a) A partnership firm was engaged in the business of manufacturing of chemicals. It had claimed deduction of interest paid on partner’s capital.
b) While making assessment, the Assessing Officer observed that investment in mutual funds was made out of interest bearing funds which also included interest bearing partner's capital.
c) The Assessing Officer was of the view that assessee had incurred expenditure including interest expenses which were attributable to earning tax-free dividend income from investment in mutual funds. Thus, the expenditure so incurred on interest was required to be disallowed.
d) Further, the CIT(A) confirmed the action of the Assessing Officer.Aggrieved-assessee filed the instant appeal before ITAT.
The ITAT held in favour of assessee as under:
1) Interest and salary received by the partners are treated on a different footing by the Act and not in its ordinary sense of term. The Section 28(v) treats the passive income accrued by way of interest as also salary received by a partner of the firm as a 'business receipt' unlike different treatments given to similar receipts in the hands of entities other than partners.
2) Under the proviso to section 28(v), the disallowance of such interest is only in reference to section 40(b) and not section 36 or Section 37. This also gives a clue that deduction towards interest is regulated only under section 40(b) and it is out of the purview of Section 36 or 37 of the Act.
3) The Firm and partners of the firm are not separate person under Partnership Act although separate unit of assessment for tax purposes. There cannot therefore be a relationship inferred between partner and firm as that of lender of funds (capital) and borrowal of capital from the partners, hence section 36(1)(iii) is not applicable at all.
4) Consequently interest paid to its partners cannot be treated at par with the other interest payable to outside parties. Thus,there could not be any disallowance of interest on partner’s capital as the investment by firm in mutual funds generating tax free income beard the characteristic of and attributable to its own capital. - QUALITY INDUSTRIES V. JCIT -  73 taxmann.com 363 (Pune - Trib.)