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Facts
The assessee, a partnership firm, did not debit depreciation in its P&L account but claimed it in the computation of income. This resulted in higher book profit and increased interest paid to partners. The AO disallowed a portion of the interest and also a part of other expenses.
Held
The Tribunal held that failure to debit depreciation in the books inflates capital balances and leads to excess interest payment to partners. However, the Tribunal found merit in the assessee's alternative submission regarding the calculation of disallowed interest and remanded the matter to the AO. The disallowance of other expenses was reduced.
Key Issues
Whether disallowance of interest paid to partners is justified when depreciation was not debited in the books, and whether the disallowance of 10% of various expenses was appropriate.
Sections Cited
40(b), 32(1), 143(2), 142(1), 143(3), 274, 271(1)(c)
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Income Tax Appellate Tribunal, PUNE BENCH “A”, PUNE
Before: SHRI R. K. PANDA & SHRI VINAY BHAMORE
Assessment Year : 2015-16 Balaji Udyog, Vs. ITO, Ward-1(3), Jalgaon. J-81, MIDC Area, Jalgaon- 425003. PAN : AAGFB2522E Appellant Respondent Assessee by : Shri Vinay Kawadia Revenue by : Shri Ramnath P. Murkunde Date of hearing : 23.12.2024 Date of pronouncement : 11.03.2025 आदेश / ORDER
PER VINAY BHAMORE, JM:
This appeal filed by the assessee is directed against the order dated 22.05.2024 passed by Ld. CIT(A)/NFAC for the assessment year 2015-16.
The appellant has raised the following grounds of appeal :- “1) Under the facts and circumstances of the case and in law the learned CIT(A). NFAC has erred in confirming the disallowance of interest paid to partners amounting to Rs.19,23,457/- u/s 40(b) of the Act. He specifically erred in law in recasting the capital accounts of the partners on account of non-provision of depreciation in books of account. 2) The Ld. CIT(A) erred on facts and in law in upholding disallowance of Rs.1,13,286/-being 10% of the various expenses debited to Profit and Loss account.
3) The appellant craves the permission to add, amend, modify, alter, revise, substitute, delete any or all grounds of appeal
, if deemed necessary at the time of hearing of the appeal.”
3. Facts of the case, in brief, are that the assessee is a partnership firm filed its return of income on 30.09.2015 declaring total income of Rs.1,38,960/-. The case was selected for scrutiny and notices u/s 143(2) and 142(1) were issued to the assessee. The assessee firm consists of four partners. The assessee has claimed depreciation of Rs.32,76,330/- in computation of income, however, in the books of accounts the assessee has not debited the above depreciation. It was further observed by the Assessing Officer that the assessee firm has paid interest of Rs.21,17,723/- to all its four partners on the credit balances standing in the books of accounts including the profit of the year. By not providing depreciation in the books higher net profit has been credited to partners capital account which has resulted into disclosure of higher value of assets & also resulted in higher payment of interest on capital. According to the AO by resorting to this practice, the assessee firm has artificially increased the credit balance of capital accounts of all four partners. Thus, the books of accounts are not disclosing true and correct capital balances of the partners and balances of the assets by not providing depreciation in the books of accounts. In other words, it is artificial inflation of capital balances so as to provide excess interest on the fictitious capital to the partners. The Assessing Officer therefore in the light of Explanation 5 to section 32(1) of the IT Act held that depreciation is required to be provided in books of accounts & since the assessee failed to do so, therefore, he re-casted the capital account of the partners by reducing the amount of depreciation of earlier years and accordingly excess interest of Rs.19,23,457/- was disallowed by the Assessing Officer. The Assessing Officer made addition of Rs.19,23,457/- by observing as under :- “33. In the light of the above discussion, it is eminently clear that the assessee firm has not charged depreciation to the P & L account only with the intention to increase the capital balance of the partners so as to provide them higher amount of interest. As communicated to the assessee vide this office letter dtd. 23.11.2017, the re-cased capital account and thus arrived at excess interest paid to the partners amounting to Rs.19,23,457/- is disallowed and added to the total income of the assessee firm. Penalty proceedings u/s 274 rws 271(1)(c) are separately initiated.”
4. The Assessing Officer also made addition of Rs.46,82,473/- regarding unexplained creditors. The Assessing Officer also made another addition of Rs.1,13,286/- towards excess expenditure claimed by the assessee and addition of Rs.3,175/- being interest of late payment of TDS. Accordingly, the assessment was completed 143(3) on a total income of Rs.68,61,351/- as against the income returned by the assessee at Rs.1,38,960/-.
5. After considering the reply of the assessee, Ld. CIT(A)/NFAC deleted the addition of Rs.46,82,473/- regarding unexplained credits. However, disallowance of interest on partners capital of Rs.19,23,457/- & disallowance of expenses of Rs.1,13,286/- was confirmed by Ld. CIT(A)/NFAC against which the assessee is in appeal before this Tribunal.
6. Ld. AR appearing from the side of the assessee submitted before us that the confirmation of disallowance of interest paid to partners of Rs.19,23,457/- and confirmation of disallowance of Rs.1,13,286/- out of various expenses is unjustified. Ld. AR submitted before the Bench that the Assessing Officer erred in re-casting the capital accounts of the partners & thereby further erred in reducing the expenditure towards interest on partners’ capital. It was contended that there is no error in not charging the depreciation in the books of accounts since the same was charged in the computation of income. It was further submitted by Ld. AR that the partners have already shown this interest income in their respective returns of income and therefore this will be double taxation if the same interest is disallowed and added back to the income of the assessee firm.
7. With regard to disallowance of interest paid to partners, it was alternatively submitted by Ld. AR that the Assessing Officer erred in deducting withdrawals by the partners from opening balance of capitals instead of on day to day basis. It was further submitted by Ld. AR that the partners have also contributed capital to the firms which was not considered by the Assessing Officer for the purpose of calculation of interest. Ld. AR submitted that the Assessing Officer further erred in deducting current year’s depreciation from the opening balance of capital instead of deducing the same at the end of the year. He also relied on the judgement of Hon’ble Madras High Court in the case of Sri Venkateswara Photo Studio vs. ACIT, [2013] 33 taxmann.com 360 (Madras).
Ld. DR appearing from the side of the Revenue relied on the orders passed by the sub-ordinate authorities and requested to confirm the same. Ld. DR further pointed out that the explanation 5 to section 32(1) of the IT Act has made it compulsory for the assessee to claim depreciation in its books of accounts and accordingly prayed before the Bench that the orders passed by Ld. Assessing Officer as well as by Ld. CIT(A)/NFAC may kindly be confirmed.
9. We have heard Ld. Counsels from both the sides and perused the material available on record including paper book furnished by the assessee which includes the written submissions filed before the Bench as well as copy of written submission furnished before Ld. CIT(A). Regarding disallowance of interest of Rs.19,23,457/- paid to partners, we find that the assessee firm has not debited depreciation to Profit & Loss Account but claimed the same in the computation of income. The assessee firm paid interest of Rs.21,17,723/- on the balance of capital accounts of partners as appearing in the books of accounts i.e. without deducting deprecation. The Assessing Officer was of the opinion that the capital balance of the partners after reducing the depreciation need to be considered, & accordingly, the Assessing Officer re-casted the balance of the partners’ capital, by reducing the amount of depreciation for earlier years and on the balance amount allowed interest at the rate of 12% and accordingly disallowed Rs.19,23,457/- being excess interest. In this regard, we find that on this ground Ld. CIT(A)/NFAC has dismissed the appeal by observing as under :- “4.3 In the instant case, failure to reduce depreciation claimed in the books results in distorted capital amounts. There is a dispute regarding the disallowance of interest paid by the firm to its partner. The Assessing Officer (AO) disallowed the interest deduction on the ground that depreciation of fixed assets was not provided in the books of account, resulting in excess payment of interest to the partners. The Section 40(b)(iv) of the Income Tax Act, not Section 40(b)(v). They argue that the payment of interest is authorized and in accordance with the terms of the partnership deed. There's a distinction made between interest paid to partners and remuneration paid to working partners, as per the provisions of Sections 40(b)(iv) and 40(b)(v) of the Income Tax Act. The argument of the appellant includes explanations of relevant sections of the Income Tax Act regarding the deduction of interest and salary payments to partners, along with explanations of terms such as "working partner" and "book profit." The assessee requests reconsideration of the disallowance of interest, presenting arguments and evidence to support their position. With various arguments and explanations regarding deductions, interest payments to partners, depreciation, and creditor confirmations. The deduction for interest payment to partners is governed by specific provisions in the Income Tax Act, but there's no restriction on deducting interest before working out depreciation. The AO (Assessing Officer) has the duty to ensure that the books of accounts reflect the true state of affairs, and interest payments can be disallowed if depreciation is not accounted for properly. Depreciation must be debited to the Profit and Loss Account to determine the real profit of the business. Not debiting depreciation leads to inflated capital balances, which does not reflect the true state of affairs. The failure to charge depreciation suggests an intention to increase capital balances to provide higher interest payments to partners. Considering the same, as the firm's practices regarding not debiting depreciation and interest payment without claiming depreciation in the books are not in line with the provisions of the Income Tax Act. Hence, the ground no. 1 relating to interest payment to partners is dismissed.”
From perusal of the above order, we do not find any infirmity in the order passed by Ld. CIT(A)/NFAC wherein disallowance of interest on capital made by the Assessing Officer has been confirmed. In this regard, we also find that Ld. AR of the assessee has relied on Judgement of Hon’ble Madras High Court (supra) which is not applicable to the instant case since the assessment year involved in that case was prior to assessment year 2002-03 whereas in the instant case the assessment year involved is 2015-16 which is after the introduction of Explanation 5 to section 32(1) of the IT Act. In this regard, we further find that prior to assessment year 2002-03 it was not compulsory for the assessee to claim depreciation on fixed assets but w.e.f. assessment year 2002-03, Explanation 5 to section 32(1) of the IT Act was inserted which makes it compulsory for the assessee to claim deprecation on fixed assets. For ready reference Explanation 5 to section 32(1) is reproduced herein below :- “Depreciation. 32. (1) In respect of depreciation of— (i) buildings, machinery, plant or furniture, being tangible assets; (ii) know-how, patents, copyrights, trade marks, licences, franchises or any other business or commercial rights of similar nature, being intangible assets acquired on or after the 1st day of April, 1998, owned, wholly or partly, by the assessee and used for the purposes of the business or profession, the following deductions shall be allowed— xxxxx Explanation 1.—Where the business or profession of the assessee is carried on in a building not owned by him but in respect of which the assessee holds a lease or other right of occupancy and any capital expenditure is incurred by the assessee for the purposes of the business or profession on the construction of any structure or doing of any work in or in relation to, and by way of renovation or extension of, or improvement to, the building, then, the provisions of this clause shall apply as if the said structure or work is a building owned by the assessee. Explanation 2.—For the purposes of this clause "written down value of the block of assets" shall have the same meaning as in clause (c) of sub-section (6) of section 43. Explanation 3.—For the purposes of this sub-section, the expressions "assets" and “block of assets” shall mean— (a) tangible assets, being buildings, machinery, plant or furniture; (b) intangible assets, being know-how, patents, copyrights, trade marks, licences, franchises or any other business or commercial rights of similar nature. Explanation 4.—For the purposes of this sub-section, the expression "know-how" means any industrial information or technique likely to assist in the manufacture or processing of goods or in the working of a mine, oil-well or other sources of mineral deposits (including searching for discovery or testing of deposits for the winning of access thereto). The following Explanation 5 shall be inserted after Explanation 4 in clause (ii) of sub-section (1) of section 32 by the Finance Act, 2001, w.e.f. 1-4-2002: Explanation 5.—For the removal of doubts, it is hereby declared that the provisions of this sub-section shall apply whether or not the assessee has claimed the deduction in respect of depreciation in computing his total income;”
In the instant case, the assessee by not claiming the depreciation in profit and loss account but crediting the same in computation of income has adopted a new device by showing more book profit and thereby crediting more profit to the capital account of the partners so as to claim higher interest from the firm and thereby reducing the tax liability of the firm. The counsel of the assessee could not demonstrate that the tax rate of the partners and the firm are in the same bracket. Under these circumstances and in view of the detailed reasoning given by Ld. CIT(A)/NFAC, we do not find any infirmity in his order. Accordingly, considering the totality of the facts of the case, we are of the considered opinion that from assessment year 2002-03, the assessee is required to claim depreciation on fixed assets and disclose the same in its books of accounts.
It was also the alternative contention of Ld. AR that as per consistent accounting practice, day-wise product method has been considered while calculating the interest. This means that all the debit and credit entries to all the partners' capital account, has been considered while calculating the interest on day to day basis. It is not the case that we had provided for interest to partners on the opening balance only. However, the Assessing Officer has calculated opening Balance after deducting withdrawals during the year under consideration, which is not correct. Amount of withdrawals are throughout the year and that's why it can't be deducted from the opening balance of capital. This fact can be verified from the capital account of the partners which are already placed on record. Further, the Assessing Officer grossly erred in arriving at the capital balance on which interest is payable without considering the additions to capital account during the year. Further, the Assessing Officer has deducted accumulated depreciation up to 31.03.2015 (Rs.70,54,819/-) from the opening balances of the partners, which is also not correct. The accumulated depreciation also includes current year's depreciation (Rs.32,76,329/-), chargeable at the year-end i.e. 31st March of every year, and accordingly current year depreciation can't be deducted from the opening balance of the capital account of the partners, as done by the Assessing Officer. To summarize, the interest is disallowable only on the amount of accumulated depreciation up to 31.03.2014 i.e. Rs.37,78,490/- i.e. amount of notional profit due to depreciation credited to capital account as on 01.04.2014. It is important to note that the Assessing Officer made the disallowance on the basis of final show cause notice issued and without considering the assessee's reply on the above lines filed in response to show cause notice. In view of above, it was contended that if at all the case deserves disallowance of interest, the same may please be restricted to Rs.4,53,418/- i.e. 12% on Rs.37,78,490/- ( the amount of Depreciation of earlier years) against the disallowance of Rs.19,23,457/- made by the Assessing Officer.
We find force in the above alternative submission of Ld. AR and accordingly set-aside the order passed by Ld. CIT(A)/NFAC and remand the matter back to the file of Assessing Officer to consider the above alternative submission of the assessee and decide the amount of disallowance of interest on partners’ capital in the light of above alternative submission.