1. In this case, at the instance of the revenue, the following question :
'Whether, on the facts and in the circumstances of the case, the interest amount of Rs. 7,777 paid by the assessee-firm to the Hindu undivided family of Sajjanram Jwaladas was, as held by the Tribunal, allowable as deduction in view of section 40(b) of the Income-tax Act, 1961 ?'
2. In this case we are concerned with the assessment year 1972-73, the previous year being Samvat Year 2027. The assessee is a registered firm carrying on business of adat in cloth. Samvat Year 2027, the previous year, commenced on October 31, 1970, and ended on October 19, 1971. The assessee-firm had three partners out of whom. Sajjandan Jwaladas, had joined the firm in his capacity as the Karta of the joint Hindu family of Sajjandas Jwaladas. During the accounting year under consideration the assessee-firm had paid interest amounting to Rs. 7,777 to the said HUF. The ITO, impliedly applying the provisions o s. 40(b) of the I.T. Act, disallowed the deduction of the said expenditure. The assessee went in appeal to the AAC but the appeal on this point was dismissed. On further appeal, the Tribunal held that the view taken in the case of this very assessee by a Bench of the Tribunal or the assessment year 1971-72 was the correct view and following that view the Tribunal held that the amount of Rs. 7,777 should be allowed to be deducted as an expenditure in the assessment of the firm. Thereafter, at the instance of the revenue, the question hereinabove set out has been referred to us for out opinion.
3. In order to appreciate the rival contentions, it is necessary to refer to some of the provisions of the I.T. Act, 1961. Under s. 28, income referred to in the clauses of that section shall be chargeable to income-tax under the head 'Profits and gains of business or profession'. Section 29 lays down that the income referred to in s. 28 shall be computed in accordance with the provisions contained in ss. 30 to 43A. Ordinarily, interest paid by a firm on moneys utilised by it in the business of the firm would be allowable as a deduction while computing the income of a firm but in order to provide against siphoning off the points of the firm in the guise of various payments to the partners of the firm, the Legislature has provided in s. 40, clause (b), that, in the case of any firm, any payment of interest, salary, bonus, commission or remuneration made by the firm to any partner of the firm shall not be deducted in computing the income chargeable under the head 'Profits and gains of business or profession'; and it is obvious that interest paid to any partner of the firm cannot be allowed as deduction in computing the income of the firm chargeable under the head 'Profits and gains of business or profession'.
4. While going through the order of the Tribunal in the instant case we find that the Tribunal has merely followed its own earlier decision in respect of assessment year 1971-72. When we turn to that order we find that it was conceded before the Tribunal in that case that there were two distinct and separate accounts. One in the name of Sajjandas Jwaladas, and the other in the name of the HUF o Sajjandas Jwaladas. It was also conceded that the interest in question was paid to the HUF of Sajjandas Jwaladas by crediting that amount to that account. But the contention of the department was that it was the HUF of Sajjandas Jwaladas which was in reality a partner in the firm and not Sajjandas Jwaladas, the individual, and, therefore, there was payment to one of the partners of the firm which was clearly disallowable under s. 40(b) of the Act, and that argument was repelled by the Tribunal.
5. As a result of a series of decisions of the Supreme Court (Vide Charandas Haridas v. CIT : 39ITR202(SC) and other decisions on the point), it is clear that an HUF cannot be a partner in a firm. Only an individual person in his own right can be a partner in a firm. Since an HUF cannot be a partner in a firm, whoever represents the HUF in the firm is a partner for all practical purposes both of partnership law and income-tax law, and it is in the light of that legal position that the whole problem has to be considered. The ITO in the instant case, and also the AAC in the instant case, have proceeded on the footing that the HUF of Sajjandas Jwaladas was the partner in the firm. That, in the eye of law, in an impossibility and, therefore, the entire basis on which the AAC expressly proceeded and the ITO impliedly proceeded in the instant case s untenable. The fact remains that there were two separate accounts and in the account of toe HUF it was shown that the HUF interest of Rs. 7,777 was paid by the firm to the HUF. There was a separate account of the individual partner, Sajjandas Jwaladas, and in that account no interest appears to have been paid in the year under consideration. Under these circumstances, it is obvious that the amount of Rs. 7,777 was paid by way of interest to the HUF which was the creditor of the firm. The fact that the karta of the HUF was a partner of the assessee-firm is totally beside the point because under s. 40(b) it is only the interest paid to the partner which is not allowed to be deducted. Interest paid to any other creditor of the firm cannot be disallowed under the provisions of s. 40(b).
6. This being the correct legal position, it is obvious that the Tribunal was right in coming to the conclusion that it did, namely, that the amount of Rs. 7,777 did not fall within the mischief of s. 40(b) and, therefore, the amount could not be disallowed while computing the income of the assessee-firm under the head 'Profits and gains of business or profession'.
7. However, Mr. Raval for the revenue has drawn our attention to several decision of different High Courts in India. The first decision to which he drew our attention was N. M. Anniah & Co. v. CIT : 101ITR348(KAR) . In that case, 'A' was a partner in the assessee-firm in his capacity as 'karta' of his HUF. Under the partnership deed, 'A' was entitled to a salary of Rs. 1,000 a month n his individual capacity. In the assessment of the assessee-firm for the assessment year 1969-70, the ITO excluded the sum of Rs. 12,000 paid to 'A' as salary. The Commissioner revised this order and directed the ITO to include the sum of Rs. 12,000 in the taxable income of the assessee-firm. The Appellate Tribunal confirmed that order on appeal. On a reference at the instance of the assessee, Division Bench of the Karnataka High Court held that s. 40(b) of the I.T. Act, 1961, which said that in the cases of a firm any payment of salary made by the firm to any partner was not deductible, was absolute in its terms and was applicable to all cases irrespective of the character in which a person had become a partner of a firm. With great respect, we agree with this reasoning of the learned judges of the Karnataka High Court because what the law looks at is the payment made to a partner and it is not considered in what capacity that particular person became a partner of the firm.
8. The next decision to which Mr. Raval drew our attention was the decision of the Andhra Pradesh High Court in CUT v. T. Veeraiah and K. Narasimhulu : 106ITR283(AP) . In that case the assessee was a registered partnership firm with four partners. One of the partners represented the interest of an HUF. In the relevant assessment years the interest paid on the capital investment made on behalf of the partner was credited to the joint family account and deducted from the income of the assessee-firm. The ITO held that in the previous years, such interest was being added to the income of the firm as interest paid to a partner, and as there was no change in the position for the two assessment years, he added back the interest payments to the income returned. The AAC held that the interest paid on the funds standing to the credit of the family could not be treated as interest paid to the partners so as to bring it within the scope of clause (b) of s. 40 of the I.T. Act, 1961, and deleted the amount in computing the assessee's profits. This was confirmed by the Appellate Tribunal. On a reference made to the High Court at the instance of the revenue, the Andhra Pradesh High court held that the capital contributed by the partner was as a partner though the funds might have managed from the joint family, that the joint family which could not itself be a partner, had not made any investment in the firm independently of the capital contributed by karta as a partner and that, therefore, it did not cease to have the characteristics of a capital investment by a partner, the interest on which was not deductible from the income of the firm under s. 40(b) of the Act. With great respect to the learned judges of the Andhra Pradesh High Court, we are unable to agree with the reasoning of this decision because what is to be looked at is, who is the creditor of the firm. If, in fact, the HUF is not the creditor of the firm and yet some amount of interest is purported t have been paid by the firm, then of course the amount cannot be allowed as a deduction, but that is not because of the provisions of s. 40(b) but because in fact the HUF was not the creditor of the firm. However, if the position clearly emerges that in a particular assessment year the HUF of which the karta is in his own capacity a partner of the firm, is a creditor of the firm, them interest paid to the HUF must be allowed and it cannot be disallowed under s. 40(b) of the Act. Section 40(b) merely looks to the fact, of payment of interest paid to a partner and not in what capacity the interest is paid to him and if, on an examination of the facts of a particular case it emerges that the HUF is a creditor of them, then s. 40(b) would not apply.
9. The next decision to which our attention was drawn by Mr. Raval is the decision in Addl. CIT v. K. G. Narayanaiah Chetty & Co. : 106ITR420(AP) . In that case the assessee was a registered firm consisting of three partners. Two of the three partners in the assessee-firm were partners on behalf of their HUFs. Their individual accounts were being credited with interest on capital advanced by them as well as their shares of profits. During the relevant accounting year, the balance in the accounts of these two partners was transferred to their HUF account. While interest was directly credited to the account of the HUFs, share of the profit was first credited to the partner's individual account and in turn transferred to the respective HUF account. Applying s. 40(b) of the I.T. Act, the ITO added interest paid on the advances standing to the credit of the account of the HUF to the income of the assessee-firm for the assessment years '1968-69 and 1969-70. On appeal, the AAC held that as the HUFs, as such, were not partners of the firm, s. 40(b) had no application and, therefore, allowed the appeal of the assessee. The appeal preferred by the revenue to the Tribunal was not successful and, on a reference at the instance of the revenue, it was held by a Division Bench of the Andhra Pradesh High Court that the question whether interest paid by the firm was to the partner or to the jointly depended upon the terms of the agreement and the entries in the account books. In the particular case before the Division Bench, the interest was first credited to the account of the individual partners and later transferred to the HUF account. If in reality the HUFs were creditors of the firm, there was no reason why there should be two separate accounts and the interest paid to the partners should be transferred to the account o the HUF. In that case, apparently the Division Bench found that the real creditor to the firm was the individual partner and not the respective HUF. That is the reason why the Division Bench of the Andhra Pradesh High Court decided in favour of the revenue and reversed the finding of the Tribunal in that particular case.
10. The next decision to which out attention was drawn is also the decision of the Andhra Pradesh High Court in Addl. CIT v. Vallamkonda Chinna Balaiah Chetty and Co. : 106ITR556(AP) . In that case the assessee-firm consisted of four partners, one of whom was R representing R's HUF. In the partnership there was no stipulation as to investment of capital by any o the partners. R's family advanced some moneys to the firm and the same was credited by the firm in the name of R who was also the karta. Up to the assessment year 1967-68, interest was credited to the account of R. Capital account in the firm was also in the name to R. But for 1967-68, the account was changed to 'R's family account'. The firm paid Rs. 4,068 to R towards the interest on the capital invested by the family and claimed deduction under s. 40(b) n the ground that the interest was really paid to the partner, R, and the change f account to 'R's family' was only to avoid the application of s. 40(b). The AAC confirmed the order while the Tribunal upheld the assessee's claim. The Andhra Pradesh High Court, when the question came before it under s. 256(2) application, upheld the view o the Tribunal and, in our opinion, they rightly did so. It was found as a matter of fact in that case that the HUF was the real creditor of the firm and it was only by a mistake in the earlier years that the amount of money advanced by the HUF was shown as having been advanced by R, the person who was a partner in the firm. In that view of the situation, it was rightly held that s. 40(b) had no application to the case because the real creditor of the firm was the HUF and not the partner, R.
11. All these three decisions of the Andhra Pradesh High Court were before the Allahabad High Court in CIT v. Landon Machinery Co. : 117ITR111(All) . In that case the assessee was a registered firm consisting of seven partners. According to the partnership deed, there were stated to be partners acting as karta of their respective HUF. The three karta-partners deposited their individual funds in the accounts of the firm. In the accounting year relevant to the assessment year 1972-73, the firm paid interest to those three partners on their deposit. The firm claimed deduction of this amount as business expenditure. The Tribunal held that since the three persons were partners in a different capacity, that is, as kartas, the interest paid to them as individuals could not be held to be payments to the partners of the firm and the firm was entitled to deduct the amount paid as interest. On a reference to the High Court it was held that payment of interest by the firm to such a partner was as a partner, no matter who really had the beneficial interest in such payments. With great respect we agree with the conclusion of the Allahabad High Court because in that particular case, payment of interest was made to the individual partner in respect of monies deposited in his own individual account. The fact that the partnership deed mentioned that the three partners represented the respective families did not make any difference to the legal position under the Partnership Act or under the I.T. Act. The Andhra Pradesh High Court again considered its earlier decision in Terla Veeraiah v. CIT : 120ITR502(AP) . In that case there was an HUF consisting of P. his son, V, and grandson, S. There was a partitions of the HUF properties and the three coparceners, P, V and S, formed a partnership firm under a deed dated December 12, 1962. They were carrying on business in e name of the firm. On January 9, 1969, P died and his son, V, succeeded to his entire property including the share in the partnership firm. The share income in respect of the share inherited by V from P had been assessed in the status of HUF in the hands of V. The account which stood in the name of P and was succeeded to by V, was credited to a separate account. The account as partner was styled as 'Terla Veeriah (HUF) Account'. For the assessment year 19070-71 and 1971-72, interest received from the partnership, namely, Rs. 7,890, was credited to the individual account of V and another sum of Rs. 8,585 to the account of Terla Veeriah (HUF) Account. The claim of the assessee in respect of deduction of Rs. 7,890 was disallowed by the ITO under s. 40(b) of the Act on the ground that the said sum represented interest paid to the partner. On appeal to the AAC and on further appeal to the Tribunal, the order of the ITO was confirmed and, on a reference, the Division Bench of the Andhra Pradesh High Court held that the Tribunal having recorded the finding that there were two accounts, namely, 'Terla Veeriah (HUF)' and 'Terla Veeriah individual', and having held that the interest was paid to V, in his capacity as karta representing the HUF, it erred in concluding that the interest was credited to the partner in both the accounts. As the interest on the capital of the HUF was separately credited to the account of the HUF and not to the account of V, as a partner of the firm, s. 40(b) had no application and the order of the Appellate Tribunal in upholding the disallowance of interest under s. 40(b) was not correct. If the facts of this case are analysed closely it would appear that what was shown as the individual account was in fact the HUF account and what was shown as T. V. HUF account was in fact and in reality the account of the partner as such and, therefore, the amount of Rs. 7,890 which was paid to the account representing the HUF in respect of moneys derived from the father's properties was rightly held as not governed by s. 40(b) of the Act. On an apparent view of the matter one is likely to disagree with the conclusion of the Division Bench of the Andhra Pradesh High Court but when facts are analysed closely it will appear that confusion is likely to arise because of the names of the accounts. That which was really the HUF account was named as individual account and the one which was the individual account of the partner was designated as HUF account and that is why a wrong impression is likely to arise. Ultimately, we agree with the conclusion of the learned judges of the Andhra Pradesh High Court.
12. Under these circumstances, in every case the test to be applied is as to who is the partner of the firm and irrespective of the character in which he is the partner of the firm, whether any interest is paid to him as partner. If the creditor of the firm is not the partner but the HUF of which the partner is the karta, then a separate entity is the creditor of the firm and interest paid to that separate entity will not be governed by s. 40(b) and cannot be disallowed.
13. In the instant case, that were two separate accounts, one in the individual name of Sajjandas Jwaladas and the other in the name of HUF of Shri Sajjandas Jwaladas. The amount of Rs. 7,777 was paid as interest to the HUF of Sajjandas Jwaladas. That being the case, it was paid to the creditor who was not a partner of the firm. Under these circumstances, the conclusion of the Tribunal was correct. We, therefore, answer the question referred to us in the affirmative, that is, in favour of the assessee and against the revenue. The Commissioner will pay the costs of this reference to the assessee.