Reduction of share in the firm of existing partners, on admission of new partners, not taxable as capital gains

The Karnataka HC has held that the reduction in the share of partners after the reconstitution of partnership firms does not amount to a taxable transfer. Further, it reaffirmed that, tax planning within the frame work of law is permitted.The principles laid down in this decision can also be applied to the limited liability partnerships, in similar circumstances.

The HC concurred with the view of the lower revenue authorities that, none of the provisions of the Act specifically envisages a situation where capital gains would be chargeable on account of reduction in the share of partnership in a firm by way of introduction of new partners.

In light of the facts of the case, the HC stated that it cannot be said that the old partners transferred their shares in the property of the firm and the amount of drawings represented the consideration received for such transfer, as for the purpose of the Act, the identity of the firm and its partners were separate and distinct, contrary to the treatment as per the Partnership Act.

The contention of the revenue authorities that, the above events represent a colourable device adopted by the partners to avoid payment of taxes is not tenable, as tax planning is legitimate, if done within the frame work of law. This is also owing to the fact that the firm was created in 1962, and land was purchased in 1967. The firm carried on business till FY 1992-93, and the old partners continued to be the partners in the firm, even though with a lower share in profits of the firm. Merely because the business was not conducted post reconstitution, one cannot hold that the firm is not genuine.

The HC observed that, the SC’s decision in the case of Kartikeya V. Sarabhai (above) cannot be applied in this case, since the assets are not owned by the partners and, hence, the question of partners relinquishing their right on the assets does not arise.

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