ITAT Chennai: Interest paid on loan borrowed to settle the debt of the outgoing partner allowed as deduction; Even if the partners are family members; the same cannot be considered as a family settlement

Brief Facts of the Case

The assessee ‘Partnership Firm’ (having family members as partners) was carrying on the business of running Hotel. The firm was reconstituted in FY 2005-06 with retirement of 4 partners and induction of 1 new partner. Before reconstitution of the firm, the assets and liabilities of the firm were revalued and credited to the capital account of the partners. On reconstitution of the firm, the capital account of retiring partners had been treated as debt of the firm. To settle outgoing partners’ capital account, the firm had borrowed loan from Bank and paid interest. The firm had also taken capital contribution from the incoming partner and paid interest as per the Partnership Deed which was in accordance with the provisions of S. 40(b).

The AO disallowed interest paid by the assessee to the capital account of incoming partner and interest on loan borrowed from Bank u/s.36(1)(iii), basis the following reasons:

• The assets were revalued only to artificially increase the credit balance of outgoing partners and ultimately funds were borrowed to settle the outgoing partner’s capital account.

• The settlement is a family arrangement since the assessee could not file any evidences to prove that their assets belong to partnership firm and it is the part of the business. Any settlement to partners towards settlement of family property cannot be considered as settlement of firm debt.

Order of the AO was further confirmed by the CIT(A)

OBSERVTAIONS OF ITAT

• The business of the assessee cannot be smoothly continued unless, the retiring partners’ capital accounts are settled. Therefore, interest paid on capital account of partners partakes the nature of funds borrowed for the purpose of business and consequently, such interest needs to be allowed as deduction u/s.36(1)(iii) of the Act.

 

• The settlement of retiring partner’s capital account is not a family settlement, because, asset was brought into the books of accounts of the firm and the firm has developed the property and exploited the property for the purpose of running its business. The firm has claimed depreciation on building, on which, the hotel was constructed and managed. Therefore, any settlement out of assets belonging to the firm to the outgoing partners, cannot be considered as settlement of family property, just because, the partners were family members.

 

• The share of partner in partnership assets means his proportion share in the assets of the firm net of liabilities. Therefore, when the outgoing partners are taking out their share in the assets of the firm, the FMV of the assets needs to be ascertained. The assessee has revalued the assets to ascertain the FMV of its assets before settlement of retiring partner’s shares in the proportionate assets of the firm. Therefore, just because, the asset has been revalued before reconstitution of firm, cannot be a reason to treat the settlement of firm properties among partners as settlement of family property.

Held:

• The firm has borrowed loan from Bank and raised fresh capital from incoming partner to settle the debt/capital account of outgoing partners. The settlement of capital account of outgoing partners becomes debt of partnership firm and discharge of said debt out of borrowed funds assumes the character of loans/funds borrowed for the purpose of business and therefore any interest paid on said loan and capital account is allowable u/s 36(1)(iii).

M/s.Ariff & Co. vs The Asst. Commissioner of Income Tax, Central Circle-II (3), Chennai. ITA No.140/Chny/2022

 

Article written by CA. Ankush Karanpuria and CA. Ankit Karanpuria – feedback if any can be sent to akassociate210@gmail.com

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