Sec 45(4) of Income Tax Act–New Jeopardy for Honest Taxpayers!

SCOPE OF THE ARTICLE:

We are well aware of the recent rationalization of provisions being made with respect to the transfer of capital asset to a partner on the dissolution or reconstitution of a firm or other Association of Persons (AOP) or Body of Individuals (BOI) (not being a company or a cooperative society) or otherwise. The erstwhile sub-section (4) of section 45 of the Income Tax Act, 1961 is substituted with a new sub-section (4) vide Clause 14 and 16 of the Finance Bill, 2021, with consequential amendments in section 48 of the Act. The applicability of these amendments is made effective w.e.f. 1st April 2021 and will apply to the assessment year 2021-22 and subsequent assessment years.

Hence, this article is confined to brief analysis of modifications with substitution of new amended section 45(4) of the Income Tax Act, 1961 with a consequential amendment of section 48.

HISTORICAL BACKGROUND:

Let me first take you to the past, wherein one of the methods resorted by the assesses to evade the tax on capital gains was by using the medium of a partnership firm or an Association of Persons (AOP) or a Body of Individuals (BOI), by transferring their individual assets to such entities at cost or at a price lower than the fair market value and later, withdrawing themselves from the said partnership or such entity, by taking only the balance in their capital accounts and allowing other partners to continue to hold these capital assets. On the other hand, when a person introduced his capital asset in such entities at a price higher than cost, the difference was held not liable to tax according to the ratio laid down by the Hon’ble Apex Court in the case of “Sunil Siddharthbhai v. CIT [1985] 156 ITR 509 (SC)”. In this case, though the Apex Court held it to be a transfer, it was also observed that the consideration thereof was indeterminate. To nullify the effect of this decision, the provisions of section 45(3) were inserted by Finance Act, 1987 w.e.f. 1-4-1988 providing that the fair market value of the capital asset so transferred shall be deemed to be the amount recorded in the books of accounts of the firm.

Another method of tax evasion was that a capital asset held by a firm was taken over by a retiring partner or distributed among the partners on dissolution of the firm at book value. To plug these lacunae, the Finance Act, 1987 inserted section 45(4) also w.e.f. 1-4-1988. But this section applied to cases of distribution of capital assets on the dissolution of a firm, an AOP and a BOI, or otherwise.

Albeit, the provisions of section 45(3) achieved its objects, difficulties arose in the implementation of section 45(4). The withdrawal of a capital asset by a partner at the time of retirement or reconstitution was not expressly covered in the erstwhile sub-section (4) of section 45. The attempt to cover such a case within the meaning of the word “otherwise” did not find any judicial favour. Reference can be drawn from “CIT v. Kunnamkulam Mill Board [2002] 257 ITR 544 (Kerala)” and “CIT v. Dynamic Enterprise (2013) 359 ITR 83 (Karnataka)”. This has led to the substitution of section 45(4) of the Act.

However, the Memorandum explaining the Finance Bill, 2021 states that there is uncertainty regarding applicability of provisions of the aforesaid sub-section to a situation wherein assets are revalued, or self-generated assets are recorded in the books of accounts and payment is made to partner or member which is in excess of the capital contribution. This Explanation holds good in case of insertion of section 45(4A).

OBSERVATIONS AND ANALYSIS BY THE AUTHOR:

Now, let us discuss the amendments being made by the newly substituted section 45(4) at a glance;

“Capital gains.

45. (4) The profits or gains arising from the transfer of a capital asset by way of distribution of capital assets on the dissolution of a firm or other association of persons or body of individuals (not being a company or a co-operative society) or otherwise84, shall be chargeable to tax as the income of the firm, association or body, of the previous year in which the said transfer takes place and, for the purposes of section 48, the fair market value of the asset on the date of such transfer shall be deemed to be the full value of the consideration received or accruing as a result of the transfer.”

As per the newly inserted provisions under Section 45(4) of the Act, following observations can be made:

1. The taxable event will be “the profits and gains arising from receipt of any money or capital asset or both by specified person from a specified entity on account of its dissolution or reconstitution”.

2. The capital asset will represent the balance in a specified person’s capital account in the books of the specified entity at the time of its dissolution or reconstitution.

3. In determining the capital account balance of the specified person, any increase on account of revaluation of any asset or due to self-generated goodwill or any other self-generated asset will be excluded.

4. These amounts will be chargeable as income of the specified entity under Capital Gains and it will be deemed to be income of the specified entity for the previous year in which such capital asset is received by the specified person.

5. As far as the computation of capital gains is concerned, the fair market value of the capital asset on the date of receipt by the specified person shall be deemed to be the full value of consideration. So far as the cost of acquisition is concerned, it is to be ascertained in the usual manner.

6. The terms “specified entity”, “self-generated goodwill” or self-generated asset” and “specified person” are defined by way of Explanation to the proposed section.

“specified entity” means a firm or other association of persons or body of individuals (not being a company or a cooperative society);

“self-generated goodwill” and “self-generated asset” mean goodwill or asset, as the case may be, which has been acquired without incurring any cost for purchase or which has been generated during the course of the business or profession.

“specified person” means a person who is partner of a firm or member of other association of persons or body of individuals (not being a company or a cooperative society), in any previous year.

AUTHOR’S OPINION:

1. As per the existing provisions, the taxable event was “distribution of capital assets on the dissolution or otherwise”. As per the substituted provisions, the taxable event will be “the profits and gains arising from receipt of “any money or capital asset or both by specified person from a specified entity on account of its dissolution or reconstitution”. Although the word “reconstitution” has not been defined in the Act, it will take its meaning from the expression “change in constitution” as appearing in Section 187 of the Act. Thus, there is now an express provision to cover cases of retirement of a partner or a reconstitution of a firm.

2. The existing provisions do not provide that balance in the capital account of a partner shall represent capital asset. But the amendment now provides that the capital asset will represent the balance in a specified person’s capital account in the books of the specified entity at the time of its dissolution or reconstitution. It is also provided that in determining the capital account balance of the specified person, any increase on account of revaluation of any asset or due to self-generated goodwill or any other self-generated asset will be excluded.

3. It is provided that so far as the cost of acquisition is concerned, it is to be ascertained in the usual manner. There was no such provision in the existing provisions.

4. Further, this provision is intended to bring into its ambit the consideration received for self-generated goodwill by the specified persons.

5. If any revaluation is done by the specified entity prior to its dissolution or reconstitution increasing the value of any asset, such revaluation will be ignored for the purpose of determination of the capital account balances of the specified persons.

6. Similarly, any increase on account of self-generated goodwill or any other self-generated asset will be ignored for the purpose of determination of the capital account balances of the specified persons.

7. The amendment is to tax any money received by the specified persons in excess of their capital account balances.

CONSEQUENTIAL AMENDMENTS TO SECTION 48:

Consequential amendment is also made in section 48 of the Act by insertion of clause (iii) to provide that in case of specified entity, the amount included in the total income of such specified entity under newly substituted sub-section (4) of section 45 which is attributable to the capital asset being transferred, shall be reduced from the full value of the consideration to compute income charged under the head “capital gains”. This is to be calculated in the manner to be prescribed. This is to mitigate the double taxation which may have happened but for this provision in a situation where an asset which was revalued and for which income under sub-section (4) of section 45 of the Act was brought to tax is transferred subsequently by the specified entity.

Now, while the scheme of taxation as finally enacted by the Finance Act 2021 is different from the scheme as proposed initially, it appears that the intention behind insertion of section 48(iii) has remained the same.
The language of the provision is not very clear. However, having regard to the Explanatory Memorandum, it appears as follows:

(a) Section 48(iii) is applicable to computation for the purpose of section 9B.

(b) The amount of income under section 45(4) will have to be bifurcated into the amount attributable to receipt of money by the specified person and the amount attributable to receipt of capital asset.

(c) The Act is silent as to the manner in which the income under section 45(4) shall be bifurcated into the amount of income attributable to receipt of money and the amount of income attributable to receipt of capital asset. Section 48(iii) states that the amount attributable to receipt of capital asset shall be calculated in the prescribed manner.

(d) The amount so calculated shall be deducted while computing capital gains under section 9B in the hands of specified entity.

To illustrate, suppose the capital gains calculated under section 9B on a standalone basis is Rs.2 crores; suppose the amount of capital gains taxable under section 45(4) and calculated in the prescribed manner under section 48(iii) is Rs.1.8 crores. In this case, the final capital gains chargeable under section 9B read with section 48 shall be Rs.20 lakhs (Rs.2 crores less Rs.1.8 crores).

The computation of capital gain under section 9B read with section 48(iii) shall be as follows:

Particular Amount

Full value of consideration received or accrued (FMV of capital asset) xxx

Less:

(a) Expenditure incurred wholly and exclusively in connection with transfer; (xxx)

(b) Cost of acquisition/indexed cost of acquisition; (xxx)

(c) Cost of improvement/indexed cost of improvement; and (xxx)

(d) The amount chargeable to tax as income of specified entity under section 45(4) which is attributable to capital asset being transferred by the said entity [section 48(iii)]. (xxx)

Income taxable under the head capital gains (before exemption under section 54EC, etc.) Xxx

It appears that the attribution under section 48(iii) has to be done capital asset wise in order to ensure that appropriate deduction is available while computing capital gains on the capital asset, as required by section 9B.

The arguments in support of the aforesaid interpretation that section 48(iii) provides for additional deduction in computation under section 9B are as follows:

As mentioned above, section 48 provides for mode of computation of capital gains. Hence, when clause (iii) is inserted in section 48, it is to provide additional deduction in computation of capital gains. Now, individual asset wise capital gains have to be computed only in the scheme of taxation under section 9B and not under section 45(4). In this circumstance, section 48(iii) can apply only in relation to computation under section 9B and not in section 45(4).

Further, paraphrasing section 48(iii),

1. the provision applies when any money or capital asset is received by a specified person from a specified entity referred to in section 45(4); and

2. if the provision is applicable, then the deduction shall be equal to the amount chargeable “under that sub-section” [that is section 45(4)] which is attributable to the capital asset transfered by the specified entity; the amount attributable shall be calculated in the prescribed manner.

Thus, section 45(4) is used in section 48(iii) for the limited purpose of,

(i) determining whether section 48(iii) applies or not (as a precondition for applicability); and

(ii) quantifying the amount of the deduction (as computation provision).

However, section 45(4) is not used in section 48(iii) for modifying the income computed under it. In other words, the measure of deduction is the amount of tax under section 45(4) but it is not by itself a deduction for section 45(4). Here, noting that the receipt of capital asset is in the hands of the ‘specified person’ but the incidence of tax is on the specified entity which does not receive the capital asset but transfers it. At this juncture, it can be pointed out that “The provisions of section 2(47) have not been amended to take care of such an exceptional situation”.

Further, newly substituted section 45(4) is now made applicable to “money” also and thus by no stretch of imagination, money can be a “capital asset”. The definition of “capital asset” given in section 2(14) of the Act does not cover it.”

ANOMOLIES STILL PERSISTS:

1. Section 45(1) provides that any profits and gains arising from the “transfer of a capital asset” shall be chargeable as “capital gains”. But the provisions of section 45(4), the taxable event is linked to “receipt of a capital asset”. For this purpose, the sub-sections (4) of section 45 have been enacted with a ‘non-obstante clause’ to override the provisions of sub-section (1) thereof. In this connection, it is important to note that the receipt of capital asset is in the hands of the specified person, but the incidence of tax is on the specified entity which does not receive the capital asset but transfers it. The provisions of section 2(47) have not been amended to take care of such an exceptional situation.

2. Further, section 45(4) now covers “money” also. By no stretch of imagination, money can be a “capital asset”. The definition of “capital asset” given in section 2(14) of the Act does not cover it.

RELEVANT JUDICIAL PRONOUNCEMENTS:

Besides, as pointed out above, attention can be drawn towards the ratyio laid down by Hon’ble Gujarat High Court in the case of “CIT Vs Mohanbhai Pamabhai (1973] 91 ITR 393 (Guj)”, that even under the artificially extended definition of ‘transfer’ under section 2(47) of the Act, there is no transfer of interest in the partnership assets involved when a partner retires from the partnership. The aforesaid judgement was later on affirmed by the Supreme Court in the case of “Addl CIT Vs Mohanbhai Pamabhai [1987] 165 ITR 166 (SC)”.

In view of the aforesaid reasons, when a partner of a firm retires from the firm and receives an amount, in respect of his share in the partnership, there is no transfer of interest of the partner in the assets of the firm and accordingly, no part of the amount received by the partner would be assessable to capital gains tax under section 45 of the Act.

Therefore, in the absence of a specific provision in section 2(47) of the Act, section 45(4) cannot assume a ‘transfer’. In this context, the following observations of the Supreme Court in the case of Sunil Siddharthbhai Vs CIT [1985] 156 ITR 509 (SC), on page 519 of the Report are relevant.

It has been held by this court in CIT Vs Dewas Cine Corporation [1968] 68 ITR 240 (SC), CIT Vs Bankey Lal Vaidya [1971] 79 ITR 594 (SC) and recently in Malabar Fisheries Co. Vs CIT [1979] 120 ITR 49 (SC) as well as by the Punjab and Haryana High Court in Kay Engineering Co. Vs CIT [1971] 82 ITR 950, the Kerala High Court in CIT Vs Nataraj Motor Service [1972] 86 ITR 109 and the Gujarat High Court in CIT Vs Mohanbhai Pamabhai [1973] 91 ITR 393, that when a partner retires or the partnership is dissolved, what the partner receives is his share in the partnership. What is contemplated here is a share of the partner qua the net assets of the partnership firm. On evaluation, that share in a particular case may be realized by the receipt of only one of all the assets. What happens here is that a shared interest in all the assets of the firm is replaced by an exclusive interest in an asset of equal value. That is why it has been held that there is no transfer. It is the realization of a pre-existing right.

The aforesaid view is also supported by the following legal precedents:

I. CIT Vs Mohanbhai Pamabhai [1973] 91 ITR 393 (Guj)

It was held in this case that section 2(47) defines ‘transfer’ in relation to a capital asset. This definition gives an artificially extended meaning to the term by including within its scope and ambit, two kinds of transactions, which would not ordinarily constitute ‘transfer’ in the accepted connotation of that word, namely, relinquishment of the capital asset and extinguishment of any rights in it. But even in this artificially extended sense, there is no transfer of interest in the partnership assets involved when a partner retires from the partnership.

II. Addl CIT Vs Mohanbhai Pamabhai [1987] 165 ITR 166 (SC)

In this case, the Supreme Court has affirmed the aforesaid judgement of Gujarat High Court.

Therefore, the aforesaid view of the Gujarat High Court regarding section 2(47) in relation to retirement of a partner from a firm, was fully affirmed by the Supreme Court.

III. CIT Vs R.L. Raghukumar [2001] 247 ITR 801 (SC) : 166 CTR 398 (SC)

It was held in this case that according to the High Court there was no transfer of any assets as contemplated by the expression ‘transfer’ as defined in section 2(47) of the Act. The High Court had placed reliance on the judgement of Gujarat High Court in the case of CIT Vs Mohanbhai Pamabhai [1973] 91 ITR 393 (Guj), which was later on affirmed by the Supreme Court in the case of Addl CIT Vs Mohanbhai Pamabhai [1987] 165 ITR 166 (SC). Accordingly, the appeal of the I.T. Department against the order of the A.P. High Court was dismissed.

It was, thus, held that on retirement of a partner from the firm there was no element of transfer of interest in partnership assets by the retired partner to the continuing partners and the amount received by him was not assessable to capital gains.

IV. CIT Vs Surendra Kumar Gupta [2004] 270 ITR 325 (All) : 191 CTR 538 (All)

In his case the assets of the firm were taken over by one of the two partners on dissolution of the firm, on payment of an agreed amount to the other partner.

It was held that the aforesaid transaction did not result in any transfer of asset as understood in common law.

V. CIT Vs P.N. Panjawani (Decd) [2012] 80 DTR 200 (Karn)

In this case, also, the provisions of section 2(47) were examined, in the context of reduction of share in partnership firm on induction of new partners.

It was held that reduction of share of old partners of the firm on reconstitution of firm by inducting new partners and withdrawal of amount by old partners out of the capital contributed by new partners, did not constitute transfer in the hands of partners, making them liable to capital gains tax.

It was also held that the provisions of section 45(3) or section 45(4) were not applicable to the facts of the case.

VI. CIT Vs Kunnamkulam Mill Board [2002] 257 ITR 544 (Ker) : 178 CTR 356 (Ker)

It was held in this case that on retirement of the partner of the firm, there is no transfer of the assets of the firm in favour of the continuing partners within the meaning of section 45(4) of the Act.

In view of the aforesaid legal precedents, it is clearly established that there is no transfer on dissolution of a firm or retirement of a partner from the firm, within the meaning of section 2(47) of the Act. Therefore, in the absence of the amendment of section 2(47) of the Act, there will be no transfer of assets in the case of the dissolution of a firm or retirement of a partner from the firm.

CONCLUSION:

While substituting new section 45(4) with the erstwhile, the Memorandum explaining the Finance Bill, 2021 describes this as “Rationalization of provision of transfer of capital asset to partner on dissolution or reconstitution”. The dictionary meaning of the word “Rationalization” is “the action of attempting to explain or justify behavior or an attitude with logical reasons, even if these are not appropriate”. It is evident that the amendment to section 45(4) is being proposed with a view to overcoming the difficulties in taxing the capital gains arising at the time of retirement/reconstitution of a Firm and other specified entity and to tax self-generated goodwill and other self-generated assets. So, these amendments are aimed at plugging the loopholes regarding taxation at the time of retirement/ reconstitution and extending the scope of taxation to self-generated goodwill, etc. However, the legislature thinks it fit to describe these attempts as “rationalization”.

Lastly, it is imperative to point out that the word “reconstitution” means “change in constitution” which is defined in section187 of the Act. Sub-section 2(b) thereof provides that change in constitution takes place when all the partners continue with a change in their respective shares or in the shares of some of them. During the subsistence of a partnership firm, the share in profits and/or loss of a partner is often changed and if on every such occasion, fair market value of the assets of the firm is required to be determined and capital gains tax is imposed, the firms would face an onerous task.

The author can be reached at : [email protected]