Capital gain implications on retirement of partner(s)
V.K. Subramani, CA
There are so many controversial issues in Income-tax law and in spite of having administered the law for about five decades, the lawmakers and the administrators find taxpayers inventing new and newer ideas, time and again to reduce their tax liability. The tax planning ideas are partly upheld by the courts. The reasoning given for such conclusion whether favourable or adverse, impacts the interested parties in such a way that the taxpayers repeat the same strategy and the legislature amending the legal provisions to nullify the court decision either on prospective or retrospective basis.
The controversy in the realm of capital gain is partly because the taxpayers are averse to pay tax on capital transactions. It is also attributable to the lacunas in the legal provisions which contain some elbow room for getting tax relief.
This write up discusses about the tax implication of a partner who retires from a firm and receives capital asset(s) in settlement of the amount due from the firm.
When a partner introduces capital asset in to the firm, section 45(3) being a deeming provision would apply and the value of capital asset as recorded in the books is deemed as the full value of consideration received or accruing as a result of transfer. This was inserted by the Finance Act, 1987 w.e.f. 01.04.1988 along with section 45(4).
Section 45(4) says that when the capital assets of the firm are distributed on dissolution or otherwise, the capital gain is chargeable to tax in the hands of the firm. The fair market value on the date of such transfer (read as distribution) shall be deemed to be the full value of consideration received or accruing as a result of transfer.
The interpretation of the expression ‘distributed on dissolution or otherwise’ has been the bone of contention between the taxpayers and the tax gatherers.
When section 45(4) is triggered?: The point of time of application of section 45(4) was discussed in CIT v. Vijayalakshmi Metal Industries (2002) 256 ITR 540 (Mad). It was held that the date of dissolution is not to be taken as the date on which ‘transfer’ of capital asset(s) had taken place. In this case, a partnership firm consisting of two partners stood dissolved by the death of one partner. The firm was dissolved by operation of law viz. section 42(c) of the Indian Partnership Act, 1932. The court held that dissolution by operation of law may take place on the demise of one of two partners. However, that would not imply that there was notional transfer of capital asset and that the capital assets of the erstwhile firm stood transferred to other partner or other persons entitled to claim the share of the deceased partner. The court held that until such time the capital asset is transferred by way of distribution no occasion arises for bringing to tax any capital gain on a transfer which has never taken place. The court was emphatic in holding that the section does not give any room for doubt as to the year in which the capital gain is chargeable to tax.
This decision implies that even when there is automatic dissolution of a partnership firm, the application of section 45(4) could not be kept in abeyance by not distributing the assets to the surviving partner or partners or to other persons having right to claim on behalf of the deceased partner. An inoperative partnership firm with capital assets can continue to postpone the tax liability since the provision is not a deeming provision for imposing tax and provides for adoption of fair market value of the capital assets of the firm, for the purpose of computing capital gain.
Enhancing the value of assets and settlement of retiring partners: In CIT v. Kunnamkulam Mill Board (2002) 257 ITR 544 / 125 Taxman 802 (Ker) there was a change in constitution of firm with the retirement of partners who received credit balances in their accounts which was enhanced due to revaluation of assets of the firm. The AO was of the view that the partners took settlement amount based on enhanced value of assets and thus section 45(4) would apply. He treated the difference between the value of assets (before revaluation as per records of the firm) and amount credited to retiring partners account by applying section 45(4). The court held that when a partnership is reconstituted by adding a new partner and on the retirement of existing partners there was no transfer of asset within the meaning of section 45(4) of the Act. The court applied the rationale of the apex court decision in the case of B.T.Patil and Sons v. CGT (2001) 247 ITR 588 (SC) and Sunil Sidharthbhai v. CIT (1985) 156 ITR 509 (SC) and the decision was in favour of the assessee.
Thus when a partnership firm revalues the asset and settles the amount to the retiring partners, section 45(4) will not apply.
Settlement to retiring partner by transfer of immovable property: The expression ‘distributed on dissolution or otherwise’ became subject matter of controversy in CIT v. A.N.Naik Associates & Another (2004) 265 ITR 346 / 136 Taxman 107 (Bom).
In this case, by a memorandum of family settlement it was agreed amongst the parties that the business of six firms would be distributed in terms of the settlement. Under the terms and conditions, the assets proposed to be divided in settlement were held by the firms and individual members. In respect firms, the settlement set out the manner in which the firms were to be reconstituted by way of retirement and admission of partners.
The Revenue taking cognizance of the settlement document and subsequent deeds of retirement executed by the firms held that the provisions of section 45(4) are applicable for levying capital gains tax on the firm.
The court held that the Finance Act, 1987 omitted section 47(ii) the result of which is that the distribution of capital assets on dissolution of firm would be regarded as transfer. It held that the word ‘otherwise’ 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. It rejected the argument of the assessee that the expression ‘otherwise’ must be interpreted in the light of the preceding word or words applying the rule of ‘ejusdem generis’. The decision thus went in favour of Revenue.
Family arrangement and capital gains: In CIT v. Kay Arr Enterprises & Others (2008) 299 ITR 348 (Mad) the issue before the court was whether the transfer of shares pursuant to the family arrangement to avoid a possible litigation among the family members would attract capital gains tax. The court held that the family arrangement does not amount to any transfer and thus no capital gain is chargeable to tax.
Transfer of asset to retiring partners: In Dy.CIT v. G.K.Enterprises (2001) 79 TTJ (Mad) 82 the assessee a partnership firm consisting of four partners underwent a change in constitution with retirement of two partners. The retiring partners as per the memorandum of retirement became eligible for two grounds of land and building. The AO taxed the transaction of settlement of land and building to the retiring partners by applying section 45(4) in the hands of the firm. The assessee claimed that the provisions of section 45(4) were not applicable as the assessee firm was not dissolved but was reconstituted and it continued to carry on its business. The first appellate authority deleted the addition made by the AO and before the tribunal the Revenue contended that the allotment of properties to retiring partners is a clear revelation of dissolution of firm and subsequently there was a change in constitution of the firm. The assessee contended before the tribunal that on retirement there was no transfer. The deed of retirement also stated in clear terms the continuation of business by the remaining partners. There was not even an iota of evidence for the Revenue to come to a conclusion that on the retirement of two partners, the firm got dissolved. The tribunal held that it could not accept the contention of the Revenue that there was dissolution of the firm upon retirement of two out of four partners of the firm. The tribunal held that the transactions as evidenced by the documents filed did not show any dissolution of firm as much as to apply the provisions of section 45(4) of the Act. It cited the decision of Gujarat High Court in CIT v. Mohanbhai Pamabhai (1973) 91 ITR 393 (Guj) affirmed by the apex court (reported in 165 ITR 166 (SC)).
The tribunal negatived the application of the decision in the case of Mrs. Arathi Shenoy & Others v. Joint CIT (2000) 75 ITD 100 (Bang). It is for the reason that the assets of the firm were given to partners on litigation by means of bidding. The court mandated handover of the assets of the firm to whichever partner made the highest bid. It was held that the facts of the case were so different that it could not be applied to the case in hand.
Readers may note that the decision in G.K.Enterprises(Supra)was rendered prior to decision in the case of A.N.Naik Associates (Supra).
Goyal Dresses’s case
In Asstt. CIT v. Goyal Dresses (2010) 126 ITD 131 (Chennai) a combination of both the aspects viz. the family arrangement and its impact in the case of partnership firm in the context of section 45(4), was discussed. The facts of the case are somewhat similar to the case of G.K.Enterprises (Supra).
The assessee firm was engaged in the business of manufacture and export of garments. It had seven partners who were related to one another. During the previous year 2003-04, one of the partners retired and the rest continued the business of the firm. The terms of retirement provided that the retiring partner must be given one property of the firm in lieu of the amount payable to her from the partnership. The firm allotted the property as agreed to the retiring partner but did not compute any capital gains since there was no dissolution of firm on retirement of a partner and also because of the belief that section 45(4) will not apply to it.
The assessee argued its ground based on the basis of the decision in the case of Dy.CIT v. G.K.Enterprises (2003) 79 TTJ 82 (Chennai) (Trib). The Commissioner (Appeals) placed reliance on tribunal decision and held that settlement of property of a partnership firm in pursuance of family arrangement is not covered by section 45(4) of the Act. The Revenue relied on the decision in the case of A.N.Naik Associates (Supra).
It was argued by the assessee that apex court in Punjab Distilling Industries Ltd v. CIT (1965) 57 ITR 1 (SC) had dealt with the meaning of the expression ‘distribution’ which necessarily involves the idea of division between several persons which is the same as payment to several persons. Section 45(4) uses the expression ‘distribution of capital assets on the dissolution of firm or otherwise’, which cannot be extrapolated to bring retirement of one partner into the ambit of legal provision.
The assessee also argued that there was no jurisdictional High court decision on the issue and the decision of the tribunal was in its favour. The tribunal held that the dictum of the apex court has been that when two views are possible, the one favourable to the assessee is to be adopted (CIT v. Podar Cement (P) Ltd (1997) 226 ITR 625 / 92 Taxman 541 (SC) and Mysore Minerals Ltd v. CIT (1999) 239 ITR 775 / 106 Taxman 166 (SC)). Accordingly, it was held that section 45(4) was not attracted on the facts of the case.
The catena of legal decisions discussed above leads us to the following conclusions:
· Dissolution of partnership firm will not automatically invoke application of section 45(4). Only on distribution of capital assets of the erstwhile firm amongst the partners section 45(4) would be attracted. Even dissolution of firm by operation of law does not attract the application of section 45(4).
· Settlement of retiring partner(s) by revaluation of assets will not have capital gain implication on the firm since the assets of the firm continue to remain with the firm.
· Settlement of property to retiring partner per se would attract section 45(4) in view of the decision in the case of A.N.Naik Associates. The tribunal while deciding G.K.Enterprises case did not have the benefit of applying the persuasive value of the Bombay High Court decision in A.N.Naik’s case (Supra).
· Family settlement and transfer of asset in pursuance of such settlement / arrangement will not attract capital gain.
· Family arrangement might not attract capital gain on transfer of any capital assets by partnership firm when such transfer is made in pursuance of such family arrangement. However, this will not apply to those in Bombay High Court jurisdiction and for others the matter might require re-look as and when it is decided by respective jurisdictional High Court.