The Article highlights the impact of recent judgment of Hon’ble SC in respect of taxability of surplus amount after revaluation of any assets, which is credited to the partners’ capital account.
As per report from Economic Times: “The SC has put an end to a rampant tax dodge, going on for decades, where land parcels, properties, and redevelopment rights worth crores changed hands through partnership firms.”
“The trick used till now was holding real estate assets in a partnership structure, revaluing the properties to current market price, bringing in new partners who infused cash in the firm, and the old partners then withdrawing the funds that comes in after their capital accounts were credited—to the extent of their share in the profits of the firm—as is as allowed in a partnership. No stamp duty, capital gains and income tax were paid as is required in a plain sale and transfer of property. The partnership entity, through which funds flowed in and out, let a new set of partners control the property.”
In an order passed 10 days back, the bench of Hon’ble SC says, “the assets so revalued and the credit into the capital accounts of the respective partners can be said to be ‘transfer’ and which fall in the category of ‘otherwise’ and therefore, the provision of Section 45(4) shall be applicable.”
While restoring the order passed by the assessing officer (AO) of I-T department, the apex court set aside orders passed by Bombay High Court (HC) and I-T appellate tribunal (ITAT).
How Methodology works actually: Let’s first understand how it works, Suppose a partnership firm having 2 partners Mr. A and Mr. B sharing 50% each, that firm having an old property worth Rs. 10 lakhs in books of accounts. At present same property revalued at fair market value of Rs. 100 lakh and the revaluation profit/ reserve of Rs. 90 lakh get credited in partners’ capital account of Rs. 45 lakh each.
After that Firm admit 2 new partners Mr. C and Mr. D for 100% stake by introducing firm value as capital and existing partners retire from the firm, then Mr. A and Mr. B get balance in their respective capital accounts, which basically includes fair value of the that property. And technically property get transferred from Mr. A & Mr. B to Mr. C & Mr. D, via partnership firm without paying any stamp duty, capital gain etc.
What Income Tax Section Says 45(4):
Before Amendment w.e.f. 01.04.2021:
(4) The profits or gains arising from the transfer of a capital assets 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.
After Amendment w.e.f. 01.04.2021
(4) Notwithstanding anything contained in sub-section (1), where a specified person receives during the previous year any money or capital asset or both from a specified entity in connection with the reconstitution of such specified entity, then any profits or gains arising from such receipt by the specified person shall be chargeable to income-tax as income of such specified entity under the head “Capital gains” and shall be deemed to be the income of such specified entity of the previous year in which such money or capital asset or both were received by the specified person, and notwithstanding anything to the contrary contained in this Act, such profits or gains shall be determined in accordance with the following formula, namely:—
A = B + C – D
Where,
A = income chargeable to income-tax under this subsection as income of the specified entity under the head “Capital gains”;
B = value of any money received by the specified person from the specified entity on the date of such receipt;
C = the amount of fair market value of the capital asset received by the specified person from the specified entity on the date of such receipt; and
D = the amount of balance in the capital account (represented in any manner) of the specified person in the books of account of the specified entity at the time of its reconstitution:
Provided that if the value of “A” in the above formula is negative, its value shall be deemed to be zero.
Provided further that the balance in the capital account of the specified person in the books of account of the specified entity is to be calculated without taking into account the increase in the capital account of the specified person due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset.
Explanation 1.—For the purposes of this sub-section,—
(i) the expressions “reconstitution of the specified entity”, “specified entity” and “specified person” shall have the meanings respectively assigned to them in section 9B;
(ii) “self-generated goodwill” and “self-generated asset” mean goodwill or asset, as the case may be, which has been acquired without incurring any cost for purchase or which has been generated during the course of the business or profession.
Explanation 2.—For the removal of doubts, it is clarified that when a capital asset is received by a specified person from a specified entity in connection with the reconstitution of such specified entity, the provisions of this sub-section shall operate in addition to the provisions of section 9B and the taxation under the said provisions thereof shall be worked out independently.
The amendment in Section 45(4) take cares the taxability of profit due to revaluation profit/ reserve as explain in above example.
How SC Judgement is far reaching from amendment take place in 2021: Amendment in income tax section take place (w.e.f. 01.04.2021) to plug the loopholes and prescribed a formula-based methodology to tax the reconstitute event in the hands of the partnership firm, which specifically required to ignore any credit in partners’ capital account due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset (by second proviso).
However, the said Hon’ble SC ruling is one step ahead and declare the revaluation of any assets and credited the same in Partners’ capital account as ‘transfer’ and it’s a taxable event. Thus, even before the distribution / withdrawal by partners, the transaction of revaluation and credit the same in partners’ capital account is itself taxable at the time of event of revaluation.
Q & A:
1. Whether it will impact earlier years
Yes, Income tax department may re-open earlier years cases considering Hon’ble SC judgment.
2. Whether SC judgment is within amendment take place in 2021.
No, SC judgment is based on section 45(4) before amendment and it’s having far reaching effect on taxability as compared to what covers under amended section 45(4).
3. Whether it will impact real estate?
Yes, Property price getting multi fold in last decade, the huge amount of tax liability may impact the real estate.
4. Is it a Tax liability on notional profit (revaluation reserve)?
It may be a matter of discussion, but the income tax having other provisions also which taxes income on notional basis.
Some Pointers:
- Accounting of revaluation of assets do not get effected.
- The ruling is one step ahead of income tax amendment under Section 45(4)
- Large number of new litigations / cases reopen are expected after that ruling.
- Important and landmark judgment to plug a loophole.
(Civil Appeal No. 8258 of 2022 Date: 24 November 2022)
Author Bio
If the capital gain tax is paid on the date of transfer, what would be the effect if the asset is sold by the firm at a later date. What would be the date of purchase and value of consideration to be reckoned ? Is it the original date of purchase and cost of purchase or date of revaluation and amount credited to the partner’s capital account.?
Please clarify
As it seems more complex situation and may be clarify later on by the department…
Prima facie, date of revaluation and revalued cost of property will be considered in case of future sale by the firm.
To Supplement , -ALSO READ through > https://taxguru.in/…/sec-45-4-income-tax-act-new…
< "ANOMOLIES STILL PERSISTS:…." Not put an end to !
“Important and landmark judgment to plug A LOOPHOLE”
Having been decided without having no due regard or even a remote consideration to the subsequent material developments – the substantive one being the 2021 Amendment , just plugging one , might serve NO PURPOSE; more so, NOT put an end to the other gaping old/ fresh loopholes or lacunae ?! On the contrary, the SC Judgment itself , -it might be urged, not without merits, -to be given have a fresh look through !
Read more at: https://taxguru.in/income-tax/sc-judgement-assets-revaluation-partnership-firmlong-lasting-impact.html?
Wonderfully explained…
How wonderfully explained by Mr Jain