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Conditions to obtain Deduction of Interest Paid to Partners in case of Firm [Section 40(b)]

The following specific conditions should be fulfilled to obtain deduction of interest paid to the partners:

  • Payment of interest should be authorised by the partnership

  • Payment of interest should pertain to the period after the partnership deed -

  • Rate of interest should not exceed 12 %

The following specific conditions, as prescribed by section 40(b), should be satisfied:

1. Remuneration Must Be Authorised By Partnership Deed

To claim deduction of remuneration paid to a partner, it should not only be authorised by the partnership deed, but should also be in accordance with the terms of the partnership deed.
Quantum of remuneration or the manner of computation of quantum of remuneration should be stated in the partnership deed and should not be left undetermined, undecided or to be determined or decided on a future date.

Conditions for Claiming Deduction of Interest  in case of Firm (Section 184)

2. It Should Not Pertain To The Period Prior To Partnership Deed –

The remuneration to the working partners as per the partnership deed, should be payable after the date of deed. In other words, if such payment is made from a date prior to the date of partnership deed, it would not be allowed as deduction, unless the earlier deed provides for such payment.

Example :
A and B enter into a partnership agreement on April 1, 2017. Each of them will be entitled for salary at the rate of Rs. 10,000 per month apart from profit. The agreement of partnership is amended on July 1, 2017 to increase the salary to Rs. 30,000 per month with effect from May 1, 2017.

In this case, salary will be deductible as follows subject to the satisfaction of other conditions:

  X (Rs.) Y (Rs.)

From April 1, 2017 to June 30, 2017

10,000 per month 10,000 per month
From July 1, 2017 onwords 30,000 per month 30,000 per month

 

3. Rate Of Interest Should Not Exceed 12 % -

Interest paid to a partner is deductible if it does not exceed simple interest @ 12 % per annum. If, however, interest payable exceeds simple interest of 12 % per annum, the excess amount is not deductible.

The Assessing Officer is not entitled to disallow payment of interest to partners by reworking capital account balances of partners under section 40(b). He can only verify whether the payment of interest to any partner is authorised by and is in accordance with the terms of partnership deed and also whether it relates to the period falling after the date of partnership deed.

When Recipient Of Interest Acts In A Representative Capacity –

Explanations 1 and 2 to section 40(b) deal with cases where the recipient of the interest acts in a representative capacity.

EXPLANATION 1 - Explanation 1 provides that where an individual is a partner in a firm on behalf, or for the benefit of any other person, interest paid by the firm to such individual otherwise than as partner in a representative capacity, is not taken into account, for the purpose of section 40(b).

It is also provided that in such cases, interest paid by the firm to such individual as partner in a representative capacity and interest paid by the firm to the person so represented, is taken into account for the purpose of section 40(b).

For Example :

X is a partner in a firm on behalf of his HUF. The firm pays to X, interest on deposit and capital—Rs. 4,000 to X (otherwise than as partner in a representative capacity) and Rs. 5,000 to X (for HUF).

In this case, section 40(b) will not be applicable in respect of payment of Rs. 4,000, it will be deductible under sections 36(1)(iii), 40(a)(i) and 40A(2).

However, the payment of Rs. 5,000 will be subject to application of section 40(b) [and it will be deductible subject to conditions of sections 36(1)(iii), 40(a)(i), 40(b) and 40A(2)].

EXPLANATION 2 - Explanation 2 provides that where an individual is a partner in a firm, otherwise than in a representative capacity, interest paid by the firm to such individual will not be taken into account for the purposes of section 40(b), if such interest is received by him, on behalf, or for the benefit, of any other person.

For Example :

A partner receives Rs. 10,000 from the firm as interest on deposit made by his minor son, Rs. 10,000 will be allowed subject to the provisions of sections 36(1)(iii), 40(a)(i) and 40A(2) while computing income of the firm.

Similarly, if X is a partner in a firm in his personal capacity, interest paid by the firm to X (not in his personal capacity but, say as representing the HUF of which he is Karta) is not taken into account for the purpose of section 40(b).

4. Interest Charged By Firm On Drawings –

Where a Firm Pays as well as Receives Interest from the same partner, interest received by the Firm will be chargeable to tax. Interest paid to the same partner will be allowed within the four corners of section 40(b).

 

More Topics...on Assessment of 'Firm'

What is Firm & 'Partnership Firm'
Conditions for Claiming Deduction in respect of Remuneration and Interest to Partner in case of Firm (Section 184)
Conditions to obtain Deduction of Interest Paid to Partners in case of Firm [Section 40(b)]
Conditions to obtain Deduction of Remuneration Paid to Partners in case of Firm [Section 40(b)]
How to find out Income and Tax Liability of a Firm
Limited Liability Partnership (LLP)
Alternate Minimum Tax (AMT) on all Persons other than Companies [Section 115JC to 115JF]
 

 
 
 
 
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