Ravi Mehta*

Ravi MehtaDispute around levy of capital gains tax on the assets/sums received by partners at the time of their retirement has been a subject matter of tax litigation for several decades. There are various judgements of the Hon’ble Courts both in favor and against as regards taxation of the amount received by the partners on their retirement.

The Finance Bill, 2021 (“FB2021”) has proposed striking ‘retroactive’ amendments in the provisions of S. 45(4) of Income tax Act 1961 (“ITA”), with the intent to put these controversies to rest and bring certainty to the tax treatment on aspects that were thus far open to varied interpretations.

Tax Positions thus far:

As per the current provisions of Section 45(4), the profits or gains arising from the transfer of a capital asset upon its distribution on dissolution or otherwise of the firm or body of individual (BOI) or association of persons (AOP) is chargeable to tax as ‘capital gains’ in the hands of the firm /BOI /AOP in the year in which such transfer takes place.

The Fair Market Value (FMV) of such asset on the date of transfer shall be deemed to be the full value of consideration under Section 48 of the ITA.

Disputes arose as to whether Section 45(4) would apply to a case when there is no dissolution but a mere reconstitution of the firm consequent to the retirement of a partner. Generally, when a Partner retires, he is able to withdraw his capital balances existing in the Firm Account on his retirement date, and generally this may also include his share of goodwill which he has contributed to build through his years of hardship and sweat, and which will continue to remain & benefit both the Firm as well as its continuing partners even post retirement of the retiring partner.

While section 45(4) doesn’t specifically cover the term ‘reconstitution’ so as to provide for the specific tax treatment on retirement, different Courts have held varying views on the subject:

Judgements favouring non-taxability:

  • The controversy dates back to the case of Malabar Fisheries Co. v. CIT, (1979) 120 ITR 49 (SC), wherein the provisions of section 47(ii) were the guiding principles. In that case, there was dissolution of firm and distribution of assets. Based on the prevalent law, the Apex Court held that the transaction does not amount to transfer and thus capital gains are not attracted. Post this, the exemption was deleted from the law and provisions of section 45(3) and 45(4) were introduced, with effect from 01/04/1988.
  • The landmark case of ACIT v. Mohanbhai Pamabhai (1987) 165 ITR 166 (SC) had approved the decision of Gujarat HC – CIT v. Mohanbhai Pamabhai, (1973) 91 ITR 393(Guj) wherein it was held that when a partner retires from partnership firm and receives consideration, which includes proportionate share of goodwill therein, the same is not taxable as there is no ‘transfer’. While approving the decision of the Gujarat HC, the Apex court relied on its decision in the case of Sunil Siddharthbhai v. CIT, (1985) 156 ITR 509 (SC). It can be observed that the decision in case of Mohanbhai Pamabhai (supra), was w.r.t the law prevailing before the amendment in 1987.
  • Relying on Mohanbhai Pamabhai, the Apex Court had in the case of CIT v. R.Lingamallu Raghukumar, (2001) 247 ITR 801 (SC) held that even if consideration paid to retiring partner, exceeds the balance in its capital account, the same shall not be chargeable to tax. A similar view taken in (i) CIT v. P.H. Patel, (1988) 171 ITR 128 (AP) (ii) Prashant S. Joshi v. ITO, (2010) 324 ITR 154.

Judgements favouring taxability:

  • The decision of Bombay High Court in CIT v. A.N.Naik Associates,(2004) 265 ITR 346 (Bom), distinguished the decision of Mohanbhai Pamabhai (supra) on the grounds that the same pertained to a period wherein the provisions of section 45(3) and 45(4) are not prevalent. Thus, it held that transfer of capital asset to partners, at the time of retirement attracts capital gains. Contrary to the same, we have the decision of National Company v. ACIT, (2019) 105 taxmann.com 255 (Mad), wherein it was held that capital asset received by the partner at the time of retirement is not liable to capital gains.
  • We further had the decision of CIT v. Gurunath Talkies, (2010) 328 ITR 59 (Kar) wherein it was held that payment of money to the retiring partner shall also be taxable. The same was in a complete contrast to the decision of CIT v. Kunnamkulam Mill Board, (2002) 125 Taxman 802 (Ker), which had clearly held that consideration received by partner at the time of retirement is not taxable. The case of Gurunath Talkies (supra) was overruled by the Full Bench decision of Karnataka High Court in the case of CIT v. Dynamic Enterprises, (2013) 359 ITR 83 (Kar)(FB).
  • There were cases such as (i) Shevantibai C Mehta v. ITO, (2004) 4 SOT 94 (Pune) (ii) Sudhakar M Shetty v. ACIT, (2011) 130 ITD 197 (Mum) (iii) Savitri Kudur v. DCIT, (ITA No. 1700/Bang/2016, dated 03/05/2019) which held that the consideration in excess of capital balance is taxable.

In addition to the above list of controversies, a view also existed that receipt of money in the hands of the partner on retirement is a capital receipt and hence, not liable to tax. Few decisions supporting this are – (i) ACIT v. Brahm Swaroop & Bros. (1984) 19 taxman 245 (Raj); (ii) ACIT v. Smt. Mahinderpal Bhasin, (1979) 117 ITR 26 (All) ; (iii) A.K.Sharfuddin v. CIT, (1960) 39 ITR 333(Mad). As against it, in CIT v. Manoranjan Pictures Corpn. (P.) Ltd, (1998) 97 Taxman 381 (Del) it has been held that such receipts are revenue receipts and accordingly, taxable.

Lastly, there has also been a controversy over the person in whose hands the consideration is to be taxed. There have been certain precedents indicating the partners are to be taxed on receipt of consideration [Refer: ITO v. Fine Developers, (2012) 26 taxmann.com 202 (Mum); Mahul Construction Corporation v. ITO, (2017) 88 taxmann.com 181 (Mum)].

The existence of conflicting ruling always kept the matter controversial and prone to litigation, especially where the capital balances of Partners were stepped up to adequately reflect his share in the Firm’s goodwill.

Rationalisation of Provisions governing taxation of Sum of Money/ Capital Assets received by the Partner on Dissolution/Reconstitution- Amendments Proposed by the FB2021

The FB2021 proposes a new code of taxation for dissolution/reconstitution – through two new provisions – Section 45(4) and S. 45(4A) – to replace the existing provisions of S. 45(4) of ITA retroactively (effective FY20-21). The Memorandum to FB2021 perceives an ambiguity with regard to self-generated assets of the entity and situations where self-generated goodwill/assets are revalued and credited to the Partner’s Balance.

While the proposed new S.45(4) applies when a partner/member (‘Specified Person’) receives ‘capital asset’ upto his Capital Balance at the time of dissolution/reconstitution of the Firm/AOP/ BOI (‘Specified Entity’), the proposed new S. 45(4A) applies when the Specified Person receives ‘money or any other asset’ from the specified entity in excess of the balance in the Capital Account at the time of such dissolution or reconstitution.

The FB2021 proposes to tax the capital gains arising from the transfer of assets or payment of money at the time of dissolution/reconstitution in the hands of the Specified entity (viz., Firm/AOP/BOI). For the purpose of determining such capital gains, the FMV of capital asset or other asset or the value of money received would classify as full value of consideration and that the tax basis of the capital asset [if covered under new S. 45(4)] or the capital balance of the retiring partner existing on the dissolution/reconstitution date [if covered under S. 45(4A)] would constitute the cost of acquisition. However, a specific proviso has been introduced in both the new sections which clarifies that any increase in capital balance consequent to revaluation of any asset or self-generated goodwill/other asset should be disregarded.

To avoid the double taxation impact, amendment is also proposed in S. 48 of the ITA to allow step-up in tax basis of the capital asset if any income relating to such asset has been offered to tax under the proposed new provisions.

Impact of the Proposed Amendment:

  • The Amendment overrules the well-established tax principles of Apex Court in Mohanbhai Pamabhai (supra) and R.Lingmallu Raghukumar (supra) that a distribution of capital balance, including share in the value of a self-generated goodwill to the retiring partner was not a taxable ‘transfer’ The Amendment has to some extent further affirmed the ruling of the Hon’ble Bombay High Court in case of CIT v. AN Naik Associates (supra).
  • Unfortunately, all the amendments specified above are proposed to be made effective retroactively (viz., from FY20-21). This contradicts the Government’s averment given upon coming to power that it would not resort to retrospective amendments that retrospectively increases the tax incidence on the Taxpayers.
  • If the Government looks to improve Investor’s confidence and pursue its ‘ease of business’ agenda, then making law amendments that departs from the well-established tax principles of Apex Court and the best globally-followed practices should be avoided. However, if the law-makers have their compelling reasons to do this, then such amendments atleast should not be made retroactive and must be only prospective (viz., from the new fiscal year following the Budget announcement).
  • Lastly, while the current language the amendment proposed in Section 48 is not happily worded, it would be prudent for the lawmakers to specifically clarify that the benefit of stepped up tax base on capital asset will be available to the Specified Person (viz., the Partner) on the subsequent sale of such capital asset acquired during retirement.

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*Authored by Ravi Mehta, Managing Director & Head – Transaction Tax, RBSA Advisors LLP with Contribution from CA Sidharth Dhir and CA Chirag Wadhwa

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4 Comments

  1. Bharat Agarwal says:

    Clause of FB2021 states that the amendments proposed will apply from FY2021-22. So whether it’s correct to say that amendment to section 45(4)/(4A) is retroactive?

    1. Ravi Mehta says:

      Thank you for your comment. Memorandum to FB2021 clearly specifies application of proposed S. 45(4) and S. 45(4A) effective AY2021-22; which means FY2020-21 (viz., the running current Financial year). Hence, it is proposed as retroactive amendment. Trust this clarifies.

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