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October 5, 2020

Know Tax Implication of Partner Drawing Remuneration from Partnership Firm

by CA Shivam Jaiswal in Income Tax

Know Tax Implication of Partner Drawing Remuneration from Partnership Firm

A partnership firm is an organization which is formed with two or more persons to run a business with a view to earn profit. Each member of such a group is known as partner and collectively known as partnership firm. These firms are governed by the Indian Partnership Act, 1932.

Section 40(b) of Income Tax Act places some restrictions and conditions on the deduction of expenses available to an assessee assessable as a partnership firm in relation to the remuneration and interest payable to the partners of such firm. The deductions regarding salary to partners and any payment of interest to partners cannot exceed the monetary limits specified u/s 40(b) and are available subject to the fulfilment of conditions mentioned therein.

Is remuneration to partners deductible under Income Tax?

Remuneration includes salary, bonus, commission. The following conditions must be satisfied before claiming any deduction in respect of salary, bonus, commission or other remuneration payable to partner by a partnership firm.

  • Such remuneration should be paid only to the working partner. Explanation 4 to section 40(b) defines working partner as one who is actively engaged in conducting the affairs of the business or profession of the firm of which he is a partner. To be a working partner, the partner has to be actively engaged in conducting the affairs of the business or profession of the firm. 
  • It should be authorized by the Partnership Deed. Also, the amount of salary or manner of its computation is to be mentioned in the deed. If there is not any such provision in deed then no deduction is allowed.
  • It should not pertain to a period prior to Partnership Deed
  • It should not exceed the permissible limit.

What is the permissible deduction specified u/s 40(b)?

Remuneration to partners should be within the permissible limits as mentioned below. This limit is for total salary to all partners and not per partner.

Book ProfitAmount deductible as remuneration under section 40(b)
If book profit is negativeRs. 1,50,000
If book profit is positive: 
On first Rs. 3 lakh of book profitRs. 1,50,000 or 90% of book profit whichever is more
On the balance of book profit60% of book profit

For instance, if the Book profit = Rs. 9 Lakhs
Then Maximum salary allowed as deduction = 3,00,000*90% + 6,00,000*60% = Rs. 6.3 lakhs

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How are book profits computed?

Book Profits are computed with the help of a simple formula as given below:

Book Profits = Profit as per Profit & Loss a/c + Remuneration to partners if debited to Profit and loss a/c + Brought forward business loss, deduction under section 80C to 80U if debited to profit and loss a/c – Income under house property, capital gain, other sources if credited to profit and loss a/c

Can a partnership firm claim deduction of interest paid on partner’s capital?

Interest is paid to partners who have introduced the capital whether by way of cash or any other mode. Non-cash capital (tangible or intangible) is evaluated in monetary terms at the time of its introduction. The interest is payable on the amount provided under the capital clause of the Partnership Deed.

For deduction of interest following conditions must be satisfied:

  • Payment of Interest must be authorized by the partnership deed and It should be related to the period of the partnership deed.
  • The rate of interest should not exceed 12%. If the amount of interest exceeds 12% of the capital then such excess amount is disallowed.
  • If a person is a partner in a firm on behalf or for the benefit of any other person then any interest paid to such person otherwise as a representative capacity shall not be taken into account for the purpose of this section. Interest paid to such person as a representative capacity and to person so represented is taken into account.
  • If interest is paid to a partner on behalf or for the benefit of any other person then such interest is not disallowed under this section.
  • If the firm receives interest on drawings from a partner then it is taxable in the hands of the firm

How is remuneration or interest taxed in the hands of the partners?

  • The amounts which are deductible as Remuneration or Interest in the hands of the firm under Section 40(b) are taxable in the hands of the partner which are receiving such amounts under the head Profit from business/profession.
  • However, if the amount is disallowed in the hands of the firm, then such amounts are exempt in the hands of a partner.
  • The partner’s share in the total income of firm will be exempt in his hands and will not be included in his total income.
  • On account of this exemption, he will not be entitled to set-off his share in the firm’s loss against his other personal income.

Reference to some case laws

In Panda Fuels Vs ITO (ITAT Cuttack), ITAT held that:

  • As per the provisions of Income tax At, the partnership deed should provide for payment of remuneration to working partners.
  • It does not provide that the remuneration paid to working partners should be fixed by the partnership deed or that the partnership deed should provide for the method of remuneration to the working partners.
  • As partnership deed provides for payment of remuneration to partners which would be as per the provisions of the Act, which meant that the remuneration payable to partners would be quantified as per the provisions of the Act and shall not exceed the maximum remuneration provided.
  • It is not in dispute that the partners were paid remuneration, which was less than the maximum provided by the Act.
  • None of the authorities have disputed the payment of remuneration and has accepted the books of account of the assessee as correct and, therefore, the remuneration was deductible while computing the income of the assessee firm.
  • ITAT, therefore, set aside the orders of lower authorities and deleted the disallowance of Rs.6,64,923 and allowed this ground of appeal of the assessee.

Supreme Court in case of Ramlik Kothari (1969) 74 ITR 57 had held that expenditure incurred by partner for earning income from partnership firm was an allowable expenditure and since in the preceding and subsequent years such salary paid to employees were allowed as business expenditure from the salary income received from the firm, therefore, CIT(A) was not justified in upholding the disallowance made by AO.

ITAT in the case of Krishna Ceramics vs. ITO held that it was clear that the remuneration was paid to the partners for attending to the affairs of business- of the partnership firm as working partners. Therefore, the CIT(A) was not justified in holding that there was no evidence that they were working partners.

Therefore, while computing business income deductions w.r.t remuneration and interest paid to partners should be computed after taking all the points mentioned above.

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