Comprehensive analysis of taxability on distribution of assets by a partnership firm to its partners on its dissolution or reconstitution

Finance Act, 2021 made some significant amendments with respect to taxability of distribution of capital assets, stock-in-trade or money by a partnership firm to its partners on its dissolution or reconstitution, which has been discussed here.

Pre-amendment era:

Section 45(4) of Income Tax Act, 1961 provided for chargeability of capital gain on the distribution of capital assets on the dissolution of a firm or otherwise in the year in which the said transfer takes place and the fair market value of the asset on the date of such transfer was be deemed to be the sale consideration u/s 48. There was controversy surrounding the applicability of section 45(4) in case of distribution of capital assets otherwise than dissolution of firm as several courts have held that section 45(4) triggers only case of dissolution of a firm and not in other cases of reconstitution of firm.

Amendment by Finance Act, 2021:

  • Insertion of a new Section 9B in the Income Tax Act, 1961 providing for chargeability of income tax on distribution of capital asset or stock-in-trade by a firm to its partner on its dissolution or reconstitution.
  • Substitution of the existing section 45(4) of the Income Tax Act, 1961 with a new section 45(4).
  • The aforesaid amendments are applicable from 1st April 2021 and will accordingly apply for the AY 2021-22 relevant to Financial Year 2020-21.

Income on receipt of capital asset or stock in trade by specified person (i.e. partner) from specified entity (i.e. firm) [Section 9B]:

The newly inserted section 9B provides as under:

(1) Such receipt of capital asset or stock by partner to be treated as deemed transfer: Where a partner of a firm receives any capital asset or stock in trade or both from that firm on the dissolution or reconstitution of that firm, then such capital asset or stock in trade will be deemed to be a transfer in the hands of the firm.

(2) Chargeable to Income Tax: Accordingly any profits and gains arising on such deemed transfer of capital asset or stock in trade shall be deemed to be the income of that firm of the year of transfer and chargeable to income tax under the head “Capital Gain” or “Profits and gains of business or profession” as the case may be.

(3) Determination of Sale Consideration for the purpose of charging income tax: The fair market value of the capital asset or stock in trade on the date of such deemed transfer will be deemed to be the full value of the consideration received or accruing as a result of such deemed transfer.

(4) Applicability of Section 45(1) for charging capital gain on such deemed transfer of capital asset:

Consequently the normal provision of section 45(1) read with section 48 and section 49 will apply on such distribution of capital asset on its dissolution or reconstitution by the firm to its partner.

Method of Computation of Capital Gain on such deemed transfer
Particular Amount
Sale Consideration xxxxxxxxx
Less: Expenses incurred in connection with such transfer xxxxxxxxx
Less: Cost of Acquisition/ Indexed Cost of Acquisition xxxxxxxxx
Less: Cost of Improvement/ Indexed Cost of Improvement xxxxxxxxx
Less: The amount chargeable to income-tax in the hands of firm u/s 45(4) which is attributable to the capital asset being transferred by the firm, calculated in the prescribed manner* xxxxxxxxx
Capital Gain (Short Term/ Long Term) xxxxxxxxx

*Note- It is consequent to amendment made in section 48 of Income Tax Act, 1961 by the Finance Act, 2021. The same is discussed in detail herein below.

(5) Applicability of Section 28 for charging income tax under the head “Profits and gains of business or profession” on such deemed transfer of stock in trade:

As far as the deemed transfer of stock in trade by a firm to its partners on its dissolution or reconstitution is concerned, the normal provision of section 28 will apply for determining profits and gains from such deemed transfer of stock in trade for the purpose of charging income tax on such deemed transfer.
Accordingly the difference between the cost of acquisition or manufacture or purchase and the fair market value is chargeable to tax in the hands of the firm as profits and gains of business or profession.

(6) Meaning of Reconstitution of the firm:

For the purpose of this section, reconstitution of the firm means:

a) Retirement of one or more of its partners;

b) Admission of one or more new partners;

c) Change in profit sharing ratio of such firm.

(7) Applicability of above provisions in case of other association of persons or body of individuals (AOPs or BOIs):

The above provisions are also applicable mutatis mutandis in case of other association of persons or body of individuals (not being a company or a co-operative society.

(8) Conclusion: While the erstwhile section 45(4) was taxing only the distribution of capital assets and not the stock in trade on the dissolution of firm or otherwise and where the applicability of that section in the case of reconstitution was in itself in dispute in various legal forums, the newly inserted section 9B attempted to tax both the distribution of capital asset as well as stock in trade on the dissolution or reconstitution of firm. Thus the applicability of taxability on such distribution in case of reconstitution is made crystal clear and various judicial pronouncements are overruled by the newly inserted section 9B.

Substitution of the existing section 45(4) of the Income Tax Act, 1961 with a new section 45(4):

The substituted section 45(4) provides as under:

(1) Capital Gain on distribution of money or capital asset of value exceeding capital balance on the reconstitution of firm: Where a partner receives any money or capital asset or both from its firm in connection with the reconstitution of such firm, then any profits or gains arising from such receipts by the partner will be chargeable to income-tax in the hands of the firm under the head “Capital gains” in the year of such receipts.

(2) Formula for calculating such profit or gains:

Such profits or gains on such receipts will be determined in accordance with the following formula:

Income Chargeable to tax as capital gain i.e. A = B + C – D

Where

A= income chargeable to income-tax u/s 45(4) as income of the firm under the head “Capital gains”;

B= value of any money received by the partner from the firm on the date of such receipt;

C= Fair Market Value of the capital asset received by the partner from the firm on the date of such receipt;

D= the amount of balance in the capital account of the partner (represented in any manner whether capital a/c or current a/c or any other a/c) in the books of account of the firm at the time of its reconstitution.

However where the value of “A” in above formula is “Negative”, its value will be deemed to be “Zero”.

(3) Calculation of balance in capital account of the partner:

The balance in the capital account of the partner in the books of account of the firm is to be calculated without taking into account the increase in the capital account of the partner due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset.

Thus the impact of revaluation of any asset or self-generated goodwill will have to be nullified while calculating capital account balance.
Further capital balance represented in manner such as capital account, current account or any other manner will be considered for this purpose.

(4) Tax is payable by the firm and not the partners:

It may be noted that in above case, although a partner is getting benefit as he is the person who receives capital asset and money which in aggregate is more than the amount standing to his credit in his capital account in the books of firm, the tax liability however is on the partnership firm and not on the recipient partner.

(5) Meaning of Self generated goodwill and Self generated asset:

For above section, “self-generated goodwill” and “self-generated asset” means goodwill or assets, which has been acquired without incurring any cost for purchase or which has been generated during the course of the business or profession.

(6) Applicability of above provisions in case of other association of persons or body of individuals:

The above provisions are also applicable mutatis mutandis in case of other association of persons or body of individuals (not being a company or a co-operative society.

Simultaneous application of Section 9B & Section 45(4) in case of receipt of capital asset by a partner from its firm on its reconstitution:

Explanation 2 to section 45(4) clarified that when a capital asset is received by a partner from a firm in connection with the reconstitution of such firm, the provisions of section 45(4) will operate in addition to the provisions of section 9B.

Thus prime facie it seems that there will be double chargeability of capital gain on a single transaction of distribution of capital asset by the firm to its partner on its reconstitution. While a capital gain will be charged as per the prevailing mechanism of charging capital gain under section 45 read with section 48 on the sale consideration less costs of such capital asset, another capital gain will be charged on value of capital asset in excess of the balance in the capital account of the partner in the books of firm.

However certain safeguard has been provided by the statute from such double charging of capital gain in the hands of partnership firm by inserting a new clause (iii) in section 48 of income tax act, 1961.

Change in method of computation of capital gain under section 45 read with section 48 in case of simultaneous application of section 9B and section 45(4):

Section 48 of Income Tax Act, 1961 provides the mode of computation of capital gain as under:

“The income chargeable under the head “Capital gains” shall be computed, by deducting from the full value of the consideration received or accruing as a result of the transfer of the capital asset the following amounts, namely :—

(i) expenditure incurred wholly and exclusively in connection with such transfer;

(ii) the cost of acquisition of the asset and the cost of any improvement thereto:”

Finance Act 2021 inserted a new clause (iii) in above section 48 of Income Tax Act, 1961, which provides as under:

“(iii) in case of value of any money or capital asset received by a specified person from a specified entity referred to in sub-section (4) of section 45, the amount chargeable to income-tax as income of such specified entity under that sub-section which is attributable to the capital asset being transferred by the specified entity, calculated in the prescribed manner:”

Thus in case where capital gain has been charged on the value of any money or capital asset received by a partner from the firm under section 45(4), the amount of capital gain so charged in the hands of that firm attributable to such capital asset will be deducted from full value of consideration for calculating capital gain in case of such deemed transfer under section 9B read with section 45(1) and section 48.

Here we will understand the applicability of both the above sections i.e. section 9B and section 45(4) with the help of illustrations:

Basic information:
Firm Name M/s ABC & Associates
Partner’s Name Mr. A, Mr. B, & Mr. C
Profit sharing ratio 1/3rd each

Illustration (1): Distribution of Capital Assets & Stock in trade in the case of dissolution:

Date of dissolution 01.04.2021
Distribution to Partners Immovable Property (Stamp Duty Value of Rs. 15 lakhs) given to Mr. A

[Indexed cost of acquisition of immovable property- Rs. 8 lakh]

  Stock in trade (FMV of Rs. 12 lakhs) given to Mr. B

[Cost of Purchase of such stock- Rs. 9 lakh]

  Shares (FMV of Rs. 10 lakhs) given to Mr. C

[Indexed cost of acquisition of shares- Rs. 9 lakh]

__

Computation of Capital Gain under section 9B read with section 45(1) & section 48

(In the hands of firm i.e. M/s ABC & Associates)

Particular Immovable Property (Rs.) Shares (Rs.)
Sale Consideration 15,00,000 10,00,000
Less: Indexed cost of acquisition 8,00,000 9,00,000
Capital Gain 7,00,000 1,00,000
Total Capital Gain 8,00,000

____

Computation of Business Income under section 28

(In the hands of firm i.e. M/s ABC & Associates)

Particular Stock in trade (Rs.)
Sale Consideration (FMV) 12,00,000
Less: cost of purchase 9,00,000
Business Income 3,00,000

Thus capital gain of Rs. 8,00,000 and business income of Rs. 3,00,000 will be chargeable to tax in above case.

Note- As this is the case of dissolution of firm, section 45(4) will not be applicable.

Illustration (2): Distribution of Money, Capital Assets & Stock in trade in the case of reconstitution:

Date of reconstitution 01.04.2021
Capital Balance as on the date of reconstitution Rs. 20 lakh each
Cause of reconstitution Mr. C retires from partnership firm with effect from 01.04.2021
Distribution to retiring partner Immovable Property (Stamp Duty Value of Rs. 15 lakhs) given to Mr. C

[Indexed cost of acquisition of immovable property- Rs. 8 lakh]

  Stock in trade (FMV of Rs. 12 lakhs) given to Mr. C

[Cost of Purchase of such stock- Rs. 9 lakh]

  Money worth Rs. 10 lakhs given to Mr. C

_____

Computation of Capital Gain under section 45(4)

(In the hands of firm i.e. M/s ABC & Associates)

Formula A= B+C-D
B i.e. value of any money received by the partner from the firm on the date of such receipt Rs. 10,00,000
C i.e. Fair Market Value of the capital asset received by the partner from the firm on the date of such receipt Rs. 15,00,000
D i.e. the amount of balance in the capital account of the partner in the books of firm at the time of its reconstitution Rs. 20,00,000
Thus A i.e. income chargeable to income-tax u/s 45(4) as income of the firm under the head “Capital gains” equals to      10,00,000

(+)15,00,000

(-) 20,00,000

(=) Rs. 5,00,000

Thus based on the given formula, Rs. 5,00,000 will be chargeable to tax as capital gain u/s 45(4) in the hands of partnership firm i.e. M/s ABC & Associates in FY 2021-22.

Computation of Capital Gain under section 45(4)

(In the hands of firm i.e. M/s ABC & Associates)

Formula A= B+C-D
B i.e. value of any money received by the partner from the firm on the date of such receipt Rs. 10,00,000
C i.e. Fair Market Value of the capital asset received by the partner from the firm on the date of such receipt Rs. 15,00,000
D i.e. the amount of balance in the capital account of the partner in the books of firm at the time of its reconstitution Rs. 20,00,000
Thus A i.e. income chargeable to income-tax u/s 45(4) as income of the firm under the head “Capital gains” equals to  10,00,000

(+)15,00,000

(-) 20,00,000

(=) Rs. 5,00,000

*Calculation of Capital Gain charged u/s 45(4) on the value of capital asset received by retiring partner from the firm for the purpose of clause (iii) of section 48:

As the capital gain of Rs. 5,00,000 so charged u/s 45(4) in the hands of partnership firm is attributable to both the receipt of money and capital asset by the partner from the firm, one need to calculate the portion of that capital gain attributable to the capital asset so received by the partner for the purpose of clause (iii) of section 48 for calculating capital gain on said deemed transfer of capital asset under section 9B read with section 45(1) of the act.

As per newly inserted clause (iii) to section 48, the manner for calculating capital gain so charged attributable to the capital asset being transferred by the firm will be prescribed by the government. However till date, no such manner has been prescribed.

Therefore in absence of any prescribed method till date, the author on his own assumptions has calculated the said capital gain attributable to capital asset in proportionate manner as under:

Capital gain charged on the value of capital asset received by retiring partner

(For the purpose of clause (iii) to section 48)

Capital gain charged on the value of capital asset equals (Total capital gain * value of capital asset)/   (Value of money + value of capital asset)
i.e. (500000*1500000)/(1000000+1500000)
i.e. Rs. 3,00,000

Note- The above calculation is based on some assumptions and therefore may be changed once the government prescribed the manner for computing the above capital gain.

Computation of Business Income under section 28:

Computation of Business Income under section 28

(In the hands of firm i.e. ABC & Associates)

Particular Stock in trade (Rs.)
Sale Consideration (FMV) 12,00,000
Less: cost of purchase 9,00,000
Business Income 3,00,000

Thus capital gain of Rs. 5,00,000 under section 45(4), Rs. 4,00,000 under section 9B read with section 45(1) & section 48 and business income of Rs. 3,00,000 under section 9B read with section 28 will be chargeable to tax in the hands of partnership firm M/s ABC & Associates.

Conclusion:

As there was uncertainty regarding applicability of provisions of erstwhile section 45(4) to a situation where 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 his capital contribution, attempt has been made to plough those uncertainty by substituting said section 45(4) and introducing a new section 9B in Income Tax Act, 1961.

Power has been given to the Board to remove, with the approval of the Central Government, any difficulty that may arise in giving effect to the provisions of section 9B and section 45(4) by issuing guidelines for the purposes of removing the said difficulty. Every guideline so issued by the Board will be laid before each House of Parliament, and will be binding on the income-tax authorities and on the assessee.

(Disclaimer: This write up is based on the understanding and interpretation of author and the same is not intended to be a professional advice.)

[The author is a Chartered Accountant and can also be reached at [email protected]]

Author Bio

Qualification: CA in Practice
Company: R D N A AND COMPANY LLP
Location: Raipur, Chhattisgarh, India
Member Since: 09 May 2017 | Total Posts: 30
Nitin Goyal is a Practicing Chartered Accountants and his core area of expertise includes Income Tax, Goods & Services Tax, Customs, and Financial Valuations. He has completed his Chartered Accountancy in Nov’2015. He secured All India Rank- 48 in his Final Exams. He is also a qualified Compan View Full Profile

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