Section 40(b) disallowance applies where firm-paid interest on partners' borrowings is in substance for the partners' benefit.

Interest paid by a partnership firm to the Life Insurance Corporation on loans taken against partners' life insurance policies was treated as interest paid to the partners where the loans were credited to their capital accounts and the borrowing was in substance for their benefit. Because the partnership deed barred interest on partners' contributions, the court applied section 40(b) of the Income-tax Act, 1961, and held the interest disallowable. The reference was answered in favour of the Revenue.

---

---

Issues: Whether interest paid by the assessee-firm to the Life Insurance Corporation on loans taken against the life insurance policies of its partners attracted section 40(b) of the Income-tax Act, 1961.

Analysis: The partnership deed provided that no interest was payable on partners' contributions to the business. The loans raised by the partners from the Life Insurance Corporation were credited to their capital accounts, and the firm paid the interest directly to the Corporation. In substance, the borrowing was for the partners' benefit and the interest payment was treated as one made to the partners. On that footing, the statutory bar under section 40(b) applied.

Conclusion: The reference was answered in the negative and in favour of the Revenue. The interest was disallowable under section 40(b).

Ratio Decidendi: Where interest on borrowings raised by partners is, in substance, paid by the firm for the benefit of partners and is credited through their capital accounts, it is treated as interest paid to partners and falls within section 40(b) of the Income-tax Act, 1961.

---