A. P. SEN C.J. - This is a composite reference under s. 66(1) and s. 256(1) of Indian Income-tax Act, 1922, and the Income-tax Act, 1961, respectively, made by the Income-tax Appellate Tribunal, Nagpur Bench, Nagpur, at the instance of the assessee, requiring certain qyestions of law, said to arise from its orders in Income-tax Appeals Nos. 521 of 1968-69, 18691 and 18692 of 1966-67, 9688 and 19396 of 1967-68 dated March 31, 1971, pertaining to the assessment years 1959-60 to 1962-63 to the High Court for its opinion, namely :
'(1) Whether, on the facts and in the circumstances of the case, the Tribunal was justified in holding that interest amounts of Rs. 31,447, Rs. 10,833, Rs. 19,200, Rs. 30,141 and Rs. 30,343 for the assessment years 1959-60, 1960-61 (two assessments), 1961-62 and 1962-63, respectively, charged on the debit balances in the accounts of two of the partners in the books of the firm constituted taxable income of the assessee
(2) Whether, on the facts and in the circumstances of the case, in apportioning the total income of the firm between the several partners as required under section 23(6) of the Act of 1922 and section 158 of the Act of 1961, the interest adjusted on the debit balances of the accounts of the partners in the books of the firm is deductible from the share in profits of the respective partners ?'
The firm, styled 'M/s. Chhotalal Keshavram, Rajnandgaon', constituted of two partners, Ghanshyamdas Chhotalal and Rameshchandra Chhotalal, carrying on business of manufacture and sale of bidis, was reconstituted by a partnership deed dated December 29, 1954, whereby a third partner, Amrutlal Somabhai, was introduced as a financing partner. At the time when the business was taken over, the total liabilities of the firm amounted to Rs. 6,44,655. After adjusting certain assets of the firm, there was an excess of liabilities over the assets amounting to Rs. 4,09,628 and this amount was debited to the accounts of the two partners, Ghanshyamdas Chhotalal and Rameshchandra Chhotalal, in equal shares.
As provided by clause 5 of the deed of partnership, funds were to be provided by Amrutlal Somabhai and he was made entirely responsible for managing the business. Clause 6 of the deed reads as follows;
'6. Every year, at the time of the settlement of the partnership accounts, interest shall be credited to the partners accounts on katmiti basis at 8 annas per cent. per month on the credit balance in the partners capital accounts. Similarly, interest at the same rate shall be charged and debited to the partners accounts on the sums standing to their debits. In this way, the partners shall get the amounts of interest adjusted to their accounts at the time of settlement of account between them.' The two partners, Ghanshyamdas Chhotalal and Rameshchandra chhotalal, who were indebted to the firm, were not allowed to draw their shares of profits till the amount due from each of them was paid off. They owned some immovable properties and agreed not to sell, gift or mortage these properties till their accounts were cleared off. For breach of this agreement, they were liable to be removed from the partnership. The third partner, Amrutlal Somabhai, was not entitled to get any salalry for managing the business, but the firm agreed to bear the expenses of his residence and messing. The constitution of the firm underwent a change by the execution of a partnership deed dated November 12, 1958, by introduction of new parties; but there was no other change in the terms and conditions of the earlier partnership deed dated December 29, 1954. There was a further change in the partnership with effect from March 15, 1959, when Ghanshyamdas Chhotalal and Rameshchandra Chhotalal went out their minor sons, Jayshankar Ghanshyamdas and Himanshu Rameshchandra, were admitted to the benefits of the partnership.
During the assessment years in question, the personal accounts of the two partners, Ghanshyamdas Chhotalal and RAmeshchandra Chhotalal, in the account books of the firm were debited with Rs. 31,447, Rs. 10,833, Rs. 19,200, Rs. 30,141 and Rs. 30,343 on account of interest payable by them to the firm for the debit balances pending in their names, of Rs. 2,66,121 each. Similarly, the personal account of Amrutlal Somabhai, who furnished capital for the going concern, was credited with interest on the amount of loan advanced by him to the firm. The amount of interest debited to the account of the two partners, Ghanshyamdas Chhotalal and Rameshchandra Chhotalal, as well as the amount of interest credited to the account of Amrutlal Somabhai, were included in the interest account maintained in the books of the firm, and the resultant amount went into the profit and loss account of the firm. Thus, it appears that the debit entries on account of interest payable by the two partners, Ghanshyamdas and Rameshchandra, passed through the books of the firm.
It was argued by the assessee before the ITO that the amount in question did not represent the real income of the firm but represented only adjustments of entries whereby the interest account of the firm was credited and the accounts of two partners were debited. It was argued that the liability to pay interest arose by virtue of the partnership agreement and not by virtue of carrying on the firms business. The contention did not prevail before the ITO and he held that the amount of interest in different years should be treated as the firms income. While apportioning the income of the partners, the ITO did not take into account the interest charged to the partners.
On the appeal, the AAc also rejected the contention of the assessee and observed that the proper place for claiming deduction on account of interest paid to the firm was in the individual assessment of the partners and not in the case of the firm. On further appeal, the Income-tax Appellate Tribunal referred to the provisions of s. 10(2)(iii) and s. 10(4)(b) of the Act of 1922 and s. 40(b) of the Act of 1961 and to the decision in Sri Ram Mahadeo Prasad v. CIT : 24ITR176(All) and quoted the following observations made in that case :
'Interest paid to the partners of a firm on moneys borrowed from them by the firm could not be deducted in computing the profits and gains of the firm by reason of the provisions of ss. 10 (2)(iii) and 10(4)(b). There is, however, nothing in the Indian Income-tax Act which excludes from the computation of the income of the firm any amount paid as interest by a partner frrrrrrrrror money borrowed by him from the firm.' The Appellate Tribunal also rejcted the contention of the assessee that the amount of interest debited to the partners did not represent the real income of the firm. It accordingly held that while apportioning the income of the firm between the partners, no deduction could be allowed for interest paid by the partners of the firm.
In our judgment, the Appellate Tribunal was right in holding that the interest debited to the two partners having been transferred to the interest account and the resultant sum having gone into the profit and loss account, they were not mere adjustment entries. These amounts are undoubtedly not only book profits but must be held to be commercial and real profits actually received by the firm in the years of account.
Kondaiah J. in CIT v. Smt. Allareddy Sudarsanamma : 83ITR759(AP) , after referring to the various authorities on the subject, observed that the real profits have been arrived at by the application of commercial principles and only by making permissible deductions as per provisions of the Act. In the commercial sense, the two partners were debited with the interest due on their outstanding liability and the amount was credited in the interest account of the firm. Thereafter, the amount of interest so credited in the interest account was taken to the profit and loss account, treating it as part of the frims income and also adjusted against the share of profits of these two partners. The earliest case to be noticed is Gresham Life Assur ance Society v. Styles  AC 309,, wherein Lord Chancellor Halsbury observed :
'The word profits I think is to be understood in its natural and proper sense - in a sense which no commercial man would misunderstand. But when once an individual or a company has in that proper sense ascertained what are the profits of his business or his trade, the destination of those profits, or the charge which has been made on those profits by previous agreement or otherwise, is perfectly immaterial. The tax is payable upon the profits realized, and the meaning to my mind is rendered plain by the words payable out of profits.'
The aforesaid dictum has been aprove by Lord Macmillan in Pondecherry Railway Co. Ltd. v. CIT, 0043/1931 . Here, we may notice the following observations of Greene M. R. in British Sugar . v. Harris : 7ITR101(Cal) :
'Once your realise that as a matter of construction the word profits may be used in one sense for one purpose and in another sense for another purpose, I think you have the real solution of the difficulties that have arisen in this case.'
In the same case, Romer L. J. said :
'Is the payment that has to be made by the trader under the contract in question a mere division of profits with another party or is it a payment to the other party, the amount of which is ascertained by reference to the profits ?'
Mackinnon L. J. stated in the aforesaid case thus :
'The whole question in this, as in other cases, is whether this, which is an annual payment, is an annual payment to be taken into account in order to ascertain the profits, or is it an annual payment payable out of the profits after they have been ascertained ........profits, as I think, quite clearly of a different description from the annual profits or gains with which one is concerned in assessing the income-tax.' See also H. M. Kashiparekh & Co. Ltd. v. CIT  39 ITR 706 (Bom), CIT v. Sitaldas Tirathdas : 41ITR367(SC) and Murlidhar Himatsingka v. CIT : 62ITR323(SC) .
The decision in CIT v. Kalooram Govindram : 57ITR630(SC) is clearly distingushable on facts. There, a HUF formed an association with another HUF to carry on a business, styled 'Govindram Sugar Mills'. Govindaram Sugar Mills incurred a heavy loss in its business transactions in the relevant year of account. Debit entries in the books of account of the association relating to interest deemed payable on investments were posted, but it could not, as a matter of law, be inferred therefrom that any part of the income of the association was distributed. The share of the HUF, which was a member, in the loss suffered by Govindram Sugar Mills was considerably in excess of the amount of interest debited as payable to its account with the association. Entries relating to interest payable to the two members of the association were posted merely for apportionment of part of the loss suffered by the sugar mills. Their Lordships held that the debit entries in the books of the association were mere book entries, not representing the true income. In the commercial sense, here, the debit entries against the two partners were not only transferred to the interest account in the books of accounts maintained by the firm, but had also gone into the profit and loss account of the firm, and, therefore, they represented the real income of the firm.
The object of s. 23(5)(a) of the Act of 1922 and s. 182 of the Act of 1961 is not only to assessee the firm itself, but also to apportion the income among the various partners. S. 23(5)(a)(i) and (ii) of the 1922 Act, so far as relevant, reads :
'(5) Notwithstanding anything contained in the foregoing subsections, when the assessee is a firm and the total income of the firm has been assessed under sub-section (1), sub-section (3) or sub-section (4), as the case may be, -
(a) in the case of registered firm,
(i) the income-tax payable by the firm itself shall be determined; and
(ii) the total income of each partner of the firm, including therein his share of its income, profits and gains of the previous year, shall be assessed and the sum payable by him on the basis of such assessment shall be determined.......' The relevant part of s. 182 of the act of 1961 reads as follows :
'182. Assessment of registered firms. - (1) Notwithstanding anything contained in sections 143 and 144 and subject to the provisions of sub-section (3), in the case of registered firm, after assessing the total income of the firm, -
(i) the income-tax payable by the firm itself shall be determined; and
(ii) the share of each partner in the income of the firm shall be included in his total income and assessed to tax accordingly.' There is a slight change brought about in clause (ii) of s. 23(5)(a) of the 1922 Act. For the words 'total income of each partner of the firm, including therein his share of its income, profits and gains of the previous year', the 1961 Act intriduces the words 'share of each partner in the income of the firm'.
s. 23(5)(a) of the Act of 1922 has been judicially interpreted by their Lordships of the Supreme Court in S. Sankappa v. ITO : 68ITR760(SC) in these words :
'It will be noticed that, under this provision, various orders have to be made by the ITO. In the case of registered firm, the ITO after computing the income, has to determine the tax payable by the firm itself, and provision is made that, thereafter, the share in the income of the firm of each partner is to be included in his total income for purposes of his individual assessment to tax. It is true that the ITO assessing the firm may not be the same officer who may be dealing with the individual assessment of the partners and, in any case, even if he be the same officer, the proceeding for assessment of the partners has to be treated as a separate proceeding; but it is also clear that the proceedings for assessment of the firm under this section do not come to an end merely on computation of the income of the firm and determination of the tax payable by the firm on that income. The ITO who deals with the assessment of the firm, has also to apportion the income of the firm, in the case of a registered firm, between its partners and the notice of that apportionment has to be given under s. 23(6) by him to the firm. This apportionment is clearly treated as a part of the proceeding for assessment of the firm and that is why the notice is to be given to the firm... All these provisions clearly show that proceedings for assessment of a firm consist of computation of the income of the firm, determination of tax payable by the firm, apportinment of the income of the firm between its partners in the case of a registered firm and, in appropriate cases, imposition of tax on the firm after including the share of the income of certain partners in the income of the firm, even though the firm is registered. The proceedings for assessment of the firm are not completed until all these steps have been taken by the Income-tax Officer, and each one those steps must be held to be a step in the proceedings for assessment of the firm.'
Shri Thakar, learned counsel for the assessee, strenuously contends that in computing the total income of the two partners, Ghanshyamdas Chotalal and Rameshchandra Chotalal, the ITO fell into an error in holding that they were not entitled to deduction, in computing their share in the frims profits, in respect of interest paid by them on their outstanding liabilities. We are afraid, the contention cannot be accepted. It will be noticed that deduction was not claimed in respect of interest paid by them on the capital borrowed for the purpose of investment in the firm. Assessment of a firm is governed by the provisions of s. 23(5). If the firm is registered, each partners share in the firms profits would be added to his other income and charged as a part of his total income. The computation of the partners share in the firms profit is dealt with by s. 16(1)(b) of the Act of 1922, which read :
'16. Exemptions and exclusions in determining the total income. - (1) In computing the total income of an assessee - ....
(b) When the assessee is a partner of a firm, then, whether the firm has made a profit or a loss, his share (whether a net profit or a net loss) shall be taken to be any salary, interest, commission or other remuneration payable to him by the firm in respect of the previous year increased or decreased respectively by his share inm the balance of the profit or loss of the firm after the deduction of any interest, salary, commission or other remuneration payable to any partner in respect of the previous year :
Provided that if his share so computed is a loss, such loss may be set off carried forward and set off in accordance with the provisions of section 24....'
This clause lays down the mode of computing the partners share in the profit or loss of the firm. The formula is to take any salary, interest, commission or other remuneration payable to the partner by the firm and to add to or subtract from it, respectively, the partners share in the balance of the profit or loss of the firm, after deduction of any interest, salary, commission or other remuneration payable to another partner. The expression 'total Income', as defined in s. 2(15) of the Act, reads :
'total income' means total amount of income, profits and gains referred to sub-section (1) of section 4 computed in the manner laid down in this Act.'
Interest paid to the partner must cecessarily be added to his share of profits, in the computation of his total income. This is by virtue of section 16(1)(b) of the Act. There is no provision made in the Act for deduction of any interest paid by a partner to the firm, in like manner. We may point out that section 67(3) of the 1961 Act has introduced a new provision, which runs thus :
'(3) Any interest paid by a partner on capital borrowed by him for the purpose of investment in the firm shall, in computing his income chargeable under the lead Profits and gains of business or profession in respect of his share in the income of the firm, be deducted from the state.' No provision, similar to this sub-section, finds a place in the 1922 Act. This sub-section gives statutory recognition to the priciple judicially recognised that a partner is entitled to a deduction, in computing his share in the firms profits, in respect of interest paid by him on the capital borrowed for the purpose of investment in the firm : Kanga and Palkhivalas Income Tax Act, seventh edition, Vol. I, page 60. This provision only relates to interest paid on the cpital borrowed for the purpose of investment in the firm. s. 67(3) has obviously no application to a case where a partner claims a deduction in respect of interest paid by him to the firm.
In Sri Ram Mahadeo Prasad v. CIT : 24ITR176(All) , the Allahabad High Court disallowed interestt paid by the firm to a partner by reason who had borrowed more than he had lent, the excess amount paid as interest was treated as profits of the firm.
For all these reasons, both the questions referred by the Income-tax Appellate Tribunal are answered in favour of the CIT and against the assessee. It must accordingly be held that the Income-tax Appellate Tribunal was justified in holding that the amounts of Rs. 31,447, Rs. 10,833, Rs. 19,200, Rs. 30,141 and Rs. 320,343, by which the parnters were debited towards interest on their outstanding liability of Rs. 2,66,121., constituted the taxable income of the assessee for the assessment years 1959-60 to the firm between the several partners as required under s. 23 (6) of the Indian Income-tax Act, 1922, and s. 158 of the Income-tax Act, 1961, the interest adjusted on the debit balances of the accounts of the partners in the books of the firm, is not deductible from the share of profits of the respective partners. The Commissioner shall have the costs of this reference Hearing fee Rs. 150.