Taxation of Partnership Firm: Retirement & Admission of a partner & Remuneration allowability u/s 40(b)

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Taxation of Partnership Firm: Retirement & Admission of a partner & Remuneration allow ability u/s 40(b)

Query]

A partnership firm has 2 partners A and B having a partnership in the ratio of 50 – 50%. If a partner B has retired after 6 months that is on 1-10-19 and on the same day a new partner C has entered the business in 50 – 50 ratio of the profit n losses then how the remuneration need to be calculated? Normally, u/s 40(b) remuneration payable is as under:

  1. a)In case of loss, or On first Rs. 3 lakh of book profit Rs. 1,50,000 or 90% of book profit, whichever is more
  2. b)On the balance of book profit 60% of book profit

How will the treatment of the year end profits be done? If the profit for full year was Rs. 10,00,000/- kindly tell what will be the salary of each partner.?

Opinion:

It’s an interesting question. How the partner’s remuneration needs to be worked out if any of the partners has retired in the middle of the year or some other partners have joined the firm in the middle of the year?

Let us first revisit section 40(b) of the Income Tax Act – 1961 which reads as under:

Amounts not deductible.

  1. Notwithstanding anything to the contrary in sections 30 to 38, the following amounts shall not be deducted in computing the income chargeable under the head “Profits and gains of business or profession”,—

(a)  in the case of any assessee….
………………….
…………………
…………………

  1. b)  in the case of any firm assessable as such,—

 (i)  any payment of salary, bonus, commission or remuneration, by whatever name called (hereinafter referred to as “remuneration”) to any partner who is not a working partner; or

(ii)  any payment of remuneration to any partner who is a working partner, or of interest to any partner, which, in either case, is not authorized by, or is not in accordance with, the terms of the partnership deed; or

(iii) any payment of remuneration to any partner who is a working partner, or of interest to any partner, which, in either case, is authorized by, and is in accordance with, the terms of the partnership deed, but which relates to any period (falling prior to the date of such partnership deed) for which such payment was not authorized by, or is not in accordance with, any earlier partnership deed, so, however, that the period of authorization for such payment by any earlier partnership deed does not cover any period prior to the date of such earlier partnership deed; or

(iv)  any payment of interest to any partner which is authorized by, and is in accordance with, the terms of the partnership deed and relates to any period falling after the date of such partnership deed in so far as such amount exceeds the amount calculated at the rate of twelve per cent simple interest per annul; or

(v)  any payment of remuneration to any partner who is a working partner, which is authorised by, and is in accordance with, the terms of the partnership deed and relates to any period falling after the date of such partnership deed in so far as the amount of such payment to all the partners during the previous year exceeds the aggregate amount computed as hereunder:—

(a) on the first Rs. 3,00,000 of the book-profit or in case of a loss: 

 Rs. 1,50,000 or at the rate of 90 per cent of the book-profit,

 whichever is more;

(b) on the balance of the book-profit: at the rate of 60 per cent :

Provided that in relation to any payment under this clause to the partner during the previous year relevant to the assessment year commencing on the 1st day of April, 1993, the terms of the partnership deed may, at any time during the said previous year, provide for such payment.

Explanation 1.—Where an individual is a partner in a firm on behalf, or for the benefit, of any other person (such partner and the other person being hereinafter referred to as “partner in a representative capacity” and “person so represented”, respectively),—

  (i)  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 this clause;

 (ii)  interest paid by the firm to such individual as partner in a representative capacity and interest paid by the firm to the person so represented shall be taken into account for the purposes of this clause.

Explanation 2.—Where an individual is a partner in a firm otherwise than as partner in a representative capacity, interest paid by the firm to such individual shall not be taken into account for the purposes of this clause, if such interest is received by him on behalf, or for the benefit, of any other person.

Explanation 3.—For the purposes of this clause, “book-profit” means the net profit, as shown in the profit and loss account for the relevant previous year, computed in the manner laid down in Chapter IV-D as increased by the aggregate amount of the remuneration paid or payable to all the partners of the firm if such amount has been deducted while computing the net profit.

Explanation 4.—For the purposes of this clause, “working partner” means an individual who is actively engaged in conducting the affairs of the business or profession of the firm of which he is a partner;

Going through above provisions from the Act, one can draw the following conclusions for allow ability of deduction u/s 40(b):
1. It can be paid only to a working partner;

  1. It has to be authorized by or has to be in accordance with, the terms of the partnership deed.
  2. Payment of remuneration to any partner should not pertain to any period falling prior to the date of such partnership deed.
  3. Interest rate cannot exceed 12% p.a.
  4. The remuneration amount cannot exceed Rs. 1,50,000 or at the rate of 90 per cent of the book-profit, whichever is more for first Rs. 3 Lakh of book profit and it can be up to 60% on the balance amount.

Coming to deduction toward remuneration to the partner in case of retirement from the firm, it may be noted that section 40(b) of the Income Tax Act – 1961 don’t place any restrictions on giving a share in the remuneration to the partner. Section 40(b) doesn’t govern the provision regarding the distribution of the remuneration amongst the partners.

Income Tax Act – 1961 simply puts a bar on the total amount which could be eligible for deduction u/s 40(b). Subject to the overall cap prescribed u/s 40(b), the partners are eligible to divide the remuneration as per the terms and conditions contained in the partnership deed.

Usually, partnership firms don’t have any specific clause as to the distribution of the remuneration among st the partners in the middle of the year. The remuneration & book profit is normally worked out at the end of the year only as technically working of “book profit” is possible at the end of the year only. Now, there could be following option in such scenario

First option:

Work out the book profit of the firm tentatively up to the date of retirement of the partner and credit the amount of interest, remuneration, profit/loss to the retiring partners in the ratio as mentioned in the partnership deed.
After the closure of the financial year, the balance amount of interest, remuneration and profit can be divided among st the remaining partners, of-course, subject to the overall cap of amount permissible u/s 40(b).
This will be the most appropriate form and may not be questioned by the department.

Second option:

Firms may refuse to give the interest/remuneration / profit to the partner who is retiring from the firm. So, the amount may be computed as per the regular provision and the amount may be divided among st the continuing partners (if there is no incoming partner as such).

If there is any incoming partner, then the incoming partner may also be given a share in the remuneration.

However, such remuneration can only be of the period falling after joining the firm. Any remuneration paid to an incoming partner pertaining to a period falling prior to joining may not be admissible for deduction in view of clause (iii) to section 40(b). This fact can be incorporated in the reconstituted partnership deed.

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