UNIT IV
Computation of Income of Partnership Firm in relation to Sec 40(b) & Tax thereon with applicable Rate of Tax
No capital expenditure or personal expenses will be allowed. Further, the remuneration paid must be only and exclusively for the purposes of the business of the firm. 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 fulfillment of conditions mentioned therein.
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.
1. 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. A partner can be said to be actively engaged in conducting the affairs of the firm even if he devotes a part and not the whole of his working hours.
Another significant point to be noted here is that the definition of “working partner” in Explanation 4 contemplates an individual. Therefore, a partner other than an individual (example a company) cannot be a working partner.
When a company is a partner in a firm, a director or shareholder of the company can very well be an employee of the firm in which the company is a partner. Any salary/remuneration paid by the firm to such an employee would be totally outside the ambit of disallowance under section 40(b). This would be so because the individual who is an employee of the firm is not a partner in the firm. Section 40(b) contemplates allowance of remuneration paid by a firm to its partners and not to other employees.
2. It should be authorized by the Partnership Deed.
Any payment of salary, bonus, commission or remuneration by whatever name called to a working partner is not allowed as a deduction, if the payment is not authorised by partnership deed or it is not in accordance with the terms of partnership deed. The partnership deed will have to contain clear directions as to the quantum of remuneration to be paid to the working partners.
3. It should not pertain to a period prior to Partnership Deed.
The remuneration paid to the working partners will be allowed as deduction to the firm from the date of such partnership deed and not from any period prior thereto.
Consequently, if for instance a firm incorporates the clause relating to payment of remuneration to the working partners by executing an appropriate deed as on July 1st, but effective from April 1st, the firm would get deduction for the remuneration paid to its working partners from July 1st onwards but not for the period from April 1st to June 30th.
4. It should not exceed the permissible limit.
The maximum amount of salary, bonus, commission or other remuneration to all the partners during the previous year should not exceed the limits given below:
On first 3 lakhs of book profit or in case of loss – Rs. 1, 50,000 or 90% of book profits (whichever is higher).
On the balance book profit - 60% of book profit.
Calculation of Book Profit
Book profit means the net profit as shown in the profit and loss account which is computed according to the manner laid down in the chapter IV-D as increased by amount of remuneration paid to partners which is allowed as deduction in the profit and loss account. Book profit is calculated in the following ways:
1. Net profit as per profit and loss account
2. Add remuneration if already debited
3. Deduct interest if it is not deducted
4. Make adjustments for expenses as per section 28 to 44D
Interest payable to partners
So far as allowability of interest paid by a firm to its partners under section 40(b) is concerned, the following conditions have been prescribed by section 40(b):
(1) The interest payable by a firm to its partners should be authorised by and in accordance with the partnership deed.
(2) The interest payable by a firm to its partners should not be for a period falling prior to the date of such partnership deed authorizing the payment of such interest.
(3) The rate of interest payable to the partners shall not exceed 12% simple interest per annum.
Note: Interest includes simple interest and not compounding interest. This means if the company is paying interest on delayed payment of simple interest, such compounding interest shall not be permitted to be deducted as per Section 40(b).
Partner in a Representative Capacity
If an individual is a partner in a firm in a representative capacity (that is on behalf and for the benefit of another person) and not in his personal capacity then interest paid by the firm to such individual in his personal capacity and not as a representative partner will not be subject to the conditions and ceiling as prescribed for disallowance.
Computation of income of partner of a firm
The partner’s share in the total income of firm (PFAS) will be exempt in his hands and will not be included in his total income. His share in the total income of the firm will be calculated as follows:
Total income of firm x = Partner's share in profits of firm as per partnership deed / Total Profit of the firm
By virtue of this exemption, a partner of PFAS will not be taxed in respect of his share in the firm’s income since the firm itself will be taxed as a separate entity @30%. There will be no allocation of income among the partners. 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.
Section 40b determines the maximum amount of remuneration and interest on capital payable to a partner under Income Tax Act. The amount over the specified limit is not allowed as a deduction to a partnership firm.
Remuneration to Partners
- Remuneration includes salary, bonus, commission .Remuneration in partnership firm is allowed as a deduction if following conditions are satisfied.
- Remuneration is allowed only to working partners.
- Remuneration must be authorised by partnership deed and according to the terms of 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. Normally people mentions in deed that salary is allowed to partners as per maximum limit defined under this section. This clause satisfies the condition for quantum of deduction.
- It should be related to the period of the partnership deed. If there is another partnership deed for another period then such deed’s provisions will be considered for that period.
- It is not allowed if tax is paid on presumptive basis under section 44AD or section 44ADA.
- Remuneration should be within the permissible limits as mentioned below. Please note that this limit is for total salary to all partners and not per partner.
Book Profit | Amount deductible as remuneration under section 40(b) |
If book profit is negative | Rs. 1,50,000 |
If book profit is positive- On first Rs. 3 lakh of book profit On the balance of book profit |
Rs. 1,50,000 or 90% of book profit whichever is more 60% of book profit |
Calculation of book profit
Profit as per Profit & Loss a/c – xxx
Add- Remuneration to partners if debited to Profit and loss a/c xxx
Add- Brought forward business loss, deduction under section 80C
To 80U if debited to profit and loss a/c xxx
Less – Income under house property, capital gain, other
Sources if credited to profit and loss a/c xxx
Book Profits xxx
Remuneration which is allowed as expenses in the hands of partnership firm will be taxable in the hands of receiving partner as “Income from Business or Profession”.
If such remuneration is not allowed as expense in hands of partnership firm then it will not be taxable in the hands of partners.
Interest on Partner’s Capital
For deduction of interest following conditions must be satisfied –
- Payment of Interest can be made to working or non-working partner.
- Payment of Interest must be authorized by the partnership deed and it should be related to the period of the partnership deed. If there is another partnership deed for another period then such deed’s provisions will be considered for that period.
- The rate of interest should not exceed 12%. If the amount of interest exceeds 12% of the capital then such excess amount is disallowed.
- It is not allowed if the tax is paid on presumptive basis under section 44AD or section 44ADA.
- 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 partner then it is taxable in the hands of the firm.
When it is said that remuneration or interest is not allowed, it means that it is not allowed as deduction for calculating net taxable profit. The firm can still pay it to the partner in cash, there is no restriction on it under partnership act.
The amounts which are deductible as remuneration or interest in the hands of the firm under section 40b 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 hands of firm, then such amounts are exempt in the hands of partner.
No TDS is to be deducted by partnership firm on salary or interest paid or credited to partner. TDS is not required to be deducted even when such salary or remuneration is taxable in the hands of partner. For more information, you can read – TDS on Salary to Partners
Key Takeaways:
- Section 40b determines the maximum amount of remuneration and interest on capital payable to a partner under Income Tax Act.
- Remuneration which is allowed as expenses in the hands of partnership firm will be taxable in the hands of receiving partner as “Income from Business or Profession”.
References:
- Www.taxguru.com
- Income Tax Act with Gist of Supreme Court Rulings Book (Bharat Law House.)
- Income Tax Law & Accounts For B.Com Vth Semester of Calicut University (English, Paperback, Dr. H.C. Mehrotra, Dr. S.P. Goyal)
