income tax

Published on 5 April 2025

Understanding Sections 40(b) and 194T of the Income Tax Act, 1961

Overview of Section 40(b) and Section 194T of the Income Tax Act, 1961

Section 40(b) of the Income Tax Act, 1961, outlines the conditions and limits for deducting partner remuneration from a partnership firm’s taxable income. This section ensures that only the remuneration of working partners, authorized by the partnership deed and adhering to specified limits, can be deducted. The Finance Act 2024 has introduced revised limits for such deductions effective from April 2025, which set the maximum allowable remuneration at Rs. 3,00,000 or 90% of the first Rs. 6,00,000 of book profits, and 60% for the remaining profits. This revision aims to keep pace with increasing business profits.

Additionally, Section 194T mandates a tax deduction at source (TDS) of 10% on partner remuneration exceeding Rs. 20,000 annually. While this provision enhances tax transparency and traceability, challenges may arise in aligning reported taxable remuneration with amounts subjected to TDS, complicating tax filings. For example, remuneration disallowed under Section 40(b) may still be present on a partner’s Form 26AS, despite being non-taxable in the firm’s hands, necessitating careful adjustments.

Understanding Section 40(b) of the Income Tax Act, 1961

Partnership firms provide remuneration to partners through various means, including interest on capital, salary, bonus, and commission, in addition to profit shares. Partnership firms are subject to a flat tax rate of 30%, while partners are taxed according to applicable slab rates. To prevent the diversion of taxable profits from the firm to the partners, Section 40(b) specifies certain conditions and limits for deduction of remuneration:

  • Disallowed Payments:
    • Remuneration paid to a non-working partner.
    • Remuneration to a working partner not authorized in the partnership deed.
    • Remuneration related to periods before the partnership deed authorization.

For example, if a firm pays remuneration to working partners from April 2023 to March 2024, but the clause authorizing this payment is added on 1st July 2023, only remuneration from 1st July 2023 onward is deductible for the firm.

  • Interest Payments:
    • Any authorized payment of interest exceeding 12% per annum is also disallowed.
  • Calculating Deductible Remuneration: The allowable remuneration for working partners is constrained by the following limits:
    • For the first Rs. 3,00,000 of book profits (or in case of loss), the maximum deductible is Rs. 1,50,000 or 90% of book profits, whichever is higher.
    • For the remaining book profits, the limit is 60%.

Book profit, as defined, means the net profit shown in the profit and loss account for the relevant previous year, adjusted by the total remuneration paid to partners if deducted while computing net profit.

Amendments Under Budget 2024

Recognizing the growth in business operations and profits, the Budget 2024 has revised the allowable remuneration limits:

  • For the first Rs. 6,00,000 of book profits (or in case of loss), the maximum deductible is Rs. 3,00,000 or 90% of book profits, whichever is higher.
  • For the remaining book profits, the limit remains at 60%.

The core conditions for allowing remuneration remain unchanged, thus facilitating potential for increased deductions.

Introduction of Section 194T – TDS on Partner Remuneration

Previously, remuneration paid to partners was neither taxable under the salary head nor subjected to TDS under Section 192 or interest on capital under Section 194A. The Finance Act 2024 introduces a new provision, Section 194T, applicable from 1st April 2025, requiring firms to deduct TDS on remuneration:

  • The firm must deduct 10% TDS at the time of crediting the remuneration to the partner's account (including capital accounts) or at the time of actual payment, whichever occurs first.
  • TDS is not applicable if the total remuneration credited or paid during the financial year does not exceed Rs. 20,000.

This new regulation enhances transparency regarding the taxation of partner remuneration.

However, practical difficulties may emerge in reconciling the total taxable remuneration with the TDS amount withheld. For instance, if a firm pays each of three partners Rs. 2,50,000, exceeding the Rs. 20,000 threshold, a 10% TDS will be deducted. If some of that remuneration is disallowed under Section 40(b), creating discrepancies on the partners' Form 26AS, it could complicate their income tax return filings.

Conclusion

The increase in allowable remuneration limits is advantageous for partnership firms as business profits rise. Furthermore, the introduction of TDS adds transparency to partner remuneration; however, clarity is needed on reconciling taxable income for partners versus the amounts subjected to withholding tax. This will help ensure smoother tax filing processes for individuals and firms in the future.