1. This reference arises under section 256(1) of the Income-tax Act, 1961 ('the Act' for short). The reference is made by the Income-tax Appellate Tribunal, at the instance of the Commissioner of Income-tax. The question referred for consideration of this court is :
'Whether, on the facts and in the circumstances of the case, the sum of Rs. 40,000 paid to two partners, Sri M. Venkataramana and Sri Laxminarayana, are allowable in view of section 40(b) of the Income-tax Act, 196 ?'
2. A partnership firm consisting of three partners, M. Venkataramana, S. Laxminarayana alias Bapu and N. S. Murthy, was constituted under a deed of partnership dated February 23, 1969. It was agreed that the partnership firm shall carry on the business of production, distribution and exploitation of films, and also that of taking on lease territorial rights in films for dubbing and exploitation and any other business incidental thereto, in the name and style of 'CHITRA KALPANA'. The partnership deed is not marked among the documents forwarded by the Tribunal. For the purpose of disposing of the reference, we found it necessary to peruse the partnership deed and note the terms and conditions governing the said partnership. We accordingly directed learned counsel for the assessee, Sri T. Anantha Babu, to make available a copy of the partnership deed. A copy is furnished to us. According to the deed of partnership, each one of the three partners contributed capital of Rs. 50,000. No interest is payable on the capital. The three partners are to share the profits and losses in equal shares. The first partner, M. Venkataramana, shall be in charge of the control and management of all the affairs and business of the firm. He is designated as the 'managing partner'. It was agreed that the managing partner and N. S. Murthy shall operate the bank accounts of the firm jointly. The partnership deed contains other usual covenants which are not relevant for our purposes.
3. For the income-tax assessment year 1971-72, the accounts of the partnership firm were closed on August 31, 1970, and a return of income was filed declaring a total income of Rs. 67,400. In declaring the above income, the partnership firm claimed deduction of Rs. 25,000 paid to the managing partner, Sir M. Venkataramana, and Rs. 15,000 paid to another partner, Sri S. Laxminarayana, known as Bapu. It was explained that the managing partner, M. Venkataramana, is a reputed story writer for films and carries on individually the profession of writing stories for films and receives consideration from various film producers. It is said that the partnership firm embarked on the production of a movie, called 'Buddhimantudu' for which the story was written by managing partner, M. Venkataramana, in consideration of which the partnership firm paid him Rs. 25,000. S. Laxminarayana alias Bapu is a reputed film director. He directed the aforementioned film for which purpose the partnership firm paid him remuneration of Rs. 15,000. The claim of the partnership firm for deduction of the aforementioned two items, in the computation of its total income for the income-tax assessment year 1971-72, was rejected by the Income-tax Officer on the short ground that in term of section 40(b) of the Act, the payments made to the partners fall to be disallowed. Aggrieved by the disallowance of the aforementioned two sums, the assessee-firm filed an appeal before the Appellate Assistant Commissioner of Income-tax, who allowed the appeal, and directed that the sum of Rs. 40,000 should be allowed as a deduction in computing the income of the assessee-firm. The Income-tax Officer filed on appeal before the Tribunal against the order of the Appellate Assistant Commissioner of Income-tax, directing allowance. After consideration of the rival contentions, the Tribunal upheld the order of the Appellate Assistant Commissioner and dismissed the appeal filed by the Income-tax Officer. Thereupon, the Commissioner of Income-tax filed an application before the Tribunal for reference under section 256(1) of the Act of the question of law referred in para 1 (p. 679) supra.
4. We have heard Sri M. Suryanarayana Murthy, learned standing counsel for the Revenue, and also Sri. T. Anantha Babu, learned counsel for the assessee.
5. Income falling under the head 'Profits and gain of business or profession' is assessable under section 28 of the Act. Section 29 of the Act provides that the income-referred to in section 28 shall be computed in accordance with the provisions contained in section 30 to 43A. Section 30 to 39 of the Act contain provisions relating to various deductions to be made in computing the income from business under section 28 of the Act. Section 40 of the Act provides that notwithstanding anything to the contrary in section 30 to 39 of the Act, certain amounts shall not be deducted in computing the income chargeable under the 'Business'. We are concerned with clause (b) of section 40 of the Act which provides that, in the case of any firm, any payment of interest, salary, bonus, commission or remuneration made by the firm, any payment of interest salary, bonus, commission or remuneration made by the firm to any partner of the firm shall not be deducted. The Revenue's contention is that the sums of Rs. 25,000 and Rs. 15,000 paid to the two partners, as mentioned above, are in the nature of the remuneration paid by the firm to the partners and, consequently, the remuneration is not deductible, pursuant to section 40(b) of the Act. The plea of learned standing counsel for the Revenue, in short, is that section 40(b) of the Act is absolute in its terms. According to him, it makes no distinction between payments made by the firm to a partner by way of salary, bonus, commission or remuneration in the capacity of a partner and payments made to the partner in a different capacity. Learned standing counsel contends that all that is required to be seen is whether the payment made by the firm to a partner answers the description of the payments specified in section 40(b) of the Act. Once the payment made by the firm to a partner partakes of the nature of salary, interest, bonus, commission or remuneration, then the amount paid by the firm to the partner cannot be allowed as a deduction in computing the income from business in the hands of the firm. In the present case, it is pointed out that the sums of RS. 25,000 and Rs. 15,000 paid to the two partners are clearly remuneration for services rendered. The managing partner rendered services by furnishing a story for producing the film produced by the firm. In either case, the amount paid to the two partners contained in section 40(b) of the Act apply and the claim for deduction of the sums paid has to be disallowed. In that view, learned standing counsel submitted that the Revenue's plea for disallowance of the aforementioned two sums in computing the income of the firm under the head 'Business' is in accordance with the terms of section 40(b) of the Act. Learned standing counsel relied on two decisions of the Karnataka High Court in N. M. Anniah & Co. v. CIT : 101ITR348(KAR) and Mysore Bangle Works v. CIT : 157ITR411(KAR) and on the Supreme Court decision in CIT v. Chidambaram Pillai : 10ITR292(SC) . Sri Anantha Babu, learned counsel for the assessee, points out that there is an essential capacity and payments made to a partner in a capacity other than a partner. It is pointed out that the managing partner, M. Venkataramana, is a reputed professional writer of stories for films. He carries on the profession of story-writing for films and, in that capacity, he receives individual hands. The sum of Rs. 25,000 paid to him by the assessee firm, it is claimed, was paid to him in his capacity as story-writer and not as a partner of the firm. Similarly the other partner, Bapu, is stated to be a famous director of films and receives remuneration from various producers for directing films. The sum of Rs. 15,000 received by Bapu for directing the film produced by the partnership firm was paid to him not as a partner of the firm but as a professional director. Sri Anantha Babu, therefore, contends that the payments in the present case were made by the firm to the partners in their capacity other than as a partners and consequently the provisions of section 40(b) of the Act are not applicable. Learned counsel relied on the decision of the Madras High Court in CIT v. Gemini production : 110ITR847(Mad) . Learned counsel also relied on a Full bench decision of the Gujarat High Court in Chhotalal & Co. v. CIT : 150ITR276(Guj) and also on a Full Bench judgment of the Allahabad High Court in CIT v. Ram Laxman Sugar Mills : 90ITR73(All) . Learned counsel also relied on a decision of this court in CIT v. T. V. Ramanaiah & Sons : 157ITR300(AP) .
6. Section 10(4) (b) of the 1922 Act corresponds to section 40(b) of the 1961 Act. Section 10(4) (b) was incorporated in the 1922 Act in the year 1939. The legislative history is sufficient to indicate that the provisions contained in section 40(b) of the 1961 Act are intended to prevent the siphoning off of the firm's income to partners in order to reduce tax liability in the hands of the firm. A part of the income earned by the firm, which is liable to be taxed in its hands may diverted to the partners so that the incomes so diverted, if deducted in the firm's hands, do not either suffer tax in the hands of the partners or suffer a lesser rate of tax. Income earned by the firm can be diverted into partner's hands by making payments on accounts of salary, bonus, interest, commission or other remuneration. Section 40(b) of the Act takes care of such attempts to avoid tax by making impermissible the deduction claimed by the firm to the partners on account of salary, bonus, interest, commission or remuneration. Reference may be made to the Indian Partnership Act. Section 12(b) of the Partnership Act provides that every partner is bound to attend diligently to his duties in the conduct the business. Section 13(a) of the partnership Act provides that a partner is not entitled to receive remuneration for taking part in the conduct of the business. This is, of course, subject to a contract between the partners. Thus, the partners in a firm are bound to work diligently while conducting the partnership business and are also not entitled to receive remuneration for taking part in the conduct of the business. If there is a contract between the partners that any partner shall be paid salary and bonus for looking after the affairs of the partnership business, such a payment would be permissible, because of the contract between the partners. The contract between the partners, providing for payment of salary and bonus, could have as its object siphoning off the firm's profits by diverting the same into the partners' hands, though under law, a partner has to work for the firm's business without payment of salary. Similarly, a partner is bound to provide capital for the running of the business without anticipating payment of any interest. If, however, there is a contract between the partners to pay interest on capital that could also be a payment with the object of diverting the firm's income into the hands of the partners. Inasmuch as a partner is bound to attend to the partnership business without anticipating any commission or other remuneration, any contract providing for the payment of commission or other remuneration, any contract providing for the payment of commission or other remuneration may have as its object diverting the firm's income into the hands of the partners. Whether or not these arrangements are bona fide, section 40(b) of the Act steps in and makes all such payments not deductible in computing the income of the firm so that attempts in any case to siphon off the firm's profits by diversion into the partners' hands may be prevented. One principle flows from out of this. That is, wherever a partner, being under a legal obligation, or duty bound to conduct the partnership business without anticipating payment of salary, bonus, commission or remuneration as quid pro quo for his services and wherever a partner is under a legal obligation to provide capital for the business without anticipating any interest on the capital, except the return in respect of capital by way of his share in the firm's profits, the amounts paid to him by way of salary, bonus, commission of other remuneration and interest are made impermissible as deductions in computing the firm's income. Could the same principle be applied if payments are made by a firm to its partners in respect of services which the partner is not bound or under a duty to rende Take for instance, the case of a partner having vacant premises in which the business of the partnership firm can be run. Surely, the partner is not bound to gratuitously allow the building to be used by the firm for its business. He is not bound to provide his premises free of rent. If the firm occupies a property belonging to a partner and pays rent, such payment of rent is not made impermissible as deduction under section 40(b) of the Act. The reason is obvious, inasmuch as the rent is paid by the firm to a partner for making available his property, which he is under no legal obligation to do, and the rent paid by the firm to the partner is a permissible deduction while computing the firm's income. From the aforementioned instances, the statutory intention is clear. Wherever a partner is under a legal obligation to provide his services or capital and yet charges a quid pro quo for such services and capital, the payment made cannot be allowed while computing the firm's income because of section 40(b) of the Act. Where, however, a partner is under no legal obligation to provide any particular service or involve himself in any particular activity, the payment made to him as a quid pro quo for such services and activities does not fall under section 40(b) of the Act. In other words, such a payment is a permissible deduction while computing the income of the firm.
7. The above principle may be applied to the facts of the present case. We have already pointed out that the managing partner, Venkataramana, and another partner, Bapu, joined the partnership as partners providing equal capital as the third partner, N. S. Murthy, provided. There was an agreement that all the three partners shall bring any additional capital, if required. There is no contract between the partners by way of a covenant in the partnership deed that Venkataramana and Bapu were under an obligation to furnish the story for producing the film and direct the film, respectively. Thus, the fee of Rs. 25,000 paid to the managing partner, Venkataramana, for furnishing the story to the firm for production of the film is in respect of services which the said Venkataramana is under no obligation to render. Similarly, the payment of Rs. 15,000 paid to Bapu for directing the film is again for services, which the said partner is under no obligation to render. In such circumstances, the payments made to them do not, in our opinion, fall to be disallowed pursuant to the provisions of section 40(b) of the Act.
8. The decision of a Full Bench of the Allahabad High Court in CIT v. Ram Laxman Sugar Mills : 90ITR73(All) is a direct authority in respect of the above proposition. In that case, the payments by way of remuneration were made to certain partners, not in. pursuance of an agreement of partnership, but under directions of the Central Government. The partners acted as authorised controllers and performed certain functions for which remuneration was paid by the firm to the partners. The Allahabad High Court held that the payments so made by the firm to the partners are allowable as deduction although the amounts were paid by way of remuneration to the partners for services rendered. The distinction is that the services of authorised controller were rendered by the partners, without there being a legal or contractual obligation to so render and, consequently, the payments are not hit by the provisions contained in section 10(4) (b) of the 1922 Act. We are in complete agreement with the aforesaid distinction. The decision of the Madras High Court in CIT v. Gemini Productions : 110ITR847(Mad) also affirms the aforesaid principle, although the decision in that case turned on slightly different facts. The Full Bench decision of the Gujarat High Court in Chhotalal & Co. v. CIT : 150ITR276(Guj) is also a decision on the point where the question was whether the interest paid to a partner on moneys advanced by him to the firm individually could be allowed as deduction in computing the firm's income. The claim was that the individual was not a partner in his individual capacity, but was representing the joint family as karta. Although qua other partners, he is a partner in his individual capacity, for purposes of tax law, the real character of the partner was taken into account and the Gujarat High Court held that the interest paid to the individual on moneys advanced by him individually to the firm cannot be disallowed under section 40(b) of the Act. Thus, the character in which the partner received the amount from the firm is relevant and significant for the purpose of determining whether the provisions of section 40(b) of the Act are applicable. The aforesaid view taken by the Gujarat High Court was also consistently taken by this court in a number of cases and it was held that interest paid to a partner in a character other than a partner could not be disallowed under section 40(b) of the Act. This principle has since received statutory recognition by the Taxation Laws (Amendment) Act, 1984, which added three Explanations to section 40(b) of the Act. Explanation 2, newly added, provides that, where an individual is a partner in a firm in a representative capacity, the interest paid by the firm to such individual otherwise than as partner in a representative capacity, shall not be taken into account for the purposes of clause (b) of section 40 of the Act. The reason for recognising the above principle statutorily is stated in the statement of objects and reasons, as mainly to streamline the procedures in the interest of better work-management, avoid inconvenience to taxpayers, reduce litigation, remove certain anomalies in, and rationalise some of, the provisions and counteract tax avoidance and tax evasion. It is, therefore, clear that an amount paid to a partner by a firm otherwise than in the capacity of a partner is not caught by the provisions contained in section 40(b) of the Act. That is precisely the contention urged by Sri Anantha Babu, learned counsel for the assessee, and we have no hesitation whatsoever in accepting the same.
9. In the aforesaid view, we uphold the Tribunal's conclusion that the sums of Rs. 25,000 and Rs. 15,000 paid by the firm to the managing partner, M. Venkatraman, and the partner S. Laxminarayana alias Bapu, respectively, are permissible deductions and the provisions of section 40(b) of the Act do not come into operation and render the payments impermissible deductions. We accordingly answer the question referred to us in the affirmative, in favour of the assessee and against the