Thursday, June 27, 2024

Legal Framework and Tax Treatment of Payments to Retired Partners

Key Legal Principles and Analytical Reasoning

Case Reference: Deloitte Haskins and Sells LLP v. National E Assessment Centre, [2024] (Mumbai - Trib.) Court: ITAT Mumbai Bench 'D' Assessment Year: 2018-19

Payments to Retired Partners

Legal Principle:

  • Payments made to retired partners, as per the partnership deed, are prior charges on the firm's gross fees and should not be considered part of the firm's income. These payments are obligations that must be deducted before calculating the firm's taxable income.

Analytical Reasoning:

Partnership Deed Obligations

Nature of the Obligation:

  • The partnership deed serves as a binding contract outlining the responsibilities and entitlements of the partners, including those who retire. It specifies that retired partners are to be compensated for their prior contributions to the firm's earnings, acknowledging that while they contributed to the firm’s revenue during their tenure, they did not fully realize the benefits due to the timing of billings and collections.

Legal Characterization:

  • Such payments are not voluntary or discretionary. They are mandatory payments enforced by the partnership deed, creating a legal obligation. This obligation takes precedence over the determination of net income and must be settled before any profit distribution or income calculation for tax purposes.

Diversion of Income by Overriding Title

Conceptual Framework:

  • The principle of "diversion of income by overriding title" posits that when income is pre-emptively diverted due to an overriding legal obligation, it does not form part of the taxpayer’s income. This diversion occurs at the source, meaning the income never actually reaches the taxpayer in the first place.

Judicial Precedents:

  • The landmark case CIT v. Sitaldas Tirathdas [1961] 41 ITR 367 (SC) provides a foundational precedent. The Supreme Court of India clarified that if an obligation is such that it diverts income before it reaches the taxpayer, it is not taxable in the hands of the taxpayer.
  • In CIT v. C.C. Chokshi & Co. ITA No.209, the ITAT Mumbai reinforced this principle, applying it specifically to payments made under partnership deeds.

Application in Deloitte Case

Income Recognition and Accounting


  • Deloitte follows the cash system of accounting, wherein income is recognized only when it is received. This contrasts with accrual accounting, where income is recognized when earned, regardless of receipt. The cash system aligns recognized income with actual cash flow, providing a more accurate financial picture for firms operating on this basis.

Service Tax and GST:

  • Taxes such as service tax and GST are based on issued invoices rather than received payments. This creates a potential mismatch between taxable income and actual cash flow, particularly for firms following the cash system. The ITAT Mumbai recognized this discrepancy and Deloitte's efforts to reconcile these differences with detailed explanations and documentary evidence.

Payments to Retired Partners

Mechanics of Payment:

  • Payments to retired partners are calculated based on their contributions and the terms specified in the partnership deed. These payments are processed from the firm’s gross receipts, ensuring that retired partners are compensated prior to the determination of net taxable income.

Tax Treatment:

  • The ITAT Mumbai concluded that such payments are not part of the firm's taxable income due to the principle of diversion by overriding title. The payments are made before the income reaches the firm and thus do not constitute taxable income.

Judicial Reasoning and Conclusion

Court's Analysis:

  • The court examined the nature of the payments, the legal obligations stipulated in the partnership deed, and the principle of diversion by overriding title. It held that these payments, mandated by a pre-existing legal obligation, must be excluded from the firm's taxable income.

Impact on Tax Assessments:

  • This decision sets a clear precedent, reinforcing that payments made to retired partners under a partnership deed are prior charges on gross income. Such payments are legally diverted before becoming income, thus not taxable. This ensures accurate income recognition and respects the legal obligations toward retired partners.


Established Law:

  • Payments to Retired Partners: Payments made to retired partners, as stipulated in the partnership deed, are excluded from the firm's taxable income due to the legal obligation and the principle of diversion by overriding title.

Analytical Reasoning:

  • The partnership deed creates a binding legal obligation, diverting income at the source. The cash system of accounting further supports this by recognizing income based on actual receipt, aligning with the legal framework established by judicial precedents.

This decision by the ITAT Mumbai Bench 'D' provides a robust legal and analytical framework for understanding the tax treatment of payments to retired partners, offering clear guidance for future tax assessments and ensuring compliance with established accounting principles and legal obligations.