1. This appeal by the assessee is directed against the order passed by the CIT under s. 263 of the Act on 12th January, 1997.
2. The appeal arises this way. The assessee is a partnership firm consisting of two partners. One is M. H. Patel, an individual, and the other is H. P. Patel (HUF). It is common ground that H. P. Patel is a partner in the firm representing the joint family of which he is the Karta. According to cl. (8) of the partnership deed, Shri H. P. Patel shall be the working partner and shall be paid a monthly remuneration of Rs. 6,000, which may be increased in future as mutually agreed upon between the partners. For the year ended 31st March, 1993, which is the first year of the business, which is in the manufacture and sale of embroidered fabrics and laces, the assessee-firm paid remuneration of Rs. 72,000 to H. P. Patel. In the return, the same was claimed as a deduction as salary paid to a working partner as per the provisions of s. 40(b) as substituted by the Finance Act, 1992 w.e.f. 1st April, 1993. The assessment was completed on 30th October, 1995 under s.
143(3) accepting the claim. In the assessment order, the AO started the computation of the total income from the figure of net profit as per the P&L a/c, added the salary of Rs. 72,000 paid to H. P. Patel as well as certain other disallowables and then from the income of Rs. 1,88,266 so arrived at, deducted the salary paid to H. P. Patel in the following words : "Less : Partners remuneration under s. 40(b) as claimed 72,000" 3. The assessee filed an appeal to the CIT(A) against the other disallowables made in the assessment, but since the partner's salary was deducted as claimed, no appeal was taken, naturally, on this point.
4. The CIT was of the view that the assessment made was erroneous and was prejudicial to the interests of the Revenue. He considered the allowance of the salary under s. 40(b) of the Act to have been given by the AO without application of mind. According to him, the deduction can be allowed only in respect of salary paid to a working partner who should always be representing himself and cannot represent an HUF. A member of the HUF or Karta thereof could represent in the firm only when the HUF is a partner not because of the individual efforts alone of the Karta but due to many other considerations, such as capital contribution, etc. He, therefore, considered the assessment to be erroneous and prejudicial to the interests of the Revenue and accordingly notice under s. 263 was issued.
5. In response to the notice, the assessee filed written objections pointing out that the Karta of the HUF looked after the day to day working of the business and was paid in consideration thereof as a working partner and the same has been credited to the capital account of the HUF. It was claimed that the Karta represents the HUF and also worked for the firm and therefore the salary paid to him was rightly claimed as deduction. It was contended that the claim was allowable considering the scheme of s. 40(b).
6. The CIT was not convinced. In his view, the intention of the legislature was to allow only the remuneration paid to a working partner. Though Mr. Patel has been mentioned as a working partner representing his HUF, in effect he was not so, according to the CIT. He then proceeded to compare the capital accounts of both the partners. He found that the share of profit of Patel was more than the other partner. No interest was paid on the capital account credit balance.
The CIT therefore came to the conclusion that the working partner, in addition to the salary, also takes a higher share of profit, which goes against "practical considerations". The CIT, in other words, was at pains to demonstrate that though Patel is described only as a working partner, he was in fact enjoying a higher return from the firm, which is inconsistent with the claim touted that he is only a working partner. The CIT was further of the view that in the eye of law also, a Karta of the HUF cannot, while representing the HUF, be a working partner. For these reasons, he directed the AO to withdraw the deduction and make a fresh computation of the total income.
7. The learned representative for the assessee contended firstly that the CIT had no jurisdiction to invoke s. 263 since the salary was allowed as a deduction only after the AO was fully satisfied that it is so allowable under s. 40(b). Reference was made in this connection to the following judgments : (ii) CIT vs. Govindram Seksaria Charity Trust (1987) 166 ITR 580 (MP) (iii) Manoharlal Nareshkumar vs. Asstt. CIT (1996) 89 Taxman 240 (Asr - Trib) 8. It was contended that when the AO had applied his mind to the issue, the mere fact that the CIT came to hold a different view of the matter would not confer jurisdiction upon him to act under s. 263.
9. We are unable to accept the contention. There is nothing in the assessment order to show that the AO had applied his mind to the question as to whether the salary paid to H. P. Patel was allowable under s. 40(b) on the footing that he is a working partner. In the assessment order, the AO merely granted the deduction as claimed. There is no discussion to show that he has applied his mind to the question.
Therefore, in our view, the CIT was perfectly justified in invoking the powers under s. 263.
10. Coming to the merits of the claim, the learned representative for the assessee pointed out that Mr. Patel was the only working partner, the other partner being a lady. He also submitted that it was not disputed even by the CIT that Mr. Patel was looking after the day-to-day business of the firm. He submitted that there is no prohibition in law that a person who was representing his joint family in the firm as partner cannot put in his individual efforts for the business of the firm and thereby receive salary for his own benefit. He submitted that the view of the CIT to the contrary is not correct in law. He further pointed out that in the return filed by the HUF, the salary was included as part of the total income and taxes were also paid and if the disallowance of the salary is upheld, there would be double taxation of the same amount which would be contrary to the ruling of the Supreme Court in CIT vs. Muralidhar Jhawar (1966) 60 ITR 95 (SC). It was therefore submitted that even on merits, the salary was rightly allowed as deduction.
11. On the other hand, the learned senior Departmental Representative strongly relied on the language of Expln. 4 to s. 40(b) and submitted that the working partner must be a partner in his individual capacity in order that the salary paid to him can be allowed as a deduction. He, therefore, submitted that an HUF as such cannot be a working partner.
He drew our attention to judgment of the Supreme Court in the case of CIT vs. Triloknath Mehrotra (1998) 231 ITR 278 (SC). As regards the contention that there would be double taxation if the disallowance is upheld, he submitted that this question was beyond the scope of the present appeal and if there is double taxation it cannot be helped. He, therefore, submitted that the order of the CIT should be upheld.12. We have carefully considered the rival contentions. From the asst.
yr. 1993-94, a new scheme of taxation of partnership firms was introduced. From the said date, the registration of firms was done away with. Correspondingly, provision was also made in s. 40(b) for allowing the salary paid to the working partner as deduction in computing the income of the firm. Earlier, under s. 40(b), any payment of interest, salary, bonus, commission or remuneration made by the firm to any partner of the firm was disallowed and added back in the firm's assessment. The new s. 40(b)(i), as introduced w.e.f. 1st April, 1993 is as under : Notwithstanding anything to the contrary in ss. 30 to 38, the following amounts shall not be deductible in computing the income chargeable under the head "Profits and gains of business or profession", - (i) any payment of salary, bonus, commission or remuneration, by, whatever name called (hereinafter referred to as "remuneration") to any partner who is not a working partner; Explanation 4. - For the purposes of this clause, "working partner" means an individual who is actively engaged in conducting the affairs of the business or profession of the firm of which he is a partner".
13. The facts are not in dispute. To recapitulate, H. P. Patel was a partner in the firm as Karta of the joint family. The other partner was Smt. M. H. Patel who is a lady. The salary of Rs. 6,000 per month was paid to H. P. Patel under cl. (8) of the partnership deed which stated that he shall be the working partner.
14. The question is whether H. P. Patel falls within the meaning of the words "working partner" as contained in Expln. 4. It is well settled after a series of the decisions of the Supreme Court that an HUF cannot as such enter into a contract of partnership with another person or persons and that the Karta of the HUF, however, may enter into partnership with others on behalf of and for the benefit of his joint family. When he does so, the other members of the joint family did not, vis-a-vis outsiders, become partners in the firm. They cannot interfere in the management of the firm or claim any account of the partnership business or exercise any of the rights of the firm which a partner is entitled to. So far as the firm and its other partners are concerned, it is the Karta who alone is in law recognised as a partner and whatever arrangements he may have with his joint family with regard to the share of income, they are essentially arrangements between him and his family with regard to which the firm as such does not enter into the picture at all. These principles are now settled and reference may be made to the following judgments of the Supreme Court : 15. A perusal of these authorities show that so far as the partnership firm is concerned, it is only the Karta who is the partner and the joint family, whom the Karta represents does not become the partner at all. This is because the HUF is not a juristic person for all purposes and is incapable of entering into an agreement with any another person or HUF. Further, from the very nature of its fluctuating composition consisting of members, some of whom may not have attained the age of majority and some may not be born at a given time, the family as a unit is incapable of entering into a partnership agreement contemplating the creation of mutual rights of agency amongst its members. Thus, if the HUF is in law incapable of entering into partnership with another person, it is difficult to see how in the present case, the payment of salary to H. P. Patel can be considered as a payment to the HUF he represents and not to him in his individual capacity. We cannot throw out notions of the partnership law even while considering a question arising under the IT Act, because s. 2(23) of the IT Act says that the expressions "firm", "partner" and "partnership" shall have the meanings respectively assigned to them in the Indian Partnership Act, 1932, with the only exception that the expression "partner" would also include a minor admitted to the benefits of the partnership. Thus, if under the partnership law, an HUF as such cannot become a partner in a firm and it is only the person who represents the HUF, such as the Karta or the manager, who can in law be considered as a partner of the firm, it is difficult to agree with the contention of the learned senior Departmental Representative that since the HUF as such cannot be considered as a working partner, the payment made to Patel, the Karta, cannot be considered as a payment of remuneration to a working partner.
In fact, an HUF cannot be considered a partner at all as we have explained earlier. It is only H. P. Patel, the Karta of the HUF in his individual capacity, who is the partner in accordance with the notions of the partnership law. He undoubtedly has put in efforts in the conduct of the day-to-day business of the firm and he has been remunerated for the same. If that is so, he falls squarely within the meaning of the expression "working partner" as contained in Expln. 4.
He is an individual, he is actively engaged in the conducting the affairs of the business of the firm and he is a partner of the firm in his individual capacity. Thus, all the ingredients of Expln. 4 are satisfied.
16. There is no warrant for the assumption of the CIT that in the eye of law, the Karta of the HUF cannot be a working partner while representing the HUF. No authority has been cited in support of this view. The conclusion would appear to go against the long line of decisions of the Supreme Court [for instance, please see V. D.Dhanwatey vs. CIT (1968) 68 ITR 365 (SC), CIT vs. Gurunath Dhakappa (1969) 72 ITR 192 (SC), CIT vs. D. C. Shah (1969) 73 ITR 692 (SC); and Rajkumar Singh Hukumchandji vs. CIT (1970) 78 ITR 33 (SC)], wherein the dispute arose as to whether the salary paid by the firm to the Karta of the joint family, where the Karta represents the joint family as partner, is his individual income or the income of the joint family. It was held that if a member of the HUF joins a partnership and is given salary for rendering services to the firm, the salary will be his individual income, but if the salary is really and in truth a part of the return for investment made by the HUF in the firm, it would be added to the income of the HUF. Such a dispute could not have arisen, if the proposition of law laid down by the learned CIT were to be correct. In the judgment of the Supreme Court in CIT vs. Triloknath Mehrotra (supra) cited by the learned senior Departmental Representative, it has been clearly held that there is no conflict between the cases where the allowability of the remuneration paid to the partner by the firm was considered and those cases where the question, whether salary so paid constituted the individual income of the partner or income of the joint family was resolved, We are, therefore, clearly of the opinion that there is no such proposition of law as is laid down by the CIT.17. The fact that the working partner derived a higher profit share as well as salary and thus became entitled to a much larger share of the profits of the firm than the other lady partner is not relevant, in our opinion, for declaring the controversy.
18. A limited departure from the legal position that so far as the firm is concerned, it cannot recognise any representative capacity under the partnership law and if the Karta of the joint family is a partner representing the joint family and on behalf of the joint family, it is only the Karta in his individual capacity who is the partner and not the joint family as such, was made by the introduction of Expln. (1) to (3) to s. 40(b) by the Taxation Laws (Amendment) Act, 1984, w.e.f.
asst. yr. 1985-86. By introducing these Explanations, the representative capacity of the Karta was sought to be recognised but that was only as far as payment of interest by the firm was concerned.
Earlier, firms were experiencing difficulties because of the application of the strict legal position as described above and even though the interest was being paid to the Karta in his individual capacity in respect of amounts lent by him to the firm, the same was being disallowed under s. 40(b) by applying the strict legal principle under the partnership law that though he represents his joint family, he was a partner only in his individual capacity and, therefore, whatever interest was paid, irrespective of the source of the funds, to him, fell to be disallowed under s. 40(b). An instance of the application of the strict legal position is to be found in Rashiklal's case cited supra. The Supreme Court in the case of Brijmohandas Laxmandas vs. CIT (1997) 223 ITR 825 (SC) and Suwalal vs. CIT (1997) 224 ITR 753 (SC) held that the Explanations were clarificatory and applied even to assessment years prior to asst. yr. 1985-86, thus, eliminating the rigour of the strict application of the principles of partnership law to income-tax assessments. However, these Explanations are confined to payment of interest alone and therefore so far as the representative capacity is concerned, the same cannot be recognised where payment of salary is involved. In fact, in Rashiklal's case (supra), the Supreme Court refused to recognise the representative capacity even though its attention was drawn to its two earlier decisions (cited supra) on the ground that those Explanations introduced w.e.f. the asst. yr. 1985-86 were concerned with the payment of interest and not with commission paid for services rendered by the partner. Therefore, so far as payment of salary is concerned, the principles of partnership law continue to apply where the interpretation of s. 40(b) is involved. This is what we have sought to do.
19. We confess that at one point of time, we thought that the order of the CIT should be upheld, but on a closer and deeper examination of the legal position, such as the impact of the partnership law on the income-tax law and the judgments of the Supreme Court on the subject, we came to the conclusion that the disallowance under s. 40(b) cannot be upheld.20. For the above reasons, we set aside the order of the CIT and restore that of the AO and allow the appeal.