Salary paid to a partner by the firm is taxed in her/his hands under the head Profits & gains of Business or Profession. Such salary has the same character as the profits earned by a firm as held by the Apex Court in a number of rulings. Given the same, if other conditions are satisfied, such salary earned should be eligible for the presumptive rate of taxation under the Section 44AD. Under the current law, the partner’s salary is allowed as a deduction (subject to specified limits) in computing the total income of the firm. Such salary can be offered to tax at presumptive rates to lessen the tax outgo in the hands of partners. Given that the scheme of taxation for an LLP is the same as that of a partnership firm, if other conditions are satisfied, the partner of an LLP should also be eligible for the presumptive rate of taxation.
The author in this article explores if salary, commission, etc., paid to partners is eligible for the Section 44AD. Read on...
In the recent case of Usha Narayanan vs. DCIT (ITA 703/ Kol/2012), the AO held that the salary of a partner of a partnership firm is liable to tax as Profits & gains of Business or Profession under the Section 28(v) of the Act and accordingly levied penalty for failure to get books of accounts audited under Section 271B of the Act. This action was upheld by the Kolkata ITAT.
An interesting outcome is the emphasis on salaries paid to partners by a partnership firm being treated as Profits & gains of Business or Profession under Section 28(v) of the Act. Section 44AD of the Act provides for small business entities the option to offer 8 per cent of their total turnover or gross receipts in the relevant financial year as income chargeable under the head Profits & gains of Business or Profession. Here, we will explore whether salary, commission, etc., paid to partners is eligible for the Section 44AD.
CA. Aditya Nagaraj Bellur
(The author may be contacted at firstname.lastname@example.org.)
Provisions of Section 44AD
1.1. Eligible assessee: Eligible assessee means:
- An individual
- A Hindu undivided family
- A partnership firm
- Being a resident.
- Eligible assessee does not include a limited liability partnership or a company.
- Such eligible assessee should not have claimed deduction under the Sections 10A, 10B, 10BA, 10AA or profit-linked deductions under the Chapter VI-A –Part C thereof (Sections 80H to 80RRB).
- Such eligible assessee should be carrying on an eligible business.
1.2. Eligible business
Eligible business means:
- Any business except business of plying hiring or leasing goods carriages
- Whose total turnover or gross receipts does not exceed Rs. 1 crore during relevant financial year
Section 44AD is not applicable in case of
- A person carrying on a profession
- A person earning income in the nature of commission or brokerage
- A person carrying on any agency business
1.4. Other points
- Section 44AD overrides normal computation provisions as it begins with Notwithstanding anything to the contrary contained in the Sections 28 to 43C…
- Advance tax is not payable when the Section 44AD applies
- Depreciation on assets shall be deemed to have been claimed and allowed
- Partners’ salary, bonus, remuneration, interest would be allowed as a deduction in computing income of firm based on limits prescribed.
Why Salary? When Share Income is Anyway Exempt?
Share of profits is not deductible in the hands of a firm and such share of profits is exempt in the hands of partners as per the Section 10(2A). However, the salaries paid to partners are deductible in the hands of a firm subject to limits laid down in the Section 40(b) and such salaries are also taxable in the hands of partners under the head Profits & Gains of Business or Profession. The benefit is to the firm which avails deduction under the Section 40(b) and to the partners who may be able to avail the flat rate of 8 per cent provided under the Section 44AD.
Legislative History of Tax on Partners’ Salaries
Prior to Finance Act 1992, the system of levy of tax on firms involved double taxation. Tax was payable by the firm on its income and balance was again taxed in hands of partners at applicable rates. Salaries, interest, etc., paid to partners were not allowed as a deduction in the hands of a firm and the same was not taxed in the hands of partners.
Finance Act, 1992 brought in a new scheme of taxation of firms and partners whereby share income was exempt in hands of partners but salaries from firms were taxed in their hands and allowed as a deduction in hands of firms.
2.1. Whether salary received by partner can be offered under the Section 44AD?
The issue would be whether the salary earned by partner from a firm carrying on eligible business can be said to be from carrying on eligible business. In CIT vs. Chidambaram Pillai, etc (106 ITR 292), a tea estate was owned by a partnership firm. The tea sold yielded income which was composite in character,being largely agricultural and partly non-agricultural.
The partners were, in addition to their share in profits, entitled to salaries for services under the firms. The question was whether the salaries paid to partners were wholly liable to tax in their hands or only part thereof
(representing the business component) was so liable.
The Apex Court referred to the Chidambaram Pillai vs. CIT (77 ITR 494) (Mad-HC, FB), wherein it was held that the true character of the salary of a partner is the same as that of the profits of the firm. The Apex Court also made the following observations:
- a. A partner cannot be employed by her/his firm as a man cannot be her/his own employer.
- b. In CIT vs. Ramniklal Kothari 74 ITR 57 (SC), it was held that the expenses incurred by partner for earning salary, interest, etc., would be allowed as a deduction in calculating his income chargeable to tax under Profits & Gains of Business or Profession.
- c. Business of the firm was business of the partners, the profits of the firm were profits of the partners and expenditure incurred by partners in earning such share was admissible for deduction in arriving at the total income (emphasis supplied).
The above ruling was rendered for the assessment years 1959-60 and 1960-61. However, the principles
enunciated in the above ruling are still valid.
2.2. Whether a partner of an LLP can avail the benefit of the Section 44AD?
Under the LLP Act, an LLP is a separate legal entity from its partners. However, given that an LLP is also included in the definition of firm under the Section 2(23) of Income-tax Act, the scheme of taxation as applies to a partnership firm should apply to an LLP as well. Consequently, other conditions being satisfied, the partner of an LLP should also be eligible for the benefit of the Section 44AD, though the LLP itself is
not eligible, being specifically excluded.
2.3. Section 28(v) versus Section 44AD
Section 28(v) provides that extent of partner’s salary not allowed as a deduction under the Section 40(b) in the hands of the firm would not be chargeable to tax in the hands of the partner. However, the Section 44AD
begins with a non-obstante clause which overrides anything to the contrary contained in the Sections 28 to 43C. From a reading of both provisions, it appears that the gross amount paid to partners (irrespective of availability of deduction under the Section 40(b) for firm) as salary will be chargeable under the Section 44AD.
2.4. Section 40/ 40A versus Section 44AD
Sections 40, 40A, 43B lay down additional conditions to claim certain deductions. Section 40 begins with a non-obstante clause regarding operations of the Sections 30 to 38. Sections 40A and 43B begin with a non-obstante clause with respect to any other provision of the Act in computation of income under the head Profits & Gains of Business or Profession.
As seen above, Section 44AD begins with a non-obstante clause which overrides anything to the contrary contained in the Sections 28 to 43C. In Surendra Pal vs. CIT (242 CTR 61), the P&H High Court held that once under the special provision of Section 44AD of the Income-tax Act apply, exemption from maintenance of books of accounts have been provided and the presumptive tax at 8 % of the gross receipts itself is the basis for determining the taxable income. The assessee was not under obligation to explain individual entry of cash deposits in the bank unless such entries had no nexus with the gross receipts. It observed:
“Though from the details filed by assessee the ld. AO observed that no TDS has been recovered, in our opinion, since assessee has disclosed the profits more than 8% of the gross receipts and there is no dispute in receipt of the gross receipts the addition made by ld. CIT(A) u/s 40(a)(ia) of the IT Act is not sustainable.”
2.5. Commission paid to a partner as per partnership deed - whether eligible under the Section 44AD?
Two main issues would need to be addressed:
- a. Whether commission paid to partners as per partnership deed is in the nature of salary paid to partners?
Section 44AD was made inapplicable (with retrospective effect from April 1, 2011) to commission, brokerage and agency business by the Finance Act, 2012. However, one may argue that commission paid to a partner as provided in partnership deed is in the nature of a share of profit and would not fall within the ambit of commission. The reason is that the source for both commission and salary paid to a partner is the partnership deed. It is merely the method of computation and timing of payment that would vary.
A contrary argument may exist that the essence of a partnership is mutual agency. Each partner has the right to enter into agreements with third parties on behalf of other partners and the firm. A question may then arise whether salary, etc paid to partner is income from agency business. It may be noted that unlike the Section 194A which exempts interest paid to a partner by a firm, no such explicit exemption exists for the Section 194H. Further, in Assam Tea House (344 ITR 507), the P&H High Court held that on payment of commission to a partner, the relationship of principal and agent comes into place and withholding is required on such payment.
- b. Whether such commission is eligible under the Section 44AD?
The extent of separation of firm and its partners are relevant. In Chidambaram Pillai (supra), the Apex Court observed that a firm is not a legal person even though it has some attributes of personality. In income tax law, a firm is a unit of assessment not a full person. Consequently, there cannot be a contract of employment, in strict law, between a firm and its partner. Any agreement for remuneration must be regarded as portion of the profits made over as a reward for human capital brought in.
Section 28(v) also provides: ...any interest, salary, bonus, commission or remuneration, by whatever name called, due to, or received by, a partner of a firm from such firm…
The language of the charging Section is similar to the definition of remuneration in the Section 40(b)(i). Going by the above observations of the Apex Court and the wording of the charging Section, it appears that the salary, commission, etc., would have the same character as the profits earned by the firm. Given the same, if the profits of the firm are from an eligible business, the same should be eligible for claim of the Section 44AD.
2.6. What would be the tests to distinguish profession from business?
Section 44AD is available only in respect of eligible business and not for a profession. The distinction between business and profession depends on facts and circumstances of the case and would depend on, inter alia, factors:
a. Extent of personal skill, reputation, knowledge employed
b. Extent of manpower ie skilled and unskilled labour employed
c. Extent of personal qualifications required vis-àvis capital employed
d. Whether the profession is organised or not
e. Whether a recognised standard of conduct is enforced on members or not
To illustrate, the running of a hospital and a clinic by a doctor may amount to carrying on of a business and a profession. Similarly, though information technology (IT) is a notified profession under Section 44AA, it may not be possible to state that big IT companies such as Infosys, TCS, etc., are carrying on a profession. The carrying on of consulting business by multinational firms may also amount to business given the different lines of practice, targets involved, skilled manpower employed, capital employed, risk involved and mitigation steps taken, succession planning, etc. The presence of multiple practice lines reduces involvement/ dependencies on individuals and may thus constitute business.
2.7. Whether foreign firm itself is eligible to the Section 44AD?
In Canoro Resources 313 ITR 2, the authority for advance ruling (“AAR”) held that share income exemption under the Section 10(2A) of Indian Income tax Act, 1961 is applicable to a Canadian firm, since
the Canadian partnership law is similar. It referred to Section 6(2) of the Indian Income-tax Act, 1961 and observed that a firm will have to be considered a resident except where, during the year, the control and management of its affairs is situated wholly outside India.
Apart from the above, in case the foreign firm has a permanent establishment (‘PE’) in India, the question whether a PE can claim the benefit of Section 44AD on the basis of non-discrimination would need to be examined.
As a corollary, the partner of such a foreign firm, if she/he is a resident, may be able to claim the benefit of
Section 44AD. If the partner is a non-resident, as per the Act, the provisions of non-discrimination article in
relevant treaty would need to be examined.
2.8. Method of accounting by partners
In DCIT vs. Vijay Kumar Patni (293 ITR (AT) 54 (Nag), where a firm followed the mercantile system of accounting and partners followed cash basis, it was held that the credit of amounts by a firm to the accounts of its partners is deemed to be received for the purposes of Section 5 and was liable to be taxed in hands of partners. The mere fact that partners had not withdrawn the amount would not mean that the amounts had not been received.
2.9. Filing of income tax returns by partners
As per the forms notified for the assessment year 2013-14 read with instructions thereto, the ITR-3 has to be used by an individual or an Hindu undivided family who is a partner in a firm and where income chargeable to income-tax under the head Profits & Gains of Business or Profession does not include any income except the income by way of any interest, salary, bonus, commission or remuneration, by whatever name called, due to, or received by him from such firm.
However, the ITR-3 should not be used by an individual whose total income for the assessment year 2013-14 includes Income from Business or Profession under any proprietorship. ITR-4S is prescribed for individuals and Hindu undivided family whose total income for the assessment year 2013-14 includes the business income computed in accordance with special provisions referred to in the Section 44AD.
The question arises whether a partner of a firm should file his ITR in the ITR-3 or the ITR-4S. While the ITR-3 is appropriate from the viewpoint of an assessee being a partner of a firm, the ITR-4S would be appropriate from the viewpoint of nature of the income being returned.
In the form ITR-3, the gross receipts from the firm minus the expenses incurred to earn the same are entered. The net income is computed as income under the head Profits or Gains of Business or Profession.There is no provision for returning 8 per cent of gross receipts as income. Keeping this in mind, the Department may argue that the benefit of Section 44AD is inapplicable for partners of a firm. Such an argument may be countered on the basis that the Act is superior to the Rules and Forms as the Act is passed by the Parliament whereas the Rules and Forms are only delegated legislation. A benefit conferred by the Act cannot be refuted by the CBDT through Rules and Forms notified by it.
The provisions of Section 44AD appear to be aimed at freeing small business entities from the rigours of maintenance of books of accounts, advance tax, etc. However, as discussed above, such benefit may also accrue to partners of partnerships and LLPs. Such benefits may also be available to foreign partnerships/ LLPs and partners hereof. In advising on the entry strategies and other structuring, this could be another selling point to favour an LLP over a company.
CA. Aditya Nagaraj Bellur
(The author may be contacted at email@example.com.)