Judgment:
1. These are appeals filed by the assessee and they relate to the assessment years 1979-80 and 1980-81. The disallowance of interest paid to a partner of the firm under Section 40(6) of the Income-tax Act, 1961 ('the Act') constitutes the subject-matter of the appeals before us.
2. The facts leading to the appeals are as follows. The assessee is a registered firm of three partners doing business in pawn-broking and money-lending. For the assessment year 1979-80, it returned an income of Rs. 27,870. The assessee itself added back the interest amounts debited to the three partners which are as follows : From the statements accompanying the returns it was disclosed that the interest actually paid to Shri Shantilal was Rs. 18,042 in respect of the loan advanced by him to the firm. However, the whole of the said interest had not been added back to the income of the firm. This omission was subsequently noticed and a notice under Section 154 of the Act dated 6-6-1983 was issued to the assessee-firm and it was asked to show cause as to why the mistake cannot be rectified. The assessee filed objections dated 24-6-1983. It is stated in those objections as follows : Shri Shantilal was carrying on separate proprietary business under the name and style of Varadaji Shantilal. In his capacity as proprietor of the said concern he had advanced a sum of Rs. 1,50,000 to the assessee-firm on which he was paid interest of Rs. 18,043 in the relevant accounting year. The said interest payment was received by him not in the capacity of a partner of Sukhraj Shantilal, a company, but in the capacity of the proprietor of Varadaji Shantilal. He had quoted several case laws whose purport was that if interest to a partner was paid not in his capacity as a partner but as a creditor or depositor or a trade advance does not attract the provisions of Section 40(6). The ITO preferred to follow the Madhya Pradesh High Court decision in Jalam Chand Mangilal v. CIT [1982] 138 ITR 347. He states that the several decisions cited by the assessee in his objections were all considered in the said Madhya Pradesh High Court decision and following the same he rejected the arguments of the assessee and he ordered adding back of Rs. 18,043 under Section 40(6). Thus, he arrived at the total income of the assessee before the firm's tax was deducted at Rs. 45,913.
3. Aggrieved against the said order the assessee filed an appeal before the AAC, Range-A, Vijayawada. The AAC consolidated the appeals for 1979-80 to 1981-82 and disposed them of by his common order dated 21-9-1985 as they comprised similar common point. We have already stated that the disallowance of interest for 1979-80 was Rs. 18,043 whereas the disallowance for the assessment year 1980-81 as having paid to Varadaji Shantilal which is the proprietary concern of Shri Shantilal was Rs. 22,867. The only difference between the assessment years 1979-80 and 1980-81 was the fact that whereas the appeal for 1979-80 arose out of a rectificatory order passed under Section 154 the appeal for the assessment year 1980-81 arose from out of a regular assessment dated 4-11-1982 completed under Section 143(3) of the Act by the ITO.4. As regards 1979-80 two contentions were raised. Firstly, it was contended that the disallowance under Section 40(6) is proper or not in the facts and circumstances of the case is not free from difficulty and it cannot be said that the original assessment order under Section 143(1) contains an obvious mistake. It is contended that the mistake, if any, in the said order can be found out only from a long drawn process of reasoning on a point on which conceivably there can be two views. There are a catena of decisions stating that when such is the situation the order of rectification cannot be valid and on that simple ground the addition made for the assessment year 1979-80 under Section 40(6) should go. However, on merits also the assessee has got a strong case and he very much relies upon the following decisions: Addl. CIT v.Vallamkonda Chinna Balaiah Chetty & Co. [1977] 106 ITR 556 (AP), CIT v.Gemini Production [1977] 110 ITR 847 (Mad.), Terla Veeraiah v. CIT [1979] 120 ITR 502 (AP), CIT v. K. Krishnaiah Chetty & Sons [1981] 131 ITR 410 (AP) and Venkatesh Emporium v. CIT [1982] 137 ITR 593 (Mad.).
As against all these the revenue relied upon the Madhya Pradesh High Court decision in Jalam Chand Mangilal's case (supra}. The revenue also relied upon the Kerala High Court decision in CIT v. Veeraiah Reddiar [1969] 73 ITR 162 and the AAC after considering the case on both sides held that the payment of interest by the assessee-firm on the borrowed money to the sole proprietary concern of a partner was in effect a payment made to a partner only. The fact that the interest was paid not to the partner but to his sole proprietary concern does not make any difference and, therefore, he held that the payment is clearly hit by the provisions of Section 40(6). It was argued before the AAC that the assessee was not under an obligation to bring in any additional capital than the capital already invested by his late father. The AAC held that this argument does not make any difference in the situation. Once interest is paid to a partner the same is hit by the provisions of Section 40(6). It was next argued that there was difference between the capital investment and other investment made by a partner. The AAC held that though there are different types of investments as far as disallowance of interest under Section 40(6) is concerned, the Act does not make any difference between the different investments made by the partner. It was also argued that under Section 28 of the Act all statutory allowances under Sections 36 and 40 of the Act should be allowed. The AAC brushed aside this argument by simply quoting the wording of Section 40 where it starts with a non obstante clause 'Notwithstanding anything to the contrary in Sections 30 to 39'.
Ultimately he had dismissed the appeals filed by the assessee. Hence the second appeals.
5. We have heard Shri M. Nageswara Rao, the learned counsel for the assessee and Shri N. Jayakar, the learned departmental representative.
Section 40(6) is as follows : Notwithstanding anything to the contrary in Sections 30 to 39, the following amounts shall not be deducted in computing the income chargeable under the head 'Profits and gains of business or profession', (b) in the case of any firm, any payment of interest, salary, bonus, commission or remuneration made by the firm to any partner of the firm.
Explanations 1, 2 and 3 were inserted under Section 40(6) by the Taxation Laws (Amendment) Act, 1984 with effect from 1-4-1985. Cases not governed by the provisions of Section 40(6) can be categorised as follows : The person who had invested the moneys and the person to whom the interest is paid are different from each other. For example, if the investment is made from out of the joint family funds and interest is paid to the joint family but if the partner happens to be a karta but at the same time becomes a partner of the firm in his individual capacity then Section 40(6) does not apply. That means the partner as well as the karta should not be one and the same person. The payment of interest must be made from out of the income of the firm. In a Madras High Court decision in Gemini Production's case (supra) it is held that this was not the case and they categorically held that the amount out of which the commission was paid must be the income of the firm of which the recipient was a partner was absent in the said case.
6. In K. Krishnaiah Chetty & Sons' case (supra) the capital which stood credited to the individual accounts of the partners was transferred to the accounts of their respective HUFs and the interest paid thereon by the partnership firm was also credited to the accounts of the respective HUFs. Further, in that case, the Tribunal found that partners were not required to contribute any capital. It is also to be seen that in that case the accounts of the respective HUFs were shown as capital of the partners in the previous year. Even then it was held that it would not be a ground for ignoring the entries in the accounts of the relevant assessment year and held that since interest payment was made only to the HUF and not to the individuals Section 40(6) had no application. Therefore, it is very clear from the said decision that the partners were partners in their individual capacities, that there is no need for them to contribute the capital, that they have transferred the amounts to the credits of their respective HUFs and the interest was credited to HUF accounts. In those circumstances the Andhra Pradesh High Court held that Section 40(6) does not apply. In that case their Lordships followed the decision in Vallamkonda Chitma Balaiah Chetty & Co.'s case (supra) and they have distinguished CIT v.T. Veeraiah and K. Naraiimhulu [1977] 106 ITR 283 (AP) and Addl. CIT v.K.G. Narayanaiah Chetty & Co. [1977] 106 ITR 420 (AP). However, in the facts of the case admittedly Shri Shantilal is one of the partners and Varadaji Shantilal who lent heavy amounts to the assessee-firm is a proprietary concern of Shri Shantilal. Thus, it cannot be said that the amount lent is not by a partner but by an outsider or a different person especially in view of the Kerala High Court decision in Veeraiah Reddiar's case (supra). In that case the Kerala High Court fully approved and adopted the interpretation of the analogous provisions by Chief Justice Rajamannar of the Madras High Court in R.A. Goodsir & Co.
v. CPJ[1948] 16 ITR 367. The following legal position is what is held by Chief Justice Rajamannar in R.A. Goodsir & Co.'s case (supra) at pages 374 and 375 : Looking, then, fairly at what has been said, it is clear that there is no distinction made between payments by way of interest, commission, salary or remuneration made to a partner as a partner and made to him in a different character. There is nothing to indicate that some categories of interest, salary, commission or remuneration, though paid by a firm to a partner, were to fall outside the scope of that provision.
We are in complete agreement with that interpretation of Section 10(4)(6). (p. 165) Therefore, simply because the interest paid is towards borrowing made from a proprietary concern of a partner does not make the borrowing one which is not made from a partner and the interest paid on such borrowings is not in any way distinguished from the interest paid on the moneys borrowed from the partners.
7. Another category which can be excluded from the operation of Section 40(6) is that if a partner is not obliged to do a particular thing and is not obliged to bring in any particular asset to a partnership firm then also Section 40(6) does not apply. Suppose a building constituting separate property of a partner is made use of by a partnership firm in which he is one of the partners, then the rent paid thereon is not hit by Section 40(6). Firstly, because it is neither interest, remuneration or commission paid to a partner and secondly because the partner is under no obligation to bring in the said asset into the firm or to make it available to the firm to carry on its business. So also, if a partnership deed does not ordain that all or some of its partners should contribute their special talents (actors, artists, photographers, etc.) but if during the course of business of the firm the services of the partners are utilised not as a partner but as any outsider for instance a artist, photographer, then also Section 40(6) does not apply. However, that is not the case here. So, in our considered opinion no case is made out by the assessee that the interest paid by it to one of the partners, viz., Shantilal falls outside the scope of Section 40(b) and, therefore, we hold for assessment year 1979-80 there was an obvious mistake in not disallowing interest by the ITO while framing the assessment under Section 143(1) and we further hold that the said mistake is an obvious mistake, a mistake on the face of the record and it can be rectified under Section 154. We also hold that interest paid to Shri Shantilal's proprietary concern Varadaji Shantilal does not amount to paying interest to any other person than the partner of the assessee-firm and hence Section 40(b) clearly applies. Therefore, the additions made for 1979-80 and 1980-81 are quite proper. We fail to see any merit in these appeals and hence we dismiss the appeals.