SECTION 40 l AMOUNTS NOT DEDUCTIBLE

378. Rate or tax levied on profits - Omission of word “cess” from clause (a)(ii) - Effect of - Only taxes paid are to be disallowed

1. Recently a case has come to the notice of the Board where the Income-tax Officer has disallowed the “cess” paid by the assessee on the ground that there has been no material change in the provisions of section 10(4) of the 1922 Act and section 40(a)(ii) of the 1961 Act.

2. The view of the Income-tax Officer is not correct. Clause 40(a)(ii) of the Income-tax Bill, 1961, as introduced in the Parliament, stood as under :

“(ii) any sum paid on account of any cess, rate or tax levied on the profits or gains of any business or profession or assessed at a proportion of, or otherwise on the basis of, any such profits or gains.”

When the matter came up before the Select Committee, it was decided to omit the word “cess” from the clause. The effect of the omission of the word “cess” is that only taxes paid are to be disallowed in the assessments for the years 1962-63 onwards.

3. The Board desire that the changed position may please be brought to the notice of all the Income-tax Officers so that further litigation on this account may be avoided.

Circular : No. 91/58/66-ITJ(19), dated 18-5-1967.

379. Disallowance of interest charged to partner on overdrawn account under clause (b)1 - Interest charged to partner on debit balance as well as allowed on credit balance - Whether gross or net interest should be added back

The Board have been advised that while there is an express provision in section 40(b) which expressly prohibits the deduction from the firm’s income of any payment by way of interest made by it to a partner, there is no provision in the Act which provides for adjustment of the interest paid by the partner to the firm. In view thereof the gross amount of interest paid to the partner will have to be added back to the income of the firm. The earlier clarification issued in the Circular No. 33D (XXV-24) of 1965 [F. No. 9/55/64-IT(A-I)], dated 8-11-1965 [Annex], to the effect that where the firm pays interest as well as receives interest from the same partner, only the net interest can be said to have been received or paid by the firm and only such net interest should be taken into consideration, is not in accordance with the provisions of the Act.

The above instructions will apply to all pending assessments. Completed assessments need not be disturbed.

Instruction : No. 882 [F. No. 228/13/75-IT(A-II)], dated 25-9-1975.2

ANNEX - CIRCULAR 33D, DATED 8-11-1965

A reference is invited to the Board’s Circular No. 55 of 1941, on the above subject. In the above circular, it was stated that interest charged to a partner on his overdrawn account should not be included in the total income of the firm. It was further stated that where it appears that the capital borrowed for the purpose of business was partly diverted towards overdrawn account, the correct procedure would be to disallow the proportionate share of the interest payable on his capital in computing the income of the firm.

2. It has been brought to the notice of the Board that under the law as it stands, it would not be correct to exclude interest received by a firm from its partners while computing the total income of the firm. Whereas the interest paid to partners has to be disallowed in the assessment of the firm under the provisions of section 40(b), there is no provision to exclude any portion of the interest or other income received by the firm from its total income. The matter has been examined by the Board and it has been decided that the interest received by a firm from its partners should be assessed as the income of the firm. However, where a firm pays interest to as well as receives interest from the same partner, only the net interest can be stated to have been received or paid by the firm, as the case may be, and only the net interest should be taken into consideration. This view also finds support in the decision of the Allahabad High Court in the case of Sri Ram Mahadeo Prasad v. CIT [1953] 24 ITR 176. In view of the above, the instructions contained in the Board’s Circular No. 55 of 1941, may be treated as modified accordingly.

 

judicial analysis

Explained in - The circular dated 8-11-1965 was referred to in Kashavji Ravji & Co. v. CIT [1990] 183 ITR 1 (SC). The Supreme Court observed :

“Sri Ramachandran contended that the circular of 1965 of the Central Board of Direct Taxes was binding on the authorities under the Act and should have been relied upon by the High Court in support of the court’s construction of section 40(b) to accord with the understanding of the provision made manifest in the circular.

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However, this contention need not detain us, as it is unnecessary to examine whether or not such circulars are recognised as legitimate aids to statutory construction. In the present case, the circular of 1965 broadly accords with the view taken by us on the true scope and interpretation of section 40(b) in so far as the quantification of the interest for purpose of section 40(b) is concerned.” (pp. 17-18)

Explained in - The above circular was explained in CIT v. Ramanaiah & Sons [1986] 157 ITR 300 (AP) with the following observations :

“. . . It is unnecessary to go into a detailed consideration of the question because the Central Board of Direct Taxes itself had accepted that the real purport of section 40(b) of the Act was to add back only the net amount of interest and not the gross amount. There is no doubt that the decision of the Allahabad High Court in Sri Ram Mahadeo Prasad v. CIT [1953] 24 ITR 176, supports the view that only the net amount of interest has to be added back. The Central Board of Direct Taxes, after referring to the abovesaid decision of the Allahabad High Court, directed the officers of the Income-tax Department to add back under section 40(b) only the net amount of interest and not the gross amount. Examining the provision independently, we are in agreement with the view that section 40(b) of the Act confers power on the Income-tax Officer to add back only the effective amount of interest paid by the firm to the partner, as was held by the Allahabad High Court in Sri Ram Mahadeo Prasad v. CIT [1953] 24 ITR 176. We may point out that this principle, which was accepted by the Central Board of Direct Taxes in the circular above referred, was given statutory recognition by the Taxation Laws (Amendment) Bill, 1984, which introduced Explanation 1 to section 40(b) of the Act. . . .” (pp. 304-305)

“Learned counsel for the Revenue invited our attention to the decision of the Madras High Court in CIT v. O.M.S.S. Sankaralinga Nadar & Co. [1984] 147 ITR 332, where the Madras High Court referred to the above circular of the Central Board of Direct Taxes and observed as under (at page 337) :

‘Learned counsel passed on us the departmental circular which was relied on by the Tribunal. When a matter comes before this court for an advisory opinion on the state of the law or of a fiscal principle, or on the construction of any provision in the taxing enactment, the last place where we should look for aid or guidance would be a circular from the Central Board of Direct Taxes on the subject. We are not bound by the Board circulars. Besides, these circulars have the knack of being inconsistent. For, they are, for the most part, circulars for the occasion. We are not, therefore, inclined even to take a look into the circular referred to us. If the circular has expressed a view which the Department has not followed in this case, the remedy is not to ask this court to render an opinion in accordance with the circular. The relief has to be sought elsewhere. It would be quite different from what or how a court of advisory jurisdiction would render on the merits.’

With respect, we are unable to subscribe to the above view. Learned standing counsel for the Revenue stated that whatever may be the efficacy of the circular of the Central Board of Direct Taxes so far as the Department is concerned, it does not bind this court and, therefore, the decision should necessarily depend upon the interpretation of the statutory provisions. We are unable to accept this submission. The law is fairly settled that the instructions and directions given by the Central Board of Direct Taxes under section 119 of the Act are binding on all the subordinate officers in the execution of the Act. . . .” (pp. 305-306)

“. . . we are unable to accede to the submission to the learned standing counsel for the Revenue that the departmental officials are not bound to implement the instructions of the Central Board of Direct Taxes, if such instructions deviate from the correct legal position. We may point out that the provisions of section 119 of the Act enjoin that the Officers of the Income-tax Department are bound by the instructions and directions given by the Central Board of Direct Taxes. Wherever the instructions given by the Central Board of Direct Taxes to relieve hardship to an assessee are violated and if such instructions are issued in exercise of the powers vested in the Central Board of Direct Taxes under section 119 of the Act, it is certainly open to this court to compel the Income-tax Officer to follow the instructions of the Central Board of Direct Taxes. This is not to say that this court is bound by the instructions of the Central Board of Direct Taxes. All that is required to be said is that, so far as the officials of the Income-tax Department are concerned, it is not open to them to say that they would not follow the instructions of the Central Board of Direct Taxes and carry matters in appeals and references. Indeed, we do not know whether the Commissioner of Income-tax, who carried this matter in reference to this court, is aware of the above-mentioned circular and, if so, why he thought it necessary to seek a reference on this point to this court when the matter is clearly governed by the circular of the Central Board of Direct Taxes. We do not wish to say anything more.” (p. 307)

relied on in - The Circular of 1965 was relied on in CIT v. Kothari & Co. [1987] 165 ITR 594 (Kar.), with the following observations :

“. . . From the Circular Instruction No. 33-D(XXV-29) of 1965, dated November 8, 1965, it is seen that the view taken by the Allahabad High Court in the said decisions has been accepted. Further, this court also in Income-tax Reference Cases Nos. 15 and 16 of 1982 (CIT v. Balaji Commercial Syndicate [1987] 165 ITR 596) disposed of on November 15, 1983, has observed that the payment of interest referred to in section 40(b) of the Income-tax Act refers to the actual net amount of interest paid to each partner and the interpretation of section 40(b) could not depend upon a particular way in which interest is accounted for in the books of the firm.” (p. 596)

380. Whether for assessment years subsequent to assessment year 1996-97, no deduction under section 40(b)(v) will be admissible unless partnership deed either specifies amount of remuneration payable to each individual working partner or lays down manner of quantifying such remuneration

1. The Board have received representations seeking clarification regarding disallowance of remuneration paid to the working partners as provided under section 40(b)(v) of the Income-tax Act. In particular, the representations have referred to two types of clauses which are generally incorporated in the partnership deeds. These are :

  (i)  The partners have agreed that the remuneration to a working partner will be the amount of remuneration allowable under the provisions of section 40(b)(v) of the Income-tax Act; and

(ii)  The amount of remuneration to working partner will be as may be mutually agreed upon between partners at the end of the year.

It has been represented that the Assessing Officers are not allowing deduction on the basis of these and similar clauses in the course of scrutiny assessments for the reason that they neither specify the amount of remuneration to each individual nor lay down the manner of quantifying such remuneration.

2. The Board have considered the representations. Since the amended provisions of section 40(b) have been introduced only with effect from the assessment year 1993-94 and these may not have been understood correctly the Board are of the view that liberal approach may be taken for the initial years. It has been decided that for the assessment years 1993-94 to 1996-97 deduction for remuneration to a working partner may be allowed on the basis of the clauses of the type mentioned at 1(i) above.

3. In cases where neither the amount has been quantified nor even the limit of total remuneration has been specified but the same has been left to be determined by the partners at the end of the accounting period, in such cases payment of remuneration to partners cannot be allowed as deduction in the computation of the firm’s income.

4. It is clarified that for the assessment years subsequent to the assessment year 1996-97, no deduction under section 40(b)(v) 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.

Circular : No. 739, dated 25-3-1996.

judicial analysis

Explained in - ITO v. Sri Sai Lakshmi : Financiaries [2002] 83 ITD 333 (Hyd.) with the following observations :

“It is evident from the above Circular that it comes into operation only when there are certain clauses stipulating payment of remuneration to the working partner, in the Partnership Deed. The said Circular has no application, when the Partnership Deed is totally silent on the aspect of payment of remuneration.” (page 339)

381. Limit on allowance in respect of benefit, amenity or perquisite under clause (c)1(iii)/clause (a)(v)2 - Reimbursement of certain expenses/pay-ments whether form part of perquisite to be restricted to one-fifth of salary

1. Under section 40(c)(iii), any expenditure incurred by a company after February 29, 1964, which results directly in the provision of any benefit or amenity or perquisite, whether convertible into money or not, to an employee (including any sum paid by the company in respect of any obligation which but for such payment would have been payable by such employee) would be admissible as a deduction in computing the company’s income, only to the extent of one-fifth of the amount of salary payable to the employee. Section 40(c)(iii) was replaced by section 40(a)(v)2 with effect from assessment year 1969-70 and was applicable to all assessee-employers, not restricted to companies only.

2. The question for consideration is whether the benefits given to the employees in the form of provision of medical facilities or reimbursement of medical expenses, electricity, gas, gardener, rent-free accommodation, motorcar and bonus or commission should form part of the “salary” or whether they fall in the category of “perquisite, amenity or benefit”. For the purpose of section 40(c)(iii)/40(a)(v), the term “salary” has to be taken as per the definition given in rule 2(h) of Part A of the Fourth Schedule. According to the definition, the term “salary” includes dearness allowance if the terms of employment so provide but excludes all other allowances and perquisites.

3. All payments in the form of benefits or amenities such as reimbursement of medical expenses, provision of electricity, water, gas at the residence of employees, payment of club bills of employees, provision of domestic servants, gardeners, etc., would be part of “perquisite” which would be restricted to one-fifth in the assessment of the employer. The list of perquisites given above is only illustrative and by no means exhaustive.

4. As regards the payment of bonus, the Board are advised that the payment of bonus will be treated as salary in the following types of cases :

   a.  payment of bonus made under a service agreement between the employer and the employee ;

   b.  bonus paid pursuant to requirement of the Payment of Bonus Act, 1965; in such a case the service agreement may be treated to have been modified to that extent;

   c.  where the bonus is paid in accordance with the decision of a trade association which is binding on its members; and

   d.  bonus paid under an award by a Labour Tribunal where the award is binding on the employer and the employees.

If the bonus is paid gratuitously without there being any legal or contractual obligation, the payment is in the nature of a perquisite and has, among other perquisites, to be linked to one-fifth of the salary for allowance under section 40(c)(iii)/40(a)(v).

As regards payment of commission to the employees the question whether it form part of “salary” or “perquisite” has to be decided on the facts of each case. If the terms and conditions of service are such that commission is paid not as a bounty or benefit but is paid as part and parcel of the remuneration for services rendered by the employee, such payment may partake of the nature of salary rather than as a benefit or perquisite. If, however, on the terms and conditions of service either there is no obligation for the employer to pay the commission or it is a matter purely in the discretion of the employer, such payment should be treated as a benefit by way of addition to salary rather than in lieu of salary.

1[These instructions are issued in supersession of the Board’s Circular No. 62 [F. No. 13A/ 103/69-IT (A-II)], dated 29-6-1971 [Annex I] and in modification of the Board’s Circular No. 32 [F. No. 10/93/68-IT (A-II)], dated 29-10-1969 [Annex II] and may please be brought to the notice of all the Income-tax Officers working in your charge.]

Circular : No. 80 [F. No. 13A/103/69-IT(A-II)], dated 4-3-1972.2

Judicial analysis

See CIT v. Indian Engg. and Commercial Corporation (P.) Ltd. [1993] 201 ITR 723 (SC).

ANNEX I - CIRCULAR NO. 62, DATED 29-6-1971

Reference is invited to Circular No. 32 issued by the Board on 29-10-1969 [printed here as Annex II] and Departmental Circular No. 30-D(LVIII-34), dated 7-11-1966. [printed here as Annex III]

The Board are advised that the instructions contained therein are not in conformity with the provisions of law.

Accordingly, Circular No. 32, dated 29-10-19691 and Departmental Circular No. 30-D of 1966, dated 7-11-1966 are hereby withdrawn with immediate effect.

The above instructions may please be brought to the notice of the assessing officers without delay.

ANNEX II - CIRCULAR NO. 32, DATED 29-10-19692

1. Reference is invited to Departmental Circular No. 30-D of 1966 [printed here as Annex III] issued by the Board on November 7, 1966.

2. Under section 40(c)(iii), now section 40(a)(v), any expenditure which results, directly or indirectly, in the provision of any benefit or amenity or perquisite, whether convertible into money or not, to an employee (including any sum paid by the assessee in respect of any obligation which but for such payment would have been payable by such employee) shall be admissible as a deduction in the computation of the assessee-company’s total income only to the extent of one-fifth of the amount of the salary payable to the employee.

3. A question has been raised whether bonus or commission paid to the employee should also be included in the value of “any benefit or amenity or perquisite” for the purpose of limiting the deduction to one-fifth of the salary as explained above.

4. The matter has been examined and it has been decided that salary, dearness allowance, bonus, commission or any other cash allowance payable to the employee in terms of his contract of service, would be regarded as salary under section 17(3) (ii) and not as “benefit or amenity” for the purposes of section 40(c)(iii)/40(a)(v). Further, only those cash payments would be covered by the expression “perquisites, amenities and benefits” which are paid to the employee voluntarily and gratuitously and not in terms of the specific provisions of his contract of employment. In other words, the employee concerned should not have been in a position to enforce the payment of these amounts in a court of law.

Judicial analysis

Relied on in - The above circular was relied on in CIT v. Vickers Sperry of India Ltd. [1993] 201 ITR 637 (Bom.), with the following observations :

“. . . We find that the Tribunal gave its finding on the basis of the circular of the Central Board of Direct Taxes bearing No. F. No. 10/93/68-IT(A-II) dated October 29, 1969. The Tribunal, following the decision of the Supreme Court in the case of Navnit Lal C. Javeri v. K.K. Sen, AAC of I.T. [1965] 56 ITR 198, held that the circular of the Board was binding on the departmental authorities under the Act and, following the same, allowed relief to the assessee.

There is no dispute before us that the circular of the Board covers the controversy. According to that, the amount in question cannot be disallowed. That being so, in our opinion, the Tribunal was right in holding that the departmental authorities were bound by the circular of the Board and to act accordingly. We do not see any error in the decision of the Tribunal in that regard.” (p. 639)

ANNEX III - CIRCULAR NO. 30-D (LVIII-34), DATED 7-11-1966

1. Under section 40(c)(iii), any expenditure incurred by a company after February 29, 1964, which results directly or indirectly in the provision of any benefit or amenity or perquisite, whether convertible into money or not, to an employee (including any sum paid by the company in respect of any obligation which but for such payment would have been payable by such employee) shall be admissible as a deduction in computing the company’s income only to the extent of one-fifth of the amount of salary payable to the employee for any period of his employment after the aforesaid date. A question has been raised whether monetary payments made by a company to its employees by way of reimbursement of medical expenses, commission and bonus should be included in the value of “any benefit or amenity or perquisite” for the purpose of limiting the deduction thereof to one-fifth of the salary as per the above section.

2. So far as the reimbursement of medical expenses is concerned, it will clearly be a benefit or amenity or perquisite to be included in the value of perquisites for the purpose of limiting the permissible deduction to one-fifth of the salary. As regards payment by way of commission and bonus, however, the question of including these payments as “benefit, amenity or perquisite” will depend upon the facts of each case. Where bonus and commission are paid as a part of the employee’s regular salary as agreed to between the company and the employee in terms of his contract of service, they should be treated as part of the employee’s remuneration and not as perquisites. For example, if an employee is appointed on a fixed monthly remuneration of Rs. 1,000 plus a commission of 1 per cent on sales, the commission being part of his remuneration, will not be a benefit, amenity or perquisite but will be regarded as remuneration. In such cases, the bonus or commission paid will not be included in the quantum of perquisites for the purpose of limiting the amount to one-fifth of the salary under section 40(c)(iii), but, on the other hand, where commission or bonus is paid, not as a part of the regular remuneration agreed to beforehand, but voluntarily and gratuitously and the payment is of casual nature, then it will have to be regarded as a perquisite for the purposes of section 40(c)(iii).

3. It may be noted, however, that the term “salary” for the purposes of section 40(c)(iii) has been defined by Explanation 2 thereof and means salary as defined in rule 2(h) in Part A of the Fourth Schedule. Under this definition, “salary” includes dearness allowance if the terms of the employment so provide, but excludes all other allowances and perquisites.

The definition of “salary” in section 17(1) is not, therefore, applicable for the purposes of section 40(c)(iii).