Partner interest on personal deposits remains deductible, with the statutory explanation treated as retrospective and declaratory.

Interest paid by a firm to a partner on that partner's personal deposit was treated as an allowable deduction and not as interest hit by section 40(b) of the Income-tax Act. The text states that Explanation 2, inserted with effect from 1 April 1985, was regarded as declaratory and retrospective, so the same principle applied even to earlier assessment years. On that reasoning, interest referable to a partner's personal funds deposited with the firm does not fall within the mischief of the statutory prohibition.

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Issues: Whether interest paid by a firm to a partner, who received it in a dual capacity as trustee and on deposit of personal funds, was disallowable under section 40(b) of the Income-tax Act, 1961 for the assessment year 1977-78.

Analysis: The disallowance under section 40(b) was examined in the light of Explanation 2 inserted with effect from 1 April 1985. The governing principle applied was that the Explanation is declaratory in nature and operates retrospectively. On that basis, interest paid to a partner on the deposit of his or her personal funds does not attract the mischief of section 40(b), even for periods before the insertion of the Explanation. The reasoning was supported by the Supreme Court's view that such interest remains allowable as a firm expenditure where the payment is referable to the partner's personal deposit and not to the prohibited category contemplated by clause (b).

Conclusion: The interest payment was allowable as a deduction and was not hit by section 40(b); the question was answered in favour of the assessee and against the Revenue.

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