INCOME TAX: Formation, Management and Taxation of Partnership Firm

A Partnership is a common vehicle in India for carrying on business activities on a small or medium scale. Partnership is the relationship between persons who have agreed to share the profits of a business carried on by all or any of them. Persons who have entered into partnership with one another are called partners individually and a firm collectively.

Partnership law as prevalent in India

The basic law relating to partnerships and firms in India is contained in the Indian Partnership Act, 1932. This Act 9 of 1932 received the assent of the Governor-General on 8th April 1932 and came into force on 1st October 1932 (except section 69, which came into force on 1st October, 1933). This Act (which is presently administered through the Ministry of Corporate Affairs, Government of India) has laid down the rules relating to formation of partnership, the rights and duties of partners, management and dissolution of partnership.

Before the enactment of the 1932 Partnership Act, the Indian Contract Act, 1872 contained a separate chapter [Chapter XI] providing for legal requirements on partnerships in India.

The Indian Partnership Act, 1932 applies to the whole of India. Apart from the Partnership Act, the general law of contracts, as contained in the Indian Contract Act, 1872 also applies to partnership firms in India. The 1932 Act is however not applicable to Limited Liability Partnerships, since they are governed by the Limited Liability Partnership Act, 2008.

As per Article 246 of the Constitution of India, which deals with distribution of legislative powers, the Union and State Legislatures have ‘concurrent power’ with respect to the subjects enumerated in List III. Under Schedule VII, [List III-Concurrent list, entry-7] of the Constitution of India, contracts including partnerships are treated as items falling under ‘concurrent list’. Accordingly, the Union and the State Legislatures have concurrent power with respect to the contracts including partnerships in India.

Under the Indian Partnership Act, 1932, the following three elements are very essential to form any firm of partnership in India:

(a) There must be an agreement between two or more persons;

(b) The agreement must be to share the profits of the business; and

All the above three essentials must co-exist before a firm of partnership can come into existence.

It was held that the mere nomenclature given to a document is by itself not sufficient to hold that the document in question is one of partnership. In other words, all the above-said three essentials must co-exist before a firm of partnership can come into existence. - [K.D. Kamath & Co. v. CIT (1971) 82 ITR 680 (SC)]

What is Partnership Firm

Section 4 of the Indian Partnership Act, 1932 defines partnership as “relationship between persons who have agreed to share the profits of a business carried on by all or any of them acting for all”.

The Income-tax Act, 1961, does not define the term “Firm”, but Section 2(23) of the Act which deals with definition simply states as under:—

‘FIRM’ shall have the meaning assigned to it in the Indian Partnership Act, 1932.

‘PARTNER’ shall have the meaning assigned to it in the Indian Partnership Act, 1932 and shall include—

(a) Any person who, being a minor, has been admitted to the benefits of partnership; and

(b) A partner of a limited liability partnership as defined in the Limited Liability Partnership Act, 2008.

‘PARTNERSHIP’ shall have the meaning assigned to it in the Indian Partnership Act, 1932, and shall include a limited liability partnership as defined in the Limited Liability Partnership Act, 2008. It is immaterial that partnership firm is registered or not registered.

Advantages and disadvantages of a partnership business

Advantages	Disadvantage
More capital	Unlimited liability
Combined managerial skills	Problem of management
Easy to start	Lack of secrecy
Tax advantages	Instability

Essential Elements of Partnership

The following three elements are necessary in partnership:—

(i) There must be at least two or more persons who must have entered

into in agreement—

v competent to contract

v the age of majority

v sound mind

v and is not disqualified from contracting by any law to which

v he is subject.

(ii) The agreement must be to carry on business and share profits.

(iii) The business must be carried on by all or any of the persons concerned, acting for all.

All the above three essentials must co-exist before a firm of partnership can come into existence. Further, a partnership can arise only from a contract and not from a status.

Entire deed must be considered to decide the existence of partnership - Three essentials must co-exist before a firm of partnership can come into existence

It was held that the fact that the exclusive power and control, by agreement of the parties, is vested in one partner, and the further circumstances that only one partner can operate the bank accounts or borrow on behalf of the firm, is not destructive of the theory of partnership provided two essential conditions are satisfied, namely (i) that there should be an agreement to share profits and losses of the business of the firm, and (ii) that the business must be carried on by all the partners or any of them acting for all. – [K.D. Kamath & Co. v. CIT (1971) 82 ITR 680 (SC)]

Who can sign a partnership deed in India?

Under the partnership law in India, the deed of partnership must be signed personally by each partner. – [CIT v. Jagannath Pyarelal (1985) 156 ITR 220 (SC)]. However, there is no infirmity in two persons signing the deed of partnership as individuals and also as representing their Hindu undivided families. – [CIT v. Nataraja Nadar (2000) 243 ITR 844 (Mad)]

Similarly, in case where a partnership deed is signed twice by one of partners, once in his ‘individual capacity’ and then in his ‘representative capacity’ as executor of will of a deceased partner, it cannot be said that partnership is not genuine. – [CIT v. Kondath Motors (1997) 224 ITR 663 (SC)]

Who can sign the partnership deed in case a minor is admitted to benefits of the partnership?

In case a minor is admitted to benefits of a partnership, it is necessary to show that the guardian had consented to the admission of the minor to the benefits of the partnership. However, the guardian of the minor need not sign the deed of partnership. In such a case, the fact that the deed had not been signed by such guardian would not invalidate the deed - CIT v. Shriram Industrial Distribution, (1989) 176 ITR 180 (Cal); CIT v. Associate Industrial Distributors (1982) 138 ITR 304 (Cal): In such cases, the consent of the guardian can be established either by ‘direct evidence’ [letter or affidavit of the guardian] or by ‘other evidence’, viz., the entries in the account books or such other evidence as may be available with the assessee. – [Safari Wines v. CIT (1988) 169 ITR 695 (AP)]

Legal consequences of any non-registration of a firm in India

If a partnership firm is not registered, it will not be possible to sue [in the court of law to claim legal rights] one partner of the firm against another partner or against the firm and vice versa. Further, it will not be possible for the firm to sue third party for enforcement of its rights. [Section 69]

Section 69 of the Partnership Act, 1932 reads:

69. Effect of non-registration.

(1) No suit to enforce a right arising from a contract or conferred by this Act shall be instituted in any court by or on behalf of any person suing as a partner in a firm against the firm or any person alleged to be or to have been a partner in the firm unless the firm is registered and the person suing is or has been shown in the Register of Firms as a partner in the firm:

(2) No suit to enforce a right arising from a contract shall be instituted in any court by or on behalf of a firm against any third party unless the firm is registered and the persons suing are or have been shown in the Register of firms as partners in the firms.

In brief :

(a) They cannot file a suit against the firm.

(b) They cannot file a suit against any third party for the recovery of claims.

Owners of a ‘partnership property’ - Firm’s property is the “joint estate” of all the partners

In a firm of partnership, its property is not separate from that of its members or partners. The firm’s property is the “joint estate” of all the partners, which is distinct from the ‘separate’ estate of the partners. In other words, the firm’s property does not belong to a body distinct in law from its partners. Even in the event of insolvency of a firm of partnership, the joint estate or the firm’s property [after meeting the liability in respect of joint debts] devolves on the partners of the firm.

Partnership is not a distinct legal entity

Under the Indian law, a partnership firm is not a distinct legal entity and therefore the partnership property belongs to all the partners constituting the firm. In other words, a partnership firm is not a distinct legal entity apart from the partners constituting it – [Malabar Fisheries Co. v. CIT (1979) 120 ITR 49 : 120 ITR 49 : 2 TAXMAN 409 (SC); David Mitchell v. CIT (1956) 30 ITR 701 (Cal.)]

A firm of partnership is thus not different from the partners composing it. To be more precise, a partner may be the debtor or the creditor of his copartners, but he cannot be either debtor or creditor of the firm of which he is himself a member, nor can be employed by his firm, for a man cannot be his own employer. – [CIT v. R.M. Chidambaram Pillai (1977) 106 ITR 292 (SC); CED v. Kamlavati / Jai Gopal Mehra (1979) 120 ITR 456 (SC)]

Residential status of a partnership firm

Under section 6(2) of the Income-tax Act, 1961, a partnership firm is generally treated as resident in India. A firm will however be non-resident in India if the control and management of the partnership firm is situated wholly outside India during that year. Based on the residential status of the partnership firm and the place where the income is earned, the income that is included in the total income of the firm shall be as under:

S. No.	Residential status	Taxable income
1	Resident	All income whether earned in India or outside India
2	Non-resident	All income earned in India.

A partnership firm will be non- resident in India if the control and management of the firm is situated wholly outside India during that year. However, the burden of proving that the firm-taxpayer is not resident in India is on the assessee. In case the assessee-firm has not proved that its case falls under exception, it cannot be treated as non-resident. - [V. VR.N.M. Subbayya Chettiar v. CIT (1951) 19 ITR 168 (SC)]

Governing Law

Partnership Act, 1932

Creation

By partnership agreement.

Agent

Partner is an agent of firm and other partners.

Management

Partners can take part in management of firm.

No minimum paid-up capital

There is no minimum paid-up capital for a partnership firm.

Duration

Limited, stands dissolved on death, retirement or insolvency of a partner.

Under section 7 of the Indian Partnership Act, 1932, a partnership where no provision is made by contract between the partners for the duration or determination of their partnership, the partnership is said to be a ‘partnership at will’.

In the case of a partnership at will, each partner of the firm is entitled to dissolution; it is a legal right under the Indian Contract Act, 1872. In other words, the circumstances in which a court of law may order dissolution of partnership during the term have no bearing in connection with a partnership at will.

Distinct entity

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. The property of a firm is owned by the partners. It can also sue and be sued in the firm’s name and partners can also be sued individually.

Transfer/Inheritance of shares

Not transferable.

Ownership of assets

Partnership cannot own assets in its name, assets must be in name of partners.

Liability

Liability of members is unlimited in a partnership firm. Partners jointly and severally liable for action.

Legality

Partnership is not a legal person.

Binding by act

Partner can bind firm by his act.

Registration

Registration of a partnership firm means entering of a firm’s name in the Register of Firm kept with the Registrar. It is guided by Indian Contract Act and Partnership Act. For a partnership firm, registration is not compulsory. It is optional. But registered firm enjoys legal position in comparison to unregistered firm.

Maintenance of Accounts and Audit

As per partnership deed.

Number of partners

Partnership firm shall have at least 2 partners and maximum 20 partners and for banking business, maximum 10 partners. All partners are legally equal.

As regards the maximum and minimum number of persons to form a partnership firm, section 11(2) of the Companies Act, 1956 has prescribed the limit. Accordingly, there must be a minimum of two persons to form any partnership firm in India. Similarly, if the firm is intended to engage in financial or banking transactions, there must be a maximum of ten persons to form such a partnership firm. On the other hand, if the firm is intended for any other (non-banking) purposes, there must be a maximum of twenty persons to form such a partnership firm. In other words, any group of more than 2 persons but not more than 20 persons [10 persons in case of banking business] may join together to carry on a business in partnership.

In this context, any partnership in India, having more than 10 or 20 partners (as the case may be) will be treated as ‘illegal’. In case where there is a partnership between two partnership firms, all the partners of each firm will be taken into account for the purpose of this provision.

However, if and when a partnership is between the Karta or any member of HUF on the one hand and another individual or individuals on the other, the members of the joint family will not be taken into account for the purpose of section 11 of the Companies Act.

But in case where two or more HUFs are carrying on business in partnership, the number of the members of those joint Hindu families except minors will be taken into account for the purpose of section 11 of the Companies Act. - [Agarwal & Co. v. CIT. AIR (1970) SC. 1343]

Who can be a partner

Any person becomes the partner except the following persons:—

(a) A minor

(b) A man of unsound mind

FOLLOWING CAN ENTER INTO A PARTNERSHIP:—

(i) Individual

(ii) Firm

(iii) Hindu Undivided Family (HUF)

(iv) Company

(v) Trustees

Can a minor become a partner in a firm of partnership in India?

Under the Indian Contract Act, 1872, in terms of section 11, a minor, who is not a person competent to contract in the eye of law as such, would not be entitled to become partner.

A minor can however be admitted to share the profits of a partnership firm. In case where a minor is admitted to the benefits of a partnership, if the minor signs himself the deed, it will become invalid. On the other hand, if the guardian, on behalf of the minor, signs the deed, it will not become invalid. – [Uttam Singh Khorana & Sons v. Income-tax Department (1956) 30 ITR 821 (J& K)]

Under section 30 of the Indian Partnership Act, 1932, a minor cannot become a partner, though with the consent of the adult partners, he may be admitted to the benefits of the partnership. – [Alagappa Chettiar v. CIT (1965) 55 ITR 605 (Mad.)]

In case where a minor is admitted to the benefits of partnership, the following propositions shall be valid:

(i) The minors should not be made liable for the losses in the firm.

(ii) The guardian of the minors should sign the deed.

(iii) The minors should not be treated as full partners.

(iv) The partnership deed, if otherwise valid, is not rendered invalid merely because the minors also have signed the deed.

(v) The deed should specify the share of the partners in the profits and losses in the firm.

Company can become a partner in an Indian firm

Legally speaking, a company or corporation can become a partner in a partnership firm. This is because a company or corporation is a legal person in the eyes of law. [Under section 11 of the Indian Contract Act, 1872, read with sections 2(e) and 3 of the Indian Partnership Act, 1932 only such persons as are competent to contract, are of sound mind, major and are not disqualified from contracting by any law in force would be entitled to become partner].

Two companies can join together to form a partnership firm in India?

A company, having a separate legal entity with distinct existence, can become a partner in a partnership firm. - CIT v. Gemini Productions (1977) 110 ITR 847 (Mad). Strictly speaking, two or more companies can also form a partnership. In other words, several companies may join together to form a valid partnership. – [Steel Bros. & Co. v. CIT (1958) 33 ITR 1 (SC)]

Trust can become a partner in a firm of partnership in India

A trust can become a partner in a firm of partnership through its trustees. It can also enter into valid partnership with an individual. - [CIT v. Juggilal Kamlapat (1967) 63 ITR 292 (SC)]

This is because the trustees may in law enter into a valid partnership on behalf of their trusts. For this purpose, the trust must be valid one and the partnership should not precede the creation of the trust. -

[S. P. Raju v. CIT (1961) 43 ITR 467 (AP); J.K. Hosiery Factory v. CIT (1971) 81 ITR 557(All)]

In case where the trustees enter into a partnership on behalf of the trust, their share income could not be included in the computation of their income. - [Addl. CIT v. Ram Krishna Gupta (1979) 117 ITR 218 (All)]

A husband and a wife enter into a valid partnership in India

An individual, being a natural person, is eligible to become a partner in a firm of partnership. In this context, any adult individual, who is of sound mind and competent to contract, can be a partner in a firm. Such adult individuals may be husband and wife. There is no law, which prohibits a husband and wife to enter into a valid partnership. In this context, a partnership formed by husband and wife and the wife’s brother would also be valid. - [Krishna Flour Mills v. CIT (1962) 44 ITR 501 (SC)]

Practicing advocates and professionals can not participate in the business of a partnership firm

In case an advocate in whole time practice participates in the business of a partnership firm, he would be liable for disciplinary action under the Indian Bar Councils Act, 1926. In this context, a partnership deed would not be rendered illegal simply because an advocate is a partner in the firm of partnership.

Under the Indian Bar Councils Act, 1926, an advocate cannot participate in the business of a partnership firm. There is however no bar for an advocate to be a sleeping partner in such business. - [Malwa Knitting Works v. CIT (1977) 107 ITR 379 (MP)]

Similar rule shall be applicable for all professionals (in whole time practice) including chartered accountants in India.

HUF can not become a partner in a firm

Under section 2(31) of the Income-tax Act, 1961, a Hindu undivided family or HUF is a ‘person’ for the purpose of the Income-tax Act. However, a HUF is not a juristic person for all purposes (viz., for the purposes of other laws) including the partnership law. Accordingly, under the Indian Partnership Act, 1932, a HUF is not a juristic person and it cannot enter into a valid partnership with any other person. - [Agarwal & Co. v. CIT (1970) 77 ITR 10 (SC)]

Firm of partnership can not become a partner in another firm

The word person in section 4 of Partnership Act contemplates only natural or artificial i.e. legal persons. Therefore only individuals or companies can be partners. A firm is not person and as such is not entitled to enter into partnership with another firm or Hindu undivided family or an individual.— [Dulichand Laxminarayan v. CIT (1956) 29 ITR 535 (SC)]

Types of partners in partnership

(a) ACTIVE PARTNER

(i) Contributes in capital

(ii) Participates in management

(iii) Shares profits & losses

(iv) Unlimited liability towards the creditors

(b) SLEEPING OR DORMANT PARTNER

(i) Contributes in capital

(ii) Does not take part in management

(iii) Shares profits & losses

(iv) Unlimited liability towards the creditors

(i) Association wants that this partner is unknown to general public

(ii) Contributes in capital

(iii) Participates in management

(iv) Shares profits & losses

(v) Unlimited liability towards the creditors

(d) NOMINAL PARTNER

(i) He allows the use of his/her name by a firm

(ii) Does not contribute capital

(iii) Does not take part in management

(iv) Generally does not share profits & losses

(v) Unlimited liability towards the creditors

‘Working partners’ for the purpose of income tax law

An individual partner of a firm shall be treated as a ‘working partner’ if and when:

(a) such an individual is a partner of the firm; and

(b) such an individual is actively engaged in conducting the affairs of the business or profession of the firm.

Mutual rights of partners in the conduct of the business

Under section 12 of the Indian Partnership Act, subject to the contract between the partners—

(i) Every partner has a right to take part in the conduct of the business;

(ii) Every partner is bound to attend diligently to his duties in the conduct of the business;

(iii) Any difference arising as to ordinary matters connected with the business may be decided by a majority of the partners, and every partner shall have the right to express his opinion, before the matter is decided, but no change may be made in the nature of the business without the consent of all the partners; and

(iv) Every partner has a right to have access to and to inspect and copy any of the books of the firm.

Can a partner be expelled from a partnership?

Under section 33 of the Indian Partnership Act, 1932, every partner has the right not to be expelled from the partnership firm by any majority of the partners.

Assessment as a Firm [Section 184(1)]

A firm shall be assessed as a firm for the purpose of Income Tax Act, if the partnership is evidenced by—

(i) an instrument i.e. Partnership deed duly stamped; and

(ii) the individual shares of the partners are specified in that instrument.

(iii) certified copy of such instrument to be furnished along with Income Tax Return

(iv) certified copy of instrument to be filed in case of change in constitution of the firm

(v) no failure as mentioned under section 144.

Assessment of Firm when section 184 complied with

If the firm satisfies the conditions laid down under section 184, the firm shall be eligible for deduction on account of interest, salary, etc. while computing its income under the head ‘Business and Profession’.

However, it will be subject to the maximum of the limit specified under section 40(b). On the other hand, if such conditions are not satisfied, no deduction shall be allowed to the firm on account of such interest, salary, bonus, etc.

Conditions of section 184

The firm should fulfill the following five conditions to satisfy under section 184:—

(i) A FIRM MUST BE EVIDENCED BY AN INSTRUMENT [Section 184(1)(i)]

The partnership firm should be evidenced by an instrument in writing. In simple words, a firm should be evidenced by a partnership deed.

(ii) INDIVIDUAL SHARE OF PARTNERS MUST BE SPECIFIED IN INSTRUMENT

The instrument of partnership (i.e. partnership deed) must specify the individual shares of partners in profits of the partnership.

(iii) CERTIFIED COPY OF INSTRUMENT SIGNED BY ALL THE PARTNERS

A certified copy of the said instrument signed by all the partners (not being minors) shall accompany the return of the firm for the first assessment as a ‘firm’. The individual share of the partners are specific in that instrument.

(iv) REVISED INSTRUMENT SHOULD BE SUBMITTED WHENEVER THERE IS CHANGE IN THE CONSTITUTION OF FIRM/PROFITSHARING RATIO

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 assessment year.

(v) 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 from assessment year 2004-05 onwards and as an Association of Persons (AOP) up to assessment year 2003-04.

(vi) THERE SHOULD NOT BE ANY FAILURE AS IS MENTIONED IN SECTION 144

If any failure is made as mentioned in Section 144 (ex parte assessment) the firm shall be assessed as a firm from assessment year 2004-05 without deducting interest and salary to partners and as an Association of Persons (AOP) up to assessment year 2003-04.

Assessment when section 184 not complied with [Section 185]

Where a firm does not comply with any of the provisions of section 184 given below:—

(a) the partnership is evidenced by an instrument;

(b) the individual shares of the partners are specified in that instrument;

(d) the certified copy of the partnership deed is submitted alongwith the return of income.

Taxation of Firm

The partnership firm is taxed as a separate entity, with no distinction as registered and unregistered firms. A partnership firm is or required to submit a copy of the partnership deed in the first year of assessment and later on only if there is a change in the terms/constitution of partnership. In computing the total income of the firm, any salary, bonus, commission or remuneration, to a partner, shall be deductible subject to certain restrictions, discussed as under:—

(i) Share Income from Firm exempt [Section 10(2A)]

The share of the partner in the income of the firm will be fully exempt from income-tax. In case such share is a loss the same cannot be set-off against partner’s other business income. It is simply ignored.

(ii) Partner’s Salary/Remuneration [Section 40(b)(i)]

Any payment of salary, bonus, commission or remuneration, by whatever name called, to any partner will be allowed as deduction in the hands of the firm subject to following conditions:—

(a) REMUNERATION SHOULD BE TO A WORKING PARTNER

For this purpose, a ‘working partner’ means an individual partner who is actively engaged in conducting the affairs of the business or profession of the firm [Expl. 4 to Section 40(b)]. Sleeping partners or financing partners cannot be allowed any remuneration etc. by the firm.

Whether a partner can be considered to be a working partner or not is a question of fact, and in cases where a dispute could arise on this question, it would be advisable to keep evidence at hand that would indicate allocation of work in a firm, or otherwise show clearly what work has been done by a partner.

KEY NOTE : It Should not be disallowed under section 37(1) or 40A(2)

(b) THE PAYMENT IS AUTHORIZED BY, AND IS IN ACCORDANCE WITH THE TERMS OF THE PARTNERSHIP

DEED [Section 40(b)(ii)]

Payment of remuneration (and interest) should be authorized by and should be in accordance with the terms of the partnership deed and should relate to any period falling after the date of such partnership deed.

The payment relates to a period which falls after the date of the partnership deed. In other words, the deduction for salary to partners cannot be claimed with retrospective date. [Section 40(b)(iii)]

KEY NOTE:—

The terms of the partnership deed providing for such payment may be changed at any time during the previous year. It however cannot be claimed with retrospective effect.

(d) THE AMOUNT OF REMUNERATION HAS BEEN SPECIFIED OR A LIMIT FOR TOTAL REMUNERATION HAS

BEEN SPECIFIED IN THE PARTNERSHIP DEED

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. [Circular No. 739, dated 25.03.1996]

Quantum of allowance is to be determined with reference to ‘book profit’ which is defined to mean an amount computed in accordance with the provisions of sections 28 to 44D of the Income-tax Act, as increased by the amount of remuneration to partners if deducted in determining book profit.

KEY NOTE:—

(i) The deduction shall not be allowed, where neither the amount of remuneration has been quantified nor even the limit of total remuneration has been specified in the partnership deed but the same as been left to be determined by the partners at the end of the accounting period. However, for the assessment years 1993-94 to 1996-97, deduction for remuneration shall be allowed in such cases.

(ii) Payment of remuneration to a non-working partner will not be allowed as a deduction.

(iii) It is not possible to attach any certificate or report with new income-tax returns forms. The assessee should, therefore, retain the certified copy of instrument (or revised instrument) of partnership with it. It may be furnished whenever the Assessing Officer wants to examine it in assessment proceedings or otherwise.

REMUNERATION TO PARTNERS

Quantum of allowance is to be determined with reference to “book profit” which is defined to mean an amount computed in accordance with the provisions of sections 28 to 44D of the Income-tax Act, as increased by the amount of remuneration to partners if deducted in determining book profit.

MAXIMUM PERMISSIBLE DEDUCTION FOR PAYMENT OF REMUNERATION TO WORKING PARTNERS [Section 40(b)(v)]

Upto assessment year 2009-10, the maximum permissible deduction was as under:—

Professional firms		Business firms
Book Profit/Loss	% or amount of deduction	Book Profit/Loss	% or amount of deduction
(i) Loss	50,000	(i) Loss	50,000
(ii) Profit 50,000	—	(ii) Profit
up to 50,000	50,000	up to 50,000	50,000
up to 1,00,000*	90%	up to 75,000*	90%
next 1,00,000	60%	next 75,000	60%
Balance profit	40%	Balance profit	40%
* (higher of Rs. 50,000 or prescribed percentage)

From assessment year 2010-11, deduction for payment of remuneration to working partners for both Business as well as professional firms has changed as under:—
Book Profit/Loss	% of amount of deduction
(i) loss or profit upto Rs. 3,00,000	Rs. 1,50,000/- or 90% of Book Profit, whichever is more
(ii) on the balance	60% of book profit

(iii) Interest to Partners [Section 40(b)(iv)]

Where a firm pays interest to any partner, the firm can claim deduction of such interest (simple interest) at a maximum rate of 12% p.a. from 01.06.2002 (18% p.a. upto 31.05.2002) according to the partnership deed. It cannot be claimed with retrospective effect. Interest paid in excess of the above will be disallowed in the hands of the firm.

Interest : Conditions

(a) Interest should not be disallowed under section 36(1)(iii), 40(a)(i) or 40A(2)

(b) Such interest is authorised by and is in accordance with partnership deed

(d) It should be within the limits specified in clause (iv) of section 40 b (12% p.a. simple interest)

Change in constitution [Section 187]

Where at the time of making assessment under section 143 or section 144, it is found that a change has occurred in the constitution of a firm, the assessment shall be made on the firm as constituted at the time of making the assessment. In other words, there will not be a separate assessment of firm even when there is a change in the constitution of the firm. There is a change in the constitution when—

(i) if one or more of the partners cease to be partners;

(ii) one or more new partners are admitted;

(iii) when there is change in their shares.

KEY NOTE:—

Dissolution of a firm due to death of any partner will not be considered as change in the constitution of the firm (Proviso to Section 187).

Succession of one firm by another firm [Section 188]

Where a firm carrying on a business or profession is succeeded by another firm, and the case is not one covered by section 187, separate assessments shall be made on the predecessor firm and the successor firm in accordance with the provisions of section 170.

As per section 170, the predecessor firm shall be assessed in respect of the income of the previous year in which succession took place up to the date of succession. The successor firm shall be assessed in respect of the income of the previous year after the date of succession.

A firm will not be deemed to be dissolved on retirement of a partner

A perusal of section 187(2)(a) shows that by legal fiction for the purpose of the Income-tax Act, if one of the partner continues to remain in the firm, the firm will not be deemed to be dissolved. Hence, even if the partnership deed says that the firm will stand dissolved on the retirement of a partner, for the purposes of the Income-tax, it will not be deemed to be dissolved in view of section 187(2)(a).—[CIT v. Ratan Lal Garib Das (2003) 261 ITR 200 : 131 Taxman 227 (All)]

Losses of the firm

Unabsorbed loss including depreciation in respect of assessment year 1993- 94 onwards of the firm will not be apportioned amongst the partners and will be carried forward by the firm only. In case of change in constitution of firm, following treatment will be given:—

(i) Calculate the share of profit of the retiring/deceased partner in the year in which there is a change in the constitution due to such retirement/death.

(ii) Compute the share of loss of the retiring/deceased partner in the brought forward loss of the firm.

(iii) Set-off of the share in the brought forward losses of the retiring/ deceased partner from his share of the profit of the current year.

This set-off of share of brought forward loss will be allowed to the extent of share of profit of such partner. The balance loss, if any, will not be allowed to be carried forward either to such partner or to the firm. On the other hand, if in the current year also the share of the partner is a loss, then share of the brought forward loss along with the share of loss of current year will not be allowed to be set-off and carried forward.

Carry forward of unabsorbed depreciation

Unabsorbed deprecation of the firm is not covered under section 78 and therefore, the entire unabsorbed depreciation will be allowed to be carried forward in the hands of the firm, even if there is a change in the constitution of the firm.

Due dates for filing return of firm

(i) 30th September (Unless extended by the government) : Where accounts of the partnership firm are required to be audited under Income-tax Act or under any other law for the time being in force.

(ii) 31st July (Unless extended by the government) : In any other cases.

Due date for filing of return of firm

Assessment year	Where accounts of the partnership firm are required to be audited under Income-tax Act or under any other law for the time being in force.	In any other cases.
2020-21	31st October, 2020	30^th November, 2020
2019-20	31st of October, 2019	31^st August, 2019.
2018-19	31st October, 2018	31st August, 2018
2017-18	07th November, 2017	31st July, 2017

Rate of tax

Flat rate of 30% on the total income after deduction of interest and remuneration to partners/designated partners at the specified rates + Surcharge of 12% if total income exceeds one crore and will be further increased by Health and Education Cess at the rate of 4% shall be levied on the amount of tax computed, inclusive of surcharge.

Tax Rates From Assessment Year 2019-20 onwards

Total Income	Tax Rates	Surcharge	Health and Education Cess
Income upto Rs. 1,00,00,000	30% of total income	NIL	4% of Income-tax and surcharge
Income Exceeds Rs. 1,00,00,000	30% of total income	12% of Income-tax	4% of Income-tax and surcharge

Surcharge is subject to marginal relief (where income exceeds one crore rupees, the total amount payable as income-tax and surcharge shall not exceed total amount payable as income-tax on total income of one crore rupees by more than the amount of income that exceeds one crore rupees).

From Assessment Year 2016-17 to 2018-19

Total Income	Tax Rates	Surcharge	EC & SHEC
Income upto Rs. 1,00,00,000	30% of total income	NIL	3% of Income-tax and surcharge [i.e. Education cess - 2% and Secondary and Higher Education cess - 1%]
Income Exceeds Rs. 1,00,00,000	30% of total income	12% of Income-tax	3% of Income-tax and surcharge [i.e. Education cess - 2% and Secondary and Higher Education cess - 1%]

Dissolution of firm or discontinuance of business [Section 189]

A partnership may be dissolved by any partner at any time. 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.

Where such discontinuance or dissolution takes place after proceedings in respect of an assessment year have commenced, the proceedings may be continued against the person referred to above firm from the stage at which the proceedings stood at the time of such discontinuance or dissolution, and all the provisions of the Act shall, so far as may be, apply accordingly.

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.

Mode of dissolution

A firm may be dissolved in any one of the following ways:—

(i) BY AGREEMENT

A firm may be dissolved with the consent of all the partners or in accordance with a contract between the partners. Partnership is created by a contract, it can also be terminated by a contract.

(ii) BY NOTICE

Where the partnership is at will, the firm may be dissolved by any partner giving the notice in writing to all the other partners of his intention to dissolve the firm. A notice of dissolution once given cannot be withdrawn without the consent of all the other partners.

(iii) ON THE HAPPENING OF CERTAIN CONTINGENCIES

Subject to a contract between the partners, a firm may be dissolved—

(a) if constituted for a fixed term, by the expiry of that term;

(b) if constituted to carry out one or more adventures or undertakings, by the completion thereof;

(d) by the adjudication of partner as an insolvent.

(iv) COMPULSORY DISSOLUTION

A firm may be compulsory dissolved—

(a) when all the partners, or all the partners but one, are adjudged insolvent;

(b) when some event has happened which makes it unlawful for the business of the firm to be carried on.

Admissibility of remuneration and interest vis-a-vis presumptive taxation

Remuneration and interest will be allowed as deduction from the presumptive income computed at prescribed rate under sections 44AD, 44AE & 44AF.

Partnership firm is not liable to deduct tax at source on partner salary and interest

As the partner are individuals taxed by the income-tax slab on individuals.

But the firm is not required to deduct TDS on the partner’s salary and interest paid to the partners.

Assessment of partners

(i) Once tax is paid by firm, no tax will be payable by the partners on share of income from the firm.

(ii) 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 section 40(b) and from assessment year 2004-05 amount disallowed in the event of any failure as mentioned in section 144 or non-compliance of section 184.

FIND OUT TAXABLE INCOME OF PARTNERS OF A FIRM

The provisions are given below:—

(i) SHARE OF PROFIT EXEMPT FROM TAX

Section 10(2A) provides that in the case of a partner (including a minor admitted for the benefit of the firm) of a firm, his share in the total income of the firm shall be exempt from tax.

(ii) REMUNERATION OR INTEREST IS TAXABLE

If condition of section 184 and section 40(b) are satisfied then interest, salary, bonus, commission or remuneration paid/payable by the firm to partners is taxable in the hands of partners (to the extent these are allowed as deduction in the hands of the firm).

KEY POINT:—

(a) Remuneration is not taxable under the head “Salaries”.

Remuneration is not taxable in the hands of partners under section 15 under the head ‘Salaries’ (Explanation 2 to section 15). It is taxable as business income.

(b) Expenses are deductible under sections 30 to 37.

Any expenditure incurred in order to earn salary/interest income can be claimed as a deduction under sections 30 to 37 from such income.

FOR EXAMPLE:—

If a partner borrows money to make his capital contribution to the firm and he has received interest on his capital contribution, the amount of such interest will be taxed under the head “Profits and gains of business or profession”, but the interest paid by him on the borrowed money will have to be allowed as a deduction.

If salary/interest is disallowed in the hands of firm under section 40(b) and/or section 184, then the same is not taxable in the hands of partners.

INCOME TAX

Saturday 16 May 2020

Formation, Management and Taxation of Partnership Firm

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