Knowing more about partnership firms – Part I

Some years ago, we had done a two part series on partnership firms. Over a period of time, we have received several emails inquiring about the formation, taxation and advantages/disadvantages of partnership firms. Hence we thought for this week, we shall reexamine the concept – what are the advantages behind having a partnership as against any other legal structure, taxation and carry forward and set off of losses in respect of the same as also the tax deductions available to partnerships.

First the basics
A partnership firm arises from a contract between two or more persons who contribute some tangible and intangible assets together with an objective of earning profits to be shared between them in a predefined proportion. Therefore: The firm should be evidenced by an instrument [Sec. 184(1i)].

The individual shares of the partners in the assets of the firm and the profits (or losses) should be specified in the instrument [Sec. 184(1ii)]. A certified copy of the instrument of partnership shall accompany the return of income of the previous year in respect of which assessment of the firm is first sought [Sec. 184(2)].

Whenever a change takes place in the constitution of the firm due to death or resignation of a partner or in the profit-sharing ratio of the existing partners, a certified copy of the revised instrument of partnership shall be submitted along with the return of income of the related year.

Where a minor is admitted to the benefit of the firm and the shares of partners are unequal, it is necessary to specify how the share of loss of the minor will be borne by the major partners.

Tangible advantages of partnership
A firm is a separate tax entity and its income chargeable to tax, after claiming all exemptions and deductions as per the provisions of the Act is charged in the hands of the firm only.

However, this is hardly any advantage. Its entire income suffers tax at the rate of 30 per cent plus surcharge at the rate of 15 per cent (if income is over Rs 1 crore) plus the cess at the rate of 3 per cent, and most importantly, without any threshold.

There is only one plus point. The joint synergy of the individual partners is much more powerful than the individual synergies working separately.  It is possible to reduce the extra tax liability of the firm by drafting the partnership instrument taking cognisance of the following:

Any salary, bonus, commission or remuneration by whatever name called, due to or received by a partner is not construed as salary and is allowed u/s 40(b) as a deduction provided —
a) It is paid only to a working partner who is an individual. The individual must be actively engaged in conducting the affairs of the business/profession of the firm.
b) The remuneration should be authorised by the partnership deed. The deduction cannot be allowed when it is not specified or even if specified, it has been left to be decided by a mutual agreement in future — [2011] 15taxmann.com76 (Del).
c) The maximum amount of such payment to all the partners during the previous year at — (i) on first Rs 3 lakh of book profit or loss: Rs 1,50,000 or 90 per cent of book profit whichever is more and (ii) on the balance: 60 per cent of book profit.
U/s 13(c) the firm can claim deduction of interest paid, if any, up to 12 per cent per annum, to any partner from its total income.

Where a firm pays as well as receives interest from the same partner, interest received by the firm will be chargeable to tax. Interest paid to the same partner will be allowed as deduction. However, no interest is payable by the firm to its partners when there are no profits — Minnow Trading Co Pvt Ltd v ITO (ITA 5261/M/06).

Where the partners themselves raise a loan on policies from any life insurer and put it in their capital account, interest paid by the firm, whether to partners or to the insurer, can be held as having been paid to the partners — CIT v Agra Tannery [1989] 179ITR44 (Punj & Har).

However, if the partners merely lend their signatures for raising the loan which is taken by the firm for business purposes, interest paid by the firm to the insurer cannot be held as payment of interest to partners — Damodar Dass Jai Chand Aggarwal v ITO (1982) 1ITD767 (Asr – Trib).

Interest, salary, bonus, commission or remuneration, by whatever name called, which is due to or received by a partner of a firm from the firm comes under the head ‘Profits and gains of business or profession’ and not ‘Salaries’.

Carry forward and setoff of loss
As per Sec. 78 if there is a change in the constitution of the firm on account of death or retirement, the firm shall not be entitled to carry forward so much of the loss as is attributable to such partner. Note that this provision does not cover the case of change in profit-sharing ratio or admission of a partner. However, as Sec. 78 is not applicable in the case of unabsorbed depreciation, it can be carried forward by the reconstituted firm.

Deductions under
Chapter VI-A
Deductions are allowed only under the following Sections —
80G: Donations to charitable institutions and funds.
80GGA: Donations for scientific research of rural development.
80GGC: Donations to political parties.
80HH: Profits from industries or hotels in backward areas.
80HHA: Profits from small scale industries and undertakings.
80-IA: Industrial undertakings in infrastructure development, etc.
80-IB: Other industrial undertakings.
80JJA: Collecting and processing of bio-degradable waste.
80TTA: Interest on savings account of a bank.

Double taxation
Sec. 10 (2A) inserted by FA92, declares that a partner is not liable to tax again on his share in the total income of the firm. Previously, even if the income chargeable to tax of a firm was nil due to certain deductions and exemptions, some ITOs levied tax on the profit credited to its partners. Now, in April 2014, CBDT has clarified that the income of a firm that has been exempted from tax cannot be taxed for its profit in the hands of its partners.

To sum
So far, we have examined the basics of the broad structure of partnership firms. Next week, we shall discuss some specific concepts like when is clubbing of income applicable between partners, capital gains and partnership firms, HUF as also some significant case laws decided by courts in respect of the concept of partnership.

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