SCHOOL OF LAW, MUMBAI

A Research paper submitted on

TAXATION OF PARTNERSHIP FIRMS

FOR SEMESTER VII OF 2020-21, IN THE SUBJECT PRINCIPLES OF TAXATION I

SUBMITTED TO:

Professor Sohini Shrivastav

SUBMITTED BY:

Gopika Mundra A034

Mayank Srivastav A058

BBA LLB (Hons.)

Fourth Year

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INTRODUCTION

Government levies a tax on income generated by individuals and entities which is known as
Income Tax. It is a legal duty of taxpayers to submit ITR i.e. Income Tax Return annually on
time. Amount collected through income tax are a source of revenue for government which is
further used for development of public infrastructures, roads, schools, defence etc.

Section 4 of the Indian Partnership Act,1932 defines the word ‘Partnership’ as the relation
between persons who have agreed to share the profits of a business carried on by all or any of
them acting for all. Persons who have entered into partnership with one another are called
individually “partners” and collectively “a firm”, and the name under which their business is
carried on is called the “firm name”. The partnership firm is taxed as a separate entity, with no
distinction as registered and unregistered firms. A partnership firm needs to submit its
partnership deed in the first year of its assessment and later on only when there is any change
in the term and constitution of partnership. The terms ‘Partnership’, ‘Partner’ and ‘Firm’ as
defined under Section 2(23) of Income Tax Act have the same meaning as assigned to them in
the Indian Partnership Act,1932.

A Limited liability partnership (LLP) is a body corporate formed and incorporated under the
Limited Liability Partnership Act, 2008. It is a legally separated entity from that of its partner.
An LLP is liable to the full extent of its assets but liability of the partners is limited to their
agreed contribution in the LLP. “Since the liability of the partners is limited to their agreed
contribution in the LLP, it contains elements of both a corporate structure as well as a
partnership firm structure” The firm shall include a limited liability partnership as defined
under Limited Liability Act 2008. Section 2(1)(n) of the Limited Liability Act 2008 defines
“limited liability partnership” as a partnership formed and registered under this act.

Under the income tax law, the total income of the firm will be determined as a separate entity
and it will be computed under various heads of income. However, while computing taxable
profits under head “profits and gains of business or profession” a deduction is allowable to the
firm on account of interest and remuneration payable to the partners.

A partnership firm and a limited liability partnership are taxed at a flat rate of 30 per cent
(excluding applicable surcharge and cess) on their income. Thereafter, the share of profit that
a partner takes out from the partnership firm or an LLP is exempt in the hands of the partner
(including the partners based overseas, subject to the double taxation avoidance

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agreement). The income earned by partners is then assessed and taxed as if a partner were self-
employed and not as an employee of an organisation.

Also, in computing the total income of the firm, any salary, bonus, commission, interest or
remuneration to a partner shall be deductible subject to certain restrictions which will be
discussed in this paper.

INCOME TAX SLAB

Income Tax payment for individuals, firm and corporate entities is a mandatory requirement as
per Income Tax Act, 1961 if their annual income is above the minimum exemption limit.
However, tax payers can also avail tax benefits under various sections of the act. In country
like India, the range of income among its citizens is diverse. So, government has categorized
the taxpayers into different group based on their income. These groups are referred as Tax
Slabs. Each year Income Tax are revised during the budget session and the budget proposals
are required to be approved by the Parliament and President’s assent before becoming law.

Partnership Firms and LLPs are to be taxed at the rate of 30% plus Surcharge1 of 12 % on tax
payable where total income exceeds Rs. 1 crore and Health and Education Cess of 4% on
Income Tax. Also, Long-term capital gain at 20% and Short-term capital gain under section
111A is at 15%.

INTEREST AND REMUNERATION TO PARTNERS

According to Section 40(b) of the Income Tax Act 1961, Interest & Salary paid to the Partners
by the Partnership Firm are allowed to be deducted as an expense only in case all the specified
conditions are being adhered to.

INTEREST TO THE PARTNERS

Partners are paid interest on their capital contribution to the firm. So, allowability of interest
paid by a firm to its partners under section 40(b) is concerned, the following conditions have
been prescribed by section 40(b):

(1) The interest payable by a firm to its partners should be authorised by and in accordance
with the partnership deed.

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Surcharge is a tax on tax. It is levied on the tax payable, and not on the income generated.

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(2) The interest payable by a firm to its partners should not be for a period falling prior to the
date of such partnership deed authorizing the payment of such interest.
(3) The rate of interest payable to the partners shall not exceed 12% simple interest per annum.

REMUNERATION TO PARTNERS

1. Payment to a non-working partner will not be allowed as a deduction.

Explanation 4 to section 40(b) provides meaning of working partner as an individual
who is actively engaged in conducting the affairs of the business or profession of the
firm of which he is a partner. If a partner is not a working partner then remuneration to
such partner will not be eligible for deduction as per section 40(b) of Income Tax Act
1961.

Another significant point to be noted here is that the definition of “working partner” in
Explanation 4 contemplates an individual. Therefore, a partner other than an individual
(example a company) cannot be a working partner.

When a company is a partner in a firm, a director or shareholder of the company can

very well be an employee of the firm in which the company is a partner. Any
salary/remuneration paid by the firm to such an employee would be totally outside the
ambit of disallowance under section 40(b). This would be so because the individual
who is an employee of the firm is not a partner in the firm. Section 40(b) contemplates
allowance of remuneration paid by a firm to its partners and not to other employees.

2. It should be authorized by the Partnership Deed.

As per section 40(b) only that salary, remuneration, bonus, commission etc payable to
working partners or any payment of interest payable to any partner will be allowed as
deduction only if it is authorized by the partnership deed. If the partnership deed
does not contain such provisions then the deductions may be disallowed if the same is
claimed by the partnership firm.
3. Quantification of remuneration to Partners in Partnership deed is must.
CBDT in its circular no. 739 dt 25/03/1996 have clarified that 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.

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 In Commissioner of Income Tax Versus M/s. Anil Hardware Store2 where
remuneration clause in partnership deed was in line with section 40(b) as in respect of
book profits upto Rs.75,000, remuneration will be entitled upto Rs. 50,000 or 90% of
the book profit whichever is more. It was contended on behalf of the revenue that in
respect of the book profits upto Rs.75,000/, even in the partnership deed, the word “upto
Rs.50,000/- or 90% of the book profits” have been used which shows that the
partnership deed does not exactly determine the remuneration of the partners. But it
was held that “The CBDT circular referred a condition. Either the amount of
remuneration payable should be specified or the manner of quantifying the
remuneration should be specified. In the present case, the manner of fixing the
remuneration of the partners has been specified.” Hence deduction was allowed.
In the case of Durga Dass Devki Nandan v.ITO3, it was held that when the partnership
deed provided that remuneration will be as per the provisions of IT Act, it is allowable
even if it was not fixed in the deed.

4. It should not pertain to a period prior to Partnership Deed.

The remuneration paid to the working partners will be allowed as deduction to the firm
from the date of such partnership deed and not from any period prior thereto.

5. It should not exceed the permissible limit.

The maximum amount of salary, bonus, commission or other remuneration to all the
partners during the previous year should not exceed the limits given below:

Book Profit/Loss % of amount of deduction

(i) if book profit is positive or

negative-
• upto first 3 lakh of book Rs. 1,50,000/- or 90% of Book Profit
profit whichever is more.
• on the balance of book profit 60% of book profit

Or as per deed whichever is low.

2
Commissioner of Income Tax Versus M/s. Anil Hardware Store, [2010] 323 ITR 368 (HP).
3
Durga Dass Devki Nandan v.ITO, (342 ITR 17)(HP).

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For computation of Book Profit, first the net profit of the firm as per Profit & Loss A/c need to
find, then adjustments need to make as per sec. 28 to 44 DB. If remuneration of partner is
debited to the P&L A/c then it needs to be added.

Aggregate all the income and need to deduct the allowable deductions under Section 80G,
80GGA, 80IA, 80IC, 80ID, 80IE, 80JJA & brought forward losses or unabsorbed depreciation
as case may be, if any from the Income. Finally, we will get Net Taxable Income & hence tax
is to be computed on this income.

CONDITIONS FOR ASSESSMENT AS A FIRM

1. The partnership should be evidenced by an instrument in writing specifying individual

share of the partners.

2. A certified copy of the instrument signed by all the partners (not being minors) shall
accompany the return of the firm for the first assessment as a ‘firm’.

3. In case of any change in the constitution of the firm or shares of the partners in any
previous year, the firm shall furnish a certified copy of the revised instrument of
partnership signed by all the partners (not minors) along with the return of income for
that A.Y.

4. If any default is made in compliance with the above provisions, the firm will be assessed
as a firm without deducting interest and salary to partners.

5. Unabsorbed loss including depreciation in respect of the firm will not be distributed
amongst the partners and will be carried forward by the firm only.

According to section 187 of IT Act, 1961, if there is change in constitution of firm, meaning if
one or more partners are admitted or cease to be partners but at least one person who was
partner of the firm before the change, continue as partner after the change or where all the
partners continue with a change in the respective Profit Sharing Ratio (PSR). In this case only
one return for Previous Year.

According to section 188 of the act, if there is succession of firm, meaning where a firm is
succeeded by another firm. In this case separate assessment will be done of the predecessor
and successor firm.

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In CIT v. K.H. Chambers4, the Supreme Court laid down the following requisites of
succession: (i) There is a change of ownership. (ii) The whole business is transferred. (iii)
Substantially the identity and the continuity of the business are preserved.

Partners’ Assessments

Once tax is paid by firm; no tax will be payable by the partners on share of income from the
firm. Amount of Interest and/or remuneration etc. received by a partner will be taxed in his
hands as ‘Business or Professional Income’, excluding the amount disallowed in the hands of
the firm being in excess of limits laid down in S. 40(b) and amount disallowed in the event of
any failure as mentioned in S. 144 or non-compliance of S. 184.

RETURN FILING PROVISIONS FOR PARTNERSHIP FIRMS

• It’s mandatory for every partnership firm to file the return of income irrespective of
amount of income or loss.
• A partnership firm may also file return of income under Electronic Verification Code.
• A firm liable to get its account audited under section 44AB shall furnish
return electronically under digital signature.
• Signing of IT Return – by Managing partner and ITR 4 Form need to be filed.

Dissolution of firm or Discontinuance of business : Where any business or profession carried

on by a firm has been discontinued or where a firm is dissolved, the assessing officer shall
make an assessment of the total income of the firm as if no such discontinuance or dissolution
had taken place, and all the provisions of this Act, including the provisions relating to the levy
of a penalty or any other sum chargeable under any provision of this Act, shall apply, so far as
may be, to such assessment. Every person who was at the time of such discontinuance or
dissolution a partner of the firm, and the legal representative of any such person who is
deceased, shall be jointly and severally liable for the amount of tax, penalty or other sum
payable, and all the provisions of this Act, so far as may be, shall apply to any such assessment
or imposition of penalty or other sum.

CONCLUSION
When considering the appropriate type of partnership, liability plays a major role. If partners
want unlimited liability then they can choose Partnership firm otherwise for limited liability

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CIT v. K.H. Chambers, (1965) 55 ITR 674.

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they can opt for LLPs. Prior to any formalized arrangement, each party should put forward
their expectations concerning profit sharing and liability in clear terms. Aligning on the risk
and return is the first step to moving forward in any professional business relationships at the
ownership level. Since the tax treatment accorded to a LLP and a general partnership is the
same, the conversion from a general partnership firm to an LLP will have no tax implications
if the rights and obligations of the partners remain the same after conversion and if there is no
transfer of any asset or liability after conversion. However, if there is a change in rights and
obligations of partners or there is a transfer of asset or liability after conversion, then the
provisions of section 45 (Capital Gains) would get attracted.