No Capital gain tax firm if it doesn’t distribute any capital asset to retiring partners

IN THE ITAT MUMBAI BENCH ‘F’

Income-tax Officer – 25(3)(4)

versus

Fine Developers

IT APPEAL NO. 4630 (MUM.) OF 2011

[ASSESSMENT YEAR 2008-09]

OCTOBER 12, 2012

ORDER

Rajendra, Accountant Member

Challenging the order dtd. 28-03-2011 of the CIT(A)-35, Mumbai, Assessing Officer (AO) has raised following Grounds of Appeal :

(i)  “On the facts and in the circumstances of the case, and in law, the ld CIT(A) erred in directing the A.O. to delete the entire addition of capital gain u/s. 45(4) of the Income Tax Act-1961 without appreciating the fact that HDIL was admitted as partner in the partnership firm with 50% share of profit, by this arrangements 50% of the interest of the existing partners have been transferred in favour of incoming partner w.e.f. 06-07-2007 resulting in transfer of assets within the meaning of section 45(5) r.w.s. 2(47) of the Income Tax Act 1961.”

(ii)  The appellant prays that the order of the Ld. CIT(A) on the above grounds be set aside and that of the Assessing officer be restored.”

(iii)  The appellant craves leave to amend or alter any ground or add a new ground.”

Assessee firm, engaged in the business of builders and developers, filed its return of income on 22.07.2008 admitting total income at Rs. Nil. Initially the return was processed u/s. 143(1) of the Income-tax Act, 1961 (Act). Later on the case was selected for scrutiny. AO completed the assessment u/s. 143(3) of the Act determining the total income at Rs. 86,72,80,450/-.

2. During the assessment proceedings, AO noted that the original partnership deed was signed on 25.11.2005 and following were the partners :-

2.1. On 06.07.2007, Housing Development and Infrastructure Limited (HDIL) was introduced as a new partner and the profit sharing ratios of the partners was as under:

2.2. AO further noticed that the assessee firm had purchased a piece of plot of land from Bhandary Metallurgical Corpn. Ltd. (BMCL) for a consideration of Rs. 28 Crores. He was of the opinion that 50% of the value of the plot of the land was transferred in favour of the HDIL on 06.07.2007 and thereby the assessee firm was liable to be taxed u/s. 45(4) of the Act. AO further found that on 15.10.2007 HDIL had entered into an agreement with Mumbai International Airport Ltd (MIAL). He held that agreement between MIAL & HDIL was the proof that the new partner had become 100% owner of the plot. On 01.04.2008, the said plot of land was revalued at Rs. 2,68,37,42,000/-. He issued a show cause notice to the assessee firm for taxing the entire value of plot amounting to Rs. 268.37Crores u/s. 45(4) of the Act under the head ‘Capital Gains’. After considering the submissions of the assessee, he held that HDIL had already dealt with the property of the firm as its own property when it had signed an MOU with MIAL for rehabilitation of the slums on the land of the firm, that it had claimed that all the ownership rights of the plot of land belonged to it, that a copy of the MOU was furnished by the assessee during the course of the assessment proceedings, that no document supporting the MOU was submitted by the assessee-firm, that capital gain arising out of the transfer on land had to be calculated by adopting the market value of the land as on the date of the transfer. Finally, he held that the capital gains for the AY under consideration worked out to Rs. 1,86,72,80,452/- and he added the same amount to the total income of the assessee. AO relied upon the case of Gurunath Talkies delivered by the Hon’ble Karnataka High Court (328 ITR 59).

3. Assessee-firm preferred an appeal before the First Appellate Authority (FAA). After considering the assessment order and the submissions of the assessee, he held that during the relevant AY there was only admission of HDIL as new partner in the firm, that there was neither retirement nor distribution of assets, nor revaluation of plot of land during the assessment year under consideration. After referring to various clauses of the MOU entered between the HDIL and MIAL he held that HDIL never treated the property as its own as wrongly assumed by the AO, that the AO, while passing the Assessment Order, had not relied on any of the clauses of the agreement to show that HDIL had dealt with the property as its own, that the plot of land in question continued to be the stock-in-trade of the appellant-firm as on 31.03.2008 as per the balance sheet which was not disputed by the AO. With reference to the case of Gurunath Talkies (supra), FAA held that in that case new partners were admitted when old partners retired whereas in the case of the assessee-firm there was no retirement of any of the partners during the year under consideration, that above decision was not applicable to the case of the assessee-firm. He held that the case of Paru D Dave (110 ITD 410) was squarely applicable to the facts of the case under consideration, that mere admission of partners did not attract provisions of section 45(4) of the Act, that during the continuance of the partnership-firm rights of the partners were confined to obtaining the share of the profit and no partner could claim exclusive claim to any assets. He further held that even if there was liability u/s. 45(4) of the Act, same had to be considered in the next assessment year because the plot of land was revalued in the next year and retirement of three partners from the partnership firm also took place in the next year. He finally held that the assessee was not liable for capital gains u/s. 45(4) in the AY 2008-09. He deleted the addition made by the AO and observed that the AO was free to consider the applicability of section 45(4) of the Act in the next assessment year.

4. Before us, Departmental Representative (DR) submitted that the provisions of section 2(47) r.w.s.45(4) were applicable in the case under consideration, that purpose of the transaction as a whole, was to transfer the all the rights to HDIL by the assessee-firm, that assessee had relinquished its rights in the relevant AY in favour of the HDIL, that relinquishment of the rights was ‘otherwise transfer’ of rights as per the provisions of section 2(47) r.w.s 45(4) of the Act. He referred to various terms of Deed of Admission in this regard and submitted that old partners had surrendered their rights in favour of the new partner i.e. HDIL, that there was extinguishment of the rights in favour of the new partner. He referred to cases of Kartikeya Sarabhai (228 ITR 163), Mrs. Grace Collis (248 ITR 323) and Gurunath Talkies (supra). Authorised Representative (AR) submitted that the provisions of section 45(4) were not applicable in the present case, that admission of partner was not covered by word ‘otherwise transferred used in the sections, that in the AY 2008-09 except admission of HDIL as a new partner nothing had happened, that the plot of land was shown as Stock-in-Trade and not as a Capital Asset in the Books of Accounts of the assessee-firm, that in the Balance Sheets for Financial Years 2005-06, 2006-07 and 2007-08 said plot was classified as ‘Work-in-Progress-BMCL-Project’ under the head ‘Current Assets’, that the AO in the past consistently and uniformly had accepted and endorsed that the impugned property was ‘Stock-in-Trade’, that orders for earlier years were also passed u/s. 143(3) of the Act, that revaluation of land had taken place on 01-04-2008, that appellant-firm was reconstituted after 1st April, 2008-when three of the partners retired, that both the events pertained to AY 2009-10, that HDIL had brought Rs. 60 Crores towards Capital contribution, that there was no transfer by the firm as contemplated by Section 45(4) r.w.s.2 (47) of the Act, that appellant was the owner of the property even till the end of the AY. He further relied upon the order of Paru D Dave (110 ITD 414) delivered by ‘F’ Bench of Mumbai Tribunal. He also referred to the cases of Texspin Engg. And Manufacturing works (129 Taxman 1) Girish Textiles Industries (10 SOT 474), Prashant S Joshi (189 Taxman 1), J. Keemat Roy & Co (11 SOT 462), P N Panjawani (21 Tax mann.com 458).

5. We have heard the rival submissions and perused the matter placed before us by the representatives of both sides. Before deciding the issue, it will be useful to summarise the basic facts and chronology of the case:

(i)  Original Partnership (dt. 25-11-2005) consisted of 4 partners.

(ii)  On 06-07-2007, HDIL became a new partner with 50% profit sharing ratio.

(iii)  Assessee-firm and MIAL entered in to MOU on 15.10.2007.

(iv)  On 0-04-2008 plot of land was revalued.

(v)  Deed of retirement was signed on 27.05.2008 and on that date out of the five, three partners retired.

5.1 AO has made addition to the total income of the assessee-firm on the basis that on admission of the new partner i.e. HDIL, existing partners had transferred 50% to their interest to it and thus there was re-distribution of the assets of the firm. As per the AO on 27-05-2008, when interest of three partners were transferred to HDIL, there was again re-distribution of assets of assessee-firm. In our opinion view taken by the AO is not based on sound legal footings. FAA, after considering the facts of the case and legal provisions, has held that there was no distribution of assets in the case under consideration. A bare perusal of Deed of Admission (dtd. 06.07.2007) and Retirement Deed (dtd. 27.05.2008) prove that on both the occasions there was no distribution of assets of the assessee-firm. On 06.07.2007 HDIL was admitted as a new partner In our humble opinion admission of a new partner to the existing partnership-firm does not result in distribution of assets. Similarly, on 27th May, 2008; when three partners retired and remaining two partners continued the business of the firm; there was no redistribution of assets of the firm. After going through the above retirement deed we are of the opinion that it is not a case where firm was taken over by the new partner and thus provisions of section 45(4) of the Act can be invoked. As per the settled principles of law of partnership, during the continuation of the partnership, partners do not have separate right over the assets of the firm in addition to interest in share of profits. The basis of the said proposition is that value of the interest of the each partner with reference to the assets of the firm cannot be isolated and carried out from the value of the partners’ interest in the totality of the partnership assets. In the case under consideration, asset of the firm i.e. plot of land, was never transferred to anybody-it always remained with the assessee -firm only. From the date of purchase of the plot from the BMCL till 27.05.2008,when three partners retired, it was the asset of the firm and there was no change in the ownership of the said plot. Thus, there was no extinguishment of rights, as envisaged by Section 2(47) of the Act, in the case of assessee-firm. Here, it will be useful to refer to a portion of decision of Paru D Dave (supra), delivered by the Tribunal-

“Revaluation of assets by partnership firm does not attract capital gains. The revaluation of assets of partnership and the credit of revalued amount to the capital account of partners in their respective share ratio do not entail any transfer as defined under s. 2(47) of the IT Act. The introduction of new partners to a partnership firm owning immovable assets and consequent reduction in the share ratio of present partners do not entail any relinquishment of their rights in the partnership property. On introduction of new partners, there is realignment of share ratio inter se between the partners only to the extent of sharing the profits or losses, if any, of the partnership business. When any new partner is introduced into an existing partnership firm, the profit sharing ratios undergo a change, which does not amount to transfer as defined under s. 2(47) of the Act, as there is no change in the ownership of assets by the partnership firm. As during the subsistence of the partnership firm, the partners have no defined share in the assets of the partnership and thus on realignment of profit sharing ratio, on introduction of new partners, there is no relinquishment of any nonexistent share in the partnership assets as the assets remained with the firm. Such an arrangement is not covered by the provisions of s. 45(4) of the Act, which covers the case of dissolution of partnership firm. Accordingly, no capital gains arise on such relinquishment of share ratio in the partnership firm.”

5.2 Though the AO has held that HDIL had treated the plot of land, owned by the firm, as its own while it had signed the MOU with MIAL, yet he has not mentioned as how he arrived at the said conclusion. We have perused the said MOU and we have not found any clause which proves that the new partner of the assessee-firm was treating the said asset as its own. We fully agree with the FAA that MOU was not analysed by the AO in correct perspective.

5.3 As per the settled principles of taxation revaluation of capital assets does not result in accrual or receipt of taxable income unless and until the capital asset is actually transferred. Secondly, revaluation of assets before conversion of a firm into company cannot be equated with dissolution of firm/transfer of assets of firm. If the above principle is applied to the basic facts of the case, it can be safely held that re-valuation of the plot of land did not result in any profit or gain to the firm and hence question of distribution of profit by the firm does not arise. Thus, the basic ingredient for invoking provisions of section 45(4) of the Act is missing in the case under consideration. The twin requirements of the section 45(4) contemplate not only the retirement of the partners from the partnership firm but also the transfer by way of distribution of capital assets. It is a fact that retiring partners had withdrawn the sums to credit in their accounts, but such withdrawals cannot be treated as ‘distribution of capital assets either on dissolution of firm or otherwise’.

5.3.1 Here, we would like to mention that sub-section 3 and 4 of the section 45 of the Act were brought on statute with specific purposes. For overcoming the difficulties, arising out of the decisions delivered by the Hon’ble Supreme Court in the cases of Malabar Fishries (2 Taxman 469) and Kartikeya Sarabhai (supra), said sub-sections were introduced. Sub-section 4 deals with the situation where a capital asset is transferred by a partnership firm and such transfer is via distribution. We find that in the case under consideration no capital asset was transferred by the assessee during the relevant AY. From the very beginning of the partnership the plot of land in question was treated stock in trade by the assessee firm. Even on 31.03.2008 it was shown as current asset (i.e. W-I-P) in the balance sheet. AO has nowhere rebutted/ doubted this factual position. Considering the above we are inclined to agree with the FAA that no capital asset was transferred by the assess-firm and hence provisions of section 45(4) should not have been invoked.

5.3.2 Hon’ble Bombay High Court in the case of A.N. Naik (265 ITR 346) has explained the expression ‘otherwise’ used in Section 45 of the Act. It was held by Hon’ble Court that the expression otherwise has to be read with word ‘transfer by way of distribution of capital asset’ and not with the word ‘dissolution’. Thus, from the above judgment also, it is clear that transfer of a capital asset is the pre-condition for invoking the provisions of Sec. 45(4) of the Act. Secondly, such a transfer should take place at the time of dissolution or other similar events such as retirement of the partners. Until such time, the shared rights of the partners become the exclusive right of any retiring partner and no occasion arises for to tax the same under the head ‘capital gains’ as envisaged by sec. 45(4) of the Act. As stated earlier, in the present case, there was no extinguishment of rights of any of the assets owned by the firm. In other words, continuing partners had not transferred any rights of the plot of the land in question in favour of the retiring partners and hence there was no transfer capital asset within the meaning of section 2(47) by the firm to the retiring/continuing partners. We would like to refer to the decision of the Hon’ble jurisdictional High Court, delivered in the case of A.N. Naik (supra):

“Section 45 of the Income-tax Act, 1961, is a charging section…..The Act of 1987 also brought on the statute book a new sub-section (4) in section 45 of the Act. The effect is that the profits or gains arising from the transfer of a capital asset by a firm to a partner on dissolution or otherwise would be chargeable as the firm’s income in the previous year in which the transfer took place. From a reading of sub-section (4) to attract capital gains tax what would be required would be as under : (1) transfer of capital asset by way of distribution of capital assets : (a) on account of dissolution of a firm ; (b) or other association of persons ; (c) or body of individuals ; (d) or other-wise ; the gains shall be chargeable to tax as the income of the firm, association or body of persons. The expression “otherwise” has to be read with the words “transfer of capital assets…. It is now clear that when the asset is transferred to a partner, that falls within the expression “otherwise” and the rights of the other partners in that asset of the partnership are extinguished.”

5.3.3 From the above, it can safely be held that allocation of assets of the firm to the retiring partners is the basis for invocation of provisions of Section 45(4). In the case under consideration, neither there was any dissolution nor other event took place that had an effect of allocation of exclusive interest in any capital asset to the retiring partners. In these circumstances, FAA was justified in holding that conditions of Section 45(4) were not fulfilled. In our opinion the firm or the continuing partners were not liable to be taxed under the head ‘capital gains’, as held by the FAA. Retiring partners had relinquished their rights in the assets of the firm and in lieu of that firm had paid the retiring partners money lying in their capital account. Obviously, assessee-firm had not transferred any right in capital asset to the retiring partners rather it is the retiring partners who have transferred the rights in capital assets in favour of the continuing partners. So, even if capital gain has to be taxed it has to be in the hands of the retiring partners not in the case of the assessee-firm.

6. We have considered the cases relied upon by the DR and the AR. As far as matter of Gurunath Talkies (supra) is concerned, we are of the opinion that facts of the present case are distinguishable, as held by the FAA. In the case under consideration assets were not taken over by the new partners. As stated earlier, section 45 was amended to overcome the difficulties faced by the Revenue because of the decisions of Malabar Fishries and Kartikeya Sarabhai (Supra). So, in our opinion they are of no help after introduction of sub-section 3 and 4 to the Sec. 45 of the Act. Case relied upon by the AR support the view taken by the FAA.

6.1 As there was no transfer of a capital asset by the assessee-firm by way of distribution or otherwise in the AY under consideration, therefore, we do not see any reason to disagree with the logical findings given by the FAA. Upholding his order we decide the Grounds against the AO.

In the result, appeal filed by the AO stands dismissed.