Capital Gain tax on distribution of assets on dissolution/reconstitution of partnership firm – ITAT explains the law on all possible scenarios
ABCAUS Case Law Citation:
ABCAUS 2921 (2019) (05) ITAT
Important Case Laws Cited/relied upon by the parties
ACIT Vs. Mohanbhai Pamabhai 165 ITR 166
CIT Vs. Dynamic Enterprises, 359 ITR 83 (Kar).
CIT Vs. A.N Naik Associates, 265 ITR 246 (Bom)
Sunil Sidharthbhai v. CIT  156 ITR 509
Malabar Fisheries v. CIT  120 ITR 49 (SC)
Tribhuvandas G.Patel Vs. CIT 115 ITR 95(Bom)
Sudhakar M.Shetty Vs. ACIT 130 ITD 197
Shevantibhai C. Mehta v. ITO (2004) 83 TTJ 542
The assessee was in appeal before the Tribunal against the order of the CIT(A) in treating sums received received by the assesee on his retirement from a partnership firm as capital gains.
The assessee was a partner in a partnership firm and had entered into a MOU with the other partners/firm whereby it was agreed that the assessee would retire from the firm on payment of specified sums.
However, the Assessing Officer (AO) taxed as capital gain, the amount paid to the assessee over and above the balance of his capital account standing on the books of the firm.
According to the AO the amount so received represented goodwill which attracted liability of Capital Gains u/s 45 as amount paid for giving up of right in existing goodwill of the firm which, by and large self generated.
Further, according to the AO, the assessee had also extinguished right to claim any share in the fixed assets of the partnership firm. The overall effect of the MOU was that, it provided for the retirement of the assessee from the partnership by way of compensation. In the MOU, there was a clause providing for the assignment of the assessees’ share in the partnership to the continuing partners.
Thus, the AO was of the view that there was a transfer by the assessee within the meaning of Section 2(47) and the liability to Capital Gains existed.
Before the CIT(A), the assessee contended that the amount received by a partner on his retirement from a firm is his share in the partnership firm and not for consideration in transfer of his inters in the partnership to the other partners. There was no transfer of interest in assets of the partnership firm in terms of the definition of the term transfer u/s 2(47) of the Act. Therefore there was no capital gain that could be brought to tax in the hands of the assessee.
The CIT(A) observed that the assessee had claimed the difference between the sum payable on retirement and the sum shown as credit in the capital account of the assessee viz. to be Goodwill. However, neither in the MOU or in the deed of reconstitution there was a reference to Goodwill. The amount shown as Goodwill in the books of the assessee and also in the capital account of the assessee was however was much lower.
The CIT(A) took the view that the AO was correct in bringing to tax capital gains on retirement of the assesee from the partnership firm.
Aggrieved by the aforesaid order of the CIT(A), the assessee had preferred the present appeal before the Tribunal.
The Tribunal observed that Section 45(1) of the Act brings to tax any capital gain that accrues or arises on transfer of a capital asset. The capital gain is charged to tax in the previous year in which the transfer takes place. Whereas section 2(47) defines what is transfer.
The Tribunal also observed that “Capital asset” has been defined in section 2(14) of the Act, as meaning “Property” of any kind held by the assessee, whether or not connected with his business or profession. The above exhaustive definition is subject to the following exclusions like stock-in-trade, consumable stores or raw material held for the purpose of business or profession, personal effects agricultural land in India, certain Gold bonds, special bearer bonds and Gold deposit bonds.
The Tribunal opined that share or interest of a partner in the partnership and its assets would be property and, therefore, a capital asset within the meaning of the aforesaid definition. To this extent, there could not be any doubt.
The question to be answered by the Tribunal was as to whether it can be said that there was a transfer of capital asset by the retiring partner in favour of the firm and its continuing partners so as to attract a charge under section 45 of the Act?
The Tribunal observed that time and again formation and dissolution of partnership has been was used as a device to evade tax on capital gains to convert an asset held individually into an asset of the firm in which the individual is a partner and conversion of capital assets into individual assets on dissolution or otherwise.
The Tribunal considered the scenarios in the lights of various judgments of the Hon’ble Supreme Court and Hon’ble High Court and explained the law as it stood after amendments.
Scenario 1 – Conversion of individual Assets into Asset of Partnership
Such introduction of own property as capital contribution by a partner up to 1-4- 1988 did not result in incidence of capital gain. However the Finance Act, 1987, introduced sub-section (3) to section 45 with effect from 1-4-1988. The effect of this is that the profits and gains arising from the transfer of a capital asset by a partner to a firm are chargeable as the partner’s income of the previous year in which the transfer took place and the amount recorded in the books of account of the firm, shall be deemed to be the full value of consideration received or accruing as a result of transfer of the capital asset.
Scenario 2 – Distribution of Asssets on Dissolution
The Hon’ble Supreme Court had held that distribution of assets of a partnership on dissolution amongst its partners would not constitute transfer within the meaning of section 2(47) of the Income-tax Act. However, the Finance Act, 1987, brought on the statute book a new sub-section (4) in section 45. The said dub-section provided for charging such transfers to tax as the income of the firm etc.
Scenario 3 – Firm continues and reconstituted whereby retiring partner is allotted capital asset of the firm for relinquishing all his rights, interest in the partnership firm as partner
In a case where it was held that where the business continued there was no dissolution of the firm and, consequently, section 45(4) was not attracted. However the Hon’ble High Court held that the expression ‘otherwise’ used in Section 45(4) of the Act, takes into its sweep not only cases of dissolution but also cases of subsisting partners of a partnership, transferring assets in favour of a retiring partner.
Scenario 4 – Firm continues and reconstituted whereby a partner retires and paid (a) on the basis of amount lying in his/her capital account (b) on the basis of amount lying in his/ her capital account + amount over and above the sum lying in his/her capital account. (c) or a lump sum consideration with no reference to the amount lying in his/her capital account. in consideration for relinquishing all his rights, interest in the partnership firm as partner.
The Tribunal opined that in situation (a) there cannot be any dispute that there can be no incidence of tax and the principle laid down by the Hon’ble Supreme Court.
However, with regard to situation (b) & (c), the Tribunal pointed out that these were subject matter of consideration in several cases and there is conflict of opinion amongst Courts on whether there would be incidence of tax or not.
According to the Tribunal, the situation involved in the instant appeal, was a case where the assessee was paid sums over and above the sum standing to the credit of his capital account i.e., situation (b) referred to above.
The Tribunal clarified that the fact that there was revaluation of the assets of the firm and resultantly the capital account of the firm stood enhanced is also not relevant. What is the credit in the capital account of the partner alone has to be seen. So long as there is no prohibition on revaluation of assets of the firm and there are no tax incidence on revaluation of assets of the firm, the credit to the partners capital account on revaluation cannot be looked at adversely.
The Tribunal noted that the Bombay High Court had dealt with an identical case and held that the transaction will have to be regarded as amounting to “transfer” within the meaning of section 2(47) of the Income-tax Act, inasmuch as the assessee could be said to have assigned, released and relinquished his interest and share in partnership and its assets in favour of the continuing partners and the transaction cannot be regarded as amounting to any distribution of capital assets upon dissolution of a firm. The above decision was followed by the Hon’ble High Court in the other two cases.
The Tribunal further observed that against the decision of the Hon’ble Bombay High Court the assessee preferred appeal before the Hon’ble Supreme Court and the two questions were framed by the Hon’ble Supreme as to (i) whether the sum received by the assessee as his share of the value of the goodwill or any part thereof was liable to tax as capital gain? And (ii) whether, the sum towards his remaining share on the assets of the firm was liable to tax as capital gain by reason of section 47(ii) of the Act? The Hon’ble Supreme Court answered both the above questions in favour of the assessee.
The Tribunal explained that the decision it was a case where the deed of reconstitution specifically referred to release of rights of the outgoing partners in the assets of the partnership and further the fact that a specified sum over and above the sum standing to the credit of the partner’s capital account was paid to the retiring partner, which excess sum was attributed to the retiring partner giving up his rights over the properties of the firm. It was only because of the provisions of Sec.47(ii) of the Act that the Hon’ble Court held that there was no incidence of tax on capital gain on the transaction.
The Tribunal clarified that the said decision of the Hon’ble Supreme Court will therefore have to be viewed as not applicable to cases after the amendment to the law w.e.f. 1-4-1989 whereby Sec.47(ii) of the Act was deleted and simultaneously Sec.45(3) & 45(4) were introduced.
The Tribunal opined that therefore the decisions of the Coordinate bench of Tribunals holding that questions of taxability of an amount received by a partner on retirement from firm would depend upon mode in which retirement is effected, holds good. Therefore taxability in such situation would depend on several factors like the intention as is evidenced by the various clauses of the instrument evincing retirement or dissolution, the manner in which the accounts have been settled and whether the same includes any amount in excess of the share of the partner on the revaluation of assets and other relevant factors which will throw light on the entire scheme of retirement/reconstitution.
The Tribunal noted that as per deed of retirement, the Assessee gave up all her rights as partner of the firm and its assets nor was the Assessee liable to pay any of its liabilities. The assessee was paid sums as agreed in the MOU over and above the balance in his capital account. The claim of the assessee that the entire difference was towards goodwill was not substantitated by entries in the books of accounts of the assessee where the book entries were for a lesser amount recorded in the assessee’s capital account as well as Goodwill Account.
Therefore the Tribunal held that the capital gain therefore would be total sums paid plus goodwill paid as per books of account minus opening balance in the capital account but since the assessee had invested in specified bonds there would no capital gain which was chargeable to tax.