JUDGMENT
K. Shivasankar Bhat, J.
1. At the instance of the Revenue, the following questions were called for and were thus referred for our consideration under section 256(2) of the Income-tax Act, 1961 (“the Act” for short) :
“(1) Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in holding that interest payment to the minor children of the partners through their natural guardians who are partners of the firm were not disallowable under section 40(b) ? and
(2) Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in law in holding that interest payments to Hindu undivided families of which the parters of the firm are the kartas were not disallowable under section 40(b) ?”
2. The assessee is a firm of 13 partners. Five of the partners withdrew some of the amounts standing to their respective credits in the capital account of the partnership; those amounts were not earning any interest. The withdrawn amounts were advanced to their respective wives, minor children and Hindu undivided families, who in turn, deposited them with the firm for interest at the rate of 15% per annum. The interest thus paid by the firm was deducted from the income of the firm (assessee herein), during the assessment year 1982-83. But the Income-tax Officer disallowed the deductions, relying on section 40(b) of the Act. the commissioner (Appeals), however, allowed the appeal filed by the assessee and excluded the interest paid as a valid deduction. This appellate order was affirmed by the Appellate Tribunal. Hence, this reference.
3. The genuineness of the transactions is not in question. The Revenue has relied on section 40(b), as it stood during the relevant assessment year, to question the deduction claimed by the assessee-firm.
4. As per section 40(b), in the case of any firm, any payment of interest, salary, bonus, commission or remuneration made by the firm to any partner of the firm shall not be deducted in computing the chargeable income of the firm under the head “Profits and gains of business or profession”.
5. Three Explanations were inserted to this section 40(b) with effect from April 1, 1985, by the Taxation Laws (Amendment) Act, 1984. Explanation 3, which is relevant here, reads :
“Where an individual is a partner in a firm otherwise than as partner in a representative capacity, interest paid by the firm to such individual shall not be taken into account for the purpose of this clause, it such interest is received by him on behalf, or for the benefit, of any other person.
There is no dispute that, in case this explanation is attracted to govern section 40(b) as explaining its provisions throughout from the inception of section 40(b) itself, then, the interest paid to the minor children and the Hindu undivided families of the five partners (though paid through respective partners), are not to be included in the income of the firm. But the Revenue contends that the Explanations inserted by the Taxation Laws (Amendment) Act, 1984, have no retrospectivity as they were specifically brought into effect only from April 1, 1985. On the other hand, the assessee contends that the purpose of the Explanations (specially Explanations 2 and 3) are clarificatory in nature, inserted by the aforesaid Amendment Act to resolve the doubt created by the conflicting views expressed by different High Courts. A few of the High Court (including a Bench of this court) opined, prior to the insertion of these Explanations that any amount referred to in section 40(b) paid to the partner of a firm was not deductible from the chargeable income of the firm even though such payments to the partner were not made in his capacity as a partner. A few of the High Courts, however, took the view that the capacity in which payment was made to the partner is a relevant factor.
6. The former view taken by a Bench of this court is reported in N. M. Anniah and Co. v. CIT [1975] 101 ITR 348. Anniah was a partner in his capacity as the karta of his Hindu undivided family; however, he was paid for certain services rendered by him to the firm and the remuneration paid to him was for his personal skill, drive and ability. The firm sought deduction of those payments. This was rejected by this court. The Bench observed at page 351 :
“We are of the view that section 40(b) which says that in the case of the firm any payment of salary made by the firm to any partner is not deductible is absolute in its terms and it is applicable to all cases irrespective of the character in which a person has become a partner of a firm. The principle underlying section 40(b) of the Act are entirely different from one another. In the first case the reason for treating the remuneration received by a karta, which is related to the family funds contributed as capital of the firm, as part of the income of the Hindu undivided family is that the karta has to be regarded as having entered into the partnership for the benefit of the Hindu undivided family and as between him and the other members of the family, he would be accountable for all profits or remuneration received by him. The object of the enacting section 40(b), however, is entirely different. Ordinarily, any salary paid to a partner for the services rendered by him to the firm in accordance with a bona fide agreement entered into by and amongst the partners would have been deductible as expenditure under section 37 of the Act but for section 40(b). The question whether an agreement to pay salary to a partner is a bona fide one or not is a question of fact. Obviously, considering the opportunities for fraud that any such alleged agreement would offer to make unreasonable and excessive claims. Parliament enacted section 40(b) making the payments referred to therein made by the firm to any of its partners non-deductible while computing the income of the firm for purposes of levy of income-tax.”
7. This was followed subsequently by this court in CIT v. Khoday Eswarsa and Sons [1985] 152 ITR 423, it was held that (headnote) :
“… the capacity with which an individual becomes a partner of a firm has nothing to do with the allowances prohibited under section 40(b). A partner may have a dual capacity as an individual by himself or as a representative of another assessable entity, but when once he becomes a partner, the bar imposed under section 40(b) is immediately attracted.”
8. This decision was rendered in September, 1984, and the principle was again applied to the facts of the case in Shri, Ramanjaneya Textile v. CIT , wherein the decision was rendered on December 17, 1984. The court has no occasion to consider the impact if the Explanations inserted by the Taxation Laws (Amendment) Act. 1984, while rendering the above opinions. Similar view as in Anniah and Co.’s case found favour with the Allahabad High Court in CIT v. London Machinery Co. [1979] 117 ITR 111, and the Delhi High Court (vide Sanghi Motors v. CIT [1982] 135 ITR 359). The High Courts of Andhra Pradesh, Gujarat and Madras, have however expressed a contrary view.
9. The impact of the Amendment Act inserting the three Explanations to section 40(b) came up for consideration before the High Court of Andhra Pradesh in N. T. R. Estate v. CIT [1986] 157 ITR 285. The Revenue contended that the earlier view of the said High Court required reconsideration and further contended that the Explanation had no retrospectivity to govern the assessment years earlier to April 1, 1985. the assessment years in question were 1973-74 and 1974-75. The Revenue’s contention was rejected. At page 289, the Bench held :
“It is true that there is a conflict of judicial opinion on this aspect (vide judgments of the Karnataka, Allahabad and Delhi high Courts above referred to on which reliance was placed by learned standing counsel for the Revenue). We do not think that any case is made out for reconsideration of the judgments of this court in Addl. CIT v. Vallamkonda China Balaiah Chetty and Co. [1977] 106 ITR 556 and Terla Veeraiah v. CIT [1979] 120 ITR 502 for two reasons “Firstly, the view taken by this court finds support in the judgments of the Gujarat High Court and Madras High Court above referred to; and, secondly, the principle enunciated by this court is now statutorily recognised by the Taxation Laws (Amendment) Act. of 1984, which will be effective from the assessment year 1985-86. By section 10 of the above Amendment Act, three Explanations were inserted. Explanations 2 and 3 deal with the matter under consideration. The effect of these Explanations is : (a) if a person is a partner in a firm in a representative capacity and if such partner lends to the partnership monies belonging to him individually, then the interest paid to such partner on the monies lent by him is not liable to be added back under section 40(b) of the Act; and (b) similarly, if a person is a partner in his individual capacity and if such partner lends to the partnership monies belonging to the Hindu jointly family of which he is the “karta”, then the interest paid on the monies lent by the joint family is not liable to be added back under section 40(b) of the Act. the above amendment to the statute is clear acceptance of the views expressed by this court, the Gujarat High Court and the Madras High Court in the decisions above referred to, it is true that Explanations 2 and 3 inserted by the Taxation Laws (Amendment) Act of 1984 will be effective from the assessment year 1985-86. It is well to bear in mind that in the Statement of Objects and Reasons introducing the Taxation Laws (Amendment) Bill, 1984, it has been specifically mentioned that the amendments introduced in the Bill are intended mainly to streamline procedures in the interest of better work management, avoid inconvenience to taxpayers, reduce litigation, remove certain anomilies in and rationalise some of the provisions of these enactments and counteract tax avoidance and tax evasion. We consider that the present amendment to section 40(b) of the Act through Explanations 2 and 3 above referred to is to avoid inconvenience to taxpayers, reduce litigation. It cannot be gainsaid that the legislature was fully aware of the conflict of judicial opinion in this matter among the various High Courts in the country and the present amendment to section 40(b) through Explanations 2 and 3 is the principle statutorily recognised by Explanations 2 and 3, following the decisions of some High Courts, is good only from the assessment year 1985-86 and ceased to be so for the preceding assessment years. In our opinion, Explanations 2 and 3 are merely clarificatory in character and must, therefore, govern the assessments prior to the assessment year 1985-86 also.”
10. The High Court applied the test as to who is the “real recipient” of the payment in question. If, in reality and in substance, the payment went to the individual capacity, then alone section 40(b) was attracted.
11. In Balchand Hashmatrai and Co. v. CIT , a similar question of payment of interest to the Hindu undivided family through the parter who was the karta of the Hindu undivided family came up for consideration in respect of the assessment year 1976-77. The Madhya Pradesh High Court Applied the Explanations inserted to section 40(b). The high Court also referred to an earlier circular issued by the Board governing the fact situation. At page 127, the Bench concluded :
“Though this Explanation is not applicable to the present case as it was brought into effect from April 1, 1985, still the Explanation so added points out the effect of interest paid in such cases. That apart, it was not disputed that there is a circular issued by the Department, which is binding on the Department.”
12. The High Court points out at page 125 that the view expressed by the Gujarat High Court in CIT v. Sajjanraj Divanchand [1980] 126 ITR 654, was sought to be challenged in appeal before the Supreme Court, but the Supreme Court refused to grant leave to appeal (vide [1983] 144 ITR (St.) 15). The Gujarat view was followed by the Andhra Pradesh High Court in N. T. R. Estate’s case [1986] 157 ITR 285 referred to above, and the Revenue’s attempt to appeal to the Supreme Court Failed, by the refusal of leave by the Supreme Court (vide [1991] 187 ITR (St.) 38).
13. The High Court of Rajasthan also took a similar view as above in Gajanand Poonam Chand and Brothers v. CIT [1988] 174 ITR 346. The Bench pointed out that when the Hindu undivided family has been treated as a distinct legal entity, there is no reason to ignore the same for the purpose of section 40(b). At page 350, it was held :
“In this scheme of things, it is obvious that under the provisions of the Income-tax Act, there is no inconsistency in treating an individual as a person distinct from the same individual representing the Hindu undivided family as its karta for the purposes of partnership in a firm. The question, therefore, is whether, in such situation, for the purpose of section 40(b) , the distinction between the two personalities of an individual, which is clearly recognised by the provisions of the Income-tax Act is to be treated as obliterated. We do not find anything in section 40(b) requiring obliteration of the distinction between these two personalities of an individual in order to hold that merely because an individual is also in his representative capacity as karta of a Hindu undivided family, a partner of the assessee firm, the interest paid to him in his distinct individual account must be disallowed under section 40(b).
It appears to us that the Legislature inserted Explanation 2 in section 40(b) with effect from April 1, 1985, to settle the controversy on account of divergence of opinion among the High Courts on this point, there being no authoritative pronouncement of the Supreme Court, In this view of the matter, we are inclined to hold that Explanation 2 is merely declaratory of the existing law as contained in clause (b) of section 40 and is intended to remove the doubt raised on account of conflicting High Court decisions; and it is not a new enacting provision carving out an exception from the general rule contained in clause (b). The ordinary purpose of an Explanation is to clarify that which is already enacted and not to enact something new. No doubt, an Explanation. We are of the view that the function of Explanation 2 inserted in clause (b) with effect from April 1, 1985, is its normal function of explaining that which is already contained in clause (b).”
14. The same question came up before the Punjab and Haryana High Court for the assessment year 1978-79 in Hindustan Steel Forgings v. CIT [1989] 179 ITR 280. The Bench regatived the Revenue’s contention in view of the circular issued by the Board. The Bench also held that the Explanations inserted to section 40(b) were clarificatory in nature. At page 282, the Bench observed :
“A reading of the same shows that the amendment has clarified that where a person is a partner in his representative capacity, interest paid to him in his individual capacity will not be disallowed under the abovementioned provisions and vice versa. Therefore, it is clear that the amendment brought in by the Amendment Act. 1984. was only clarificatory with a view to explain what was hidden so as to make it apparent to the naked eye. Such an amendment is always considered retrospective so that what looked hidden hithertofore should be considered as apparent and if that is so, the clarification which has been brought about by the amendment should be read as if the unamended provision was also to be read in the same way and if that is so, the rulings which interpreted section 40(b) before the amendment to mean that the position of an individual in his individual capacity and that individual representing a Hindu undivided family as a karta, were two separate known legal entities for the purpose of the Income-tax law as also for the purpose of ‘person’ as defined in section 2(31) of the Act. Even in the definition of ‘person’, a Hindu undivided family is a distinct antity as compared to an individual. By the amendment and particularly in view of the circular issued by the Central Board of Direct Taxes [1984] 149 ITR (St.) 127, the decision, were accepted so that the provision, as it existed before the amendment, was to be read in the light of the amendment provision.”
15. The Revenue’s contention found favour with the majority of the judges who constituted the full Bench in CIT v. Nitro Phosphetic Fertilizer [1988] 174 ITR 269 (All). As to the impact of the Explanations inserted by the Amendment Act, 1984, the majority held at page 280 :
“An Act can be considered declaratory when a provision is made to that effect in the amending Act itself. In the instant case, nothing was said by Parliament indicating its intention as to whether it wanted to affect the past years as well, one would have expected a provision for reopening of the amendment is not retrospective. Parliament was aware of the same and it was for this reason that the Explanations were made applicable with effect from 1985-86. In the absence of any indication in the Statement of Objects and Reason, it is difficult to hold that the said section was retrospective. We have notices above that no court had never held section 40(b), but that could not be considered to be an omission for the clearing of which the Explanations have been added. One line of thinking can be that the Explanations have been added with the object of laying down that in future, that is, after 1985-86, the interest paid by an individual on the investments of his monies would be liable to be deducted. In Central Bank of India v. Their Workmen [1959] 29 Comp Cas 367 (SC), the Proviso introduced in section 10(b)(iii) of the Banking Companies Act, 1949, by the amending Act of 1956, though held to be remedial, was not applied for a period anterior to the date of operation of the amending Act. S. K. Das J., in that case, observed (at. p. 392) :
‘A remedial Act, on the contrary, is not necessarily retrospective; it may be either enlarging or restraining and it takes effect prospectively, unless it has retrospective effect by express terms or necessary intendment.’
Section 10 of the Taxation Laws (Amendment) Act, 1984 neither is, nor purports to be, declaratory or retrospective from a date prior to the assessment year 1985-86. At least, if the amending Act had been made retrospective, one could have thought it was a clarificatory piece of legislation. But the Legislature has given effect to the amending Act from 1985-86. this would mean that the Explanations as inserted by the Taxation Laws (Amendment) Act, 1984, would not apply to earlier assessment years.”
16. In spite of the divergence of view expressed by various High Courts as to the scope of section 40(b), the majority view proceeds as if there was no ambiguity at all as to its scope. With the utmost respect to the learned judges, we cannot agree with this assumption. The fact that a large number if learned judges expressed differing views is a clear indication that the statute in question was not clear and the intention of Parliament in enacting section 40(b) has been understood differently by different judges.
17. The dissenting opinion in the aforesaid decision of the Allahabad High Court appeals to us as being in consonance with our line of approach. At page 289, the learned judge said :
“To my mind the real test in such a case is to find out as to in what capacity the payment of interest is being made by the firm. If the payment has been made not in the capacity of a partner, then if it is just a chance that the same person happens to hold a dual capacity, that by itself will not be the consideration for holding that such payment is hit by the provisions of section 40(b) of the Act.”
18. Again at page 290 :
“Obviously there is a difference between the capital of a partership business and the finance required for the said business. The distinction lies in this that ‘capital’ is contributed by the partners under the agreement in their capacity as partners while finance is provided by the lenders. Such lenders may be either the partners or even persons other that partners. It cannot be averred even that a person who provides finance to the firm becomes in any way a partner of the said firm, the Indian Partnership Act also does not make it obligatory on the part of the partners to contribute capital to the firm.”
19. As to the scope of an explanation, the learned judge observes at page 294 :
“… it is manifest that the object of an Explanation to a statutory provision is –
(a) to explain the meaning and intendment of the Act itself;
(b) where there is any obscurity or vagueness in the main enactment, to clarify the same so as to make it consistent with the dominant object which it seems to subserve.
An explanation cannot in any way interfere with or change the enactment or any part thereof but where some gap is left which is relevant for the purpose of the Explanation, in order to suppress the mischief and advance the object of the Act, it can help or assist the court in interpreting the true purport and intendment of the enactment, and consequently, we find that the function of an Explanation to a statutory provision is :
(c) to provide additional support to the dominant object of the Act in order to make it meaningful and purposeful;
(d) to help or assist the court in interpreting the true purport and intendment of the enactment, in order to suppress the mischief and advance the object of the Act where some gap is left which is relevant for the purpose of the Explanations though it cannot in any way interfere with or change the enactment or any part thereof.”
20. We have quoted elaborately from several decisions to highlight the problem posed by the wording of section 40(b) without the Explanations now added to it. The words “any payment… made by the firm to any partner”, if read literally as conveying the physical act of payment without reference to the nature of the payment and the capacity in which the partner received the payment, is likely to lead to anomalous results. Suppose, a partner has received interest on behalf of his friend who has gone abroad; the physical payment of the interest to the parter as an agent of his friend would lose all its legal significance, if such a payment of interest to such a guardian representing the minor would not be covered by section 40(b). But, if the partner himself acted as the guardian of the minor son, the physical act of receiving the interest in the minor’s deposit would be covered by the mischief of section 40(b), in case the Revenue’s contention is correct. If the object of section 40(b) is only to overcome possible devices that may be adopted on behalf of the partner to receive payments from the firm and the firm is allowed deduction on these payments, appropriate machinery would have been evolved under section 40(b) or elsewhere to probe into the nature of the payments and find out the real recipient of the payments. If the real recipient of the payment is the minor child or the Hindu undivided family, though payment is made through the partner (either as the guardian or as the karta), there is no reason to disallow deduction of such a payment from the chargeable income of the firm. Parliament cannot be attributed with an intention of suspecting every assessee in this country as a tax evader and unworthy of credence. It has always to be assumed (in the absence of clear words conveying a different meaning), that the genuineness of a transaction or of a payment is properly treated by the law-maker.
21. Our above observation should not be taken as questioning in any way the observations made by this court earlier in Anniah (N. M.) and Co.’s impact of the Explanations inserted to section 40(b) by the Amendment Act, 1984, either in the said case or in the other two subsequent decisions. The entire approach to section 40(b) took a different turn by the removal of the ambiguity in the words used in section 40(b) and, in the background of this amendment, we are of the view that we are entitled to take a fresh look into the meaning of section 40(b).
22. The normal principle in construing an Explanation is to understand it as explaining the meaning of the provision to which it is added; the Explanation does not enlarge or limit the provision, unless the Explanation purports to be definition or a deeming clause; if the intention of the Legislature is not fully conveyed earlier or there has been a misconception about the scope of a provision, the Legislature steps in to explain the purport of the provision; such an explanation has to be given effect to, as pointing out the real meaning of the provisions all long.
23. Mr. Raghavendra Rao, learned counsel for the Revenue, cited, D. S. Nakara v. Union of India, , while urging that retrospectivity should not be attributed to the Explanations added to section 40(b). In the said case, the Supreme Court was concerned with the scope of the Pension Scheme and whether the said scheme would benefit only those persons who retired after a particular date. Apart from considering the scope in the background of article 14 of the Constitution, the Supreme Court also held that, having regard to the nature of the pension and the purpose behind its payment, the particular date of retirement of a government servant was irrelevant to extend the benefit of the scheme. It was not a case of making the scheme retroactive at all. The Supreme Court observed that (at. p. 143). “A statute is not properly called a retroactive statue because a part of the requisites for its action is drawn from a time antecedent to its passing.” The following observations at page 144, relied upon by learned counsel for the Revenue, in no way advance his case further :
“But we make it abundantly clear that arrears are not required to be made because to that extent the scheme is prospective. All pensioners whenever they retired would be covered by the liberalised pension scheme, because the scheme is a scheme for payment of pension to a pensioner governed by the 1972 Rules. The date of retirement is irrelevant. But the revised scheme would be operative from the date mentioned in the scheme and would bring under its umbrella all existing pensioners and those who retired subsequent to that date. In the case of pensioners who retired prior to the specified date, their pension would be computed afresh and would be payable in future commencing from the specified date. No arrears would be payable. And that would take care of the grievance and retrospectivity.”
24. The Explanations inserted to section 40(b) would govern all pending cases; obviously, that is the only limitation contemplated by Parliament when it was enacted that these Explanations would be effective from April 1, 1985; in other words, Parliament purposely, did not provide for reopening of completed proceedings involving section 40(b). That was to be so, because, one of the objects behind the Amendment Act, 1984, was to reduce litigation and simplify the proceedings.
25. Therefore, we are of the view that :
(1) section 40(b) did not affect the payment of the sums referred to therein made by the firm to a partner, when such a payment to the partner was only a payment in its physical sense, but the real recipient was someone else; the real legal nature of the payment has to be the criterion to consider the applicability of section 40(b).
(2) There was real and substantial doubt as to the scope of section 40(b) which was remedied by the insertion of the three Explanations by the Amendment Act, 1984.
(3) The Explanations convey the real meaning of section 40(b) from the very inception of the said section. By applying these Explanations to consider the scope of section 40(b), the court will be advancing the real purpose of those Explanations. This is not a case of unduly stretching the amendment to make it retroactive, in the sense, retroactivity is normally understood. Explanations are to be applied in the manner in which, normally, a “Legislative Explanation” is understood.
26. Consequently, we answer both the questions referred to us in the affirmative and against the Revenue.
27. Reference answered accordingly.