Income Tax 31 Jan,2020
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Tax Conundrum of Excess Consideration Received by Retiring Partner
Sridhar RPartner – Grant Thornton India LLP

The taxability of excess consideration received by retiring partner from partnership firm upon retirement, under the provisions of the Income-tax Act, 1961 (IT Act), has been an issue prone to litigation for many years. Various courts and tax authorities have ruled both in favour of and against the taxation of such excess consideration as capital gains. This warrants for clarity of law and if considered in this Budget, will lead to a long pending matter to be settled.

There is lack of clarity in the IT Act regarding the provisions that govern the taxation of any goodwill paid to the retiring partners i.e.,

  •  Whether such excess consideration should be taxed in the hands of the retiring partners under Section 45(1); or

  •  Whether such excess consideration should be taxed in the hands of the partnership firm under Section 45(4).

Before discussing the taxability of excess consideration it is pertinent to understand if such excess consideration is a capital asset under Section 2(14) of the IT Act. Section 2(14) of the IT Act, defines capital gains to mean property of any kind held by an assessee, whether or not connected with his business or profession. Hence, on plain reading of the provisions of the IT Act, such excess consideration squarely falls under the definition of the Capital Asset, being right in the partnership firm, and does not fall under the negative list in the definition.

Taxability under Section 45(1) of the IT Act

Section 45(1) of the IT Act, provides for the taxation of profits/gains arising from the transfer of a capital asset in the previous year of transfer under the head 'Capital gains'. The fundamental question to be answered with respect to taxation of excess consideration (i.e. consideration over and above credit in partner's capital account) under Section 45(1) of the IT Act is whether there was a transfer of capital asset by the retiring partner in favour of the firm and its continuing partners. In this context, it would be relevant to understand and analyze the judicial interpretations.

The Gujarat High Court in CIT vs Mohanbhai Pamabhai1 held that:

  •  Amount paid as consideration to the retiring partner is only towards his/her share in the net partnership assets and there is no element of transfer of interest in the partnership assets by the retiring partner to the continuing partners.

  •  When a partner retires from a partnership, what the partner receives is his share in the partnership which is worked out by taking accounts and this does not amount to a consideration for the transfer of his interest to the continuing partners.

  •  Hence, Capital gains would arise only if the consideration is paid towards the extinguishment of the retiring partner's interest in the firm i.e., towards extinguishment of right to obtain his share of profits from time to time and to get the value of share in the net assets on dissolution or retirement. Consequently, there is no transfer under Section 2(47) of the IT Act and the amount paid to the retiring partner is not capital gains under Section 45 of the IT Act.

This can be better understood with an example. Suppose there is a partnership firm with 4 partners having equal share in assets as below:

It is evident from the example that the consideration being paid to the retiring partner is calculated based on the share in the net partnership assets and there is no direct transfer of interest in the firm to the continuing partners, since their share in net assets in absolute terms remains constant. Hence, the consideration is only for the share in net partnership assets and there is no transfer of interest in firm.

Furthermore, the appeal against the above judgment of the Gujarat High Court was dismissed by the Apex Court in CIT v. Mohanbhai Pamabhai2 by placing reliance on the decision in Sunil Siddharthbhai v. CIT3.

The principle flowing from the above ruling has been relied on in the following rulings:

1. CIT vs R. Lingmallu Raghukumar4

2. Tribhuvandas G. Patel5

3. Prashant S. Joshi v. ITO6

4. CIT v. Riyaz A. Sheikh7

5. PCIT v. R.F. Nangrani HUF8

At this stage, it is pertinent to discuss the Mumbai ITAT's judgement in Sudhakar M. Shetty v. ACIT9, wherein it was held that the capital gains shall be the excess of consideration paid over and above the credit in the retiring partner's capital account. However, in this case, the mode of retirement employed involved the retiring partner assigning, releasing and relinquishing the interest in the partnership in favour of the continuing partners (which was clearly covered in the retirement deed), satisfying the conditions of transfer of capital assets as laid down in CIT v. Mohanbhai Pamabhai (discussed above).

Recently, the Bangalore ITAT in Savitri Kadur vs DCIT10, placing reliance on the above decision of Mumbai ITAT, held that amount received by a retiring partner over and above the credit in capital account on relinquishment of all rights/interest in partnership firm is chargeable as capital gains. The Tribunal recomputed the capital gain by reducing the amount of book goodwill (based on revaluation of asset) credited to the capital account and has taxed only the balance excess consideration.

The Bangalore ITAT has discussed the following situations in connection with the payment of consideration to retiring partner on relinquishment of interest in the partnership firm:

a) Consideration on the basis of amount in retiring partner's capital account;

b) Consideration on the basis of amount lying in capital account plus amount over and above the sum lying in the capital account or a lump sum consideration with no reference to the amount lying in the capital account.

Based on the Supreme Court's decision in CIT v. Mohanbhai Pamabhai (discussed above), the ITAT held that there would be no tax incidence in situation (a). However, in other situations, the excess consideration would be taxable if the terms of deed of retirement/mode of retirement employed by the retiring partner constitutes release of any assets of the firm in favor of the continuing partners.

Thus, there is a view that goodwill appearing in the books of the firm, which is credited to the retiring partner's capital account is not taxable as capital gain and only the excess consideration being the consideration paid in excess of the credit in capital account (including credit of book goodwill in the Partner's account) is taxable under Section 45(1) of the IT Act, provided the retiring partner has transferred the right in the firm in favour of the continuing partners.

In view of the above judicial precedents, the general understanding emerging is that only excess consideration received for transfer of interest in the partnership firm would result in a capital gain. However, even in these cases where consideration is paid as per situation (a) discussed above, the retiring partner's interest in the firm is relinquished and indirectly transferred to the continuing partners. To be precise, the share of the continuing partners in the net partnership assets might remain the same, but their share of profit undergoes a change and to that extent, there is an indirect transfer in the interest in the firm.

For this purpose, let us consider the example discussed above:

From the above it is clear that, even though the share in net assets remains constant, the interest of each continuing partner increases from 25% to 33.33%; indicating an indirect transfer of 25% interest in the partnership held by D equally to the remaining partners.

The above rulings point to a loophole in the law as taxpayers can potentially escape tax by attributing the consideration to share of net partnership assets and not towards the interest in the firm.

Taxability under Section 45(4) of the IT Act

Section 45(4) of the IT Act, taxes gains arising from the transfer of a capital asset by way of distribution on dissolution of firm or otherwise, in the hands of the firm in the previous year in which the transfer takes place. For the purpose of computing capital gains, the FMV of the asset on the date of transfer shall be deemed to be the consideration.

Before the introduction of section 45(4) of the IT Act, there was clause (ii) of section 47 which exempted the distribution of capital assets on the dissolution of a firm, body of individuals or other association of persons from the scope of Transfer under Section 2(47) of the IT Act.

The introduction of Section 45(4) of the IT Act, can be tracked down to the Apex Court's decision in the case of Malabar Fisheries v. CIT11 wherein it was held that "A partnership firm under the Indian Partnership Act, 1932 is not a distinct legal entity apart from the partners constituting it and equally in law the firm as such has no separate rights of its own in the partnership assets......................therefore, the consequence of the distribution, division or allotment of assets to the partners which flows upon dissolution after discharge of liabilities is nothing but a mutual adjustment of rights between the partners and there is no question of any extinguishment of the firm's rights in the partnership assets amounting to a transfer of assets within the meaning of section 2(47) of the Act."

To plug this loophole, the Finance Act, 1987, introduced Section 45(4) of the IT Act, with effect from 1 April 1988.

The Bombay High Court issued a landmark ruling in the case of CIT v. A N Naik Associates and Anr.12, wherein the court applied the mischief rule and observed that the expression 'otherwise' should not be read ejusdem generis with the expression 'dissolution of a firm or body or association of persons'. Therefore, 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.

However, the Full Bench of Karnataka HC in CIT vs Dynamic Enterprises13 held that after the retirement of partners, the partnership continued to exist and the business was carried on by the remaining partners. Hence, there was no dissolution of the firm.

In view of the ratio laid down by the above High Courts, the applicability of Section 45(4) to distribution of capital assets to retiring partners is still an issue for debate and is open to litigation.

Moreover, this Section is applicable only on distribution of capital assets to partners and not when consideration is paid in cash. This principle has been upheld by the Supreme Court in Tribhuvandas G. Patel14.

Hence, where goodwill (on revaluation of the asset) is accounted for in the books of accounts of the partnership firm and the same is distributed to the retiring partner, the FMV of such goodwill being capital asset has to be offered to tax as capital gains. However, where goodwill is not recorded in the books, it represents the unidentified share of the retiring partner in the firm and would be difficult to compute the capital gain on distribution.

At this stage, the recent ruling of the Bombay HC in PCIT v. R.F. Nangrani HUF (referred above) which upheld the order passed by the ITAT in the same case brings up an interesting aspect. The ITAT had linked the Supreme Court's decision in CIT v. Mohanbhai Pamabhai15 and the applicability of Section 45(4). The ITAT ruled that the partner upon retirement did not receive consideration towards extinguishment of interest in partnership and hence, the consideration received (as cash or any other form) would not attract the provisions of Section 45(4).

The above ruling affirmed by the Hon'ble Bombay High Court by placing reliance on judicial precedents seems to have been delivered without considering the legislative intent of Section 45(4) of the IT Act.

Expectations

In light of the above, Budget 2020 is a chance to provide certainty to the tax position on payment of excess consideration to the retiring partner at the time of retirement. Either of the following tax treatments can be clarified or prescribed, so that the excess consideration received by the retiring partner be taxed accordingly without having room for any tax leakage (arising as a result of attributing consideration towards share of net partnership assets instead of relinquishment of interest in the firm):

1. There is no dispute on the taxation of capital gain under Section 45(4) where capital asset is distributed by the firm to the retiring partner. Nevertheless, having witnessed the ambiguity in the principles flowing from the judicial precedents discussed above, a clarification by way of an explanation to Section 45(4) of the IT Act, wherein retirement of a partner from the partnership firm would also be treated as dissolution under Section 45(4) of the IT Act should suffice.

2. However, Section 45(4) of the IT Act does not apply when the consideration paid to the retiring partner is not a capital asset. In this regard, it would be ideal to draw a parallel between the issue in hand and the Government's inclusion of non-compete fee received/receivable as "Profits and gains of business or profession" under Section 28 of the IT Act vide Finance Act, 2002.

A similar treatment can be provided by the Government by way of an insertion, of a sub-section to Section 28 of the IT Act wherein the receipt of excess consideration (not in the form of capital asset) representing the actual goodwill be treated as profit/gains from business or profession in the hands of the retiring partners.

Sridhar R, Partner - Grant Thornton India LLP with inputs from CA Subham Kumar and CA Bhavesh Kumar

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1.  [1973] 91 ITR 393 (Gujarat HC)

2.  [1987] 165 ITR 166 (SC)

3.  [1985] 156 ITR 509 (SC)

4.  [2001] 247 ITR 801 (SC)

5.  [1999] 236 ITR 515 (SC)

6.  [2010] 324 ITR 154 (Bom HC)

7.  [2014] 41 taxmann.com 455 (Bombay HC)

8.  [2018] 93 taxmann.com 302 (Bombay HC)

9.  [2011] 130 ITD 197 (Mumbai Trib.)

10.  [2019] 177 ITD 259 (Bangalore ITAT)

11.  [1979] 120 ITR 49 (SC)

12.  [2004] 265 ITR 346 (Bombay HC)

13.  [2013] 40 taxmann.com 318 (Karnataka HC) (FB)

14.  [1999] 236 ITR 515 (SC)

15.  (SC) [1987] 165 ITR 166