Tax deduction for interest on partner’s capital

Interest is calculated and paid to each partner based on the capital contributed to the firm. Capital contribution and interest on it has to be specified in the deed of Partnership.

After preparing Partnership deed, partners are required to apply for firm’s permanent account number by filing form 49B. Only document to be attached with form 49B is the certified copy of firm’s deed of Partnership.

After getting PAN, the firm can file it’s return of income with the government by calculating it’s taxable business income.

However, while calculating firm’s taxable business income, the entire amount paid as interest on capital contribution may not be allowed as tax deductible. Quantum of interest allowed as tax deductible is to be calculated based on the provisions of section 40(b) of Income Tax Act,1961.

Conditions to claim interest on capital as business expenditure

To get tax deduction, you must draft your partnership deed according to the income tax laws. As per section 40(b) of income tax act, 1961, interest on partner’s capital must be authorised by the partnership deed.

The deed should be defined in such a way that the interest on capital should be for the period falling after the date of the partnership deed.

This means if the deed of Partnership doesn’t authorize to pay interest on capital, then it cannot be allowed as expenses while calculating firm’s taxable business income. It should also be calculated and paid on the capital contributions after the date on which the deed is executed and became effective.

Here are two exceptions to the above conditions;

  • If the individual is a partner on behalf of or for the benefit of any other person (karta of HUF, director of company), and interest is paid to the individual otherwise than as partner in a representative capacity.
  • Where an individual is a partner in his individual capacity and interest is received by such individual from the firm on behalf or for the benefit of any other person (Karta of HUF, Director of Company)

Maximum permissible limit allowed as business expenditure

If conditions are satisfied then simple rate of interest on partner’s capital up to a maximum limit of 12% is allowed as a business expenditure for calculating firm’s taxable business income.

Please remember that the maximum permissible limit is not calculated on the basis of firm’s book profit or gross receipt. In the case of partner’s remuneration, book profit is required to determine eligibility.

In following cases interest on partner’s capital is not allowed as business deduction;

  • If partnership deed is silent on it,
  • If it has been paid to someone who is not taken as a partner in the deed.

If interest on partner’s capital is more than 12% then the excess amount paid over and above the maximum limit of 12% will be disallowed.

This means, only 12% will be allowed as tax deductible. Balance left out after taking out 12% from the total amount paid as interest on capital will get added to the book profit and taxable accordingly. This means excess amount will be disallowed.

Please remember, 12% is the maximum Limit. If the deed has prescribed any rate which is less than 12%, then such lower rate will be considered.

In the hands of the partner, the amount allowed as tax deductible from firm’s income is taxable and whatever disallowed from firm’s income will not be taxable.

This means, in our above case, whatever left out after allowing simple rate of interest @12% on capital will not be allowed as business expenditure in the hands of the firm.

As it’s not allowed as business expenditure for firm, it’s not taxable in the hands of the partner. As an individual, they will consider interest income @ 12% or the amount received, whichever is lower as their income.

Remuneration to partners is allowed as tax deductible if its paid to those who are working for the firm. However, in case of interest on capital, such type of restriction is not there. If it’s paid to a non working partner, then it can be calculated in similar manner and claim as a business expenditure while calculating firm’s income.

Same provision is applicable while calculating taxable business income of a LLP, as it’s taxable as a firm.

is a fellow member of the Institute of Chartered Accountants of India. He lives in Bhubaneswar, India. He writes about personal finance, income tax, goods and services tax (GST), company law and other topics on finance. Follow him on facebook or instagram or twitter.