A clause-by-clause technical analysis under the Income Tax Act, 1961
Section 40(b) of the Income Tax Act, 1961 governs the deductibility of interest and remuneration paid by a partnership firm to its partners. It operates alongside Section 184 (which lays down the conditions a firm must satisfy to be assessed as a firm), Section 28(v) (which taxes these receipts in the hands of the partner), and, from Assessment Year 2025-26, Section 194T (which mandates TDS on such payments). This article sets out the statutory scheme clause by clause, explains how “book profit” is computed under Explanation 3, and works through a complete numerical example.
Threshold condition: assessment as a firm under Section 184
Section 40(b) applies only where the entity is “assessed as a firm.” Section 184 requires that the partnership be evidenced by an instrument of partnership, that the instrument specify the individual shares of the partners, and that a certified copy of the instrument accompany the firm’s return of income for the relevant assessment year (and again whenever the terms of the partnership, or the profit-sharing shares, change during the year). Where these conditions are not satisfied, the firm can lose the benefit of the Section 40(b) deduction scheme entirely, so the partnership deed and its filing are the starting point of the analysis, not a formality to be handled afterward.
The structure of Section 40(b): clauses (i) to (v)
Section 40(b) is drafted as a list of disallowances — it identifies what a firm cannot deduct, rather than affirmatively granting a deduction. In substance, the five clauses operate as follows.
| Clause | What it disallows |
| (i) | Any remuneration paid to a partner who is not a working partner — disallowed in full, regardless of amount or deed authorisation |
| (ii) | Any remuneration or interest that is not authorised by, or not in accordance with, the partnership deed |
| (iii) | Any remuneration or interest that is authorised by the deed but relates to a period before the date of that deed (i.e., no retrospective effect) |
| (iv) | Interest to a partner in excess of 12% simple interest per annum, even where the deed authorises a higher rate |
| (v) | Remuneration to a working partner in excess of the aggregate limit computed on book profit under Explanation 3 |
Clauses (i) to (iii) are essentially gatekeeping conditions — a payment either qualifies for consideration under the section or it doesn’t. Clauses (iv) and (v) are the quantitative caps: a 12% ceiling on interest, and a slab-based ceiling on remuneration.
The four Explanations
Four Explanations to Section 40(b) fill in definitions and edge cases that the clauses themselves don’t spell out.
Explanation 1 addresses a partner who both receives interest from the firm and pays interest to the firm — for instance, where a partner has a debit balance in one account and a credit balance in another, or borrows back from the firm. In such a case, only the net interest paid by the firm to that partner is taken into account for testing against the 12% ceiling, rather than the gross interest paid.
Explanation 2 deals with a partner who holds their interest in the firm in a representative capacity — for example, an individual who is a partner “on behalf of,” or “for the benefit of,” another person (a common structure where an HUF’s interest is represented by its karta, or a trust’s interest is represented by a trustee). Interest paid to that individual in their personal capacity, as distinct from their representative capacity as partner, falls outside Section 40(b) altogether; interest paid to them qua partner, and interest paid to the person they represent, is what the section actually tests.
Explanation 3 defines “book profit” — the base figure to which the clause (v) remuneration slabs are applied. It is not the accounting net profit; it is the net profit as per the profit and loss account, computed in the manner laid down for income under the head “Profits and gains of business or profession,” as increased by the remuneration to partners where that remuneration has already been debited to the profit and loss account.
Explanation 4 defines a “working partner” as an individual partner who is actively engaged in conducting the affairs of the business or profession of the firm. This definition does the heavy lifting behind clause (i): a partner who has contributed capital but takes no active part in the business cannot receive deductible remuneration, however the payment is labelled in the deed.
Computing book profit under Explanation 3
Because book profit excludes the deduction for remuneration itself (that deduction is what’s being tested against it), and because it is confined to income taxable under the business head, arriving at it requires a short sequence of adjustments starting from the profit and loss account:
Begin with the net profit as per the profit and loss account. Add back any remuneration to partners already debited as an expense. Add back interest on partners’ capital disallowed under clause (iv) — i.e., any excess over 12% simple interest per annum. Add back any other expenditure disallowed under the Act, such as amounts caught by Section 40A(3) (cash payments beyond the prescribed limit) or Section 43B (certain statutory dues not paid before the due date for filing the return). Then deduct any income credited to the profit and loss account that is chargeable under a head other than business income — capital gains, house property income, or interest on an income-tax refund, for instance.
What remains is the book profit for the purposes of clause (v).
Interest on capital: clause (iv) in practice
A firm may pay interest to partners on their capital contributions, but the deduction is conditional on two things holding simultaneously: authorisation under the partnership deed (clauses (ii) and (iii)), and a rate not exceeding 12% simple interest per annum (clause (iv)). Partners are free to agree commercially to a higher rate in the deed, but the deduction available to the firm remains capped at 12%; the excess is added back under clause (iv) regardless of what was actually paid. Where the deed specifies a rate below 12%, that lower contractual rate governs, since clause (ii) tests the payment against what the deed actually authorises, not against the statutory ceiling.
Remuneration to working partners: clause (v) and the current slabs
Clause (v) caps deductible remuneration to a working partner at an aggregate figure computed on book profit. The Finance (No. 2) Act, 2024 revised this slab structure with effect from Assessment Year 2025-26, roughly doubling the ceiling that had applied since Assessment Year 2010-11.
| Book profit | Maximum deductible remuneration under clause (v) |
| Book profit is a loss | ₹3,00,000 |
| First ₹6,00,000 of book profit | ₹3,00,000, or 90% of book profit — whichever is higher |
| Balance of book profit above ₹6,00,000 | 60% of the balance |
For assessment years up to 2024-25, the first slab was ₹3,00,000 (with a ₹1,50,000 floor) rather than ₹6,00,000 (with a ₹3,00,000 floor); the 60% rate on the balance is unchanged across both regimes.
The clause (v) figure is a ceiling, not an entitlement — the deduction available to the firm is the lower of the amount actually authorised and paid under the deed, and the clause (v) limit. Where the deed authorises less than the ceiling, only the lower, actual amount is deductible; where it authorises more, the excess above the ceiling is disallowed.
A worked example
Consider a firm with two working partners, X and Y, who have contributed capital of ₹10,00,000 and ₹5,00,000 respectively. The deed authorises interest on capital at 14% per annum and remuneration up to the clause (v) limit.
The firm’s profit and loss account shows a net profit of ₹7,00,000, computed after debiting interest on capital at the deed rate of 14% (₹1,40,000 to X and ₹70,000 to Y, totalling ₹2,10,000) and remuneration of ₹3,50,000 to the two partners. The account also includes ₹15,000 of interest on an income-tax refund, taxable under “Income from Other Sources” rather than as business income.
Testing the interest payment against clause (iv): at 12%, X and Y are entitled to ₹1,20,000 and ₹60,000 respectively, or ₹1,80,000 in total, against the ₹2,10,000 actually paid at 14%. The excess of ₹30,000 is disallowed under clause (iv), notwithstanding that the deed authorised the 14% rate.
Computing book profit under Explanation 3: net profit of ₹7,00,000, plus the ₹3,50,000 remuneration already debited, plus the ₹30,000 interest disallowed under clause (iv), less the ₹15,000 of refund interest taxable under a different head, gives a book profit of ₹10,65,000.
Applying the clause (v) slabs to this book profit: on the first ₹6,00,000, the higher of ₹3,00,000 or 90% (₹5,40,000) applies, giving ₹5,40,000; on the remaining ₹4,65,000, 60% gives ₹2,79,000. The clause (v) ceiling is therefore ₹8,19,000. Since the firm actually paid only ₹3,50,000, well within this ceiling, the entire amount is deductible and no part of the remuneration is disallowed.
The firm’s business income chargeable to tax is therefore the accounting net profit of ₹7,00,000, adjusted for the ₹30,000 disallowed under clause (iv) and the ₹15,000 excluded as income under another head, giving ₹7,15,000. No separate adjustment for remuneration is required in this instance because the amount actually paid was already within the clause (v) ceiling; the entire adjustment in this example arises from the interest exceeding the 12% cap.
Taxability in the partner’s hands: Section 28(v)
Section 28(v) taxes interest and remuneration received by a partner as business income, but only to the extent the amount has actually been allowed as a deduction to the firm under Section 40(b). In the example above, X and Y are taxed under Section 28(v) on the ₹1,80,000 of interest allowed and on their respective shares of the ₹3,50,000 remuneration allowed, but not on the ₹30,000 disallowed under clause (iv) — that amount has already been subjected to tax once, at the firm’s level, and a proviso to Section 28(v) keeps it out of the partner’s income to prevent double taxation.
The TDS overlay: Section 194T
From 1 April 2025, Section 194T requires a firm to deduct tax at source at 10% on salary, remuneration, commission, bonus, or interest credited or paid to a partner, once the aggregate of such sums to that partner in the financial year exceeds ₹20,000. The deduction is triggered at the time of credit (including credit to the partner’s capital account) or payment, whichever is earlier. Because Section 194T operates on amounts actually credited or paid, while Section 40(b) governs what the firm may deduct, TDS can end up reflected in a partner’s Form 26AS even on a component that is later disallowed at the firm’s level under clause (iv) or clause (v) — a reconciliation point worth flagging when the return is filed.
Recurring errors in practice
The most frequent error is applying the clause (v) slabs directly to accounting net profit rather than to book profit as defined in Explanation 3 — omitting the add-back of remuneration already debited, or failing to strip out amounts disallowed under clause (iv) and income taxable under other heads. A second common error is paying remuneration to a partner who does not meet the Explanation 4 definition of a working partner; such payments are disallowed under clause (i) in full, irrespective of amount or deed authorisation. A third is a partnership deed that fixes a rupee figure for remuneration rather than referring to “remuneration up to the maximum permissible under Section 40(b), as amended from time to time” — a deed drafted the first way requires amendment every time the statutory slabs change, and until it is amended, clause (ii) limits the deduction to what the unamended deed actually authorises, even if that is less than the current statutory ceiling.
Summary
Section 40(b) disallows remuneration to non-working partners outright under clause (i); disallows any interest or remuneration not authorised by, or predating, the partnership deed under clauses (ii) and (iii); caps deductible interest at 12% simple interest per annum under clause (iv); and caps deductible remuneration to working partners at a slab-based percentage of book profit under clause (v). Book profit itself is a defined, tax-specific figure under Explanation 3, not the accounting net profit. Amounts allowed as a deduction to the firm are taxed in the partner’s hands under Section 28(v); amounts disallowed are not taxed again at the partner’s level. Since Assessment Year 2025-26, these payments also carry a TDS obligation under Section 194T, independent of how much of the payment is ultimately allowed as a deduction to the firm.
This article sets out the general scheme under Section 40(b) of the Income Tax Act, 1961, including amendments made by the Finance (No. 2) Act, 2024 effective from Assessment Year 2025-26. Clause and Explanation numbering reflects the structure as commonly applied in professional practice; readers relying on this for a specific filing should cross-check the current bare Act text and consult a chartered accountant, since limits and provisions are revised periodically through subsequent Finance Acts.
Blog By : Mittal & Co.