No capital gain tax on revaluation of assets on conversion of firm into private limited company

ITAT AHMEDABAD BENCH ‘A’

Income-tax Officer

Versus

Alta Inter-chem Industries

IT APPEAL NO. 223 (AHD.) OF 2012
[ASSESSMENT YEAR 2008-09]

OCTOBER  19, 2012

ORDER

A. Mohan Alankamony, Accountant Member

This appeal of the Revenue is directed against the order of the learned Commissioner of Income-tax (Appeals)-XI, Ahmedabad, in I.T.A. No. CIT(A) XI/388/W 6(4)/ 10-11 dated November 28, 2011, for the assessment year 2008-09.

2. Though the Revenue has raised three grounds, the crux of the issue is that “the Commissioner of Income-tax (Appeals) erred in deleting Rs. 92,07,817 made by the Assessing Officer under the head ‘Capital gains’.”

3. Briefly, the assessment in the case of the assessee-firm was reopened under section 147 of the Act by issuance of a notice under section 148 of the Act on the ground, according to the Assessing Officer, that during the course of assessment proceedings for the assessment year 2007-08, it was noticed that on March 30, 2007, the assets of the firm consisting of land and building have been revalued by the assessee in the following manner :

4. It was, further, observed by the Assessing Officer that on March 16, 2007, there was a major change in the shareholding pattern of the firm and five new partners have been introduced. It was the stand of the Assessing Officer that this way, by revaluation of assets, the investments made by the new partners had appreciated without paying any taxes. It was the case of the Assessing Officer that as the assessee had not fulfilled the provisions of section 47(xiii) of the Act, it was disentitled for exemption and, thus, capital gains under section 45(iv) of the Act was attracted in this case. Accordingly, an addition of Rs. 92.07 lakh was made under the head “Capital gains”. Aggrieved, the assessee had approached the learned Commissioner of Income-tax (Appeals) for relief. After due consideration of the lengthy and comprehensive submission of the assessee as recorded in the impugned order under consideration, the learned Commissioner of Income-tax (Appeals) had observed thus :

Commissioner of Income-tax (Appeals) page 13

“2.2 . . . It is seen that the hon’ble courts including Ahmedabad Tribunal are consistently taking a stand that in the process of conversion from firm to company, transfer is not involved. Accordingly, appreciation of assets in the process of conversion is not liable to be taxed under the head ‘Capital gains’.

2.3 The hon’ble Ahmedabad Income-tax Appellate Tribunal in the case of Well Pack Packaging v. Deputy CIT reported at [2003] 78 TTJ (Ahd) 448 has held that revaluation of depreciable assets and conversion of a partnership firm into company does not lead to incidence of capital gain inasmuch as revaluation is made in the hands of the assessee by writing up the value of assets in the books. In view of the provisions of sections 575, 576 and 577 of the Companies Act, 1956, there is no transfer involved when a company got itself registered under Part IX of the Companies Act. In view of this, there is no question of applicability of the provision of section 45 or 50 or any other provisions of the Income-tax Act arise on conversion of a firm into company.

The hon’ble Bangalore Income-tax Appellate Tribunal in the case of Asst. CIT v. Unity Care and Health Services [2006] 286 ITR (AT) 121 (Bang) has held that to bring to charge capital gains to tax under section 45(4), what is required is distribution of capital assets on dissolution of firm or otherwise. It is further held by the hon’ble Income-tax Appellate Tribunal that in case of conversion of firm into private limited company, there is neither dissolution of firm nor distribution of capital asset to partners and, therefore, in such a situation, no capital gain is chargeable under section 45(4) of the Income-tax Act. In this case, the hon’ble Income-tax Appellate Tribunal has discussed the provisions of section 47(xiii) vis-a-vis provisions of section 45(4). The hon’ble Income-tax Appellate Tribunal observed as under (page 130) :

‘The insertion of section 47(xiii) has not changed this situation. Section 47(xiii) merely excludes certain transfers from the purview of definition of the word “transfer” as provided in section 2(47). To bring to charge the capital gain under section 45(4), what is required is distribution of capital assets on dissolution of firm or otherwise.’

2.5 In the instant case, there is no distribution of capital asset to partners. There is no dissolution of firm. Partners, who were earlier to register under the Partnership Act, were registered under the Companies Act and, accordingly, section 45(4) would not apply in such a situation. Accordingly, no capital gain was chargeable in such a situation as there is no distribution of capital assets on dissolution of firm or otherwise. In the instant case also, there is no distribution of capital assets on dissolution of firm or otherwise. In view of above facts, I am of the considered view that in the case of revaluation of assets and its conversion of firm into a private limited company does not attract provisions of section 45(4). Accordingly, the addition made by the Assessing Officer of Rs. 92,07,817 is ordered to be deleted.”

5. Aggrieved, the Revenue has come up before us with a plea that the Commissioner of Income-tax (Appeals) had erred in law in deleting the addition of Rs. 92,07,817 under the head “capital gains”. It was, further, submitted that the Assessing Officer had analysed the issue in-depth and came to a conclusion, by extensively quoting various judicial pronouncements on a similar issue, that the contentions of the assessee were rejected on the following grounds :

(a)          the Part IX of the Companies Act, 1956 does not have any overriding effect on the provisions of the Income-tax Act, 1961, and

(b)          the assessee failed to produce evidences to prove that the assessee fulfilling all the four condition of section 47(xiii) to ascertain whether the succession of firm by the company is not a transfer.

6. To strengthen his arguments, the learned Departmental representative had placed reliance on the following case laws, namely :

(a)          ITO v. Om Namah Shivay Builders & Developers[2011] 43 SOT 397; and

(b)          Asst. CIT v. Goel Udyog[2011] 45 SOT 444.

7. It was, therefore, pleaded that the findings of the Commissioner of Income-tax (Appeals) require to be reversed and that of the stand of the Assessing Officer is to be restored.

8. On the other hand, the learned authorised representative vociferously supported the findings of the Commissioner of Income-tax (Appeals) on this issue. To drive home his point that the Commissioner of Income-tax (Appeals) was within his realm to reverse the stand of the Assessing Officer etc., the learned authorised representative reposed his confidence on the following case laws :

(i)           ITO v. Gulabdas Printers [2010] 4 ITR (Trib) 264 (Ahd.) ;

(ii)           Well Pack Packaging v. CIT[2003] 130 Taxman 215 (Ahd.) ; and

(iii)          Asst. CIT v. Unity Care and Health Services[2006] 103 ITD 53 (Bang).

9. We have carefully considered the rival submissions, diligently perused the relevant case records and also the case law quoted by either party. It was the stand of the Assessing Officer that if the full contributions of the partners are taken, it was noticed that the shares in the company have not been allotted in the same proportion as the capital accounts of the partners as they stood in the books of the firm on the date of succession. Therefore, it was the case of the Assessing Officer, that proviso (b) to section 47(xiii) is squarely applicable to the assessee’s case which made the transfer of the assets and liabilities of the firm liable to capital gains tax. He had also further stated that if it were to be held at the appellate stage that the two capital accounts were indeed separate, even then the conditions prescribed in the proviso (c) to section 47(xiii) was not met. The said proviso says that the partners of the firm will not receive any consideration or benefit directly or indirectly, in any form or manner from the company except by way of allotment of shares. However, in the present case all the eight partners’ current capital account has been taken by the company as loan and so reflected in the balance-sheet. Therefore, it was observed by the Assessing Officer, the erstwhile partners have received consideration in the form of interest as well as benefit from the company. Therefore, the succession is hit by proviso (c) to section 47(xiii) also.

10. However, the Commissioner of Income-tax (Appeals) took a divergent view, by taking shelter on the findings of various judiciary, that in the process of conversion from the firm to company, transfer was not involved and, therefore, appreciation of assets in the process of conversion was not liable to be taxed under the head “Capital gains”.

11. At this juncture, we shall proceed to analyse the judicial views on a similar issue as under :

(1) Well Pack Packaging (supra).

It was held by the hon’ble earlier Bench of this Tribunal that since there was no transfer on conversion of the firm into a company under Part IX of the Companies Act, there does not arise any question of applicability of section 50 or 45 or any other provisions of the Act.

12. Aggrieved, the Revenue took up the issue before the hon’ble jurisdictional High Court through a reference application. The Tax Appeal No. 368 of 2001 of the Revenue was, however, dismissed by the hon’ble court with an observation that no question of law, much less substantial question of law arose out of the order of the Tribunal. The Revenue preferred a SLP before the hon’ble Supreme Court against the ruling of the hon’ble High Court (supra). The hon’ble Supreme Court in CIT v. Well Pack Packaging[2009] 309 ITR 338 had ruled as under (page 340) :

“We do not agree with the view taken by the High Court. In our opinion, the questions of law raised by the Revenue before the High Court are substantial questions of law which arise from the order of the Tribunal. The High Court should have decided these questions by recording its findings thereon. Accordingly, the impugned order is set aside. Tax Appeal No. 368 of 2001 is admitted on the aforementioned four questions of law. We request the High Court to record its findings on these questions. The matter is remitted to the High Court for a fresh decision on the aforesaid questions in accordance with law.”

As per the Revenue’s version, the appeal is still pending before the hon’ble jurisdictional High Court for disposal [source : Assessing Officer’s letter dated June 18, 2012 to the Departmental representative].

(2) The hon’ble Income-tax Appellate Tribunal, Bangalore Bench in the case of Unity Care and Health Services (supra) had observed as under (page 130) :

“When a conversion of a firm into company takes place under the provisions of the companies law, such conversion can be construed only as occasioned by operation of law. Hence, no controversy could arise on the application of this principle even for purposes of capital gains under section 45(4). By insertion of section 47(xiii), it cannot be said that the conversion of a firm into a company under Part IX is to be first treated as dissolution of firm within the meaning of section 45(4) and only if the condition as contained in section 47(xiii) are complied with, the exemption will be available.

Section 47(xiii) applies only to a case of transfer by sale, but there is no authority for capital gain at all in the absence of a transfer under Part IX of the Companies Act inasmuch as such conversions do not fall within the definition of ‘transfer’ under section 2(47).”

While disposing of the Revenue’s reference application against the Tribunal’s order, the hon’ble Karnataka High Court had, in I.T.A. No. 3170 of 2005 dated July 5, 2010, ruled as under :

“(On page 6) 5. In the instant case, it is not in dispute that the assets of the partnership firm have become the assets of the company. All the partners of the firm have become the shareholders of the company. In proportion to their shares in the partnership firm, they have been allotted shares in the company. Admittedly, no amount is paid in any manner and in any form to the partners. In that view of the matter, the impugned transaction is not a transfer so as to attract capital gains under section 45. Therefore, the Tribunal was justified in setting aside the order passed by the first appellate authority as well as the assessing authority and in holding that the transaction in question does not constitute a transfer under the Act. In that view of the matter, we answer the first substantial question of law framed, against the Revenue and in favour of the assessee.”

(3) In the case of Gulabdas Printers (supra), the hon’ble earlier Bench of this Tribunal had recorded its findings as under (headnote) :

“Where a firm becomes a limited company under Part IX of the Companies Act, 1956, section 45(4) is not attracted as the very first condition of transfer by way of distribution of capital asset is not satisfied. In the circumstances, latter part of section 45(4) which refers to computation of capital gains under section 48 by treating the fair market value of the asset on the date of transfer, does not apply.”

Aggrieved, the Revenue had preferred a reference application before the hon’ble jurisdictional High Court in Tax Appeal No. 1559 of 2010 which, according to the Assessing Officer, is still pending for disposal before the hon’ble court (Refer : The Assessing Officer’s letter dated June 18, 2012 to the Departmental representative)

13. Let us now analyse the case laws relied on by the Revenue as under :

(1) Om Namah Shivay Builders & Developers (supra) :

After analysing the issue in detail, the hon’ble Mumbai Tribunal ([2011] 43 SOT 397) had concluded its findings as under :

“(On page 2) When upon retirement of a partner from partnership of two partners, the assets were taken over by one partner who continued the business as a proprietor, there was a dissolution of the firm and therefore, the difference between the fair market value of the assets and the book value in the books of the firm was assessable as capital gains in the hands of the firm in terms of section 45(4).”

We have, with due respects, perused the findings of the hon’ble Bench and of the considered view that it has no relevance to the issue under consideration. In that case, consequent on the retirement of a partner from the partnership of two partners, the assets were taken over by another partner who continued the business as a sole proprietor and, thus, there was a dissolution of the erstwhile firm whereas in the case under consideration, there was no dissolution of the firm, but, conversion of the firm into a company.

Thus, we are of the considered view that the case law relied on by the Revenue cannot come to its rescue.

(2) Goel Udyog (supra) :

The finding of the hon’ble Tribunal of Delhi “C” Bench is not applicable to the issue under consideration in the sense that in that case, on dissolution of firm and distribution of assets to partner excess of market value over book value with regard to land and building and plant and machinery has to be assessed as capital gain as per section 45(4). However, the issue before us, as already mentioned, is on a different footing and, thus, the case law quoted by the learned Departmental representative is clearly distinguishable.

14. Taking into account all the facts and circumstances of the issue as deliberated upon in the foregoing paragraphs, we are of the considered view that the Commissioner of Income-tax (Appeals) was justified in deleting the addition of Rs. 92,07,817 made by the Assessing Officer under the head “Capital gains”. It is ordered accordingly.

15. In the result, the appeal of the Revenue is dismissed.