The introduction of Section 194T by the Finance (No. 2) Act, 2024 in the Income-tax Act, 1961 (‘Act’), represents a pivotal shift in the tax regime governing payments made by partnership firms and LLPs to their partners. Effective from 1 April 2025, the provision mandates the deduction of tax at source (‘TDS’) at 10% on amounts (either single sum or in aggregate) exceeding INR 20,000 in a financial year. Such payments must be ‘in the nature of salary, remuneration, commission, bonus or interest’.
While the legislative intent is to enhance tax transparency and plug revenue leakages, the provision, in its current form, presents significant interpretative issues.
Section 194T – Scope and applicability
Section 194T requires the firm[1] to deduct TDS on payment of any sum which is in the nature of salary, remuneration, bonus, commission or interest. These payments are often made under the terms of the partnership deed and are allowable as deductions u/s. 40(b) of the Act, subject to specified limits.
Notably, the phrase ‘in the nature of’ used in the provision significantly broadens its scope. It implies that not only the explicitly mentioned terms but also any payment akin to salary, remuneration, commission, bonus, or interest may fall within the ambit of TDS under this section. However, if the payment is not ‘in the nature of salary etc.’, then TDS u/s. 194T may not get attracted. Thus, the determination of nature of payment by the firm to partner, either at the time of credit or payment, is essential before withholding tax under this section.
Key interpretational challenges
While the legislative intent appears to ensure tax traceability on partner payouts, several interpretational issues merit attention:
Lack of definition for key terms
Section 194T does not define the terms such as ‘salary,’ ‘remuneration,’ ‘bonus,’ and ‘commission.’ These terms are generally understood in the context of an employer-employee relationship, which is conspicuously absent between a partner and the firm. Further, these terms are also not defined in Section 40(b) of the Act. The definitions provided in Section 15 of the Act shall not be applicable to Section 194T. This is because the Explanation 2 to Section 15 of the ITA explicitly states that any salary, bonus, commission or remuneration paid to a partner shall not be regarded as ‘salary’ for the purposes of the head ‘Salaries.’ As a result, the ordinary meaning of these terms must be drawn from judicial precedents, accounting literature, or commercial practice.
In the absence of clear legislative definitions under Section 194T, a risk arises that revenue authorities may adopt a broad interpretation of these terms, potentially expanding the scope of the section. To avoid any ambiguity, the partnership deed must spell out the nature of different payments that shall be made to the partners.
Capital Account Credits and revaluation implications
Another ambiguity pertains to whether certain credits to a partner’s capital account which are on account of revaluation of assets, recognition of goodwill, restructuring of the firm or other notional allocations, would also fall within the ambit of Section 194T. It shall depend on determination of nature of these payments, i.e. whether such payments are ‘in the nature of salary, commission, bonus or remuneration’.
Payment / credits on account of revaluation of assets or recognition of goodwill or change in profit sharing ratio etc. are on account of adjustment / settlement of inter-se obligations between the partners and firm. These are not in the nature of salary etc. as sought to be covered by the provision. TDS u/s. 194T shall be applicable on those payment made to partners which are in consideration of the services rendered by them to the firm. Then irrespective of the nomenclature, TDS u/s. 194T may get attracted.
Further, mere credit of any and every amount to ‘the account of the partner (including the capital account)’ shall not attract Section 194T. As aforesaid, such payment must be ‘in the nature of’ salary etc. If not, then credits to partners account shall not attract this section.
Classification ambiguities between profit share and remuneration
The profit share of a partner, being exempt under Section 10(2A), falls outside the TDS purview. However, in practice, many partnership deeds lack sufficient clarity in distinguishing between profit share and remuneration or commission. The absence of clear classification can lead to an application of Section 194T on such payments, potentially triggering tax demands and interest liabilities.
Timing of TDS on interim withdrawals
A common operational challenge arises in scenarios where partners withdraw funds periodically throughout the financial year without any immediate classification as to the nature of such withdrawals. The determination of nature of these withdrawals as capital withdrawals, remuneration, commission, interest or otherwise, is only determined upon finalisation of accounts.
Section 194T mandates that TDS must be deducted at the time of credit or payment, whichever is earlier. This requirement places the onus on firms to identify the character of each withdrawal at the time it is made. If withdrawals are later classified as remuneration or commission but no TDS was deducted at time of withdrawals, then the firm may face penal consequences for failure to deduct tax u/s. 194T.
Final settlement with retiring partners
When a partner retires, the final settlement usually encompasses multiple components such as capital contributed, accumulated profits, interest accrued on capital, and in some cases, a share of the firm's goodwill or intangible assets. The complexity arises when these elements are not clearly delineated in the partnership deed, leading to ambiguity in how each component should be treated for tax purposes. In such cases, there is a significant risk that portions of the payout, especially those linked to the partner's continued involvement or past contributions, may be recharacterized by tax authorities as remuneration or bonus rather than capital receipts.
If a firm retrospectively categorises a portion of the final settlement as remuneration, it could trigger TDS liability from the date of payment or credit, potentially exposing the firm to interest and penalties for non-compliance.
TDS on book entries without cash flow
Section 194T imposes TDS liability at the time of credit or payment, whichever is earlier, even if no actual cash payment takes place. This provision therefore applies even in cases where a firm merely records remuneration, interest, or similar amounts due to a partner as a credit in the partner’s capital account. Such entries, while not involving any outflow of funds, shall attract TDS compliance u/s. 194T.
This has significant implications not only for partnership firms, particularly those operating with limited liquidity, but also for the partners themselves. When amounts such as remuneration or interest are merely credited to a partner’s account, without any actual cash payment, rigours of Section 194T gets attracted. Simultaneously, the partner is required to report such credited amounts as income and may need to pay tax thereon, even though the corresponding funds have not been received. This dual burden results in a timing mismatch between tax liability and actual cash flow, potentially leading to financial strain for both the firm and the partner.
Disallowance under Section 40(b) vs. TDS on gross amount
Section 40(b) prescribes limits on the deductibility of remuneration etc. paid by the firm to its partners. Section 28(v) of the Act provides that the interest and remuneration etc. earned by the partner shall be adjusted to the extent of non-allowability u/s. 40(b). In other words, the amount of deduction allowed to firm u/s. 40(b) on account of payment of remuneration etc. is the same amount which is assessable as business income in the hands of partner u/s. 28(v). The amount not allowed to firm u/s. 40(b) of the Act is also not treated as business income of the partner u/s. 28(v) of the Act. However, TDS under Section 194T is to be deducted on the entire amount paid or credited, regardless of its allowability u/s. 40(b) of the Act. This may create a disconnect between the TDS by the firm u/s. 194T and income taxable in the hands of the partner u/s. 28(v) of the Act.
For instance, if a firm credits INR 3,00,000 as remuneration to a partner, but only INR 2,00,000 is allowable u/s. 40(b), then the firm is still required to deduct TDS u/s. 194T on full amount of INR 3,00,000. In contrast, the partner is only liable to pay tax on the INR 2,00,000 u/s. 28(v). This will create a mismatch between the Form 26AS (which will income credit of INR 3,00,000) and the income reported in the partner’s return (i.e., INR 2,00,000).
Such mismatches can trigger unnecessary scrutiny from the tax department.
Interest on loans vs. Capital contribution
Interest paid by a firm to partners is exempt from TDS u/s. 194A(3)(iv) of the Act. However, with the introduction of Section 194T, any interest credited to a partner, whether on account of loan given by the partner or on their capital contribution, shall suffer TDS u/s. 194T.
Applicability to non-resident partners and DTAA interaction
Withholding of tax on payments to non-resident is governed by Section 195 of the Act provided such payments are chargeable to tax under the provisions of the Act. Thus, the taxability or non-taxability of payments to non-residents is determined as per the provisions of the Act read with relevant tax treaties. If a payment is not chargeable to tax in India under the tax treaties, then no withholding of tax is required u/s. 195 of the Act.
However, Section 194T does not distinguish on payments by a firm to its resident and non-resident partners. The section is applicable on payments by a firm to its partners.
There are no guidelines as to which section would prevail on payments to non-residents partner i.e., whether deductibility would be examined u/s. 194T or 195. This is relevant because the withholding of tax u/s. 194T is not affected by the taxability of payments. Whereas TDS u/s. 195 of the Act is applicable only on those payments which are taxable under the Act. Therefore, it will be crucial to decide on applicability of Section 194T or 195 on payments by a firm to its non-resident partners.
Conclusion
The intent of the legislature in introducing Section 194T was to enhance tax transparency. However, there are several interpretational and procedural challenges which need to be addressed. The absence of clear definitions, issues in their application to the different transactions between firm and its partners, and delineation of nature of payments could give rise to inconsistent compliance and increased litigation risk. The partnership deeds / LLPs agreements must be carefully worded and must spell out the nature of transactions between the firm and its partners.
In this context, timely and comprehensive guidance from the Central Board of Direct Taxes (CBDT) is essential. This may take the form of detailed FAQs, explanatory circulars, or other administrative instructions to address the ambiguities in scope, timing, and classification of partner payments.
[The authors are Partner and Principal Associate, respectively, in Direct Tax practice at Lakshmikumaran & Sridharan Attorneys, Mumbai]
[1] Section 2(23) of the ITA defines ‘firm’ to include LLP
