CA Vinay V. Kawdia

CA Vinay V. Kawdia

Introduction: S. 45(3) and S. 45(4) were brought in to the statute book to deem pooling of assets by partners in to the firm and distribution of assets by the firm to partners on dissolution or otherwise, as transfers for tax purposes with a view to block certain escape routes for avoiding capital gains tax. Section 2(47) of the Act, which inclusively defines the term “transfer” in relation to capital assets, becomes a stranger  in this context. Typical tax controversies qua transfer of property between firm and partners are discussed hereunder.

Section 45. (3) The profits or gains arising from the transfer of a capital asset by a person to a firm or other association of persons or body of individuals (not being a company or a co-operative society) in which he is or becomes a partner or member, by way of capital contribution or otherwise, shall be chargeable to tax as his income of the previous year in which such transfer takes place and, for the purposes of section 48, the amount recorded in the books of account of the firm, association or body as the value of the capital asset shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of the capital asset.

Legislative intent as explained by CBDT in circular No. 495 dt. 22.09.87: One of the devices used by assessees to evade tax on capital gains is to convert an asset held individually into an asset of the firm in which the individual is a partner. The decision of the Supreme Court in Kartikeya V. Sarabhai v. CIT [1985] 156 ITR 509 has set at rest the controversy as to whether such a conversion amounts to transfer. The Court held that such conversion fell outside the scope of capital gain taxation. The rationale advanced by the Court is, that the consideration for the transfer of the personal asset is indeterminate, being the right which arises or accrues to the partner during the subsistence of the partnership to get his share of the profits from time to time and on dissolution of the partnership to get the value of his share from the net partnership assets. With a view to blocking this escape route for avoiding capital gains tax, the Finance Act, 1987 has inserted new sub-section (3) in section 45.

Section 45. (4) The profits or gains arising from the transfer of a capital asset by way of distribution of capital assets on the dissolution of a firm or other association of persons or body of individuals (not being a company or a co-operative society) or otherwise, shall be chargeable to tax as the income of the firm, association or body, of the previous year in which the said transfer takes place and, for the purposes of section 48, the fair market value of the asset on the date of such transfer shall be deemed to be the full value of the consideration received or accruing as a result of the transfer.

Legislative intent as explained by CBDT in circular No. 495 dt. 22.09.87: Conversion of partnership assets into individual assets on dissolution or otherwise also forms part of the same scheme of tax avoidance. Accordingly, the Finance Act, 1987 has inserted new sub-section (4) in section 45 of the Income-tax Act, 1961.

A) Legislative Background:

Prior to introduction of s. 45(3) / s. 45(4), the settled legal position was that, a partnership firm is not a distinct legal entity and the partnership property in law belongs to all the partners constituting the firm, though the partnership firm may possess a personality distinct from the persons constituting it and, therefore, on dissolution, as the firm has no separate rights of its own in the partnership assets, the consequence of distribution, division or allotment of assets of the partners which flows upon dissolution after discharge of liabilities is nothing but a mutual adjustment of rights between the partners and there is no question of any extinguishment of the firm’s rights in the partnership assets amounting to a transfer of assets within the meaning of s. 2(47) of the Act.

Similarly, in case of retirement of partners, prior to the Finance Act, 1987, in the case of a partnership it was held that the assets are of the partners and not of the partnership. Therefore, if on retirement, a partner received his share of the assets, may be in the form of a single asset, it was held that there was no transfer as in case of dissolution of the partnership.

Thus, Sec. 45(4) seems to have been introduced with a view to overcome the judgment of the apex Court in Malabar Fisheries Co. vs. CIT (1979) 120 ITR 49 (SC) and other judgments which took a view that the firm on its own has no right but it is the partners who own jointly or in common the asset and thereby remedy the mischief occasioned.

Sub-section 4 of section 45 imposes tax, w.e.f. 01.04.1988, on the firm when its capital assets are distributed on dissolution or otherwise; and for this purpose, the FMV of the assets on the date of such distribution is deemed to be full value of consideration accruing to or received by it. In view of this change, s. 47(ii) was deleted by the same Act w.e.f. the same date. By enacting s. 45(4), parliament has provided that firm shall pay capital gain tax as if there is a transfer (by legal fiction), even though there would be none under the general law of partnership.

[Note: Before the introduction of ss. (4), there was cl. (ii) of s. 47 to the effect that, any distribution of capital assets on the dissolution of a firm, BOI or other AOP shall not be regarded as “transfer”]

Prior to introduction of section 45(3)/ 45(4), courts were invariably referring to the definition of ‘transfer’ u/s 2(47) to decide whether there is chargeable transfer of property between firm and partners in case of dissolution/retirement/reconstitution etc. However, in view of the above peculiar legislative history, post amendments w.e.f. 01.04.1988, it appears that, section 45 (4) is a charging section/ self-contained code and the same should be interpreted independantly without referring to the definition of ‘transfer’ under s. 2(47) of the Act, which is otherwise an inclusive definition.

In fact, these provisions were introduced to cover certain cases of transactions between partner/member and firm or AOP/ BOI as the case may be. These special provisions have specific purpose and are exceptions to general rules about transfer between partner/ member and firm /AOP, etc.

Thus, in view of omission of cl. (ii) of s. 47 w.e.f. 1st April, 1988, any transaction resulting in distribution of assets on dissolution of a firm or otherwise has to be considered as ‘transfer’ despite the fact that there is no amendment in s. 2(47). Therefore, transfer of assets to the partner on dissolution is chargeable to tax under s. 45(4) [CIT vs. A.N. Naik Associates (2004) 265 ITR 346 (Bombay)]. A CBDT Circular No. 495 dt. 22.09.1987 has also clarified that Sec. 47(ii) was omitted and S. 49(1)(iii)(b) was amended in consequence of inserting S. 45(4).

A.1) “Distribution” or “otherwise” – Meaning: Whether this sub section covers only a transfer on dissolution or also a transfer during the subsistence of a firm is controversial and depends on the meaning of the words “Distribution”, and “or otherwise”. Distribution is akin to final settlement. As held by Bombay High Court, every transfer is not a “distribution” because the later involes “division, realisation, encashment of assets and appropriation” after settling the creditor dues etc. The recostruction of firms (retirement/ introduction of partner etc.) should not come within the expression “or otherwise”because it will render the words “distribution of capital assets” otiose. In fact it runs contrary to legislative intent, which was simply to bring tax transfers in the course of final settlement between partners (thus the word ‘distribution’), which is the reason s. 47(ii) was deleted by the amendment that introduced subsection 45(4).

Thus, the purpose and object of the Act of 1987 was to charge tax arising on distribution of capital assets of firms which otherwise was not subject to taxation. Therefore, language of s. 45(4) should be construed to mean that the expression “otherwise”, has not to be read ejusdem generis with the expression, “dissolution of a firm or body or AOP“. The expression “otherwise” has to be read with the words “transfer of capital assets” by way of distribution of capital assets. If so read, it becomes clear that even when a firm is in existence and there is a transfer of capital assets to retiring partner it comes within the expression “otherwise” as the object of the Amending Act was to remove the loophole which existed whereby capital gain tax was not chargeable. [CIT vs. A.N. Naik Associates (2004) 265 ITR 346 (Bombay) followed in Vikas Academy vs. ITO (2015) 60 taxmann.com 349 (Chennai), etc.]

B) Chargeability of sums/assets received by partners on retirement/dissolution:

There are a number of judgements of the Supreme Court, as well as the High Courts, according to which when a partner retires from a firm and receives an amount in respect of his share in the partnership, there is no transfer of interest of the partner in the assets of the firm and no part of the amount received by him would be assessable to capital gains tax under section 45 of the Act. The reason for the same is that an amount paid to a partner upon retirement, after taking accounts and upon deduction of liabilities, does not involve an element of transfer within the meaning of section 2(47) of the Act.

In support of the above, reliance is placed on the following precedents:

(i) CIT Vs Mohanbhai Pamabhai [1973] 91 ITR 393 (Guj)

The Gujarat High Court, in the case of CIT Vs Mohanbhai Pamabhai [1973] 91 ITR 393 (Guj), held that when a partner retires from the firm and receives his share of an amount calculated on the value of the net partnership assets of the firm, there was no transfer of interests of the partner in the assets of the firm and no part of the amount received by him would be assessable as capital gains under section 45 of the Act.

The Department preferred an appeal to the Supreme Court against the aforesaid judgement of the Gujarat High Court.

The Supreme Court, in view of its earlier judgement, in the case of Sunil Siddharthbhai Vs CIT [1985] 156 ITR 509 (SC), dismissed the appeal of the Department and thus, the aforesaid judgement of the Gujarat High court was affirmed by the Supreme Court [(1987) 165 ITR 166].

It was held in the aforesaid judgement of Gujarat High Court that when a partner retires from a firm and the amount of his share in the partnership assets after deduction of liabilities and prior charges is determined on taking accounts in the manner prescribed by the partnership law, there is no element of transfer of interest in the partnership assets by the retired partner to the continuing partners and the amount received by the retiring partner is not “capital gain” under section 45 of the Income-Tax Act, 1961.

(ii) CIT Vs P.N. Panjawani (Decd) [2012] 80 DTR 200 (Karn)

In this case, the provisions of section 2(47) were examined, in the context of reduction of share in partnership firm on induction of new partners.

It was held that reduction of share of old partners of the firm on reconstitution of firm by inducting new partners and withdrawal of amount by old partners out of the capital contributed by new partners, did not constitute transfer in the hands of partners, making them liable to capital gains tax. In other words, admission of new partners and assignment of right in the firm to the new partners out of the rights of the assessee for consideration does not amount to transfer in the hands of assessee u/s 2(47) and consequently not liable to tax u/s 45.

(iii) The correct position of law was reiterated by Bombay High Court in case of Prashant S.Joshi Vs ITO [2010] 324 ITR 154 (Bom) :

Facts: The assessee, who was partner in a firm, retired from partnership on 11-3-2005. Under the deed of dissolution, he, in addition to the balance lying to his credit on capital and current accounts, also received certain amount during the relevant assessment year in full and final settlement of his dues on account of his retirement. In the returns of income for the relevant assessment years, the assessee disclosed receipt of said amounts but did not offer same to tax on ground that it was a capital receipt not liable to tax.

It was held in this case that ex-facie section 45(4) deals with a situation where there is a transfer of a capital asset by way of distribution of capital assets on the dissolution of a firm or otherwise.

Evidently, on the admitted position, there was no transfer of a capital asset by way of distribution of a capital asset on the dissolution of a firm or otherwise on the facts of the case.

It has been clearly laid down in this judgement that,

During the subsistence of a partnership, a partner does not possess an interest in specie in any particular asset of the partnership. During the subsistence of a partnership, a partner has a right to obtain a share in profits. On dissolution of a partnership or upon retirement, a partner is entitled to a valuation of his share in the net assets of the partnership which remain after meeting the debts and liabilities. An amount paid to a partner upon retirement, after taking accounts and upon deduction of liabilities, does not involve an element of transfer within the meaning of section 2(47) of the Act. Therefore, there is no transfer of capital asset by way of a distribution of the capital assets, on the dissolution of a firm or otherwise.

iv) CIT V/s. R. Lingamallu Raghukumar [2001] 247 ITR 801 (SC)

Held: On retirement of assessee-partner from the firm there was no element of transfer of interest in partnership assets by the retired partner to the continuing partners and the excess amount received by him was not assessable to capital gains.

Followed in –

  • CIT vs. Riyaz A. Sheikh (IT Appeal No. 1969/2011) (Bombay High Court)

Held: Amount received by an erstwhile partner on his retirement from partnership firm arising on transfer of goodwill is not liable to be taxed as long term capital gain.

  • ITAT Pune in- ITO vs. Rajnish M. Bhandari (ITA No. 469/PN/11)

Facts: Assessee was a partner to the extent of 37.5% of the shares and was paid Rs 54,59,083/- over and above the balance in his capital account. Assessee claimed this amount as capital receipt not liable to tax. As per Revenue, the additional consideration received by the assessee was on account of relinquishment of his pre-existing rights in the partnership firm, and therefore, the same was in the nature of capital gain liable to tax as per the provisions of sections 45 read with section 2(47)(i) & (ii) of the Act.

Held: The amount under question received by assessee on retirement from partnership firm is not liable to be taxed as capital gain. [Followed by ITAT Pune in Sachin B. Nikam vs. DCIT, ITA No. 1288/PN/2014 dt. 26.08.16]

  • ACIT vs. N. Prasad [(2015) 113 ITD 257 (Hyderabad)]

Facts: On retirement, the assessee apart from his share capital of Rs.1 crore had received Rs.25 lakhs surplus from the partnership firm. The Assessing Officer held that surplus received by assessee from the firm is nothing but goodwill paid to him for leaving the firm. The goodwill is taxable under the head capital gains income.

Held: The amount of Rs.1.25 cores was paid to the assessee towards his share capital and not for relinquishing or extinguishing his rights over any assets of the firm. Accordingly, receipt was held to be not taxable as capital gain.

  • Chalasani V. Rao vs. ITO (ITA No. 70 of 2000 dt. 03.08.12 (Andhra Pradesh)

On dissolution/reconstitution of partnership firm, only firm is taxable on capital gain on assets distributed to Partners: The legislature did not choose to amend the law by making the partner liable when it amended the I.T. Act, 1961 by introducing clause (4) to s.45 by the Finance Act,1987 w.e.f 1.4.1988 and made only the firm liable. Therefore the contention of the assessee has to be accepted and that of the Revenue is liable to be rejected.

  • Sharadha Terry Products Ltd vs. ACIT [2016] 68 taxmann.com 282 (Chennai)

Whatever amount assesse receives on retirement as partner from firm, on account of credit balance standing in capital account/ current account, is his share in partnership and not any consideration for relinquishing or extinguishing his rights over any assets of firm, and accordingly the same is not chargeable under section 45(4) as capital gains.

[Alert: Delhi High Court in Bishan Lal Kanodia v. CIT [2002] 257 ITR 449 (Delhi) taken the view that where the retiring partner leaves the firm by acceptance of a lump sum consideration by assigning or relinquishing his interest, there can be liability for him, if he receives more than what he has invested. The issue is pending before Supreme Court as on date. Therefore, it is better for taxpayers to avoid the route of retirement by assignment or relinquishment for a lump sum consideration.]

Whether, the receipt under question is taxable u/s 28 under the head ‘Profits and Gains of Business/Profession’?

In case of Prashant S. Joshi V/s. ITO (supra) the revenue had sought to urge that the amount received by the assessee was chargeable to tax under clauses (iv) and (v) of section 28.

Held: Section 28 provides certain categories of income which shall be chargeable to income-tax under the head ‘Profits and gains of business of profession’. Clause (iv) of section 28 specifies the value of any benefit or perquisite, whether convertible into money or not, arising from business or the exercise of profession. Ex facie, section 28(iv) does not apply to benefits which are paid in cash or money. Similarly, clause (v) of section 28 refers to any interest, salary, bonus, commission or remuneration, by whatever name called, due to or received by a partner of a firm from such firm. A payment made to a partner in realization of his share in the net value of the assets upon his retirement from a firm does not fall under clause (v) of section 28.

C) Firm distributing immovable asset to partners on dissolution-S. 45(4):

In CIT v. Vijaylaxmi Metal Industries [2002] 256 ITR 540 (Mad), The High Court found that Section 45(4) would have application only where there is distribution and not where business of the firm continued apparently by the surviving partners with legal heirs. The liability gets crystallized only when the firm’s assets are transferred either to surviving partners or legal heirs of the deceased partner. It is only in the year in which such transfer of asset took place, that there could be liability. In other words, if distribution occurred only in a later year, the assessment can be made only in such later year. If there is no distribution at all and the business is carried on by the successor firm/AOP, there can be no occasion for the liability under section 45(4) [S.B. Bilimoria and Co. v. Asst. CIT [2009] 317 ITR (AT) 203 (Mum), CIT vs. Manglore Ganesh Beedi Works (2004) 265 ITR 658 (Kar.)]

In yet another case, where a retiring partner’s account was settled without any distribution of assets to the retiring partner, it was held that there can be no liability under section 45(4) for the firm as held by Tribunal in Purayannur Indsutries v. Asst. CIT [2009] 317 ITR (AT) 56 (Cochin).

D) Partner receiving immovable asset while continuing with the firm as a partner – taxability in the hands of firm-s. 45(4):

Under such situation, there is no distribution of asset on dissolution or otherwise and accordingly, section 45(4) shall not apply. However, the consequences shall be decided by applying section 2(47) of the act. And, accordingly provisions of section 50C may also apply in the hands of the firm.

Apex Court in B.T. Patil & Sons vs. CGT (2001) 247 ITR 588 (SC) held that, [prior to introduction of section 45(4)]:

“In our view, when there is a dissolution of a partnership or a partner retires and obtains in lieu of his interest in the firm, an asset of the firm, no transfer is involved … But the position is different when, during the subsistence of a partnership, an asset of the partnership becomes the asset of only one of the partners thereof; there is, in such a case, a transfer of that asset by the partnership to the individual partners.”

The ratio of the judgment as applicable today is that when a subsisting partner receives from the firm an asset then there is a transfer of that asset from the partnership to the individual partner.

E) Two partners – one died – other continuing business as a going concern / takeover of business by one of the partners on dissolution of firm as proprietory concern:

Section 45(4) deems transfer of assets distributed to a partner on dissolution or otherwise. There should not only be dissolution, but also distribution to attract the provision. Where one of the two partners of the firm dies, there is dissolution of the firm. But where the surviving the partner carries on the business with all the assets and liabilities as a going concern, there is no distribution within the meaning of the guidelines  given by the Supreme Court in Sakthi Trading Co. v. CIT [2001] 250 ITR 871 (SC). Therefore there is no liability for the Capital gains tax [CIT v. Moped and Machines [2006] 281 ITR 52 (MP)]

Contrary decisions:

Kerala High Court in CIT v. Southern Tubes [2008] 306 ITR 216 (Ker) has held that there  was liability for capital gains tax, when the entire business was taken over by surviving partner consequent on dissolution under section 45(4). Further, Hon’ble Kerala high Court while deciding as above referred to section 2(47)(vi) to hold that since, Sec. 2(47)(vi) covers every agreement or arrangement in whatever manner which has the effect of transferring or enabling enjoyment of any immovable property, it will also cover dissolution of firm and takeover of assets by partner.

[NOTE: However, Clause (vi) of Section 2(47) of the Act, as explained by CBDT in its circular No.495 dated 22.9.1987, was introduced to cover those cases of transfer of ownership where the prospective buyer becomes owner of the property by becoming a member of a company, cooperative society, AOP or by way of any agreement or any arrangement whereby such person acquires any right in any building which is either being constructed or which is to be constructed [C.S. Atwal vs. CIT, ITA No. 200 of 2013 (P & H)]. Even otherwise, as discussed earlier, post section 45(4) it is not correct to refer the definition of transfer u/s 2(47) in above circumstances. ]

Capital gains—Applicability of s. 45(4)—Take over of business of firm by one of the partners on dissolution—In view of omission of cl. (ii) of s. 47 w.e.f. 1st April, 1988, any transaction resulting in distribution of assets on dissolution of a firm has to be considered as ‘transfer’ in terms of s. 2(47) despite the fact that there is no amendment in s. 2(47)—Therefore, transfer of assets to the partner on dissolution was chargeable to tax under s. 45(4) [Suvardhan vs. CIT (2006) 287 ITR 404 (Kar.)]

F) Four partners – two newly introduced- thereafter in the same year original four partners retired- S. 45(4):

Capital gains—Applicability of s. 45(4)—Reconstitution vis-a-vis dissolution of firm—On reconstitution of firm, two new partners admitted and on second reconstitution all the four old partners retired and the newly introduced partners continued the business of firm—There was thus transfer of assets of the firm in the sense that the assets of the firm as had been held by the erstwhile partners is transferred to the newly added two partners though all along the assets of the firm continued in the hands of the firm—Therefore, there is transfer of capital assets within the meaning of s. 2(47), attracting the capital gain transaction in terms of s. 45(4). [CIT vs. Gurunath Talkies (2010) 328 ITR 59 (Kar.)]

In author’s opinion this is case of reconstruction of firm to which section 45(4) should not apply.

Change in constitution of firm:

Applicability of s. 45(4) – Change in constitution of firm – Ownership of the property does not change with the change in the constitution of the firm. As long as there is no change in ownership of the properties of the firm there is no transfer of capital asset. If a partner retires he does not transfer any right in the property in favour of the continuing partners. What is transferred is the right to share the income of the properties in favour of continuing partners. Similarly, when a partnership is reconstituted by adding a new partner, there is no transfer of assets within the meaning of s. 45(4) [CIT vs. Kunnamkulam Mill Board (2002) 257 ITR 544 (Kerala)]

Reconstitution of firm – No transfer of capital assests – Applicability of Section 45 – Assessee-firm was reconstituted and five partners were inducted into firm by deed—Three old partners retired through deed of retirement- when retiring partners took cash and retired, they were not relinquishing their interest in immovable property—But they relinquished their share in partnership—Therefore, there was no transfer of capital asset—No capital gains or profit had arisen—Thus, Section 45(4) was not applicable—When retiring partner takes only money towards value of his share and when there is no distribution of capital asset/assets among partners there is no transfer of capital asset and consequently no profits or gains is payable u/s 45(4) [CIT vs. Dynamic Enterprises (2014) 223 TAXMAN 331 (Karn)]

The High Court in CIT v. P.N. Panjawani [2013] 356 ITR 676 (Karn) endorsed the view, that liability on reconstitution or dissolution is covered by Section 45(4), which is applicable only where there is distribution of assets to retiring or erstwhile partners.

G) Two partners – immovable assets revalued – excess amount transferred to the capital accounts of the partners – thereafter two new partners were added:

Admission of partner, revaluation and withdrawal of capital account balances by retiring partners don’t give rise to taxable capital gains in firm’s hands. [ITO vs. Fine developers [2012] 26 taxmann.com 202 (Mum.)]

Capital gains—Transfer of capital asset—Assessee was a partnership firm-During the year, two new partners were admitted and both of them brought into certain capital-The land owned by assessee firm was revalued as on 01.04.2005 and increase capital on account of revaluation of the land was added to the capital account of existing partners-AO held that long term capital gains of specified amount u/s. 45(4) arose on revaluation of certain assets at time of induction of two new partners to Assessee firm—Held, implication of amendment of S. 45(3) and (4) was that when firm transfers any asset to partner it would be liable to “capital gain” on fair market value on date of transfer—Such transfer could be at time of dissolution of firm when assets were transferred to partners or when any partner was allocated any asset of firm while leaving firm—In absence of transfer of any asset of firm to partners, S. 45(4) could not be invoked— As long as there was no change in ownership of firm and its properties, merely for simple reason that partnership of firm stood reconstituted by adding new partner, there was no transfer of capital asset within the meaning of S. 45(4)—In present case, assessee continued to be owner of land and no transfer took place which was necessary to invoke S. 45(4) for levying capital gain on transfer of capital asset—Orders of authorities below set aside—Assessee’s appeal allowed. [Radhu Palace vs. ACIT (2014) 148 ITD 424 (Delhi)]

H) Distribution of assets by firm on dissolution to partners as well as ex-partners:

While sub-s. (4) of s. 45 does not specifically provide that the distribution of assets should be to the partners of the firm or members of the AOP, it follows logically that the assets of the firm can only be distributed among the partners. Therefore, such condition will have to be read in s. 45(4) and, thus, distribution of assets to outsiders for satisfaction of their debts, representing their capital on the date of retirement is not caught within the mischief of s. 45(4).

Capital gains—Land was purchased with the funds of the firm and it was shown in the balance sheet of the firm from year to year—Land was distributed in connection with the dissolution of the firm—Therefore, such transfer is covered directly under s. 45(4)—However, three partners had retired earlier and the distribution made to them to the extent of 38 per cent of land at the time of dissolution was not qua partners but as ex-partners—Distribution of assets to outsiders for satisfaction of their debts representing their capital on the date of retirement is not caught within the mischief of s. 45(4)—Hence, only 62 per cent of the value of the land is to be considered for the purpose of computing capital gains under s. 45(4). [Gandamal & Sons vs. ACIT (2007)107 TTJ 228 (Pune)]

I) One of the partners introduced immovable capital asset as capital in the firm by book entry – firm sold the asset thereafter:

When a partner pools his asset with partnership assets by contributing such asset as capital of the firm, it becomes the property of the firm under section 14 of The Partnership Act by operation of law without the formality of the conveyance.

Where an immovable property is contributed as capital by the partner crediting his capital account and debiting his asset account, such pooling would convert the proprietary property as firm’s property by operation of the partnership law, though it is not registered because there is no conveyance requiring registration.

FACTS:

Two individuals purchased plot jointly in 1983. They jointly constructed hospital building on the plot in 1988. Partnership firm was formed in 1992 with 3 partners. Partners introduced the said property towards their capital contribution when the assessee firm was formed w.e.f. 01-04-1992. Thereafter, the land and the building of the hospital have been shown as the asset of the partnership firm.

The land, building and the machinery of the hospital has been sold on 31/12/2007. Firm has been dissolved w.e.f. 02/04/2008. Therefore, the assets of the firm have been sold before the dissolution of the firm.

The contention of revenue was that the capital gain on sale of property was taxable in the hands of the partnership firm and not the individual partners.

The contention of the assessee firm is that there was no transfer of the ownership to the assessee firm by the partners even though the land and hospital building was introduced as a capital contribution. Even if the immovable property is introduced by the partners towards their capital contribution but same must be by way of proper conveyance deed registered under the Indian Registration Act.

Held by ITAT in M/s. Chakrabarty Medical Centre vs. TRO – ITA No. 2277/PN/2012 (ITAT Pune):

Under s. 239 of the Indian Contract Act and s. 14 of the Indian Partnership Act, for the purpose of bringing the separate properties of a partner into the stock of the firm it is not necessary to have recourse to any written document at all, that as soon as a partner intends that his separate properties should become partnership properties and they are treated as such, then by virtue of the provisions of the Contract Act and the Partnership Act, the properties become the properties of the firm and that this result is not prohibited by any provision in the Transfer of Property Act or the Indian Registration Act. The legal position, therefore, appears to be that no written or registered document is necessary for an individual to contribute any land or immovable property as a contribution against his share of the capital of a new partnership business. Consequently, the capital gain on sale of the property is assessable in the hands of the firm;

[In K. D. Pandey Vs. CWT 108 ITR 214.(All.) their Lordship referred to Sec. 14 of the Indian Partnership Act, 1932, Sec. 5 of the Transfer of Property Act, 1882 and Sec. 17(1)(b) of the Registration Act, 1908 and held that the partner can bring his immovable property into the stock or capital of the firm otherwise than by means of a registered instrument of conveyance.]

J) Individual introducing immovable capital asset in the firm by book entry – s. 45(3) vis-à-vis S. 50C:

As per section 45(3) of the Act, whenever a partner contributes any capital asset in the partnership firm then for the purpose of section 48, the value of capital asset recorded in the books of accounts of the firm shall be deemed to be the full value consideration received as a result of such transfer for the purpose of computing capital gain.

Therefore, the issue that arises here is that in case of contribution of land or building in partnership firm whether the value recorded in books of accounts of the firm [as per deeming fiction of section 45(3)] or the value adopted for stamp duty purpose [as per deeming fiction of section 50C] will be considered as the full value consideration for the purpose of computing capital gain u/s 48.

In author’s opinion, as discussed earlier, post amendments w.e.f. 01.04.1988, it appears that, section 45 (3) is a charging section/ self-contained code and the same should be interpreted independently without referring to section 50C. Even otherwise, both S. 45(3) and S. 50C are independent deeming provisions as regrads ‘full value consideration received as a result of transfer’ for the purpose of section 48, and one deeming fiction shall not override the other unless otherwise provided specifically.

A plain reading of section 45(3) would reveal that the profits or gains arising from the transfer of a capital asset to another entity by way of capital contribution or otherwise shall be chargeable to tax. The profit or gain would arise only when the transfer has been made at a price which is more than the cost price and the difference between the cost price and amount at which transfer has taken place can be charged under section 45(3). In the instant case the purchase price of land as recorded in the transferor’s book and recorded in the books of the joint venture are the same. As per provisions of section 45(3) price of land recorded in the books of joint venture is required to be considered as receipt of full value of consideration received or accrued as a result of transfer of capital assets. Once the price recorded in the joint venture’s books is treated as full value of consideration, the provisions do not permit substitution of any value so as to make addition under section 45(3). S. 45(3) does not permit AO to substitute the full value of consideration other than the amount recorded in the books of account of the joint venture. [ITO vs. Chiraayu estate & Dev. P. Ltd. (AY-06-07) (2011) 14 taxmann.com 41 (Mum.), Similar View: ITO vs. Orchid Griha Nirman Pvt. Ltd. (2016) 74 taxmann.com 187 (Kol.)]

[Alert:  There are judgments’ to the effect that, where immovable property is transferred by a partner to the firm as a capital contribution and registration does not take place by paying stamp duty, the case would be covered under section 45(3) and the provisions of section 50C cannot be invoked [Carlton Hotels vs. ACIT (2009) 122 TTJ 515 etc.]. However, post amendment to section 50C by F.A. 2009, even unregistered transfers shall also be subject to section 50C. However, in author’s humble opinion, still after the said amendment, section 50C shall not override section 45(3), though there are no judicial precedents available to this effect, for the post amendment years.]

K) Vesting of firm properties in company on conversion of firm to Pvt. Ltd. Company:

  • The closing stock of the firm on conversion of firm to Company should be valued at the cost price and not market value. [CIT v. Hansa Footwear ( 344 ITR 30)(AP)]
  • There was no dissolution of firm when the Co was formed with same partners as its shareholders. Properties of the erstwhile firm vested in the limited company and there is difference between distribution on dissolution and vesting. Therefore, s. 45(4) is not attracted [CIT v. Texspin Eng.& Mfg. Works ( 263 ITR 345)(Bom.)]
  • Revaluation of assets before conversion of firm into Company does not attract 45(4) [CIT v. Rita Mechanical Works [(2012) 344 ITR 544)(P&H)] ITO v. Gulabdas Printers (4 ITRTrib. 264)(Ahd.)]

L) Asset received on dissolution/retirement by partner – Period of holding:

Capital gains—Short-term or long-term—Property taken over by partner on dissolution of firm—Benefit of s. 49(1)(iii)(b) is available only if the dissolution of the firm has taken place at any time before 1st April, 1987—In the instant case, the firm was dissolved on 15th April, 2001—Therefore, benefit of the ss. 2(42A) r/w 49(1)(iii)(b) is not available to the assessee and the period of holding of the assets by the assessee is to be reckoned only from the date of dissolution of the firm—Therefore, assessee became the owner of the property only on taking over the property on the dissolution of the firm—Since he sold the property within three days of acquiring it, the property was rightly treated as a short-term capital asset [P.P. Menon vs. CIT (2010) 325 ITR 122 (Kerala)]

Another view: [prior to introduction of s. 45(3)/ 45(4)]:

Capital gains—Long-term or short-term- A.Y. 1979-80- Machinery received on retirement from firm—Firm held the machinery for over sixty months—That period should be taken into account for determining the period for which the assessee partner had owned the machinery—Capital gain arising to assessee on sale of machinery was long-term capital gain.—CIT vs. Kamala Devi  (1997) 227 ITR 701 (Mad) followed. [CIT vs. S. Vijaylaxmi (2000) 242 ITR 46 (Mad.)]

M) Asset in the nature of stock in trade/current asset introduced as capital in the firm – whether section 45(3) attracted?

From the overall scheme of section 45 and from the plain reading of section 45(3), it appears that, section 45 is confined to transfer of capital assets only. Therefore when stock in trade is introduced as capital in the firm, the deemed consideration as recorded in the books of the firm [as per s. 45(3)] can have no value on transfer of stock in trade.

Section 45(3) is applicable only in respect of a capital asset, thus, where partners of a firm had in fact brought in land into partnership business as a current asset and said firm upon receipt of said land also accounted for it as a current asset and not a capital asset, section 45(3) would be inapplicable. [ITO vs. Orchid Griha Nirman Pvt. Ltd. (2016) 74 taxmann.com 187 (Kol.)]

Alternate view – against the assessee:

Surplus arising from making over assessee’s personal asset, i.e., plot of land in question, to the firm as his contribution to its capital account is a profit or gain accrued to the assessee and is chargeable to tax—Whatever may be the nature of the asset initially held by a partner before the same is contributed by him as capital contribution to a partnership firm, it shall assume the character of a capital asset at the time when it is contributed to a firm as capital contribution and any surplus arising therefrom is chargeable to tax as capital gain… AO is directed to compute the capital gain arising after taking the value of the consideration received or accruing as a result of such transfer at Rs. 11.50 crores being the amount recorded in the books of account of the firm as well as in the books of the assessee. [DLF universal Ltd. vs. DCIT (2010) 128 TTJ 121 (SB)(Delhi)]           

Conclusion:

There is an old saying – Prevention is always better than cure!! Therefore, to the extent possible, it is always better to plan the introduction of partners in to firm and retirement from the firm well in advance and with utmost care so as to avoid future tax controversies and litigations in the hands of the partners as well as firm.

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Tags : Capital Gain (328) Partnership (25)

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