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