Correct Journal entry for transferring interest on capital to Profit…

The correct answer is Option (1) → Profit and Loss Appropriation A/c Dr. To Interest on Capital A/c

Interest on capital is recorded in two steps. First it is allowed to the partners: Interest on Capital A/c is debited and the partners' capital/current accounts are credited. Then, at the end of the year, the interest on capital account is closed by transfer to the Profit and Loss Appropriation Account, because it is an appropriation of profit:

Profit and Loss Appropriation A/c     Dr.
    To Interest on Capital A/c

The appropriation account is debited as the interest is a use of profit, and Interest on Capital A/c is credited so that it is closed. The entry with the partners' accounts (option 2) is the earlier step that allows the interest; the transfer to the appropriation account is a later, separate entry.