Section 40b of Income Tax Act

Section 40b of Income Tax Act:-Partner’s Remuneration, salary & Interest on capital

Overview

In the case of any firm assessable as such or a limited liability partnership (LLP), the following amounts shall not be deducted in computing the business income:

Remuneration to non-working partner –

Any salary, bonus, commission, remuneration by whatever name called, to any partner who is not a working partner. (In the following discussion, the term ‘remuneration’ is applied to denote payments in the nature of salary, bonus, commission).

Remuneration to a working partner not authorized by deed –

Any remuneration paid to the working partner or interest to any partner which is not authorised by or which is inconsistent with the terms of the partnership deed.

Also Read: Section 269ST of Income Tax Act

Remuneration or interest to a partner authorized by deed but relates to an earlier period –

It is possible that the current partnership deed may authorise payments of remuneration to any working partner or interest to any partner for a period which is prior to the date of the current partnership deed. The approval by the current partnership deed might have been necessitated due to the fact that such payment was not authorised by or was inconsistent with the earlier partnership deed. Such payments of remuneration or interest will also be disallowed.

However, it should be noted that the current partnership deed cannot authorise any payment which relates to a period prior to the date of earlier partnership deed.

Next, by virtue of a further restriction contained in section 40(b)(iii), such remuneration paid to the working partners will be allowed as deduction to the firm from the date of such partnership deed and not for any period prior thereto.

Consequently, if, for instance, a firm incorporates the clause relating to payment of remuneration to the working partners, by executing an appropriate deed, say, on July 1, 2019 but effective from April 1, 2019 the firm would get deduction for the remuneration paid to its working partners from July 1, 2019 onwards, but not for the period from April 1 to June 30.

In other words, it will not be possible to give retrospective effect to oral agreements entered into vis a vis such remuneration prior to putting the same in a written partnership deed.

Also Read: Section 286 of Income Tax Act-Country by Country Reporting

Interest to any partner in excess of 12% p.a.-

Any interest payment authorised by the partnership deed falling after the date of such deed to the extent such interest exceeds 12% simple interest p.a.

Remuneration to a working partner in excess of prescribed limits –

Any remuneration paid to a working partner, authorised by a partnership deed and falling after the date of the deed in excess of the following limits:

Book ProfitsQuantum of deduction
On the first Rs. 3 lakh of book profit or in case of lossRs. 1,50,000 or 90% of book profit, whichever is higher
on the balance of book profit60% of book profit

Explanations to section 40(b)

(i) Where an individual is a partner in a firm in a representative capacity:

  • (a) 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.
  • (b) 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 1 to section 40(b)].
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(ii) Where an individual is a partner in a firm otherwise than in a representative capacity, interest paid to him by the firm shall not be taken into account if he receives the same on behalf of or for the benefit of any other person [Explanation 2 to section 40(b)].

Meaning Of Book Profit [Explanation 3 To Section 40b of Income Tax Act]

Book profit means the net profit, as shown in the profit and loss account and after making the additions and deductions as per section 28 to 44D of the Act and increased by the total remuneration paid or payable to all the partners of the firm if such amount has been deducted while computing the net profit. Interest paid/payable to partners in excess of 12% shall also be disallowed as per section 40(b).

How to Calculate Book Profit

ParticularsAmt.
Net Profit under PGBPxx
(-)Current Year (+) B/F Depreciation(xx)
xx
(+)Remuneration (if it is debited to P&L A/c)xx
Book Profitxx

In simple terms, Book profit means PGBP before Remuneration.

Examples

1. A firm assessed as such has paid Rs. 7,50,000 as remuneration to its partners for the P.Y.2019-20, in accordance with its partnership deed, and it has a book profit of Rs. 10 lakh. What is the remuneration allowable as deduction?

Ans. The allowable remuneration calculated as per the limits specified in section 40(b)(v) would be –

ParticularsAmt.
On first Rs. 3 lakh of book profit [Rs. 3,00,000 × 90%]2,70,000
On balance Rs. 7 lakh of book profit [Rs. 7,00,000 × 60%]4,20,000
Total6,90,000

2. The partners entered into a partnership agreement on 1.4.2019 and no salary was provided in the deed. On 31.1.2020, the partners entered into an agreement to amend the above deed with retrospective effect from 1.4.2019 to provide a salary of Rs. 3,000 each per month to each partner.

Ans. Salary paid to partners for the period 01.04.2019 to 31.01.2020 shall not be allowed as a deduction to the firm. Salary paid to partners for the period 01.02.2020 to 31.03.2020 shall be allowed as a deduction to the firm, subject to the limit specified under section 40(b).

3. Mr. X is a partner in a firm in his individual capacity. He is also the karta of a HUF. The firm pays interest of Rs. 10,000 to Mr. X on the loan given by HUF to the firm. The firm also pays Rs. 15,000 to Mr. X on his capital in the firm. [Hint: Explanation 2 to section 40(b)]

Ans. In this case, section 40(b) will not be applicable to the interest of Rs. 10,000. The said interest is deductible under section 36(l)(iii) subject to the provisions of section 40A(2). The interest payment of Rs. 15,000 will however be subjected to the provisions of section 40(b).

4. Mr. X is a partner in a firm on behalf of his HUF i.e. partner in a representative capacity. Mr. X has given a loan to the firm out of his self-acquired funds and the firm pays interest of Rs. 10,000 to Mr. X. The firm also pays interest of Rs. 15,000 to Mr. X on the capital of HUF. [Hint: Explanation 1 to section 40(b)]

Ans. In this case section 40(b) will not be applicable to the interest payment of Rs. 10,000. Rs. 10,000 interest is allowable under section 36(l)(iii) subject to section 40A(2). The interest payment of Rs. 15,000 is however subjected to the provisions of section 40(b).

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