Special Provisions Governing the Assessment of Firms and Association of Persons | Income Tax Act, 1961

The Income Tax Act, 1961 lays down a comprehensive framework for the taxation of different types of assessees, including individuals, companies, firms, and associations of persons (AOPs). While general provisions of assessment apply to all assessees, special provisions govern the assessment of firms and AOPs, considering their unique structure and the way income is shared among partners or members.

This article analyses the key statutory provisions, case laws, and procedural aspects that pertain to such assessments.

Legal Definition and Status

1. Firm [Section 2(23)]

A 'firm' means a partnership as defined in the Indian Partnership Act, 1932 and includes a limited liability partnership (LLP) as per the Limited Liability Partnership Act, 2008.

2. Association of Persons (AOP)

An AOP refers to two or more individuals voluntarily coming together for a common purpose, usually to earn income, but without forming a legal partnership. It is not defined under the Act but recognised for tax purposes.

In M/s. Bangalore Club v. Commissioner of Income Tax & Anr., (2013) 350 ITR 509 (SC), the Supreme Court held that interest income earned by a club—an Association of Persons (AOP)—from fixed deposits with member banks is taxable, as it does not qualify under the doctrine of mutuality.

The Court observed that once the funds were deposited with banks (even if member banks), they were used for commercial purposes outside the mutual circle, breaking the identity between contributors and beneficiaries—a key condition for mutuality. Thus, the interest income bore the taint of commerciality and was liable to income tax.

Taxation Framework

1. Assessment of Firms – Chapter XVI

a. Section 184: Conditions for assessment as a firm

A firm is assessed as such only if:

• A partnership is evidenced by an instrument.
• The individual shares of the partners are specified.
• A certified copy of the partnership deed is submitted along with the return.

b. Section 185: Assessment when conditions are not met

If the conditions of Section 184 are not fulfilled, the firm is not assessed as a firm, and no deduction is allowed for salary, interest, etc., payable to partners.

2. Assessment of LLPs

LLPs are taxed similar to firms. Finance (No.2) Act, 2009 introduced LLPs into the tax framework. They are assessed under the same provisions as partnership firms.

3. Assessment of AOPs

Tax Rates for AOPs

• If shares of members are determinate: taxed at individual slab rates.
• If shares are indeterminate: maximum marginal rate applies (Section 167B).

AOP v. BOI

• AOP: combination of persons (individuals).
• BOI: group of individuals (may not act jointly).

Case Law:

ITO v. Ch. Atchaiah (1996) 218 ITR 239 (SC): 

In this landmark judgment, the Supreme Court held that under the Income Tax Act, 1961, the Assessing Officer must tax the right person—i.e., the person legally liable for the income—and not whoever has been previously assessed.

The Court clarified that, unlike the 1922 Act, the 1961 Act does not give the officer discretion to choose between taxing individual members or the Association of Persons (AOP); if the income belongs to an AOP, it must be taxed in the hands of the AOP only.

The Court overruled the Andhra Pradesh High Court’s decision that barred reassessment of the AOP after earlier taxing the individuals. This judgment emphasised that taxing the wrong person earlier does not prevent the Department from subsequently taxing the correct assessee. The appeal was allowed, and the matter was remanded for appropriate proceedings.

Deductions and Disallowances

Section 40(b): Disallowances in case of Firms

Deductions for the following are allowed only if conditions are met:

• Remuneration to partners: Must be authorised by the partnership deed.
• Interest on capital: Not exceeding 12% p.a.

Remuneration limits:

• First ₹3 lakhs of book profit: 90% or ₹1.5 lakhs, whichever is higher.
• Balance: 60% of the remaining book profit.

Filing of Returns and Audit

1. Section 139(1):

Firms and AOPs are required to file returns if their income exceeds the basic exemption limit, even if there is no taxable income, provided they are required to get accounts audited under Section 44AB.

2. Section 44AB: Audit Requirements

Audit is mandatory if:

• Turnover exceeds ₹1 crore (for business).
• Gross receipts exceed ₹50 lakhs (for profession).

Liability of Partners/Members

1. Section 188A: Joint and Several Liability

Each partner is jointly and severally liable for tax, penalty, or other sums due from the firm.

2. Section 167B: Taxation of AOPs

If the individual shares of members are not known or indeterminate, tax is charged at the maximum marginal rate.

Assessment Procedure

1. Return Filing

Firms and AOPs must file returns in Form ITR-5.

2. Scrutiny Assessment – Section 143(3)

The Assessing Officer may call for evidence to verify income, claims of deductions (e.g., partner remuneration), and the genuineness of the firm or AOP.

3. Reassessment – Section 147

Reassessment can be done if income has escaped assessment due to failure to disclose material facts or otherwise.

Section 194T Introduced: TDS on Payments to Firm Partners

The Finance (No. 2) Act, 2024 introduced Section 194T, mandating a 10% TDS on payments made to a partner of a firm, such as salary, commission, bonus, remuneration, or interest—if the total exceeds ₹20,000 in a financial year. TDS must be deducted at the time of credit or payment, whichever is earlier.

Budget 2025: Key Changes in TP Assessments and Loss Carry Forward

• Block Transfer Pricing (TP) Assessments Introduced: A new provision allows optional block assessments for transfer pricing over three financial years, easing compliance. This option is not available for search and seizure cases. Once validated by the Transfer Pricing Officer (TPO), the arm's length price of one year applies to the next two years for similar transactions.
• Loss Carry Forward in Reorganisations: In cases of amalgamation or business reorganisation, the successor can carry forward and set off the predecessor’s losses for up to eight years from the original assessment year.

Conclusion

The assessment of firms and AOPs under the Income Tax Act involves a unique blend of general principles and special provisions tailored to their structure. From compliance with statutory conditions under Section 184 to disallowances under Section 40(b), and liability under Sections 188A and 189, the legal landscape is intricate. Understanding these provisions is crucial for taxpayers and professionals alike to ensure compliance and mitigate litigation risks.

References

[1] Income Tax Act, 1961

[2] Indian Partnership Act, 1932

[3] Limited Liability Partnership Act, 2008

[4] Finance Act 2009

[5] Finance Act 2024

[6] Union Budget 2025-2026, Available Here