2025 (6) TMI 1140 - AT - Income Tax

Partners' Interest Deduction Under Section 40B: Permissible When Deed Authorized, Rate

Muthoot Bankers Versus ITO, Ward-2, Aluva

The SC/Tribunal examined the allowability of interest paid to partners under section 40B of the Income Tax Act. It held that interest deduction is ... Disallowance of interest paid to partners - whether the interest paid to partners as per the partnership deed is allowable as a deduction u/s 40B? - HELD THAT:- We note that section 40B permits deduction to interest paid to the partners provided that it is authorized by the partnership deed not exceeding 12% with simple interest per annum. In the present case, the assessee paid interest in accordance with terms and conditions of the partnership firm and rate of interest did not exceed 12% p.a. and moreover the assessee-firm is following cash basis accounting and payment of Rs. 5,00,000/- was actually made during the year. Reasoning adopted by the lower authorities disallowing interest paid to the partners solely on business activity, is not sustainable in the eyes of law and the addition is hereby set aside. The core legal question considered in this appeal is whether the interest of Rs. 5,00,000 paid to partners as per the partnership deed is allowable as a deduction under section 40B of the Income Tax Act, 1961, given the facts and circumstances of the case.Additional related issues include:Whether the interest paid to partners must be connected to income derived by the firm to be allowable.The relevance of the utilization of partners' capital for business purposes in allowing interest deduction under section 40B.The applicability of the cash system of accounting for determining the allowance of interest paid.Issue-wise Detailed Analysis1. Allowability of Interest Paid to Partners under Section 40BRelevant Legal Framework and Precedents: Section 40B of the Income Tax Act allows a deduction for interest paid to partners by a firm, provided such interest is authorized by the partnership deed and does not exceed 12% per annum on the capital contributed by the partners. The provision is designed to recognize the cost of capital introduced by partners as an allowable business expense.Court's Interpretation and Reasoning: The Tribunal noted that the assessee-firm had paid Rs. 5,00,000 as interest to partners in accordance with the terms of the partnership deed, at a rate not exceeding 12% per annum. The firm followed the cash system of accounting, and the payment was actually made during the relevant year. The Tribunal rejected the Assessing Officer's and CIT(A)'s reasoning that disallowed the interest on the ground that the partners' capital was not actively utilized in business operations or that the firm did not derive income directly related to the interest paid.Key Evidence and Findings: The assessee submitted the partnership deed authorizing interest payments, evidence of actual payment of Rs. 5,00,000 during the year, and documentation of income earned from M/s Muthoot Fincorp Ltd. The firm's accounting system was cash-based, meaning expenses are recognized only when paid.Application of Law to Facts: The Tribunal applied section 40B strictly on its terms, focusing on whether the interest was authorized by the partnership deed, the rate limitation, and actual payment during the year. It held that the law does not prescribe a condition that capital must be exclusively used for business purposes to claim interest deduction. The fact that the firm earned income by way of interest from a third party further supported the business nature of the firm's operations.Treatment of Competing Arguments: The Assessing Officer and CIT(A) argued that the interest was not allowable because the partners' capital was not employed in active business operations and the firm did not generate income directly linked to the interest paid. The assessee countered by emphasizing the partnership deed's authorization, the cash system of accounting, and the actual payment made. The Tribunal found the assessee's arguments more persuasive and consistent with the statutory framework.Conclusion: The Tribunal concluded that the disallowance of Rs. 5,00,000 interest paid to partners was not sustainable. The interest payment met all statutory requirements under section 40B and was properly deductible.2. Necessity of Business Activity or Utilization of Capital for Allowance of InterestLegal Framework: Section 40B does not explicitly require that the capital introduced by partners be actively utilized in business or that the interest paid be linked to income derived from such capital. The provision focuses on authorization by the partnership deed and the rate of interest.Court's Reasoning: The Tribunal clarified that the lower authorities erred in imposing an additional condition that partners' capital must be actively used in business operations or that income must be directly related to the interest paid. The Tribunal emphasized that the statutory language does not support such a condition.Application to Facts: The firm's capital showed no active utilization in business, and the partners' current account had a credit balance. However, since the interest payment was authorized and actually made, and the firm earned business income by way of interest from a third party, these facts sufficed for allowing the deduction.Conclusion: The Tribunal held that the absence of active business utilization of partners' capital is not a valid ground to disallow interest under section 40B.3. Impact of Cash System of Accounting on Allowability of InterestLegal Framework: Under the cash system of accounting, expenses are recognized only when actually paid, not when accrued. This accounting method is permissible under the Income Tax Act for certain taxpayers.Court's Reasoning: The Tribunal accepted the assessee's submission that it follows the cash system of accounting. Therefore, the interest expense is allowable only to the extent actually paid during the year. The payment of Rs. 5,00,000 was made during the year, making it an allowable deduction.Application to Facts: The Assessing Officer's disallowance was partly based on the contention that the firm had accrued interest liability of Rs. 52.82 lakhs but paid only Rs. 5,00,000. The Tribunal held that under cash accounting, only the amount actually paid (Rs. 5,00,000) can be allowed as deduction.Conclusion: The Tribunal upheld that the cash system accounting treatment supports allowance of interest paid during the year, irrespective of accrued but unpaid amounts.Significant Holdings'Section 40B permits deduction to interest paid to the partners provided that it is authorized by the partnership deed not exceeding 12% with simple interest per annum.''The reasoning adopted by the lower authorities disallowing interest paid to the partners solely on business activity, is not sustainable in the eyes of law.''The Act does not prescribe any condition that the capital introduced by the partners must be utilized exclusively for business purposes to allow interest u/s 40B.''The firm following cash basis of accounting and payment of Rs. 5,00,000/- was actually made during the year, which entitles the assessee to claim deduction of interest paid.'The final determination was that the interest of Rs. 5,00,000 paid to partners was allowable as a deduction under section 40B of the Income Tax Act. The disallowance by the Assessing Officer and the CIT(A) was set aside, and the appeal was partly allowed accordingly.