The amendment to section 45(4) of the Income Tax Act, 1961 with effect from 01/04/2021 (FY 2020-21) has raised more issues than solved any. The legislature, in a hurry to collect more revenue and that too front end has brought in a very complex provision in the form of amended section 45(4). The said provision is so complex that it unsettles all the limbs of a taxing jurisprudence from chargeability to computation, including the quantum and tax rate and person chargeable etc.
In this article we have restricted ourselves to one part of the said provision and that is the applicability of the said provision where a retiring partner is being given “money” in excess of his capital balance as on the date of retirement.
So let’s assume, that a retiring partners capital balance as on the date of retirement is Rs.1.00 crore and he is getting 70 lakhs over and above that in money form at the time of retirement. The provision of amended section 45(4) shall apply. The first question is to determine the “nature / character” of this excess payment. The said excess payment may be either the share of goodwill of the firm or it could be revaluation of the assets held by the firm.
However, if the firm is holding immovable property as “stock in trade” and there are no capital assets in the balance sheet, like, in a typical case of a real estate developer, the true nature of excess payment would raise controversy.
We have analyzed the amended section 45(4) in light of the above facts.
Whether Goodwill?
Certain tax experts believe that the excess payment made to a retiring partner over and above the capital balance is to be deemed as “Goodwill”. They further rely on Example 3 provided by CBDT in its Circular no.14 dated 2nd July, 2021, where the CBDT has clarified that the excess amount paid being Goodwill shall not be allowed as a deduction to the firm.
In the author’s opinion, this observation is factually erroneous for the following reasons:
a. No such Goodwill can be presumed when there is no agreement between the partners stating or agreeing that the excess payment over and above the capital balance is towards purchase of Goodwill. The valuation of Goodwill is a matter of contract and involves a formal valuation based upon the working of the partnership firm. In absence of any such contract it would be a misnomer to state that the excess payment is goodwill.
b. One also has to consider whether the firm had actually carried out business or not before the retirement of a partner. Sometimes, it so happens that the firm is holding land only without commencing development. In such a case there cannot be goodwill for the said firm because the firm has not carried out any business in the past.
c. The Example 3 of CBDT Circular-14 is also inapplicable because it clearly lays down that the Goodwill was valued at Rs.30 lakhs through a government approved valuer. The relevant fact is reproduced hereunder:
“As per the valuation report there is also self-generated goodwill of Rs.30 lakh”.
This is in contrast to a situation where no goodwill is valued between partners and excess payment reflects the increase in value of the stock of the firm.
d. The above opinion is further supported by the decision of Supreme Court in the case of A.L.A. Firm v. Commissioner of Income Tax (1991) 189 ITR 285 (SC) wherein the SC has observed that when a partner retires what he gets is the share of unearned increase in the value of properties held by the firm. This means that even if the land is held as “Stock in trade” yet in the commercial world while retiring the retiring partner would seek his share of increased value of such stock in trade. Hence, to call such an excess payment as a Goodwill is not correct. Ideally in such a situation the fact of increased value in the stock in trade (in this case land) be documented by the Partners to avoid any other interpretation.
Long Term or Short Term Gain?
The next question to be determined is whether the gain taxable in the hands of the firm under section 45(4) is a “long term capital gain” or “short term capital gain”. Unfortunately, the provision of law is silent on this aspect, however, the legislature has enacted Rule 8AA to supplement the provisions of the Act. The said Rule lays down how and when the nature of gain will be determined as long term or short term when deciding the retirement of a partner against money. For the sake of convenience the relevant portion is reproduced hereunder:
(5). In case of the amount which is chargeable to income-tax as income of specified entity under sub-_ section (4) of section 45 under the head – “Capital gains”,-
(i) the amount or a part of it shall be deemed to be from transfer of short term capital asset, if it is attributed to,-
- (a) capital asset which is short term capital asset at the time of taxation of amount under sub-section (4) of section 45; or
- (b) capital asset forming part of block of asset; or
- (c) capital asset being self-generated asset and self-generated goodwill as defined in clause (ii) of Explanation 1 to sub-section (4) of section 45; and
(ii) the amount or a part of it shall be deemed to be from transfer of long term capital asset or assets, if it is attributed to capital asset which is not covered by clause (i) and is long term capital asset at the time of taxation of amount under sub-section (4) of section 45.
A perusal of the above Rule reveals that in sub rule (i), three situations are provided where the excess payment over and above capital balance will be treated as “Short Term Capital Gain’. If nothing in Rule 8AA(5)(i) applies, then as a residuary rule 8AA(5)(ii) shall apply, which provides that the gain will be long term capital gain.
Now if we go by the process of elimination then, as per the observation made in paras above, none of the items mentioned in the Rule 8AA(5)(i) applies to a situation where the partner retires against money and there are no capital asset/s held by the firm.
Therefore, in the opinion of the author the applicability of para 5(i)(c) of Rule 8AA is ousted and the Rule 8AA(5)(ii) will apply as a residual clause. The said residual clause states that what is not short term capital gain is a long term capital gain. This is in line with the definition of the Short term capital asset as defined in section 2(42A) of the Income Tax Act read with Section 2(29AA) of the Income Tax Act [renumbered from Section 2(29A) by Finance Act, 2021]. Again the definition of Long Term Capital Asset in the Act is a residual clause.
As per the said Section 2(29AA) of Income Tax Act, 1961, unless the context otherwise requires, the term “long-term capital asset” means a capital asset which is not a short-term capital asset.
“Capital Asset” for amended 45(4):
The next question to be considered is whether the firm is transferring any “asset” so as to be liable to tax under section 45(4) of the Act. If we go back in time we realise that erstwhile section 45(4) was based on taxing gain arising on transfer of “capital asset” to the retiring partner. The said aspect has now been shifted to the section 9B. On the other hand section 45(4) has been recasted by making following two important changes:
a. Now even if no capital asset is transferred but excess money is paid over and above the capital balance of the retiring partner it is made taxable under the head capital gain. Here the actual gain is not to the firm, but it is to the retiring partner since he is receiving more than the capital invested. However, still the firm is liable to pay the said tax for such income of partner, as a reverse charge.
b. The computation of capital gain u/s 45(4) is not based on the cost of transfer of any asset but on the basis of capital balance of the retiring partner as is evident from the formula given for computation in the said provision. Thus, the calculation of 45(4) has deviated from the cost of acquisition of capital asset to capital balance of partner being treated as a cost.
We have to ask ourselves as to what is the capital asset being transferred where the retiring partner is paid more than the capital balance invested by him. The only answer which comes to my mind is that it’s the right of the retiring partner which is getting extinguished and hence, the legislature has treated the capital balance of such a partner as a cost in the formula provided for computation and also treated it as capital gain. This right in partnership is a “property” of the retiring partner as held by various courts and is a settled issue.
The aforesaid chargeability is enacted under the head “capital gain” only because the legislature is aware that the rights of a partner in a partnership property is a capital asset and excess payment to a retiring partner is classified as a “capital gain” and not “business income”.
It is also to be noted that where the firm is transferring the capital asset the transaction is covered in section 9B also being the gain on difference between cost of such asset and fair market value. However, the excess money paid over and above the capital balance is not covered in section 9B only because it’s not a transfer of any asset by the firm.
Thus, where excess amount is paid to the retiring partner, the asset being transferred is right of retiring partner in the firm and it belongs to the retiring partner and not to the firm.
Period of Holding:
Now as a natural corollary the period of holding of such “property” (rights in partnership) is to be determined from the date when the retiring partner became a partner. This means that if the partner had become the partner three years back then such gain is a long term capital gain and if he became a partner within 3 years then such a gain is a short term capital gain.
Deduction to Firm:
Now, having opined that the excess payment is connected to the increased value of the land due to approvals received against cost, and having paid tax on the said excess amount, can one say that the firm will not be entitled to deduction of the said excess amount paid on the ground that it’s not covered in section 48(iii) of the Act. Even though section 48(iii) allows deduction to the firm only where it holds capital asset, yet in my opinion the said excess amount paid to retiring partner over and above the capital balance is allowable as normal business expenditure to the firm under the head “Profits and gains from business or profession”. My opinion is based upon the following reason:
1. As discussed above the capital gain tax paid by the firm is actually a capital gain of the retiring partner and the firm is merely a chargeable entity under the reverse charge. For the firm the said excess amount paid to the retiring partner is actually a business expense as without paying the said compensation the retiring partner will not retire thereby creating an impasse. As also discussed it’s a premium paid for the increased value of the land.
2. Secondly, section 48(iii) which provides for such deduction is applicable only in the case of capital asset held by the firm and not where the firm is holding a stock in trade. Where the firm only has stock in trade one has to see the provisions of Chapter IV-D relevant to PGBP and not Chapter IV-E relevant to Capital Gain to determine whether the said amount paid to partner is an allowable expense or not.
3. Some experts hold a view that since no amendment is brought under the head PGBP, no deduction of excess amount paid to retiring partner will be allowed. I beg to differ on this view, since, section 37(1) is wide enough to include all expenses paid for the purpose of business. It’s an enabling clause and there is no provision introduced which refuses to allow such a claim of business expense on which tax is paid by the firm. The provisions of section 48(iii) do not make any mention of non allowability under section 37(1) nor can it do so. One can further refer the decision of Mumbai ITAT in the case of Kamakshi Land Developers & Associates bearing ITA no. 6722/Mum/2008 order dated 21/04/2010 for the decision on the allowability of compensation to a retiring partner. One can also refer to Kantilal and Sons [1985] 14 ITD 388 (Mum) in further support of the said opinion.
Conclusion:
The amendments made by introducing section 9B and 45(4) have really created multiple issues in the transactions of retirement or restructuring of partnership firms and LLP. The effect of the said provision is such that the normal commercial understanding between the partners have become subservient to the effect of tax. What we have touched upon in the above article is only the tip of the iceberg. In the times to come the courts will have to deal with a large number of issues which may or may not bring in certainty on these provisions.
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