ORDER
Deepak R. Shah, Accountant Member
1. All these appeals by the assessee and cross-objections by the revenue are arising out of the orders of the learned Commissioner of Income Tax (Appeals) – I, Bangalore dated 26.8.99 pertaining to Assessment Years 1995-96 and 1996-97.
2. The only issue in appeal is against clubbing of income of the wife of appellant invoking provision of Section 64(1)(ii) of the Income-tax Act (the Act). The appellant and his wife are partners in M/s. Agro Input Consultancy Centre, a partnership firm carrying on business at Madikeri. During the years under appeal, the spouse of the appellant was allowed remuneration in conformity with the limits laid down under Section 40(b) of the Income-tax Act. The Assessing Officer included the said income under Section 64(1)(ii) while computing the income of the appellant. The appellant filed an appeal against the order of assessment. The learned CIT(A) confirmed. The appellant is aggrieved and hence the present appeal.
3. The learned counsel for the assessee submitted that the salary of partner is another mode of sharing of profit in the firm. Thus such salary is not remuneration as such, but share of profit only. Reliance was placed on the decision of Hon’ble Supreme Court in the case of CIT v. RM Chidambaram Pillai (106 ITR 292). It was submitted that earlier Section 64(1)(i) was on the statute book. As per Section 64(1)(i) if the husband and wife both are partners in same firm, the share of profit was clubbed. In such situations Section 64(1)(ii) was held not applicable. Reliance was placed on the decision of Hon’ble Madras High Court in Shivashankari Chandrasekaran v. CIT (189 ITR 51). Section 64(1)(i) has been deleted in view of new scheme of assessment of firm and its partners and the remuneration payable to the partners are now held allowable provided conditions stated in Section 40(b) is complied with. In the present case, it is found that the wife of assessee is working partner in the firm and the remuneration payable to her is held allowable. In such situation, Section 64(1)(ii) is not applicable. It was also submitted that in view of proviso to Section 64(1)(ii) since the wife of assessee is possessing such qualification and experience so as to look after the business of the firm, Section 64(1)(ii) is not applicable. Reliance was also placed on the decision of ITAT, Bangalore in ITA No. 376 to 379/Bang/1999 in the case of Mohan Baliga v. ITO dated 22.5.2001, where on identical issues, Section 64(1)(ii) was held not applicable.
4. The Learned Departmental Representative on the other hand submitted that Legislative intent is clear for such inclusion as in Section 64(1)(ii) as also in Section 40(b). For the purpose of such inclusion under Section 64(1)(ii), the nomenclature nor the head of income under which such payment is assessable are not relevant. The requirements are that:
i) the assessee is an individual,
ii) Income arises directly or indirectly,
iii) The income arises to the spouse or minor child of such individual,
iv) The payment is by way of salary, commission, etc., whether is in cash or in kind,
v) The payment is from a concern in which such individual has substantial interest,
vi) Proviso under Section 64(1)(ii) are not applicable.
In the instant case, all the above requirements are satisfied. The arguments of the assessee that Section 64(I)(ii) is applicable where ‘salary’ is assessable under Section 15 and which is received out of ’employer-employee’ relation is not tenable. The CIT(A) elaborated on this point and also considering the case laws quoted, has held that the assessee’s arguments are untenable, and held that the Section 64(1)(ii) is clearly attracted. Reliance was also placed on the decision of Hon’ble Gauhati High Court in CIT v. Smt. Pratima Saha (239 ITR 570). In reply it was contended that in the present case the wife is possessing required professional and technical knowledge coupled with experience and hence in view of proviso, Section 64(1)(ii), is not applicable.
5. We have carefully considered the rival submissions, relevant facts of the case and the decisions relied upon.
5.1. In the present context, it may be useful to trace the history of Section 64. Section 16(3) of the Indian Income-tax Act, 1922 was brought on statute book by the amendment Act of 1936 effective from Assessment Year 1937-38. The provision was designed to overtake and circumvent a growing tendency on the part of the taxpayer to endeavour to reduce liability to tax by admitting the spouse as a partner in which the tax payer himself was a partner, Sections 64(1)(i) and 64(1)(ii) which are relevant in the present case read as under:-
“In computing the total income of an individual, there shall be included all such income as arises, directly or indirectly,
(i) to the spouse of such individual from the membership of the spouse in a firm carrying on a business in which such individual is a partner;
(ii) to the spouse of such individual by way of salary, commission, fees or any other form of remuneration whether in cash or in kind from a concern in which such individual has a substantial interest.”
Provided that nothing in this clause shall apply in relation to any income arising to the spouse, where the spouse possess technical or professional qualification and the income is solely attributable to the application of his/her technical or professional knowledge and experience.
5.2 Section 64(1)(ii) in the present form was not there in the Indian Income Tax Act, 1922. This provision of section was also not there when the Act of 1961 was enacted. The above provision was brought on statute book by the taxation Laws Amendment Act, 1975 effective from 1.4.76. The reason for the introduction of this clause is to be seen at page 77 of the report of Wanchoo Committee. The extracts are as under:-
“Of the various devices to divert income, one that is most frequently resorted to by a tax payer in business or profession is the practice of remunerating substantially the spouse by having the spouse as an employee purchasing/selling agent, consultant, etc., in respect of business in which he or she has a substantial interest. Remunerating the spouse in this manner is often nothing but an attempt to camouflage one’s own income as the income of the spouse. We recommended that it should be provided in law that in computing the total income of an individual there shall be included all such income as arises directly or indirectly to the spouse of such individual by way of salary, commission, fees or any other form of remuneration from a concern in which such individual has substantial interest. For this purpose, an individual may be deemed to have a ‘substantial interest’ (a) in the case of a Limited Company, if its shares carrying not less than 20 percent of the voting power were, at any time during the previous year, owned beneficially by such individual either singly or along with his relatives and (b) in the case of any other concern, if such individual either singly or along with his relatives was entitled in the aggregate at any time during the previous year, to not less than 20 per cent of the profits of such concern. For this purpose, the term ‘relative’ should have the same meaning as in Clause (41) of Section 2 of the Income-tax Act, 1961.”
The intention of the law appears to be to check tax evasion by diversion of income using the spouse as a conduit pipe and at the same time to recognize the right of the spouse to earn income by application of knowledge and experience.
5.3 Under the corresponding provision of section of Indian Income-tax Act, 1922, the question arose before the Bombay High Court in the case of Magnus v. CIT (33 ITR 538) whether the salary received by a partner from a firm in which her husband was also a partner was liable to be included in the total income of the husband. The court held that a partner cannot be an employee of the firm and that the salary received by the partner is nothing but his share of profit and therefore, is liable for inclusion in the hands of the husband under Section 16(3a)(i) of Indian Income-tax Act, 1922 (corresponding to Section 64(1)(i) of the present Act).
5.4 A similar question arose for the consideration of Madras High Court in the case of Shivashankari Chandrasekaran v. CIT (189 ITR 51). The facts in that case –
“The next question we have to examine is whether the salary received by the husbands of the assessee’s in pursuance of Clause (8) of the deed of partnership can be considered as income arising directly or indirectly from their membership of the firm. In R.M. Chidambaram Pillai v. CIT [1970] 77 ITR 494 (Mad) [FB], A full Bench of this court, while considering the nature and character of salary paid to a partner, held that the salary received by a partner of a firm for services rendered by him to it is only a mode of adjustment in his share of the firm’s income and continues to bear, for the purposes of charge at his hands, the same character as part of the total income of the firm, which has to be shared between its partners. The Supreme Court, in the decision in CIT v. R.M. Chidambaram Pillai [1977] 106 ITR 292 (SC), while confirming the decision of the Full Bench of this court in R.M. Chidambaram Pillai v. CIT [1970] 77 ITR 494 [FB], held that, in strict law, there cannot be any contract of service between the firm and one of its partners and, consequently, there can be no question of a partner of a firm being an employee thereof and that the salary paid to a partner represents the special share of the profits and retains the same character of the income of the firm. The Supreme Court in above mentioned decision further held as follows:
“The anatomy of the provision is obvious, even if the explanation or motivation for it may be more than one. It is implicit that the share of income of the partner takes in his salary. The telling test is that where a firm suffers loss the salaried partner’s share in it goes to depress his share of income. Surely, therefore, salary is different label for profits, in the context of a partner’s remuneration …. Salaries are profits known by a different name and must be Treated as such for taxation purposes…
In view of the above position of law as laid down by the Supreme Court, it has to be held that the salary received by the husbands of the two assessee’s form part of their share income and, consequently, it is income arising to them directly from their membership of the firm. In these circumstances, the Tribunal rightly held that the salary paid to the husbands of the two assessee’s by the firm in pursuance of Clause (8) of the deed of partnership should also be include in the assessments of the two assessee’s for Assessment Year 1974-75. We, therefore, answer the question referred to us in the affirmative and against the assessee’s”.
From the above observations, it is clear that the salary received by a partner from a firm of which he is a partner will have to be considered only as a part of profits coming within the scope of Section 64(1)(i) of the Act and cannot be construed as salary within the meaning of Section 64(1)(ii) of the Act.
5.5 It may be useful in this context also to note the law between 1976 to 1992 when both Clause (i) and Clause (ii) of Section 64 were operative. At that point of time, the salary paid by a firm to its partner was considered as a share of profit by virtue of Section 67(1) of the Act. Subsequent to Assessment Year 1992-93, Section 28(v) specifically provides that any salary allowed as such in computing the income of the firm shall be considered as the income of the partner chargeable under the head “Profits and gains from business/profession”. Similarly, explanation to 2 Section 15 clarifies the position that any salary received by a partner of a firm shall not be regarded as salary for the purposes of Section 15 (Refer 194 ITR 133 Statute). The reason for treating the salary received by a partner of a firm as a share of profits is to be seen from the decision of the Supreme Court in CIT v. R.M. Chidambaram Pillai 106 ITR 292. Reference may be made to the following two paragraphs appearing at page 309 of the Report:-
“Any interest, salary, bonus, commission or remuneration paid by a firm to any of its partners cannot be deducted by the firm as an expenditure in its profit-computation. The reason is this: The partners in a firm are ultimately entitled to the entire profits of the firm, according to their shares in the business. Therefore, the entirety of such profits should be brought to a charge and no portion be exempted by giving the same away to a partner as his salary, bonus, commission, remuneration or interest. A partner is bound to find the necessary finances for the partnership and hence any interest on capital supplied by the partner is not deductible. A partner’s rendering services to the firm stands on the same footing as his providing capital; only instead of in money, in kind. Further, no remuneration is permissible to a partner for his rendering services to the firm, since the carrying on of the business of the partnership is a primary duty which all the partners, or some of the partners acting for all, are required to do by the law relating to partnership.
The matter may be looked at another way too. In law, a partner cannot be employed by his firm, for a man cannot be his own employer. A contract can only be bilaterial and the same person cannot be a party on both sides, particularly in a contract of personal employment. A supposition that a partner is employed by the firm would involve that the employee must be looked upon as occupying the position of one of its own employers, which is legally impossible. Consequently, when an arrangement is made by which a partner works and receives sums as wages for services rendered, the arrangement should in truth be regarded as a mode of adjusting the amount that must be taken to have been contributed to the partnership’s assets by a partner who has made what is really by a partner who has made what is really a contribution in kind, instead of contribution in money.”
From the above observations of the Supreme Court, it is clear that the salary payment by a firm to its partners is only a profit sharing arrangement and there exists no employer/employee relationship between the firm and its partner. It may be noted that at pages 295 of the report their lordships have analyzed the provision of Section 40(b) and 67 (corresponding provisions are Section 10(4b) and Section 16(1b). This is what they have said –
“In the Income-tax Law, a firm is a unit of assessment, by special provision, but is not a full person which leads to the next step that since, a contract of employment requires two distinct persons viz., the employer and the employee, there cannot be a contract of service, in strict law, between a firm and one of its partners. So that any agreement for remuneration of a partner for taking part in the conduct of the business bust be regarded as portion of the profits being made over as a reward for the human capital brought in Section 13 of the Partnership Act, brings into focus this basis of partnership business.
This legal ideology expresses itself in the Income Tax Act, in Section 10(4)(b) and Section 16(1)(b). A firm, partner and partnership, according to Section 2(6B) of the Act, bear the same sense as in the Partnership Act. The taxable income of a firm has to be its business profits, as provided in Section 10(1), 10(2) and 10(4). What is the real nature of the salary paid to a partner vis-à-vis the income of the firm? On principle, payment of salary to a partner represents a special share of the profits and is, therefore, part of the profits and taxable as such and Section 10(4)(b) stipulate accordingly. May be, we may usefully read here Section 10(1) and 10(4) to the extent relevant.
“10. (1) The tax shall be payable by an assessee under the head ‘Profits and gains of business, profession or vocation’ in respect of the profits or gains of any business, profession or vocation carried on by him….
(4) Nothing in Clause (ix) or Clause (xv) of Sub-section (2) shall be deemed to authorize the allowance of any sum paid on account of any case, rate of tax levied on the profits or gains’ and nothing in Clause (xv) of Sub-section (2) shall be deemed to authorize….
(b) any allowance in respect of any payment by way of interest, salary, commission or remuneration made by a firm to any partner of a firm…..”
It is plain that salaries paid to partners are regarded by the Income Tax Act, as retaining the character of profits and not excludible from the tax net, whatever the reason behind it be. The procedure for computation of the total income of a partner, found in Section 16(1)(b) also fits into this understanding of the law behind the law.
The Supreme Court further noted that the decision of the Madras High Court in Mathew Abraham v. CIT (51 ITR 467) is not on sound reasoning and held as under:-
“We regard this conclusion as unsound, the source of the error being a failure to appreciate that the salary of a partner is but an alias for the return, by way of profits, for the human capital – sweat, skill and toil are, in our socialist republic, productive investment – he has brought in for common benefit. The immediate reason for payment of salary was service contract but the causa causans is partnership.”
In view of the above, we hold that since what the spouse of the assessee receives is not salary, commission, fees or remuneration but by way of share of profit only and since Section 64(1)(i) is deleted, such income cannot be clubbed in the hands of the assessee.
5.6 It is also necessary to examine further whether the proviso to the section is also applicable. The said proviso read as under:-
“Provided that nothing in this clause shall apply in relation to any income arising to the spouse, where the spouse possess technical qualifications and the income is solely attributable to the application of his/her technical or professional knowledge and experience.”
It is clear from the proviso that Section 64(1)(ii) does not apply to a case where a spouse possesses technical or professional qualification and the income is solely attributable to such knowledge and experience. In view of the above, it is clear that in order to apply the proviso, it is not necessary that the spouse should have a qualification being a ‘degree or diploma of a University”.
5.7 In the context of a working partner, the technical or professional qualification will have to be understood as an educational qualification that is enough to discharge the function of a working partner. In the instant case, Smt. Prema Kushalalppa has been regularly attending the affairs of the firm. Therefore, the latter part of the proviso which requires that the income in question must be solely attributable to the application of the knowledge and experience is fully satisfied. No special technical or professional qualification is necessary to become a working partner of a firm carrying on the business of hardware. As submitted, the spouse is a graduate in arts and in the backdrop of the business of the firm this qualification shall be construed as a technical qualification required to run a hardware shop is minimum and it is sufficient if the partner knows the different brands of the items dealt with by the firm and their different uses etc. Consequently, it is held that the proviso is applicable and hence the inclusion of income is not warranted.
The dececision of Hon’ble Gauhati High Court will also be not applicable as in the said case, the spouse of the assessee was not receiving salary as partner thereof and it was also held that she does not possessed any professional or technical knowledge, Section 64(1)(ii) was held applicable which is not so in the present case.
In the result, the appeals of the assessee are allowed and the cross objections are dismissed.