Changes In Taxation Of Partnership Firms

Updated: Mar 31 2003, 05:30am hrs
The provisions relating to the taxation of partnership firms are contained in Chapter XVI of the Income Tax Act, 1961 (the Act). Under section 184(1) of the Act, with effect from April 1, 1993 a firm shall be assessed as a firm (PFAS), if the following conditions are fulfilled: The partnership is evidenced by an instrument (partnership deed) and a certified copy thereof, duly signed by all the partners, is filed along with the Return of Income (ROI). The individual shares (profit/loss) of the partners are also specified in the instrument. Further, whenever there is any change in the constitution of the firm, the firm is required to furnish along with the ROI a certified copy of the partnership deed, duly signed by all the partners. A change in constitution of the firm is defined under section 187 of the Act to include the admission of new partner(s), retirement of existing partner(s) and change in the profit/loss-sharing-ratio and exclude dissolution of the firm on death of any of its partners.

However, where a firm does not comply with either of the above conditions under section 184 or fails to comply with the provisions of section 144 of the Act, then, the firm shall not be assessed as a PFAS but shall be assessed as an Association of Persons (PFAOP), and all the other provisions of the Act relating to an AOP shall apply accordingly. The taxation of PFAS and PFAOP differs as under: Payment of Interest, Salary, Bonus, Commission or Remuneration to working Partners: In the case of a PFAS, these payments made to working partners, duly authorized by the partnership deed, are an allowable expense to the PFAS subject to the limits stated in section 40(b)(iv) and (v) of the Act. However, in the case of a PFAOP, such payments are not an allowable expense under section 40(ba) of the Act. Tax liability of a PFAS/PFAOP and the Partners: The PFAS will have to pay tax at 36.75 per cent (35 per cent plus 5 per cent surcharge thereon) for assessment year 2003-2004. The share of income/loss of the partners from the PFAS is exempt under section 10(2A) of the Act. But, the above mentioned payments made to partners will be taxable in the respective partners hands. In contrast, in the case of PFAOP, the provisions are hereunder: Where no partner has income exceeding the maximum amount chargeable to tax: income of the PFAOP is taxable as if it were an individual. The share of the partners shall be included in the income of the partners if the PFAOP has paid tax. But, the partners can claim rebate under section 86 of the Act. Where any one of the partners has income exceeding the maximum amount chargeable to tax: income of the PFAOP is taxable at the maximum marginal rate of 31.50 per cent (30 per cent plus 5 per cent surcharge thereon) for assessment year 2003-2004. The share of the partners shall not be included in the income of the partners under section 86 of the Act. : income of the PFAOP as it relates to the share of the Domestic Company is taxable at 36.75 per cent and the balance income is taxable at 31.50 per cent for assessment year 2003-2004. The share of the partners shall not be included in the income of the partners.

The Union Budget 2003-2004 proposes to amend sections 184(5) and 185, whereby with effect from April 1, 2004, if the partnership firm fails to comply with the provisions of sections 144 and 184 respectively, then the firm shall be assessed as a partnership firm (PFAS) and no deduction by way of payment of interest, salary, bonus, commission or remuneration made by the firm to its partners shall be allowed in computing the taxable income of the firm and such payment shall not be taxable under section 28(v) of the Act.

To understand the implications, let us consider an illustration of a firm where one of the partners is a company and the partners attract personal income tax at the maximum marginal tax rate for assessment years 2003-2004 and 2004-2005, as per the Budget provisions.

For assessment 2003-2004, we observe the following: For a PFAS, the total tax is Rs 343,875. But for a PFAOP, the total tax is Rs.315,000 i.e. Rs.28,875 or 8.40 per cent less than the total tax in the case of PFAS. Looking at this anomaly, a partnership firm may not comply with the provisions of section 184 of the Act to claim the above benefit of overall lower tax. However, partnership firms opting not to comply with sections 144 or 184 of the Act to be assessed as a PFAOP in order to save the differential tax could attract application of the ratio of the landmark decision in McDowell & Co. Ltd. vs. Commercial Tax Officer (1985) 154 ITR 148 (SC) where the thin line between tax planning and tax evasion was tested and ruled against the assessee. Nevertheless, it is pertinent to note here that under the erstwhile section 183 of the Act - Assessment of unregistered firms - omitted by the Finance Act, 1992 with effect from April 1, 1993, there was a provision that the Assessing Officer, if, in his opinion, the aggregate amount of tax payable by the firm, if it were assessed as a registered firm, and tax payable by the partners individually if the firm were so assessed would be greater than the aggregate amount of the tax payable as an unregistered firm and the tax payable by the partners individually, may proceed to make the assessment as a registered firm and all provisions relating to registered firm will apply to the unregistered firm. However, such a clause was not inserted in the Finance Act, 1992 to nullify any benefit accruing to the assessee from a PFAOP vis--vis PFAS.

For assessment year 2004-2005, if a partnership firm doesnt comply with sections 144 or 184, it will still be assessed as a firm (PFAS) but no deduction by way of payment of interest, salary, bonus, commission or remuneration made by the firm to its partners shall be allowed in computing the taxable income of the firm and such payment shall not be taxable under section 28(v) of the Act. From the table, we see that in for assessment year 2004-2005, if the firm doesnt comply with the requirements of sections 144 or 184 of the Act, the total tax increases from Rs 343,875 to Rs 358,750 or 4.33 per cent. Thus, the Budget now proposes to plug the above referred anomaly/loophole by amending sections 184(5) and 185 of the Act.