SADANANDASWAMY J. - Since the Division Bench which heard this matter in the first instance was of the opinion that it involves a point of law of considerable importance, it has been referred to this Bench. This is a reference under the Income-tax Act. The assessee is a registered firm having two partners, Shri M. L. Malpani and Shri M. L. Mahindra. The firm was deriving income from sale, cultivation and manufactur of tea. The Income-tax Offecer computed the income of the firm for the assessment year 1962-63 at Rs. 58,485 and under rule 8 of the Income-tax Rules, 1962, 40% of this income was made taxable under the Income-tax Act. The Income-tax Officer, while allocating the share of the income between the partners, allocated 100% of the salary and interest to the partners which totalled up to 100% of the firms income and not merely 40% which was taxable. In appeal, the Appellate Assistant Commissioner took the view that only the income which was taxable to income-tax could be allocated and that only 40% of the salary and interest had to be considered while allocating the profits of the firm among the partners. The Appellate Tribunal followed the Full Bench decision of the Madras High Court in R. M. Chidambaram pillari Commissioner of Income-tax : 77ITR494(Mad) and agreed with the Appellate Assistant Commissioner that only 40% of the salary and interest should be allocated or the purpose of arriving at the share income of the parnters. On the above facts, the following question has been referred to this court :
"Whether, on the facts and in the circumstances of the case, the Tribunal is right in law in upholding the Appellate Assistant Commissioners decision that only 40% of the salary and interest should be allocated for the purposes of arriving at the share income to be assessed in the hands of the partners ?"
Under section 40(b) of the Income-tax Act it is provided that in the case of any firm any payment of interest, salary, bonus, commission or remuneraton made by the firm to any parnter of the firm shall not be deducted in computing the income chargeable as "profits and gains of business or profession". A sum of Rs. 33,227 was received by the parnter, Shri M. L. Malpani, as interest and sums of Rs. 16,200 and Rs. 9,217 were received by Shri M. L. Mahindra towards salary and interest respectively during the relevant priod. The relevant part of section 67 reads kas follows :
"67. (1) In computing the total income of an assessee who is a parnter of a firm, whether the net result of the computation of total income of the firm is a profit or a loss, his share (whether a net profit or a net loss) shall be computed as follows :-
(a) any interest, salary, commission or other remuneration paid to any partner in respect of the previous year shall be deducted from the total income of the firm and the balance ascertained and apportioned among the partners;
(b) where the amount apportioned to the partner under clause (a) is a profit, any salary, interest, commission or other remuneration paid to the partner by the firm in respect of the previous year shall be added to that amount, and the result shall be treated as the partners share in the income of the firm;
(c) where the amount apportioned to the partner under clause (a) is a loss, any salary, interest, commission or other remuneration paid to the partner by the firm in respect of the previous year shall be adjusted against that amount, and the result shall be treated as the partners share in the income of the firm.
(2) The share of a partner in the income or loss of the firm, as computed under sub-section (1) shall, for the purposes of assessment be apportioned under the various heads of income in the same manner in which the income or loss of the firm has been determined under each head of income."
Since the total amount of the salary and interest paid to the partners exceeded Rs. 58,486, the total income of the firm, the net result was that the firm incurred a loss of Rs. 64 as computed under section 67(1). Since the partners of the firm were liable to meet 70% and 30% respectively of the loss of the firm the Income-tax Officer deducted Rs. 45 from the amount payable to Shri M. L. Malpani and arrived at his share in the income of the firm as Rs. 33,182. He deducted the 30% of the loss of Rs. 64, namely, Rs. 19, from the total amount paid to Shri M. L. Malpani and arrived at under at under section 67(1)(c) amounted to Rs. 58,580. According to the Commissioner of Income-tadx, the petitioner before us, the computation has been done correctly under section 67(1)(c) by the Income-tax Officer. The contention of the respondents is that the total income of the firm for the purposes of section 67 is Rs. 23,394, i.e. 40% of the total income of the firm. It is their further contention that while allocating the share of the loss of each of the partner under section 67(1)(c) 70% of the loss of the firm should be dedducted from 70% of the interest paid to Shri M. L. Malpani : similarly 30% of the loss should be deducted from 30% of the salary and interest paid to Shri M. L. Malpani and the shsare income allocated to him should be Rs. 10,147. Thus, according to them, the total income of the firm conlputed under rule 8, i.e. Rs. 23,394, should be allocated to the partners after deducting their shares of the loss. This is what the Tribunal has done.
In Mathew Abraham v. Commissioner of Income-tax : 51ITR467(Mad) the assessee was the managing patner of a firm which carried on the manufacture and sale of tea. He was entitiled to a monthly allowance and a commission of 12% on the profits of the firm. It was held that rule 24 of the Income-tax Rules, 1922 (correspoding to rule 8 of the present Rules), was not applicable to the monthly allowance and commission received by the assessee, even though they were paid out of the profits and that only 40% of the share income received by him was assessable to tax. But this dicision has been overruled in R. M. Chidambaram Pillai v. Commissioners of Income-tax : 77ITR494(Mad) . The question which arose for decision before the Full Bench of the Madras High Court in that case was similar to the one which is before us now. If was held that a partner cannot be an employee of the firm, that though a firm is a taxable entity under the Income-tax Act it has no independent existence in the eye of law and that the income of the firm was the income of the partners constituting the firm. It was further held that this position in law of the partners in relation to the firm wasw recognised by the provisions of the Income-tax.
Subsequent to the hearing of the arguments it has been brought to our notice by the learned counsel for the respondents that the above-said decision of the Madras High Court has been affirmed by the Supreme Court in Civil Appeals Nos. 17 to 21 of 1972 (Commissioner of Income-tax v. R. M. Chidambaram Pillai : 10ITR292(SC) ) secided on November, 17, 1979. The learned counsel were heard again.
A copy of the said judgment has been furnished by him. In that case, two tea estates were owned by two firms with several partners. The tea sold yielded income which was partly agricultural and partly non-agricultural. Both the firms were registered under the Income-tax Act. Two of the partners who were the respondsents in the appeals before the Supreme Court were, in addition to their share of profits, entitiled to salaries for services rendered to the firms. The question was whether the sums so drawn as salaries were wholly liable to income-tax or only to the extent of 40% thereof which fell within the non-agricultural sector. While considering the question whether a firm is a legal person, it was observed as follows - See : 10ITR292(SC) :
"Here the first thing that we must graps is that a firm is not a legal person evon though it has some attributes of personality. Partnership is a certain relation between persons, the product of agreement to share the profits of a business. Firms is a collective noun, a compendious expression to designate an entity, not a person. In income-tax law firm is a unit of assessment, by special 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 service, in strict law, between a firm and one of its partners. So that any agreement for remuneration of a partner for taking 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 Partnershilp act brings into focus this basis of partnership business."
This legal position, it was observed, expresses itself in the Income-tax Act in section 10(4)(b) and section 16(1)(b). The real nature of a salary paid to a partner was held to represent a special share of the profits and is, thererore, part of profits taxable as such. It was further observed that the salaries paid to partners are regarded by the Income-tax Act as retaining the character of profits and not excludible from the tax net, whatever the reason behind it may be. While considering the procisions of section 16(1)(b) of the Act it was observed as follows - See : 10ITR292(SC) :
"It is implict that the share income of the partner takes in his salary. The telling test is that where a firm suffers loss thesalafied partners share in it goes to depress his share of income. Surely, therefore, salary is a different label for profits, in the context of a partners remuneration.
It was further held that the scheme of the Act, evening it with special reference to section 10(4)(b), treats the employees salary as profit where the servant is none other than a partner, i.e., a co-owner of the business. It was, therefore, held that salaries paid to a partner are profits though known by a different name and must be treated as such for taxation process. Consequently, the portion of profits from taxation by a grower which is agricutural in character is excluded from taxation under the Act, recognising the constitutional provision excluding taxation by the Union, of agricultural income by means of rule 24. It was, therefore, held that 60% of the total income represents the agricultural income and the salary paid to partners out of it, being only profits, enjoys the same exemption which is conferred on the portion of the income which is treated as agricultural income under rule 24.
The following statement of law by the law by the Madras Full Bench in Chidambaram Pillis case : 77ITR494(Mad) was referred to with approval :
"Income derived from the sale of tea grown and manufactured by the seller in the taxable territories shall be computed as if it were income derived from business, and 40 per cent. of such income shall be deemed to be income, profits and gains liable to tax."
since only 40% of the income from sales of tea is treated as taxable under the Act and the balance, namely, 60%, is regarded as agricultural income and exempt from tax under the Act and 60% of the salaries paid to the partner comes out of this exempted gross sum, it was held that the said part of the salaries also gets the benefit of the exemption under the Act. The following statement of the law as to partnership by Lindley on the Law of partnership, 12th edition, page 28, that :
"In point of law, a partner may be the debtor or the creditor of his co-partners, but he cannot be either debtor or creaditer 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."
was approved and it was observed that the Indian law of partnership is substantially the same. It was held that a partnership is only the collective name of separate person and not a legal person in itself and that, therefore, the salary paid to a partner from the firm is in reality a mode of division of the firms profits since no person can be his own servant in law, as a contract of service postulates two different person.
It was father held that on account of the method of computation prescribed in Income-tax Act, 60% of the income of the firm is agricultural in character and, therefore, it cannot be taxed under the Income-tax Act, that even though the flexible arrangement among partners regarding distribution of this sum may take different forms, the essential agricultural character and the consequent immunity from tax cannot be lost simply because it is called salary. The following passage from The Law of Income-tax bu A. C. Sampath Iyenger, 6th edition, 1973, pages 1063, pages 1063-1064, Vol. II, was referred to with approval :
"Any interest, salary, bonus, commmission or remuneration paid by a firm to any of its partners cannot be deducted by the firm as an expenditure in its profit-computation. The reason is this : The partners in a firm are ultimately entitled to the entire profits of the firm according to their shares in the business. Therefore, the entirety of such profits should be brought to charge and no portion be exempted by giving the same away to a partner as his salary, bonus, commission, remuneration or interest. A partner is bound to find the necessary finances for the partnership and hence any interest on capital supplied by the partner is not deductible. A partners rendering services to the firm stands on the same footing as his providing capital; only instead of in money, in kind. Further, no remuneration is permissible to a partner for his rendering services to the firm, since the carrying on the business of the partnership is a primary duty which all the partners or some of the partners acting for all, are required to do by the law relating to partnership.
The matter may be looked at another way too. In law, a partner cannot be employed by his firm, for a man cannot be his own employer. A contract can only be bilateral and the same person cannot be a party on both sides, particularly in a contract of personal employment. A supposition that a partner is employed by the firm would involve that the employee must be looked upon as occupying the position of one of his own employers, which is legally impossible. Consequently, when an arrangement is made by which a partner works and receives sums as wages for services rendered, the agreement should in truth be regarded as a mode of adjusting the amount that must be taken to have been contributed to the partnerships assets by a partner who has made what is really a contribution in kind,instead of contribution in money. Hence, all the aforesaid payments are non-deductible."
The contrary view taken in Mathew Abraham v. Commissioner of Income-tax : 51ITR467(Mad) was held to be unsound since it failed to take into consideration the fact that the salary paid to a partner is only by way of profits in lieu of his contribution by way of skill and effort to the common benefit of all the partners.
In view of the above definite statement of the law, it is not necessary to consider the various decision relied on by either side. The principle as stated above applies equally to the interest paid to one of the partners since it is the return on the monetary contribution made by the partner which can be said to form part of the capital for the purposes of the business carried on by all the partners. The Tribunal was right in law in upholding the decision of the Appellate Assistant Commissioner that only 40% of the salary and interest should be allocated for the purpose of arriving at the share income to be assessed in the hands of the partners. we answer the question referred to us accordingly.
This judgment covers Income-tax Reference No. 19 of 1973 also in which the partners are the same.
The parties shall bear their own costs in both the cases.
BAHARUL ISLAM J. - I agree.
D. PATHAK J. - I agree.