Tax Implication of Partnership Firm

Mayank Chandrakar[1]

 

Introductory Theme

A partnership is a common vehicle in India for carrying on business activities on a small or medium scale. A profession is generally carried on through a partnership. There is no restriction on a company's participation in a partnership, but this is rate in practice.

Under partnership law, a partnership firm is not a legal entity, but only consists of individual partners for the time being to generate income or get profit but for income tax and sales tax purpose it has limited identity and considered as the legal entity.

Partnership is the relationship between persons who have agreed to share the profits of a business carried on by all or any of them. Persons who have entered into partnership with one another are called partners individually and a firm collectively. Hence we can authoritatively say that the tax implication of firms comes under the corporate taxation.

 

1. Definition of Firm, Partner [Section 2(23)]

The Income-tax Act, 1961, does not define the term "Firm". Section 2(23) which deals with definition simply states that Firm, Partner and Partnership have the meanings respectively assigned to them in the Indian Partnership Act, 1932, as a person[2] but the expression Partner shall also include any person who being a minor, has been admitted to the benefits of partnership.

Thus, under the scheme of income-tax, Firm has a distinct assessable personality. However, for a definition of firm we have to refer back to the provisions of Indian Partnership Act, 1932. As per Section 4 of The Indian Partnership Act, 1932, Partnership is the relationship between persons who have agreed to share the profits of a business carried on by all or any of them. Persons who have entered into partnership with one another are called partners individually and a firm collectively. Section 5 states that the relation of partnership arises from contract and not from status.[3]

2. Firm cannot be a partner: The word person in section 4 of Partnership Act contemplates only natural or artificial i.e., legal persons. Therefore only individuals or companies can be partners. A firm is not person and as such is not entitled to enter into partnership with another firm or Hindu undivided family or an individual.[4]

But, however, if on true reading of the instrument of partnership, it is found that the constituent members of a firm and not the firm itself have entered into partnership and that fact is borne out both by the recital and the fact that the partnership deed has been signed by the constituent members of the two firms, the refusal to register the firm on the ground that there was no valid partnership is erroneous.[5]

3.  HUF as a partner: Though Hindu undivided family is included in the definition of person in section 2(31) of the Income-tax Act, 1961, but it is not a juristic person for all purpose. HUF is not like a corporation or limited company, and it has, therefore, no legal entity different from, and separate from the members who comprise the Hindu undivided family.[6]

However, it was held that there is no legal bar in members of the HUF entering into partnership.[7] Mere mention of a partner as representing as Karta of a family will not make a HUF as a partner.[8]

When a Karta or a Manager of HUF enters into a contract of partnership with a stranger, the other members of the family do not ipso facto become partners in the firm. In such a case, family as a unit does not become a partner. The other members of the family are not parties of the firm so constituted and as such the other members cannot demand an inspection of the account books of the firm nor bring about dissolution of the firm or winding up the business.[9] The Karta can join others in partnership in dual capacity i.e. in his individual capacity as well as Karta of the HUF.[10]

4. Firm should carryon business and share profits: The next point that will be noticed is that these persons must run a business. Then, the business must be run by them with the intention of realizing profits. Then, it is not sufficient if the profits are intended to be taken' exclusively by one of the partners. The agreement must be that everyone of the partners should share the profits. Then, there must be an agreement between the parties that the business would be run by all or by one of them acting for all. However in Mandsaur Starch and Chemicals v CIT[11]  it was held that if there is no intention to carryon business, then there is no partnership under section 4 of the Partnership Act.

Other instances of carrying on of business:

(i) Financing others business was held as carrying on of business.[12]

(ii) Activity of catering and providing facilities for indoor and outdoor games.[13]

(iii) Sharing of profits by sub-partnership formed by divided members of the family through

Karta as partner in the main firm.[14]

(iv) Taking coal mine on lease and then leasing it out to agent.[15]

Instances where it was held that business was not carried on:

 (i) Where entire business of the colliery was leased out.[16]

5. Business Classification under the Income-tax Act not conclusive: The important thing to be noted is that the activity must come within the purview of the term as used in the Partnership Act. The term business is of wide import and represents some organized activity. Therefore, so long there is some real, substantive, systematic and organized course of activity or conduct with a set purpose, it would constitute business.

6. Co-ownership and partnership are different: Co-ownership should not be confused with an agreement of partnership. There might be some common characteristics between both of them, but basically both are quite different e.g., two co-owners may appoint a common manager for facility of cultivation and management of their farms without entering into a partnership and the fact that the profits or even the losses are distributed in accordance with the shares of the two owners does not necessarily establish a partnership within the meaning of the Partnership Act.

7. Position of Firm under the Income-tax Act: Legally, a partnership firm does not have a separate entity from that of the partners constituting the firm as the partners are the owners of the firm. However, a firm is treated as a separate tax-entity under the Income-tax Act. Salient features of the assessment of a firm are as under:

  (1) A firm is treated as a separate tax entity.

(2) While computing the income of the firm under the head 'Profits and gains of business or profession', besides the deductions which are allowed u/S 30 to 37, special deduction is allowed to the firm on account of remuneration to working partners and interest paid to the partners. However, it is subject to certain limits laid down u/S 40(b).

(3) Share of profit which a partner receives from the firm (after deduction of remuneration and interest allowable) shall be fully exempt in the hands of the partner. However, only that part of the interest and remuneration which was allowed as a deduction to the firm shall be taxable in the hands of the partners in their individual assessment under the head 'profits and gains of business or profession’.

         (4) The firm will be taxed at a flat rate of 35%[17] plus surcharge @ 2.5%[18] plus education cess @ 2% after allowing deduction for interest on capital and loan of the partners and remuneration to working partners.

        (5) The firm will be assessed as a firm provided conditions mentioned under section 184 are satisfied. In case these conditions are not satisfied in a particular assessment year, although the firm will be assessed as firm, but no deduction by way of payment of interest, salary, bonus, commission or remuneration, by whatever name called, made to the partner, shall be allowed in computing the income chargeable under the head "profits and gains of business or profession" and such interest, salary, bonus, commission or remuneration shall not be chargeable to income-tax in the hands of the partner.

8.  Assessment of firm: From point (5) above, it may be concluded that if the firm satisfies the conditions laid down under Section 184, the firm shall be eligible for deduction on account of interest, salary, etc. while computing its income under the head business and profession. However, it will be subject to the maximum of the limit specified under Section 40(b). On the other hand, if such conditions are not satisfied, no deduction shall be allowed to the firm on account of such interest, salary, bonus, etc.

Besides the above, as per Section 184(5), if there is any such failure on the part of the firm as mentioned in Section 144, the firm shall not be eligible for any deduction on account of any interest to the partners or remuneration to the working partners.

9. Essential conditions to be satisfied by a firm to be assessed as firm and to be eligible for deduction of interest, salary, etc. to the partners [Section 184]

(A) In the first assessment year the following conditions must be satisfied by the firm:

(1) Partnership is evidenced by an instrument i.e. there is a written document giving     the terms of partnership.

      (2) The individual share of the partners are specified in that instrument

      (3) Certified copy[19] of partnership deed must be filed

(B) In the subsequent assessment years: Once the firm is assessed as a firm for any assessment year, it shall be ·assessed in the same capacity for every subsequent year if there is no change in the constitution of the firm or the share of the partners.

Where any such change had taken place in the previous year, the firm shall furnish a certified copy of the revised instrument of partnership along with the return of income for the assessment year relevant to such previous year.

Circumstance where the firm will be assessed as a firm but shall not be eligible for deduction on account of interest, salary, bonus, etc.:

In the following two cases, the firm shall be assessed as a firm but shall not eligible for any deduction on account of interest to a partner and remuneration to a working partner although the same are mentioned in the partnership deed:

(a) Where there is, on the part of the firm, any such failure as is mentioned in section 144 (relating to the best judgment assessment). [Section 184(5)]

(b) Where the firm does not comply with the conditions mentioned under section 184 discussed above. [Section 185]

10. Computation of Total Income of the firm

As discussed above, the total income of the partnership firm will be determined as a separate entity and it will be computed under various heads of income. However, while computing taxable profits under the head 'profits and gains of business or profession, a deduction is allowable to the firm on account of interest and remuneration payable to the partners. Deduction of interest to a partner is allowable u/S 36 and remuneration to a working partner will be allowed u/S 37.

Section 40(b) deals with the amounts which are not deductible in case of a firm assessable as such. Therefore, deductions on account of interest and remuneration to the partners can be claimed under Sections 36 or 37, as the case may be, but it will be subject to the conditions prescribed by Section 40(b), which are as under:

(1) Payment of salary, bonus, commission or remuneration by whatever name called, to a non-working partner shall not be allowed as deduction.

(2) Payment of remuneration to working partners and interest to any partner will be allowed as deduction only when it is authorised by and is in accordance with partnership deed.

(3) Payment of remuneration/interest, although authorised by the partnership deed but which relates to a period prior to the date of such partnership deed, shall not be allowed.

(4) Interest payable to a partner, although authorised by the partnership deed shall be allowable as a deduction subject to a maximum of 12% (18% up to 31-5-2002) simple interest per annum. If the partnership deed provides for interest at less than 12% p.a., the deduction of interest shall be allowed to the extent provided by the partnership deed.

(5) The payment of remuneration to working partner, although relates to a period after the date of the partnership deed and authorised by the partnership deed, shall be allowed as a deduction only to the extent of the following limits:

10A. Remuneration paid to individual who is a partner in representative capacity: In the case of Rashik Lal & Co v CIT[20] the Supreme Court held that if commission is paid to a member of HUF who is a partner in a firm representing his HUF, such commission paid cannot be regarded as payment to HUF and such commission shall be in his individual capacity and will thus be hit by the provisions of section 40(b). However, the Supreme Court in the case of K.S. Subbaiah Pillai v CIT[21] (SC) held that where the remuneration is paid by a business, which is financed by the joint family, the issue as to whether such amount should be considered in the hands of the joint family or in the individual assessment has to be decided on the facts as to whether such amount is payable because of the personal qualification and exercise of individual exertion, or whether it is because of investment of family funds in the business of the company .

10B.Clarification: In some cases, the partnership deed does not specify the amount of remuneration payable to each individual working partner. It just mentions that the remuneration to working partners will be the amount of remuneration allowable under the provisions of Section 40(b). Similarly, some partnership deeds mention that the amount of remuneration to working partners will be as mutually agreed between the partners at the end of the year.

In respect of the above, the CBDT has given a clarification that from assessment year 1997-98 no deduction u/s 40(b) will be admissible unless the partnership deed either specifies the amount of remuneration payable to each individual working partner or lays down the manner of quantifying such remuneration.

11. Computation of Book Profit [Explanation 3 to Section 40(b)]

Book-Profit, as stated above, will be computed as under:

Step 1: Compute the income of the firm under the head 'profit and gains of business or profession' as per Sections 28 to 44D i.e. start with the net profit as per profit and loss account and make additions and deductions as per Sections 28 to 44D already explained under the chapter Business or Profession. Interest paid/payable to partners in excess of 12%/18% shall also be disallowed as per section 40(b).

Step 2: Add aggregate amount of remuneration paid/payable to all the partners (whether working or non-working) of the firm, if it has been debited to profit and loss account. The aggregate of Step-l and Step-2 is Book Profit.

12. Provisions regarding set off and carry forward of losses of firms

There are no special provisions for set off and carry forward of losses of firms. These are the same as applicable in case of other assesses.

12A. Carry forward and Set off of losses in case of change in constitution of firm [Section 78]: (1) Where a change has occurred in the constitution of a firm, due to retirement of a partner or death of a partner, the firm shall not be entitled to carry forward and set off so much of the loss proportionate to the share of a retired or deceased partner as exceeds his share of profits, if any, in the firm in respect of the previous year. [Section 78(1)]

(2) Where any person carrying on any business or profession has been succeeded in such capacity by another person otherwise than by inheritance, no person other than the person incurring the loss shall be entitled to have it carried forward and set off against his income. [Section 78(2)]

13. Treatment of share of profit, interest and remuneration received by a partner from a firm

1. Share of profit in the hands of the partner shall be fully exempt under Section 10(2A).

2. Interest received/receivable by a partner shall be included in the Total Income of the partner under the head 'Profits and gains of business or profession' to the extent deduction of interest was allowed to the firm as per Section 40(b), which cannot exceed 12% per annum.

3. Remuneration to a working partner shall also be included in the Total Income of the partner under the head 'profits and gains of business or profession' to the extent deduction of remuneration was allowed to the firm as per Section 40(b)[22].

14.  Change in constitution of a firm [Section 187]

Where at the time of making an assessment under section 143 or section 144, it is found that a change has occurred in the constitution of a firm, the assessment shall be made on the firm as constituted at the time of making the assessment.

When is there a change in the constitution of the firm [Section 187(2)]: There is a change in the constitution of the firm-

(a) if one or more of the partner cease to be partners or one or more new partners are admitted, in such circumstances that one or more of the persons who were partners of the firm before the change continue as partner or partners after the change; or

(b) where all the partners continue with a change in their respective shares or in the shares of some of them.

Where a partnership deed provides that death shall not result into the dissolution of the firm, such provision is lawful under section 42 of the Partnership Act; on the death of the partner, a partnership is not dissolved and the business is continued by the re­constituted partnership, then only one assessment is to made for the entire year.[23]

15. A firm will not be deemed to be dissolved on retirement of a partner even if the partnership deed says so: A perusal of section 187(2)(a) of the Income-tax Act, 1961, shows that by legal fiction for the purposes of the Income-tax Act, if even one of the partners continues to remain in the firm then the firm will not be deemed to be dissolved. Hence, even if the partnership deed says that the firm will stand dissolved on the retirement of a partner, for the purposes of the Income-tax Act, it will not be deemed to be dissolved in view of section 187(2)(a).[24]

16. Dissolution of a firm due to death of any partner will not be considered as change in the constitution of the firm [Proviso to section 187]

However, in the case of CIT v Jai Mewar Wine Contractors[25]  it was held that even if the partnership deed is silent on the contingency of death of a partner, it need not dissolve the firm as it was pointed out that a clause for continuation of the partnership without dissolution may not be express and it may be inferred from the conduct of the partners consequent on the death. The only exception in this case shall be where there are only two partners so that death of one cannot avoid dissolution.

17. Succession of one firm by another firm [Section 188]

Where a firm carrying on a business or profession is succeeded by another firm, and the case is not one covered by section 187, separate assessments shall be made on the predecessor firm and the successor firm in accordance with the provisions of section 170.

As per section 170 the predecessor firm shall be assessed in respect of the income of the previous year in which succession took place up to the date of succession. The successor firm shall be assessed in respect of the income of the previous year after the date of succession.

18. Final dissolved or business discontinued [Section 189]

Where any business or profession carried on by a firm has been discontinued or where a firm is dissolved, the Assessing Officer shall make an assessment of the total income of the firm as if no such discontinuance or dissolution had taken place, and all the provisions of this Act, including the provisions relating to the levy of a penalty or any other sum chargeable under any provision of this Act, shall apply, so far as may be, to such assessment.

Every person who was at the time of such discontinuance or dissolution a partner of the firm, and the legal representative of any such person who is deceased, shall be jointly and severally liable for the amount of tax, penalty or other sum payable, and all the provisions of this Act, so far as may be, shall apply to any such assessment or imposition of penalty or other sum.

Where such discontinuance or dissolution takes place after any proceedings in respect of an assessment year have commenced, the proceedings may be continued against the person referred to above from the stage at which the proceedings stood at the time of such discontinuance or dissolution, and all the provisions of this Act shall, so far as may be, apply accordingly.

19. Tax treatment of LLP

 

UK LLP Act, Section 10 lays down that a trade, profession or business carried on by an LLP, with the view to profit, will be treated as carried on in partnership by its members and not by the LLP itself. Thus, any asset held by an LLP, or any tax chargeable on gains made will be treated as held by the partners, or gains made by the partners, and not by the LLP itself. In other words, an LLP enjoys a pass through status and is not taxable as such; the taxation liability falls on the partners in their individual capacity. In the USA, too, LLPs enjoy a pass through status for the purposes of taxation. The profits or losses of the LLP pass through the business and are reported on each partner’s personal returns.

The committee[26] recommended the same pass through status for LLPs in India. However, the committee recognized that it has neither consulted, nor got the views of the Ministry of Finance (Department of Revenue) in this regard. While recommending a taxation regime similar to that obtaining in the USA and UK, the committee urged the Department of Company Affairs to incorporate such a regime in consultation with the tax authorities concerned.

The partners of an LLP, which is carrying on a business in partnership with a view to profit, are treated for the purpose of income tax and capital gains tax as if they were partners carrying on business in partnership, despite the fact that an LLP is a body corporate. It also provides that property of LLP will be treated for those purposes as property of its partners. This ensures that the partners will be individually liable to tax on their share of the profits of the trade, profession or business carried on by the LLP. Further, the assets of LLP will be treated as assets held by partners for the purpose of taxing capital gains. This ensures that the partners of LLP, rather than the LLP itself, will be liable to tax for capital gains on the disposal of LLP assets. This approach brings LLPs in line with the approach adopted for partnerships, which similarly treats assets as held by the partners rather than by the partnership.[27]

20. Unlimited Liability Is Major Disadvantage - The major disadvantage of partnership is the unlimited liability of partners for the debts and liabilities of the firm. Any partner can bind the firm and the firm is liable for all liabilities incurred by any firm on behalf of the firm. If property of partnership firm is insufficient to meet liabilities, personal property of any partner can be attached to pay the debts of the firm.

20A. Partnership Firm is not a legal entity - It may be surprising but true that a Partnership Firm is not a legal entity. It has limited identity for purpose of tax law. As per Section 4 of Indian Partnership Act, 1932, 'partnership' is the relation between persons who have agreed to share the profits of a business carried on by all or any one of them acting for all. Under partnership law, a

partnership firm is not a legal entity, but only consists of individual partners for the time being. It is not a distinct legal entity apart from the partners constituting it.[28]

20B. Firm Legal Entity For Purpose Of Taxation - For tax law, income-tax as well as sales tax, partnership firm is a legal entity.[29] Though a partnership firm is not a juristic person, Civil Procedure Code enables the partners of a partnership firm to sue or to be sued in the name of the firm.[30] A partnership firm can sue only if it is registered.

21. Concluding Remark

By going through all the relevant provisions provided under the legislation it is clear that what is the position of partners and firm for tax imposition. Although there are certain areas which are different from the other nation states like UK and USA but very much effective in Indian scenario.  Under the general law a partnership is not a separate entity distinct from the partners, but for tax purposes a partnership is an entity. Typically, in many countries, partnership firms are considered pass-through entities for tax purposes. Hence, in such cases, it is the partners of the partnership firm who are subject to tax in respect of their share of income from the partnership firm. An interesting issue which arises for consideration in such situations is whether such foreign partnership firms are eligible to claim the benefit of the double tax avoidance agreements.

Under the provisions of such tax treaties, benefits are normally available only to persons/entities that are considered tax residents of their respective countries. The tax treaty provisions dealing with tax residency inter-alia provide that the term “resident of a contracting state” means any person who under the laws of that respective country is liable to tax therein by reason of domicile, residence, place of management or any criterion of similar nature.

In last few years some of the provisions has been omitted/modified and tried to reduce the complexity for imposition of tax in partnership firms.

 



[1] Student – 4th Year, Hidayatullah National Law University, Raipur, Email – mayank_hnlu@yahoo.co.in

[2] See Section 2(31) states: 'Person' includes: (i) an individual; (ii) HUF; (iii) a, company; (iv) a firm, etc.

[3] From the analysis of the above definition of the partnership it will be seen that it contains three elements:  (i) There must be at least two or more persons who must have entered into in agreement. (ii) The agreement must be to carryon business and share profits. (iii) The business must be carried on by all or any of the persons concerned, acting for all.

[4] Dulichand Laxminarayan v CIT (1956) 29 ITR 535 (SC)

[5] Chhotalal Devchand v CIT (1958) 34 ITR 219 (SC)

[6] Ram Laxman Sugar Mills v CIT (1967) 66 ITR 613 (SC)].

[7] CIT  v Maskara Tea Estate (1977) 108 ITR 70 (Gau)

[8] CIT v  R. S. Singh & Co (1979) 118 ITR 30 (Cal)

[9] CIT v  Bagyalakshmi & Co (1956) 55 ITR 660 (SC).

[10] CIT  v  Raghavji Anandji & Co. (1975) 100 ITR 246 (Bom).

[11] (1981) 127 ITR 727 (MP)

[12] CIT  v Degaon Gangareddy G Ramkishan & Co. (1978) 111 ITR 93 (AP)

[13] A.N. Rangappa & Sons v CIT(1984) 145 ITR 250 (Kar)

[14] Shiv Narain Agarwal v CfT,  (1983) 139 ITR 999 (All)

[15] CIT v Pure Dhansar Coal Co., (1985) 154 ITR 857 (Pat)

[16] CIT v Koya & Khas Koya Colliery Co.,(1985) 156 ITR 206 (Pat)

 

[17] 30% for assessment year 2006-07.

[18] 10% for assessment year 2006-07.

 

[19] What a certified copy means: The Explanation to Section 184(2) lays down the implication of the term certified copy of the instrument which is to accompany the return. The certified copy means that the copy of the instrument of partnership is to be certified in writing by all the partners except minors. It means that the copy of the deed should carry the expression certified to be true copy and below that it should carry the signature with date of all the major partners.

 

[20] (1998) 229 ITR 458 (SC)

[21] (1999) 237 ITR 11

[22] For example, if the partner was paid a remuneration of Rs. 60,000 by the firm, but as per section 40(b) deduction was allowed to the firm on account of such remuneration to the extent of Rs. 50,000, Rs. 50,000 only will be included in the Total Income of the partner. Balance Rs. 10,000 may be treated as share of profit which is exempt.

 

[23] CIT v Empire Estate, (1996) 218 ITR 355 (SC)

[24] CIT v Ratanlal Garib Das, (2003) 261 ITR 200 (All)

[25] (2001) 251 ITR 785 (Raj)

[26] Naresh Chandra Committee Report.

[27] http://news.indiamart.com/news-analysis/global-tax-norms-lik-15085.html 

[28] Malabar Fisheries Co. v. CIT (1979) 120 ITR 49 

[29] State of Punjab v. Jullender Vegetables Syndicate - 1966 (17) STC 326 (SC), CIT v. A W Figgies - AIR 1953 SC 455, CIT v. G Parthasarthy Naidu (1999) 236 ITR 350

[30] Ashok Transport Agency v. Awadhesh Kumar 1998(5) SCALE 730 (SC).