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Quiz for the week (12 Aug 2024):

Harish & Co (firm) is regularly assessed to income tax and is engaged in running a textile showroom. It consists of 5 partners with equal share. The partnership deed provides working partner salary to all the partners @Rs.50,000 each per month. Also, the deed of partnership provides for interest on capital @12% on their fixed capital of Rs. 20 lakhs each. For the year ended 31st March, 2024 the income of the firm was Rs.25 lakhs before paying interest on capital and working partners salary. Partners of the firm in August 2024 before finalising the results approach you to know whether they can reduce their working partner salary proportionately as the profits are not sufficient to pay entire salary to all of them. Advice.

 

Best Answer :

Section 40 of the Income-tax Act, 1961 has the title "Amounts not deductible". Clause (b) of section 40 says that in the case of any firm assessable as such

  • (i) any payment of salary, bonus, commission or remuneration by whatever name called (hereinafter referred to as "remuneration") to any partner who is not a working partner; or
  • (ii) any payment of remuneration to any partner who is a working partner, or of interest to any partner, which, in either case, is not authorised by, or is not in accordance with, the terms of the partnership deed; or
  • (iii) any payment of remuneration to any partner who is a working partner, or of interest to any partner, which, in either case, is authorised by, and is in accordance with, the terms of the partnership deed, but which relates to any period (falling prior to the date of such partnership deed) for which such payment was not authorised by, or is not in accordance with, any earlier partnership deed, so, however, that the period of authorisation for such payment by any earlier partnership deed does not cover any period prior to the date of such earlier partnership deed; or
  • (iv) any payment of interest to any partner which is authorised by, and is in accordance with, the terms of the partnership deed and relates to any period falling after the date of such partnership deed in so far as such amount exceeds the amount calculated at the rate of twelve percent simple interest per annum; or
  • (v) any payment of remuneration to any partner who is a working partner, which is authorised by, and is in accordance with, the terms of the partnership deed and relates to any period falling after the date of such partnership deed in so far as the amount of such payment to all the partners during the previous year exceeds the aggregate amount computed as hereunder:-

(a) on the first Rs.3,00,000 of the book- profit or in the case of a loss

Rs.1,50,000 or at the rate of 90 per cent of the book-profit, whichever is more;

(b) on the balance of the book-profit

at the rate of 60 per cent

The proviso to section says that in relation to any payment under this clause to the partner during the previous year relevant to the assessment year commencing on the 1st day of April, 1993, the terms of the partnership deed may, at any time during the said previous year, provide for such payment.

The partnership firm has a net profit of Rs.25 lakhs before deduction of interest on capital and working partner salary. Total capital of the firm Rs.100 lakhs for which interest authorised being Rs.12 lakhs @ 12% is deductible if it is authorised by the deed of partnership.

The resultant book-profit would be Rs.13,00,000 and whereas the partnership deed provides for working partner salary of Rs.50,000 per month for all the five partners. The total working partner salary authorised is Rs.30 lakhs. The firm can debit working partner salary as per the deed of partnership and show net loss of Rs.17 lakhs.

While computing the total income, the firm would get allowance of Rs.2,70,000 (being 90% of book-profit of Rs.3 lakhs) plus 60% of the balance of book-profit of Rs.10 lakhs being Rs.6 lakhs. The total income of the firm would be Rs.25 lakhs less interest on capital Rs.12 lakhs less working partner salary allowed Rs.8.70 lakhs with resultant figure of Rs.4.30 lakhs. The firm has positive income for the purpose of income-tax and any addition made subsequently may enhance the quantum of deduction in respect of working partner salary to the extent of 60% and the balance of 40% of the addition to the income would be chargeable to tax in the hands of the firm.

The partners of the firm have to admit only Rs.1.74 lakhs as salary from the firm in addition to interest on capital of Rs.2.40 lakhs (12% of Rs.20 lakhs).

In case the partners do not wish to show net loss in the books of the firm by charging fully the working partner salary they may ascertain the reasons such as absence of partners acting as working partners during the year and accordingly deny working partner salary to them where any such partner(s) has not attended to the affairs of the firm.

If the deed of partnership provides for proportionate reduction of working partner salary in the event of inadequacy of book profits, then the working partner salary could be reduced accordingly.

However, if the deed of partnership does not contain reduction of working partner salary in the event of inadequacy of profits then reduction of working partner salary would be arbitrary and may expose the firm to the consequence of the entire working partner salary being disallowed since it is not in accordance with the terms of the partnership deed. But such action would not go to deny the status of the firm to the partnership.