1997 (12) TMI 2 - SC - Income Tax

Partnership firm cannot deduct commission paid to individual partner under Section 40(b)

Rashik Lal And Company Versus Commissioner of Income-Tax

Rashik Lal And Company Versus Commissioner of Income-Tax - [1998] 229 ITR 458 (SC) The core legal question considered by the Court was whether the commission paid by a partnership firm to an individual partner, who was also the karta of a Hindu undivided family (HUF), could be allowed as a deduction under section 40(b) of the Income-tax Act, 1961, while computing the business income of the firm.Several interrelated issues emerged from this primary question: (1) the nature of partnership and whether a Hindu undivided family can be a partner in a firm; (2) the legal status of a partner acting in a representative capacity for an HUF; (3) the applicability and scope of section 40(b) of the Income-tax Act concerning payments made to partners; and (4) the interpretation of relevant precedents and statutory provisions governing partnerships and taxation.Issue 1: Whether a Hindu undivided family can be a partner in a firmThe Court examined the legal framework under the Indian Partnership Act, 1932, which defines partnership as a relation between 'persons' who have agreed to share profits of a business carried on by all or any of them acting for all. The term 'persons' was interpreted strictly to mean individuals, not entities such as firms or Hindu undivided families. The Court relied heavily on the precedent set in Dulichand Laxminarayan v. CIT, where it was held that a firm is not a 'person' capable of entering into a partnership and, by parity of reasoning, a Hindu undivided family, being a fluctuating body of individuals, cannot be a partner in a firm.The Court emphasized that the partnership is essentially a contract among individuals. Even if a partner is a nominee of an HUF, the partnership is between the individual and the other partners, not between the HUF and the firm. The HUF's rights, if any, are internal and do not affect the legal status of the partner vis-`a-vis the firm.Issue 2: The legal status of a partner acting in a representative capacity for an HUFThe Court analyzed the contention that the partner had joined the firm not in his individual capacity but as a representative of the HUF, and thus payments to him should not be treated as payments to a partner under section 40(b). The Court rejected this argument, holding that within the partnership, the individual partner acts in his personal capacity regardless of any external representative role. The partner's obligations and rights are governed by the Partnership Act, and the firm deals with the individual partner, not with the HUF.The Court referred to authoritative commentary from Mulla's Hindu Law and the decision in CIT v. Bagyalakshmi and Co., which clarified that a partner may have a dual position-personal capacity in the partnership and representative capacity externally-but the partnership relationship is exclusively contractual among the individuals who have entered into it. The firm is not concerned with any sub-partnership or internal arrangements the partner may have with the HUF.Issue 3: Applicability of section 40(b) of the Income-tax Act to payments made to partnersSection 40(b) prohibits deduction of payments made by a firm to any of its partners by way of interest, salary, bonus, commission, or remuneration while computing the firm's business income. The Court noted that the language of the section is clear and unambiguous. The commission paid to the partner, Rashiklal, was disallowed as a deduction because it was a payment to a partner.The Court acknowledged an argument based on the existence of a special contract allowing such commission payments, which under the Partnership Act (section 13) is generally not permissible unless explicitly agreed. Even if such a contract existed, section 40(b) would still prohibit deduction of such commission payments for income-tax purposes.The Court distinguished the present case from precedents dealing with interest payments to partners acting in representative capacities, where Explanation 2 to section 40(b) was introduced to allow certain exceptions. Since no interest payment was involved here but a commission, the Explanation did not apply.Issue 4: Treatment of competing arguments and application of law to factsThe Court critically examined the argument that the commission payment was not to the partner but to the HUF, which was the 'real' partner. It held that this was legally untenable because the partnership deed and the Income-tax Act require identification of individual partners, their shares, and signatures. The partnership firm is a collective of individuals and not a body or association. The partner's personal capacity in the firm cannot be circumvented by reference to external arrangements.The Court also highlighted that the firm's assessment under the Income-tax Act must be conducted strictly according to the law. Allowing deductions by treating payments to partners as payments to other entities would defeat the statutory purpose of section 40(b).Significant holdings and core principles established:'A firm is a compendious way of describing the individuals constituting the firm. A Hindu undivided family directly or indirectly cannot become a partner of a firm because the firm is an association of individuals.''Even if a person nominated by the Hindu undivided family joins a partnership, the partnership will be between the nominated person and the other partners of the firm. The partner may have to account for the monies received to another person or family, but that will not alter the fact that commission was paid by the firm to one of its individual partners.''Section 40(b) of the Income-tax Act clearly applies to any payment of commission by a firm to any partner of the firm. Such payment will not be allowed as a deduction from the business income of the firm.''The partner does not act in a representative capacity in the partnership. He functions in his personal capacity like any other partner. The provisions of the Partnership Act and the Income-tax Act relating to partners and partnership firms apply in full force in respect of such a partner.''The assessment of a firm will have to be made strictly in accordance with the provisions of the Income-tax Act. Neither the firm nor its partners can evade the tax law on the pretext that although in law he is a partner, in reality he is not.'In conclusion, the Court held that the commission paid by the firm to the partner, who happened to be the karta of an HUF, was a payment to a partner within the meaning of section 40(b) and, therefore, was not deductible from the firm's business income. The appeal was dismissed accordingly.