the Gujarat and Madhya Pradesh High Courts and dissented from the Allahabad, Delhi, Karnataka and Patna High Courts.
29. The Gauhati High Court in the case of CIT v. Jain Hardware Stores [1990] 186 ITR 272, agreeing with the Gujarat, Bombay and Madhya Pradesh High Courts held that, where the karta of a Hindu undivided family was a partner in a firm in his representative capacity, interest paid by the firm to him on his individual investment could not be disallowed under Section 40(b).
30. Thus, the Andhra Pradesh, Bombay, Gujarat, Madhya Pradesh, Rajasthan, Punjab and Haryana and Gauhati High Courts and the Madras High Court in its later decision have taken the view favourable to the assessee whereas the Allahabad, Delhi, Karnataka and Patna High Courts and the Madras High Court in its earlier decision have taken the other view. Preponderance of judicial opinion is in favour of the view that the dual capacity has to be recognised and that interest paid on individual investment of a partner representing his Hindu undivided family cannot be disallowed under Section 40(b).
31. Under Section 40(b), any payment of interest made by a firm to any partner of the firm shall not be deducted in computing the income of the firm. For attracting the disallowance under Section 40(b), the interest must be paid by the firm to a person in his capacity as a partner of the firm. No disallowance of interest can be made under Section 40(b), if the interest is paid by the firm to such person in any capacity other than that of a partner. If the person is a partner in a representative capacity, the payment of interest made to him in such capacity alone would be hit by Section 40(b). However, if interest is paid to such person in some other capacity, then the same cannot attract the disallowance under Section 40(b). When a person is a partner in the firm as a karta representing his Hindu undivided family, the capital is contributed by the Hindu undivided family and the share of income also belongs to the Hindu undivided family. Any loan advanced by the partner representing his Hindu undivided family would come out of the funds of the Hindu undivided family, and the interest paid by the firm thereon would belong to the Hindu undivided family. The partner cannot claim such share of income or the interest as his own. Such share of income and interest would also be assessed to tax in the hands of the Hindu undivided family. There can be no question of assessment of such share of income or interest in the personal or individual file of the partner representing his Hindu undivided family. In terms of Section 2(31), an "individual", a "Hindu undivided family" and a "firm" are treated as distinct persons or entities for the purposes of the Income-tax Act. Thus, for the purposes of assessment of income, the Revenue would take note of the representative character of the partner and make assessment of the income in the hands of the assessee whom the partner represents. The situation would, however, be different in case a partner representing his Hindu undivided family advances a loan to the firm in his individual capacity. In such a case, the loan would come out of the individual funds of the person and the interest received by him thereon would belong to him and be assessed to tax in his hands. The Hindu undivided family cannot lay any claim to such interest. Thus, the Revenue, while assessing the recipient would take into consideration the dual capacities in which he is acting vis-a-vis the firm. In our view, the position under Section 40(b) cannot be different. For the purpose of making the disallowance under Section 40(b), the Revenue has to consider the real character of the person to whom the payment is made and only the interest paid to a partner as such can be disallowed. In case a person is acting in a dual capacity, the interest paid to him only in his capacity as partner can be subjected to the disallowance under Section 40(b). Interest paid to such person in any other capacity cannot be subjected to the disallowance under Section 30(b). The payment in the latter case has to be treated on par with a payment made to a stranger.
32. This position was accepted by the Central Board of Direct Taxes as is evident from the circular dated 26, ..... 1978. It provides as follows:
"The kartas of their respective Hindu undivided families were not the partners in the firm in their representative capacities. They were partners in the respective firms in their own right as individuals. There are two separate accounts in the books and accounts of the firm, one in respect of the partner in his individual capacity and another in the name and style of the Hindu undivided family which appears simply as a depositor and has nothing to do with the capacity of the karta as a partner. This is because the Hindu undivided family as such is not a partner in both the cases through its karta. The interest paid by the firm is debited to the profit and loss account and credited to the respective accounts of the Hindu undivided families. The Hindu undivided family is a separate legal entity as against the individual who is the partner in the firm."
33. Although the said circular refers to the situation where an individual was a partner and interest was paid to him as karta of his Hindu undivided family, it recognises the necessity to make a distinction where a person is acting in a dual capacity, The said circular is a pointer to the fact that for the purposes of Section 40(b), the distinction between a person acting in a representative capacity as a karta of his Hindu undivided family and the same person acting in his individual capacity was duly recognised and accepted by the Revenue.
34. The decisions which have taken the view that, for the purpose of Section 40(b), no distinction could be made with respect to the capacity in which a person was a partner and that interest paid to a person in his individual loan account would also be disallowed under Section 40(b) notwithstanding that he is a partner in a representative character as "karta" of his Hindu undivided family, do not correctly lay down the law. In the context of the provisions of the Income-tax Act, if the Revenue recognises the dual capacity in which the recipient is acting while assessing the income, there is no reason why the same should be ignored for the purpose of Section 40(b) while considering the deductibility of the same amount in the hands of the firm making the payment. If the position under the partnership law that it recognises only the karta and not the Hindu undivided family which he represents is to be applied for the purposes of Section 40(b), then in a case where the Hindu undivided family advances a loan to the firm, it would amount to the karta giving the loan and notwithstanding that the karta may be a partner of the firm in his individual capacity, the interest paid to the karta representing his Hindu undivided family would have to be disallowed.
35. Our attention has been drawn to the decision of the Supreme Court in the case of Keshavji Ravji and Co. v. CIT [1990] 183 ITR 1, which held that, for the purposes of Section 40(b), where interest was paid by a firm to any partner who has also paid interest to the firm, the amount of interest to be disallowed was to be united to the interest paid to the partner by the firm in excess of what was received from the partner. There was a divergence of opinion between the different High Courts on this aspect also and Explanation 1 inserted in Section 40(b) by the said Amendment Act with effect from April 1, 1985, dealt with this aspect. Before the Supreme Court, a contention was raised on behalf of the assessee that the said Explanation 1 was merely clarificatory and had to be given retrospective effect.
36. The contention of the Revenue is that the Supreme Court in fact has laid down that the Explanations to Section 40(b) are prospective in operation and therefore until the assessment year 1985-86, the interest paid by the firm to its partners has to be disallowed under Section 40(b).
37. In our view, the Supreme Court did not decide finally the contention on the retrospective operation of the Explanation to Section 40(b). This will be evident from the observations of the Supreme Court which we quote hereafter (at page 18) :
"Sri Ramachandran urged that the introduction, in the year 1984, of Explanation 1 to Section 40(b) was not to effect or bring about any change in the law, but was intended to be a mere legislative exposition of what the law has always been. An 'Explanation', generally speaking, is intended to explain the meaning of certain phrases and expressions contained in a statutory provision. There is no general theory as to the effect and intendment of an Explanation except that the purpose and intendment of the 'Explanation' are determined by its own words. An Explanation depending on its language, might supply or take away something from the contents of a provision. It is also true that an 'Explanation' may--this is what Sri Ramachandran suggests in this case--be introduced by way of abundant caution in order to clear any mental cob-webs 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. Explanation 1 inserted into Section 40(b) in the year 1984 has had that effect.
The 'Notes on Clauses' appended to the Taxation Laws (Amendment) Bill, 1984, say that Clause 10 which seeks to amend Section 40 will take effect from April 1, 1985, and will, accordingly, apply in relation to the assessment year 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. In view of what we have said on point (c), it appears unnecessary to examine this contention any further."
38. It is no doubt true that, ordinarily, a statute, particularly when the same has been made applicable with effect from a particular date, should be construed prospectively and not retrospectively. But this principle will not be applicable in a case where the provision construed is merely explanatory, clarificatory or declaratory. The object of an Explanation is to explain the meaning and intendment of the Act itself. In the present case, having regard to the clarification made by the Board in 1978 by the circular referred to above, Explanation 2 must be held to be clarificatory.
39. If a coparcenar can possess separate property which belongs exclusively to him and if no other member of the coparcenary, not even his male issue acquires any interest in it by birth, there is no reason why a "karta" who represents a firm on behalf of the Hindu undivided family cannot invest his separate or self-acquired property in the firm and earn interest therefrom which a stranger could have done. If a joint Hindu family, through the agency of its karta, can enter into contractual relations either with a stranger or even with an individual coparcenar in respect of his separate property and also with a firm, there cannot be any reason why a karta, although a partner of a firm representing his undivided family cannot invest his separate property in that firm and earn interest therefrom which he could have easily done by investing it in another firm where he is not a partner.
40. For the reasons aforesaid, the first question in this reference is answered in the affirmative and in favour of the assessee. The second question is answered by saying that Explanation 2 to Section 40(b) is clarificatory in nature and will govern the assessment year in question and as such the Tribunal was justified in deleting the addition of interest paid to the partners in their individual capacity.
41. There will be no order as to costs.
Shyamal Kumar Sen, J.
42. I agree.