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Assessment of Firm
Computation of Total Income of the firm
(Including Limited Liability Partnership)


As discussed above, the total income of the firm (including LLP) will be determined as a separate entity and it will be computed under various heads of income. However, while computing taxable profits under the 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. Deduction of interest to a partner is allowable under section 36 and remuneration to a working partner will be allowed under section 37.

SECTION 40(B) deals with the amounts which are not deductible in case of a firm assessable as such. Therefore, deductions on account of interest and remuneration to the partners can be claimed under sections 36 or 37, as the case may be, but it will be subject to the conditions prescribed by section 40(b), which are as under:
(1) Payment of salary, bonus, commission or remuneration by whatever name called, to a non-working partner shall not be allowed as deduction.

(2) Payment of remuneration to working partners and interest to any partner will be allowed as deduction only when it is authorised by and is in accordance with partnership deed.

(3) Payment of remuneration/interest, although authorised by the partnership deed but which relates to a period prior to the date of such partnership deed, shall not be allowed.

(4) Interest payable to a partner, although authorised by the partnership deed shall be allowable as a deduction subject to a maximum of 12% simple interest per annum. If the partnership deed provides for interest at less than 12% p.a., the deduction of interest shall be allowed to the extent provided by the partnership deed.

(5) The payment of remuneration to working partner, although relates to a period after the date of the partnership deed and authorised by the partnership deed. shall be allowed as a deduction to the extent provided in the partnership deed but subject to maximum of the following limits:

(a) On the first Rs. 3,00,000 of the Rs. 1,50,000 or at the rate of 90% of
      book profit or in case of a loss the book profit whichever is more
(b) On the balance of the book profit at the rate of 60%

Working partner :- As per Explanation 4 to section 40(b) "working partner" means an individual who is actively engaged in conducting the affairs of the business or profession of the firm of which he is a partner. Thus only individuals are capable of being working partners.
Interest payable to a partner in representative capacity [Explanation 1 to section 40(6)]: Where an individual is a partner in a firm on behalf of and for the benefit of any other person, interest paid by the firm to such an individual otherwise than as a partner in a representative capacity shall not be taken into account for the purpose of section 40(6). 
However, the interest paid by the firm to such an individual as' a partner in a representative capacity and interest paid by the firm to the person so represented is taken into account for the purpose of this section.

Example: 
Suppose R is a partner in a firm on behalf of his HUF and the HUF has contributed Rs. 1,00,000 as its capital contribution. Besides, R has also given a loan of Rs. 50,000 to the firm in his individual capacity. The firm pays interest @ 20% p.a. on capital as well as on the loan.
(a) Interest amounting to Rs. 10,000 paid to R on loan of Rs. 50,000 will not be covered u/s 40(b) and would be allowed as deduction in full to the firm;
(b) Out of the interest on capital amounting to Rs. 20,000 paid to the partner R who represents the HUF, interest @ 12% p.a. will only be allowed as a deduction, because it is hit by the provisions of section 40(b).
Similarly, if the interest is received by an individual who is a partner in a firm on behalf and for the benefit of any other person, restriction imposed by section 40(b) will not operate on the interest received by him on behalf of other person. [Explanation 2 to section 40(b)].

Example:
R is a partner in a firm. He is also karta of HUF who has given loan to the firm. The firm pays Rs. 20,000 as interest on capital and loan given by R. The firm also pays Rs. 30,000 to R on the loan given by HUF to firm. In this case section 40(b) will be applicable on interest of Rs. 20,000 but it will not be applicable on interest of Rs. 30,000. However such interest can attract the provisions of section 40A(2).
Computation of Book Profit [Explanation 3 to section 40(6)]
Book-Profit, as stated above, will be computed as under:

STEP I: 
Compute the income of the firm under the head 'profit and gains of business or profession' as per sections 28 to 44D i.e. start with the net profit as per profit and loss account and make additions and deductions as per sections 28 to 44D already explained under the chapter Business or Profession. Interest paid/payable to partners in excess of 12% shall also be disallowed as per section 40(b).

STEP 2:
Add aggregate amount of remuneration paid/payable to all the partners (whether working or non-working) of the firm, if it has been debited to profit and loss account. The aggregate of Step-1 and Step-2 is Book Profit.

1. For purpose of book profit only income under the head Business or Profession is to be computed. Therefore, if there is income chargeable to tax under the heads 'Income from house property', 'Capital gains' and 'Income from other sources', credited to profit and loss account, that will be deducted from the net profit to compute book profit. Similarly expenses on such incomes which are taxable under other heads will be added back if they are debited to profit and loss account.

2. Brought forward business loss will not be deducted for computation of book profit but unabsorbed depreciation brought forward from earlier years will be deducted as unabsorbed depreciation is allowable as deduction under section 32(2). However, for allowing unabsorbed depreciation, brought forward business loss shall have to be notionally allowed first from the current business income.

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