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ASSESSMENT OF FIRMS AND A.O.P.

s –
Assessment of Firms
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PFAS PFAOP
• Partnership Firm Assessed as such (PFAS) –
To be assessed as PFAS, a firm should fulfil the
following conditions -
(h) It should be evidenced by a Partnership Deed.
(i) Shares of partners should be specified in the
Partnership Deed.
(c) A copy of the Partnership Deed certified by all
the partners shall be filed with the Return of
Income of the P. Y. in which it comes into
existence.
(d) In case of change in the constitution of the firm
or in the Profit Sharing Ratio, a certified copy of
the revised Deed shall be filed with the Return of
Income of the relevant A. Y.
(e) There should not be a failure on the part of the
firm of the nature specified in S. 144 of the I.T.
Act.
Where a certified copy of the Deed was not filed
with the Return, Revised Return with such copy
may be filed.
Once assessed as PFAS, it will continue to be
assessed as such in case of no change in the
constitution or PSR and no failure u/s. 144.
Computation of Income –
In computing income of PFAS under the head
Business or Profession, the following
deductions are allowable –
• Remuneration to Working Partners –
The following conditions u/s. 40(b) should be
satisfied.
(a) Remuneration should be paid to a working partner –
Working partner – Individual partner actively engaged
in conducting the business or profession of the firm.
Where H.U.F. is a partner in a firm and remuneration is
paid to the karta, remuneration shall be taxable in the
hands of the karta, if karta has rendered services and
the salary has no connection with the investment of
H.U.F. assets in the firm. Such remuneration shall be
deductible in the hands of the firm.
Rasik Lal & Co. v. C.I.T. 229 ITR 248 (S.C.)
C.I.T. v. Trilok Nath Mehrotra 231 ITR 278 (S.C)
(b) Should be authorised by the Partnership Deed –
The deed should provide for remuneration in
clear terms and not in vague terms.
(c) It should be prospective in effect.
(d) Prescribed Limit u/s. 40(b) –
In the case of a firm engaged in Profession –
On first Rs.100000 of book – Rs.50,000 or 90%
profit or in case of loss of book profit
whichever is more
On the next Rs.100000 of – 60% of book
book profit profit
On the balance of book Profit – 40% of such book
profit
In the case of any other firm –
On first Rs.75,000 of book - Rs.50,000 or 90% of
profit book profit whichever
is more
On next Rs.75,000 of book - 60% of such book profit
profit
On the balance of book - 40% of such book
profit profit

Book profit means book profit computed under Chapter


IV D before allowing remuneration to partners as
deduction.
Application of s. 40A(2) –
As per assurance given by the F. M. while moving
the Finance Bill, 1992, CBDT was supposed to
instruct the A.O.s to ensure that the power
should not be used in the case of small firms
and even otherwise, it should be sparingly used.
Interest allowed to partners –
Interest on capital to partners is allowed subject
to the following conditions –
(v) Capital introduced by partners is used for the
business or profession of the firm.
(vi) Interest is authorised by the Partnership Deed.
(iii) Interest is for the period subsequent to the date
of Partnership Deed.
(iv) rate of interest should not exceed 12% p.a. –
simple interest.
(v) Where an individual is a partner in
representative capacity, interest on his personal
loan to the firm not disallowable u/s. 40(b).
(vi) Where an individual who is a partner in the
firm, is chargeable to tax on interest u/s. 64, e.g.
minor son, such interest not disallowable u/s.
40(b).
Interest received by the firm on debit balance of
a partner is chargeable to tax in the hands of the
firm.
Application of S. 40A(2) –
If interest to partners is considered unreasonable
or excessive by the A.O., although it is within
12% p.a., he can disallow interest considered
excessive u/s. 40A(2).
Assessment in the hands of partners –
• Share of Profit – Exempt u/s. 10(2A)
• Remuneration and/or Interest –
(i) Taxable to the extent allowed as deduction to
the firm under the head Business or profession
(ii) Expenses deductible u/ss. 30 to 37.
(II)Partnership Firm assessed as AOP – PFAOP –
When assessed as A.O.P.?
(d) Firm not evidenced by Partnership Deed
(e) Shares of partners not specified in Partnership
Deed.
(f) A certified true copy of Partnership Deed not
submitted with Return of Income of the first
A.Y.
(g) A certified true copy of revised Partnership
Deed not submitted with the Return of Income
of the A.Y. in which change of constitution or
profit sharing ratio has taken place.
(e) Where there is failure of the nature specified in
S. 144 for any A.Y.
Computation of Income –
The following shall not be allowed as deduction
in computing the income of a PFAOP u/s.
40(ba)
(d) Remuneration to partners.
(e) Interest on capital/loan to partners.
Expln. 1 to S. 40(ba) –
Where PFAOP pays interest to and receives
interest from a partner, only net interest shall
be disallowed.
Expln. 2 to S. 40(ba) –
Where an individual is a partner in representative
capacity, any interest paid to him on his personal
loan to the firm not disallowable u/s. 40(ba).
Expln. 3 to S. 40(ba) –
Where an individual is a partner in a firm and he
receives interest in a representative capacity on
behalf of any person, the same cannot be
disallowed u/s. 40(ba).
Circular No. 739 dated 25.3.1996 –
The above circular of the CBDT clarifies that
deduction in respect of remuneration to partners
and interest on capital of partners shall be
allowed u/s. 40(b), only if the provision
authorising these payments in the Partnership
Deed is very specific and not vague. Mere
reference to limit specified u/s. 40(b) will not be
enough.
Some Decisions
• (1) If there is no provision in the
Partnership Deed that the firm shall not
result in dissolution on death of a partner, it
shall stand dissolved and two assessments
have to be made for the period before and
after the date of death.
• CIT v. Empire Estate 218 ITR 355 (S. C.)
• (2) Stock in trade of the firm cannot be
valued at cost or market value whichever is
less on dissolution of the firm. It has to be
valued on real basis. Real rights of partners
cannot be adjusted on any other basis and
the surplus, if any, shall be considered as
chargeable profit of the firm.
• ALA Firm v. CIT 189 ITR 285 (S.C.)
• (3) Where a partnership is dissolved as a result of
death of one of the partners, but it is reconstituted
and continued by the remaining partners, stock in
trade shall be valued at cost or market value
whichever is less as the firm continues to carry on
the same business.
• Sakthi Trading Co. v. CIT 250 ITR 871(S.C.)
• (4) Where Partnership Deed provided for
continuance of the firm by sons of senior
partner subject to payment of 25% share of
net profits to their mother on his death, it
had the effect of creating diversion of
income by overriding title.
• CIT v. Nariman B. Bharucha &Sons 130
ITR 863(M.P.)
• (5) Where on dissolution of a firm, lumpsum
amount has been paid to a partner waiving his
debit balance, such waiver is not to be treated as
income of the firm.
• CIT v. Ganesa Chettiar 133 ITR 103 (Mad.)

• (6) H.U.F. cannot be a partner in law and if any


remuneration is paid to karta it is taxable in his
hands as a partner. S. 40(b) will apply.
• Rasiklal & Co. v. CIT 229 ITR 458(S.C.)
• (7) Remuneration paid to a partner is governed by limits
prescribed u/s. 40(b). Where S.40(b) applies, S.40A(2) has
no application.
• Chhajed Steel Corpn. V. ACIT 77 ITD 419(Ahd.) Binit
Corpn. V. ITO 24 TTJ 571(Ahd.)

• (8) Loans taken by partners against their L.I.C. Policy and


introduced in firm as capital. The firm paid interest to
L.I.C. directly. It is interest paid to partners and shall be
disallowed u/s. 40(b), if Partnership Deed does not provide
for interest on capital to partners.
• CIT V. A. Gratannery 179 ITR 44 (P&H)
• (9) All partners of a firm were members of H.U.F.. H.U.F.
gave loans to the firm. On partial partition of H.U.F. loan
given to firm was divided among members. As partial
partition is not recognised, interest paid by firm on loan is
interest paid to H.U.F.and, therefore, not hit by S.40(b).
• CIT v. B. S. Sundaravadivel Mudaliar & Sons 260 ITR
662(Mad).

(10) Interest received by firm from one partner cannot be


adjusted against interest paid to another partner. Interest
paid to partner subject to S. 40(b).
• Sugar Dealers v. CIT 122 ITR 826(All)