When it comes to tax liabilities in a business setup, a change in the constitution of a firm can complicate matters. Often triggered by the retirement or death of a partner, these shifts have significant tax implications. Special provisions like Section 78 of the Income Tax Act help guide the process, yet their nuanced regulations require close examination. This article delves into the tax liability on the change in the constitution of a firm or during a business succession, providing detailed analysis and practical illustrations.
Firm is an assessable entity. As such a firm is allowed to carry forward losses like an individual or a Company. The Act makes special provisions under section 78 to take care of situation arising on account of change in constitution of the firm. The term Change in Constitution is not defined or explained in the Act. However, it would mean, in the context of section 78, one or more partners leaving the firm either on account of retirement or death. Retirement of partner is mostly occasioned by his resignation. Section 78 also provides for succession of one person by another person and how the losses in such case of the predecessor entity will be dealt with.
Section 78 prescribed formula to deal with losses of the firm in case of change in constitution of the firm.
Change in the Constitution of Firm:
How the losses will be dealt with in case of Change in Constitution.
The firm will not be able to carry forward so much of the loss proportionate to the share of a retired or deceased partner as exceeds his share of profit in respect of the previous year.
Change in the constitution at middle of the year:
In case change in constitution of firm takes place in the middle of the previous year, the loss up to the date of change should be computed. Retiring partner’s or deceased partner’s share in the loss will be determined and as much loss will be determined and as much loss as falls to his share will lapse.
Illustration: XYZ & Company is a partnership firm with three partners with the following shares in profits.
| Name | Percentage |
|---|---|
| Mr. X | 30% |
| Mr. Y | 25% |
| Mr. Z | 45% |
Mr. Z retired on 1st July, 2023. The accumulated losses up to 31st March, 2023 are Rs.1,00,000 and the loss from 1st April, 2023 to 30th June, 2023 is Rs. 25,000. Thus the aggregate loss up to 30th June, 2023 is Rs. 1,25,000. Since Z’s share in Profits is 45%, loss of Rs. 56,250 being proportionate to his share will left.
If in this illustration, if the entire loss arises after 1st July, 2023, nothing will lapse.
Succession and its Exceptions:
Section 78(2) covers succession of a person in business or profession. If a person, be it an individual or a corporate body, is succeeded by another person otherwise than by inheritance, the losses of the first person will not be carried forward either by him or by his successor. Sections 72A, 72AA and 72AB are the special provisions that constitute exceptions to this general rule.
Inheritance – An Exception:
Section 78(2) makes an exception in case of an inheritance. If a business is succeeded by way of inheritance, the loss of predecessor in business is allowed to be carried forward by the successor. It may be noted that section 78(2) relates to “loss” as opposed to depreciation allowance. Therefore, unabsorbed depreciation allowance of the predecessor cannot be carried forward by the successor in inheritance.
Illustration:
Mr. A was a proprietor of his business. He dies leaving behind a will. As per the will his running business with trademarks and other assets and liabilities is bequeathed to his only son. The son n this case will be entitled to carry forward the loss assessed in the hands of deceased.
Mergers, etc, cannot be regarded as inheritance:
Mergers, amalgamations etc. do not result in inheritance of business. The new entity formed as a result of such mergers, amalgamation cannot claim to have inherited the losses of the predecessor in business. Based on the following facts the Rajasthan High Court said that there can not be inheritance in such cases.
Conclusion: Understanding the tax implications of a change in the constitution of a firm or during business succession is essential for sound financial planning. While Section 78 provides a guide, it has its complexities and exceptions that businesses should thoroughly understand. Knowing how losses are carried forward or lapse during transitions can aid in avoiding legal pitfalls and ensuring the firm’s financial stability.
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