Holding

Explanation 2 to Section 40(b) is declaratory and, even for periods before its insertion, interest paid to a partner representing his HUF on personal deposits does not fall within the mischief of Section 40(b) and is deductible.

Summary

The assessee firm, whose partners were Karta of their respective Hindu Undivided Families, advanced personal funds to the firm and received interest on those deposits. The firm claimed a deduction for this interest under Explanation 2 to Section 40(b) of the Income Tax Act, 1961, but the Income Tax Officer disallowed it, a decision upheld by the Appellate Tribunal. The matter was referred to the Supreme Court due to divergent High Court rulings on the scope of Section 40(b). The Court held that Explanation 2 is declaratory and, even for assessment years before its insertion (pre‑1 April 1985), interest paid to a partner acting as Karta of an HUF on his personal deposits does not fall within the mischief of Section 40(b). Consequently, the interest is an allowable deduction. The appeal was allowed and the reference answered in favour of the assessee.

Issues considered

Whether interest paid to a partner, who is a Karta of a HUF, on deposits made by him in his individual capacity, is disallowable under Section 40(b) of the Income Tax Act, 1961.
Whether Explanation 2 to Section 40(b), inserted by the 1984 amendment, applies retrospectively to assessment years prior to its enactment.

Legislation cited

Income Tax Act, 1961s. 2(31), s. 40(b) Explanation 2
Indian Partnership Acts. 13

Subjects

Income TaxSection 40(b)Explanation 2Interest deductionPartnershipHUFRetrospective applicationSupreme Court reference

Judgment

SUWALAL ANANDILAL JAIN A
v.
COMMISSIONER OF INCOME TAX, BIHAR, RANCHI

MARCH 10, 1997

B
[A.M. AHMADI, CJ., SUJATA V. MANOHAR AND
K. VENKATASWAMI, JJ.]

Income Tax Act, 1961 : Section 40(b) Explanation 2 (added in 1984).

Income Tax---Deduction~AY 1976-77-Assessee-fir.m comprised of C
partners in their capacity as Kartas of their respective HUF~Such partners
invested their personal funds in the assessee- firm-Held: Interest paid by the
Jinn to such partners on deposits made by them in their individual capacity
even prior to 1.4.1978 was an allowable deduction by virtue of Expln. 2 to S.
40(b). D

The assessee-firm comprised of partners in their capacity as Kartas
of their respective HUFs. The said partners had advanced monies to the
assessee-firm in their individual capacity. The assessee-firm paid interest
to them on the interests made in their respective individual capacity. For
the assessment year 1976-77 the assessee-firm claimed that the interest E
paid to such partners was an allowable deduction by virtue of Explanation
2 to Section 40(b) of the Income Tax Act, 1961. The Income Tax Officer
(ITO) disallowed the claim. The Income Tax Appellate Tribunal confirmed
the view taken by the ITO. In view of the divergence of views among the
High Courts on the application of S. 40(b) of the Act, issue has been · F
referred to this Court, under S. 257 of the Act.

Answering the reference in favour of the assessee, this Court

HELD : 1. Section 40(b) of the Income Tax Act, 1961 is based upon,
and is a recognition of, the basic nature of relationship between a firm and G
its partners. Explanation 2 to Section 40(b) of the Act is merely declaratory
in nature. Accordingly even for the period anterior to 1.4.1985, any interest
paid to a partner, who is a partner representing his HUF on the deposit
of his personal/individual funds, does not fall within the mischief of
Section 40(b) of the Act. [796-D, 797-D] H
793
794 SUPREME COURT REPORTS [1997] 2 S.C.R.

A Brij Mohan Das laxman Das v CIT, JT (1997) 1 SC 155, relied on.

Gajanand Poonam Chand & Bros. v. CIT, (1984) 174 ITR346 (Raj.),
approved.

CIT v. Chidambaram Pillai, (1977) 106 ITR 292, referred to.
B
Makhan Lal Hamarayan v. CIT, Tax Case No. 83- 84of1971 (Pat.),
overruled.

CIVIL APPELLATE JURISDICTION: Tax Reference Case No. 1
of 1993.
c
From the Order dated 22.9.81 of the Income Tax Appellate Tribunal,
Patna in LT.A. No. 871 (Pat.) of 1980.

A. Subba Rao for the Applicant.

D A. Raghuvir, Ms. Lakshmi Iyengar and B.K. Prasad for the
Respondent. ,

The Judgment of the Court was delivered by

K. VENKATASWAMI, J. The question that has been referred to this
E Court under Section 257 of the Income Tax Act, 1961 (hereinafter called
"the Act") reads as follows :

''Whether on the facts and circumstances of the case, the assessee's
claim to the benefit of clause (b) of Section 40 of the Income Tax
Act, 1961 has been rightly disallowed?".
F
The assessment year in question is 1976-77. The case of the assessee
firm was that M/s. Shanti Kumar Jain, Asok Kumar Jain, Raj Kumar Jain
and Niranjan were partners in the firm in their capacity as. Karta of
respective HUF. They have advanced monies to the assessee firm in their
individual capacity. The assessee firm paid interest to them on the invest-
G ment made in their respective individual capacity. It is the further case of
the assessee firm that it has maintained two separate ledger accounts of
the partners : one of individual as loan creditor and another of Karta of
HUF as partner in the firm. The sources of the money, according to the
assess, are quite separate. The assessee firm claimed that the interest paid
H to them shall not be included while computing the mcome chargeable
S.A JAIN v. C.l.T. [K. VENKATASWAMI, J.] 795

under the head "profits and gains of business or profession". Notwithstand- A
ing such claim, the Income Tax Officer applied Section 40((b) of the Act
and completed the assessment by Order dated 29.1.1978. The result was
that the interest paid to the partners in the circumstances stated above was
included under the head "profits and gains of business or profession".

On appeal to the Appellate Assistant Commissioner, the assessment B
was confirmed by an Appellate Order dated 27.8.1980. Still aggrieved, the
assessee firm preferred further appeal to the Income Tax Appellate
Tribunal. The Tribunal relying upon an unreported decision of the Patna
High Court in Tax Case No. 83-84 of 1971 in the case of Mis. Makhan Lal
Hamarayan v. Commissioner of Income Tax, Bihar, confirmed the view C
taken by the Income Tax Officer and Upheld by the Appellate Assistant
Commissioner. In view of the Divergence of views among the High Courts
on the application of Section 4o(b) of the Act; the issue has been referred
to this Court.

We have heard counsel on both sides . D
. Under identical circumstances, this Court in Mis. Brij Mohan Das
Laxman Das v. Commissioner of Income Tax, Amritsar, JT (1997) 1 SC 155
had occasion to consider an identical issue. Jeevan Reddy, J. speaking for
-· the Bench after noticing the subsequent amendment to Section 40 by
Taxation Law (Amendment) Act, 1984, Under which Explanation (2) inter E
alia has been added, has observed as follows :

"In Gajanand Poonam Chand v. Commissioner of Income Tax,
(1984) 174 I.T.R. 346, the Rajasthan High Court has taken a view
that the said Explanation is merely declaratory in nature and that, F '
therefore, even for the assessment prior to April 1, 1985, the
position of law should be understood to be the same. In support
· of this proposition, the High Court relied upon the fact that
ordinarily the purpose of an Explanation is to clarify that which is
already enacted an:d not to introduce something new. The High
Court opined that the Explanation was inserted by the Parliament G
with a view to settle the controversy as to the mf;aning and effect
of the said clause among the several High Courts and that the
Explanation puts a seal of approval on the view taken by the
majority of the High Courts. The High Court also referred to the
definition of "person" in clause (31) of Section 2. It pointed out that H.
• '
796 SUPREME COURT REPORTS [1997] 2 S.C.R.

A the definition shows clearly that an individual, a H. U .F. and a firm
are distinct persons/entities for the purpose of the Income Tax Act.
The High Court, therefore, concluded that since an individual and
a H.U.F. are two distinct entities for the purpose of the Act, clause
(b) of Section 40 has no application where the interest is paid to
the partner on deposits made by him with the firm in his individual
B capacity where such person is a partner not in his individual
capacity but as representing a H.U.F. Sri G.C. Sharma, learned
counsel for the appellant-assessee, strongly relies upon this
decision and commends it for our acceptance. Learned counsel
points out that even before the enactment of Taxation Law
c (Amendment) Act, 1984 (which inserted Explanation 2 aforesaid),
a majority of the High Courts in the country had taken the same
view though a few High Courts have no doubt taken a contrary
view. Looked at from any angle, Sri Sharma says, the issue must
be answered in favour of the assessee.
D Clause (b) of Section 40 is based upon and is a recognition of
the basic nature of relationship between a firm and its partner. In
Commissioner of Income Tax v. Chidambaram Pillai, {1977) 106
I.T.R. 292, this Court observed :
·•
E "Here the first thing that we must grasp is that a firm is not a legal
person even though it has some attributes of personality. Partner-
ship is a certain relation between person, the product of agree-
ment to share the profits of a business. 'Firm' is a collective noun,
a compendious expression to designate an entity, not a person. In
Income-Tax law, a firm is a unit ·of assessment, by special
F
provisions, but is not a full person which leads to the next step
that since a contract of employment requires two distinct persons .
viz, the employer and the employee, there cannot be a contract
of the service, in strict law, between a firm and one of its partners.
So that any agreement for remuneration of a partner for taking
G part in the conduct of the business must be regarded as portion
of the profits being made over as a reward for the human capital
brought in. Section 13 of the Partnership Act brings into focus this
basis of partnership business.

H This Court also quoted with approval the passage form Lindley on
•
S.AJAINv. C.l.T. [K VENKATASWAMI, J.] 797

the law of Partnership to the effect : In point of law, a partner may A.
be the debtor or the creditor of his co- partners, but he cannot be
either debtor or creditor of the firm of which he is himself a
member, nor can he be employed by his firm, for a man cannot be
' his own employer". The provisions in Chapters III and IV of the
Partnership Act amply define and delineate the duties. Obligations B
and rights of the partners vis-a-vis the firm. The question yet
remains where an individual is a partner in one capacity, e.g. as a
representative of another person, can he have no other capacity
vis-a-vis the firm. To be more. precise, does the above position of
law preclude an individual, who is a partner representing a H.U.F.
from depositing his personal funds with the partnership and receiv- C
ing interest thereon? Explanation 2 says in clear terms that there
is no such bar. This is the legislative recognition of the theory of
different capacities an individual may hold - no doubt confined to
clause (b) of Section 40. Once this is so, we see no reason to hold
that this theory of different capacities is not valid or available for D
the period anterior to April 1, 1985. Accordingly, we hold that
even for the period anterior to April 1, 1985, any interest paid tci
a partner, who is a partner representing his H.U.F. on the deposit
of his personal/individual funds, does not fall within the mischief
of clause (b) of Section 40. In this vie'f of the matter we agree
with the view taken by the Rajasthan1 High Court in Gajanand E
Poonam Chand that Explanation 2 in the context of clause (b) of
Section 40 is declaratory in nature. IAccordingly, we allow this
appeal, set aside the judgment of the High Court and answer the
question referred under Section 256 in the affirmative, i.e. in favour
of the assessee and against the Revenue." F
In view orthe above pronouncement of this Court, we do not thmk
that this question requires any further elucidation. Accordingly the ques-
tion is answered in favour of the assessee and against the Revenue. There
will be no order as to costs.

v.s.s. G
Answering the reference in favour of the assessee.

-