Capital Gain Tax on Dissolution/Reconstitution of Partnership Firms in the Hands of Partners & Firms

Taxability in the event dissolution/reconstitution of Partnership Firms have always been point of contentions before various Judicial Forums and the provisions of Income Tax has been amended from time to time to address the ambiguity in taxing the same. Our article is limited to Taxation in following situations

1. Dissolution of Firms

2. Reconstitution of Firms

Taxation on Dissolution of Firms:

Normally in the case of Dissolution of Firm, the firm itself will be dissolved, its business will be shut down and its assets will be realised or transferred to its Partners in proportion of their capital account. Prior to amendment vide Finance Act 1987, the said transaction of ‘transferring of assets by the firm to partners” is not regarded as a transfer by virtue of sec.47(ii) and the said provision was misused largely to avoid capital gain on transfer of capital assets by way of seller and buyer of property entering into Partnership and capital assets purported to transferred is brought in the books of firm and subsequently the firm will be dissolved and the capital asset will be transferred to its partner i.e., intended seller.

In order plug the above loophole sec.47(ii) is removed and sec.45(4) was inserted to tax the gain on Capital Assets transferred to partner in the hands of the firm and the issue has been settled to some extent but what is largely unaddressed is taxability of transaction on reconstitution of firms.

Taxation on Reconstitution of Firms:

In case of reconstitution of firm, the firm will continue to exist but only partners will be changed either by way of admission or retirement. On reconstitution of firm, firms account will be drawn as on the date of reconstitution which will result in revaluation of its assets and valuation of goodwill and same will be credited to the existing partners capital account. In case of retirement the outgoing partner will be paid consideration which is envisaged in the below circumstances

1. Retiring partner is allotted a capital asset of a firm as a consideration for retirement

2. Retiring partner is paid by way of cash in accordance with balance lying in his capital a/c

3. Retiring partner is paid by way of cash in accordance with balance lying in his capital a/c plus amount over and above the sum lying in his capital a/c

Taxability in all the above circumstances is prone to litigation with main point of contention being

1. Whether it is taxable, if so in whose hand it is taxable firm or partners,

2. What should be the sale consideration and Cost of acquisition

To make it further complicated Solution to the above varies on each of three circumstances arises on retirement of partners

Retiring partner is allotted a capital asset of a firm as a consideration for retirement :

Relevant charging provision of sec.45(4) is reproduced below better understanding

“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”

In the case of CIT Vs. A.N. Naik Associates(2004), Bombay High court rules that transfer of capital assets to outgoing partner on reconstitution of firm is also taxable in the hands of firm by virtue of sec.45(4). The court has interpreted the word ‘or otherwise’ in the provision to include reconstitution also. The said interpretation have been upheld on various subsequent judicial pronouncement.

Retiring partner is paid by way of cash in accordance with balance lying in his capital a/c:

In the above scenario, there is no transfer of capital assets by the firm and hence there is no tax liability in the hands of the firm.

Is it taxable on retiring partners hand?

It is pertinent to answer the following questions before discussing the taxability of the above circumstance

1. Whether retiring partner transferring any of his rights in the firm to the continuing partner? If so what is consideration for the said rights.

Before discussing the above issue let us draw the imaginary accounts on reconstitution

In above case say partner ‘x’ retires and paid consideration of Rs.200 which is the balance lying in capital account. Supreme court in the case of CIT vs Mohanabai Pamabai(1987) observes that when a retiring partner receives amount lying in his capital a/c, it is nothing but his share in the net assets of the Partnership firm and it involve no transfer of rights to the continuing partners and hence there is no gain which is taxable in retiring partners hands.

Retiring partner is paid by way of cash in accordance with balance lying in his capital a/c plus amount over and above the sum lying in his capital a/c:

In above illustration let say the retiring partner ‘x’ is paid a consideration of Rs.250 which over and above the balance lying in his capital a/c. ITAT in the case of Savithri Kadur Vs. DCIT (2019) observe that excess consideration received by a retiring partner is in lieu of transfer of his rights in business of the firm in favour of the continuing partners and held that excess amount is subject to capital gain tax in the hands of retiring partners. Hence it is pertinent to conclude that what is taxable is consideration received over and above the balance in the capital account and not gain on account of revaluation or goodwill.

In my opinion, the rationale behind the decision of ITAT is subjective, since goodwill is merely a book entry and partners capital account balance can be artificially inflated by higher goodwill valuation and will open pandora of litigations unless necessary clarifications or amendment is brought down by the department.