R. Kumar, B.Com. MBA (Finance)
Normally the partnership would stand dissolved on the death of a partner unless it is otherwise contracted for, but if it is found from the subsequent conduct of the parties that despite the death of partner, partnership business continued to function, then it would be taken that it continued by virtue of contractual relationship. [Devji Goa vs. Tricumji AIR 1945 PC 91] The dissolution must be established from the circumstances leading clearly to such an inference [Gordhandas vs. Bhulabhai AIR 1937 Bom 316].
Dissolution of the firm leads to the dissolution of partnership as between the partners but the partnership itself subsists, through only for the purpose of winding up it’s business and adjusting the rights of the partners inter se. [Chaturbhuj vs. Damodar AIR 1960 Bom 424]
Up to the assessment year 1987-88 distribution of assets on dissolution of firm was not subjected to capital gains taxation. As a matter of fact Sec. 47(ii) specifically provided that it will not be considered to be a transfer. In Malabar Fisheries Co. vs. CIT (1979) 120-ITR-49(SC), the Supreme Court held that distribution of assets among partners on dissolution does not involve transfer as it is only because of pre-existing rights. This settled position was upset by introduction of Sec. 45(4) and deletion of Sec. 47(ii) with effect from 1-4-1988 i.e., A.Y. 1988-89 onwards. The reasons for the introduction of the new Section and for disturbing the settled position is explained by Circular No. 495, dated 22-9-1987, vide para 24.3. It was felt that the route of dissolution was used in a scheme of tax avoidance, which enabled the participants of the scheme to transfer assets from one hand to another hand without payment of legitimate tax.
The Section since its introduction has been the subject matter of intense debate and discussion, as it threw open a large number of complex and unresolved issues including: Sec.2(47) of the Act which defines the term ‘transfer’ has not been amended to provide specifically for inclusion of the case of distribution of assets on dissolution. In view of that, a doubt has arisen relating to the enforceability of Sec. 45(4).The Section covers the cases of dissolution ‘or otherwise’. In view of that, a doubt has arisen about the applicability of Sec. 45(4) in cases of retirement and withdrawal of assets.
The profits or gains are deemed to have arisen in the previous year in which the transfer takes place. The identification of the year of transfer becomes an issue in cases where the year of distribution happens to be different than the year of dissolution. The term ‘distribution’ is a legal and accounting concept which has given rise to a debate as to whether the Section will apply in a case where all the assets are taken away by one of the partners. An issue also has arisen as to whether the sale of capital assets to a partner could be treated as distribution of assets or not. A doubt has arisen about the entity in whose hands the deemed capital gain could be taxable, i.e., whether the gain would be taxed in the hands of the firm or in the hands of the group of partners as the firm has been dissolved and ceases to continue.
Sec. 45(4) of the Income-tax Act provides for taxation of the deemed capital gains arising on distribution of capital assets in the course of dissolution. The essential requirement for attracting this provision is that there is a dissolution, and that in the course of such dissolution, capital assets are distributed.
The said Sec. 45(4) reads as under:
“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 S. 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 result of the transfer.”
Ordinarily, capital gains arise on transfer of a capital asset. ‘Transfer is considered to be ‘sine qua non’ of capital gains. The term ‘transfer’ is defined by Sec. 2(47) of the Act, which reads as under :
“ ‘transfer’, in relation to a capital asset, includes: the sale, exchange or relinquishment of the asset; or the extinguishments of any rights therein; or the compulsory acquisition thereof under any law; or in a case where the asset is converted by the owner thereof into, or is treated by him as, stock-in-trade of a business carried on by him, such conversion or treatment; or any transaction involving the allowing of the possession of any immovable property to be taken or retained in part performance of a contract of the nature referred to in Sec. 53A of the Transfer of Property Act, 1882 (4 of 1882); or any transaction (whether by way of becoming a member of, or acquiring shares in, a co-operative society, company or other association of persons or by way of any agreement or any arrangement or in any other manner whatsoever) which has the effect of transferring or enabling the enjoyment of, any immovable property;
Explanation : For the purposes of sub-clauses (v) and (vi), ‘immovable property’ shall have the same meaning as in clause (Id) of the Sec. 269UA”.
From a bare reading of the above provisions, it is seen that the distribution of capital asset in the course of dissolution is not specifically included in the definition of the term ‘transfer’. Instead, a direct charge is sought to be created by introducing a deeming fiction in the form of Sec. 45(4) for bringing to tax the deemed capital gains on such distribution. It is this act of by passing the provision of Sec. 2(47) by the Legislature that has become the subject matter of an interesting controversy where under a possibility of rendering Sec. 45(4) nugatory is being debated.
One view of the matter is that Sec. 45(4) is a charging Section that brings in an effective charge in the circumstances provided therein, independent of Sec. 2(47). This view is supported by the decisions of the Karnataka and the Goa Bench of the Bombay High Court. The other view of the matter holds that without a specific amendment in Sec. 2(47) amending the definition of ‘transfer’, Sec. 45(4) has no independent application. This view is supported by a decision of the Madhya Pradesh High Court.
CIT v. Moped and Machines [ (2005) 281- ITR- 52 (MP)]
The assessee in that case was a partnership firm that consisted of two partners. One of the partners expired on April 19, 1990. In the course of assessment proceedings for the A.Y. 1991-92, the assessee firm was asked that since the firm stood dissolved after the death of one of the partners, why the tax on the capital gains should not be imposed on it. Eventually, the Assessing Officer applied provisions of Sec. 45(4) for including the deemed capital gains in the hands of the firm.Being aggrieved, the assessee preferred an appeal before the CIT(A).
It was contended before him that Sec. 45(4) of the Act would not apply unless the gains had arisen from the transfer of the capital asset within the meaning of Sec. 2(47) of the Act. It was also contended that the Finance Act, 1987, by which Sec. 45(4) was inserted, did not amend the definition of transfer as contained in Sec. 2(47), so as to include the distribution of capital asset on dissolution of a firm. It was also highlighted that the distribution of assets of a dissolved firm to the partners did not constitute a sale, exchange, relinquishment of asset or the extinguishment of any right therein, and therefore, it did not fall within the definition of ‘transfer’, and as there was no ‘transfer’ as is envisaged u/s. 2(47), there would be no capital gains. The CIT(A) appreciating the contentions came to hold that levy of capital gains did not meet the test of the basic requirement, namely, ‘transfer’. He also held that no capital gains tax can be levied on an entity which was non-existent. In the Revenue’s appeal before the Tribunal, the Tribunal found that the issue was squarely covered in favour of the assessee by the decision of the Income-tax Appellate Tribunal, Jabalpur Bench, in the case of Asst. CIT v. Thermoflics India, 60 ITD 554. Following the same, the Tribunal held that there was no transfer of asset on the dissolution of the firm.
Aggrieved by order Revenue went to High Court and submitted that the Tribunal and the CIT(A) had erred by holding that there had been no transfer in the case at hand and that the definition clause, namely, Sec. 2(47) did not cover the act of distribution of capital asset on dissolution. It was also submitted that the CIT(A) had erred in law by expressing the view that no capital gains could be levied on the firm which was not-existent. For the assessee, the submissions that were advanced before the CIT(A) were reiterated and it was also contended that in the absence of distribution of assets, Sec. 45(4) of the Act was not attracted.
The Madhya Pradesh High Court upholding the decision of the Tribunal observed that there was no transfer of capital assets within the meaning of the term as defined u/s. 2(47), and in the circumstances, provisions of Sec. 45(4) were not applicable to the facts of the case. In view of the aforesaid pronouncement of law, the Court was inclined to hold that there was no transfer of assets as per Sec. 45(4) of the Act, that there could not be a transfer as contemplated u/s. 2(47) of the Act on dissolution in the circumstances specified in Sec. 45(4).
Suvardhan v. CIT [(2006) 287- ITR- 404(Kar.)]
The assessee in that case was a registered firm which came into existence by way of partnership deed dated July 23, 1986. The partnership consisted of three persons. On July 1, 1988, one of the partners retired and the other two continued the partnership in terms of the partnership deed dated October 17, 1988. A survey was conducted in the business premises of the assessee. It came to light that the firm had been dissolved and the business had been taken over by one of the partners, Smt. Anuradha Maruthi Gokarn. It was also noticed that the partnership was dissolved on April 1, 1992, and the assets and liabilities had been taken over by the said lady. The Assessing Officer proposed to apply Sec. 45(4) of the Act. Notice was issued. The assessee filed a nil return. Thereafter, the Assessing Officer concluded the assessment u/s.144 of the Act charging capital gains in the hands of the firm in respect of the assets transferred by the firm. The appeal filed by the assessee stood dismissed by the CIT(A). The assessee’s appeal to the Tribunal was also rejected by it.
Matter went to High Court. The Court observed that the admitted facts revealed a dissolution of the firm; that the dissolution deed showed that the retiring partner had no objection whatsoever in continuation of business in the same name, either as a sole proprietary or in any other manner as the other partner thought fit; that the other partner in terms of the materials placed on record had taken over the entire assets and liabilities of the partnership firm.
The Court further observed that a reading of Sec. 45(4) showed that the profits or gains arising from the transfer of capital assets by way of distribution of capital assets on the dissolution of a firm was chargeable to tax as the income of the firm, in the light of the fact that a transfer had taken place. The Court also took notice of the assessee’s contention that the term ‘transfer’ had been defined u/s.2(47) of the Act and that if Sec. 2(47) was read with Sec. 45(4), there was no transfer at all, and in any case if there was any transfer, it was not by the assessee, but by the retiring partner.
For considering the issue on hand, the Court was inclined to notice Sec. 47 of the Act. It noted that Sec. 47 was a special provision which would define the transactions not regarded as transfer and a reading of the said Sec. 47 of the Act showed that several transactions were considered as ‘no-transfer’ for the purpose of Sec. 45 of the Act.
It noted Sec. 47(ii), prior to its deletion read as : “any distribution of capital assets on the dissolution of a firm, body of individuals or other association of persons.”; that the said provision was omitted by the Finance Act, 1987 with effect from April 1, 1988; that therefore, any transaction resulting in distribution on dissolution of a firm had to be considered as ‘transfer’ in terms of Sec. 47; that on omission of clause (ii) of Sec. 47, it could not be said that Sec. 45 was inapplicable to the facts in the case on hand.
The Karnataka High Court further distinguished the judgement of the Madhya Pradesh High Court in CIT v. Moped and Machines, 281 ITR 52 relied upon by the assessee by observing that in the said judgement, there was no reference to omission of clause (ii) of Sec. 47 as it stood prior to April 1, 1988; that in the said judgement, what was considered was the provisions of Sec. 45(4) and Sec. 2(47), as it stood then; that therefore, the said judgement would not be applicable to the issue involved in the case on hand; that on the other hand, the decision of the Bombay High Court in the case of CIT v. A.N. Naik Associates, 265 ITR 346 was found to be applicable, as in the said decision, the Bombay High Court had noticed the effect of the omission of the said clause (ii) of Sec. 47 by the Act of 1987.
The Karnataka High Court, in respectful agreement with the judgement of the Bombay High Court, noted that when the Parliament in its wisdom had chosen to remove a provision which provided for the cases of ‘no transfer’, there was no need for any further amendment to Sec. 2(47) of the Act. The Court accordingly held that despite no amendment to Sec. 2(47), in the light of removal of clause (ii) to Sec. 47, the transaction was liable to capital gains tax at the hands of the authorities.
Normally, in cases of firms consisting of more than two partners, the death or insolvency of a partner would result in dissolution of the firm as per the provisions of the said Act. However, there would be no dissolution in a case where the partners have agreed to continue the partnership and the business even after death or insolvency, on certain terms and conditions. On compliance of such terms, the firm will be said to have continued. In such cases, there is a consensus of opinion that the provisions of Sec. 45(4) will not apply.
Cases which create real difficulty are the cases of partnership consisting of two partners only. It is in such cases that a difficulty arises, where one of the partners dies or is declared insolvent or retires. In such cases, the firm shall stand automatically dissolved on death or insolvency or on retirement by operation of the law. In such cases of severe hardships, the recent decision of the Madras High Court in the case of CIT v. Vijaya Metal Industries, 256 ITR 540, provides a major breakthrough. In that case, the assessee partnership consisted of two partners, which was dissolved on death of one of the partners. The business of the partnership firm was continued by the surviving partner with the assets of the partnership firm. The Income-tax Department applied the provisions of Sec. 45(4) and brought to tax the deemed capital gain by holding that the transfer took place on dissolution of the firm. The Tribunal held that though the dissolution of firm took place by operation of law, it was not followed by transfer of capital assets by way of distribution of such assets. The Madras High Court confirmed the decision of the Tribunal.
The decision in the case of Vijaya Metal Industries provides a much needed relief. With this, one thing is certain that the dissolution by itself will not result in distribution of assets of the firm. The distribution will take place only on taking of a positive action by the parties concerned for distributing the assets. Till such time, the assets may be treated as jointly held by the parties. This by itself is a big relief for the assessees who are caught unaware. It is also certain that it is possible to defer the year of taxation to the year in which the distribution takes place. This will enable an assessee to comprehend the impact of Sec. 45(4) and plan for the same. In view of the above, a new possibility has emerged where under the surviving partner can successfully join hands with the legal heirs of the deceased partner, in partnership and continue the business with the assets of the erstwhile firm. In such a case, the above-referred decision will help in contending that the assets of the erstwhile firm are not distributed amongst the parties entitled to it and till such time no liability to tax by virtue of Sec. 45(4) will arise.
(Author can be reached at email@example.com)