All About ‘Dissolution and Reconstitution Tax’ on Partnership Firm

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  • Last Updated on 6 September, 2021

Table of Contents:

1. Transfer of Capital Asset, Stock-in-Trade, etc. to Partners or Members on Dissolution or Reconstitution of Firms, AOP, etc. [Sections 9B, 45(4), 48]1

1.1 Background

1.2 Section 9B and Section 48(iii)

1.2.1 Preconditions for Applicability

1.2.2 Implications

1.2.3 Resolution of Difficulty

1.3 Definitions

1.3.1 “Specified entity”

1.3.2 “Specified person”

1.3.3 “Reconstitution of the specified entity”

1.4 Analysis and Issues

1.4.1 Specified Person

1.4.2 Specified Entity

1.4.3 Reconstitution of the Specified Entity

1.4.4 Dissolution

1.4.5 Receives

1.4.6 Capital Asset or Stock-in-Trade

1.4.7 In Connection with

1.4.8 Deemed Transfer

1.4.9 Year of Transfer

1.4.10 Year of Taxation of Income

1.4.11 Manner of Computation of Income

1.4.12 Modification in Computation on Account of Section 48(iii)

1.4.13 Profits and Gains

1.4.14 Amount of Consideration

1.4.15 Sections 50C, 50CA and 43CA are not Applicable

1.4.16 Rate of Tax

1.4.17 Cost of Acquisition in the Hands of the Specified Person

1.4.18 Impact on WDV of Block of Assets

1.5 Section 45(4)

1.5.1 Pre-conditions for Applicability

1.5.2 Implications

1.5.3 Irrelevant Factor

1.5.4 Taxation under Section 9B is Permitted

1.5.5 Definitions

1.6  Analysis and Issues

1.6.1 Section 45(4) overrides section 45(1)

1.6.2  Receives

1.6.3 Money or Capital Asset

1.6.4 Capital Asset

1.6.5 In Connection with

1.6.6 No Deemed Transfer/Consideration

1.6.7 Profits or Gains

1.6.8 Year of Taxation of Income

1.6.9 Computation of Fair Market Value

Dissolution and Reconstitution Tax Master guide to Income tax act partnership firm

1. Transfer of Capital Asset, Stock-in-Trade, etc. to Partners or Members on Dissolution or Reconstitution of Firms, AOP, etc. [Sections 9B, 45(4), 48]1

1.1 Background

Section 45(4), prior to its substitution by the Finance Act, 2021, provided that

(a) the profits or gains arising from the transfer of a capital asset on the dissolution of a firm or other association of persons (AOP) or body of individuals (BOI) (not being a company or a co-operative society) or otherwise, was chargeable to tax as the income of such firm or AOP or BOI of the previous year in which the said transfer takes place;

(b) the fair market value (FMV) of the asset on the date of such transfer shall be deemed to be the full value of the consideration for the purposes of section 48.

Where any amount or property is distributed to or received by a partner or erstwhile partner on account of dissolution or reconstitution of the firm, the income-tax implications in such cases in the hands of partner or the firm have always been a controversial matter. Some of the issues are listed below:

(a) Whether the expression “dissolution of the firm or otherwise” in section 45(4) includes reconstitution of the firm?

(b) Whether money or other property received by a retiring partner from the firm could be said to chargeable to tax in his hands?

(c) Whether money paid to a partner could be taxable in the hands of the firm under section 45(4)?

(d) Whether transfer of property (stock-in-trade and capital asset) by a firm to its partners is chargeable to tax in the hands of firm?

(e) What is the mechanism to compute income in such cases?

(f) Where a firm does the revaluation of the property or record self-generated asset in the books of account and credits the corresponding gain to the capital accounts of the partners, what should be the tax treatment of the amount received by partner in excess of his capital contribution made on account of such revaluation or self-generated asset?

The Finance Act, 2021 has addressed the aforesaid issues by inserting section 9B, substituting section 45(4) and inserting section 48(iii). Before understanding the amendment, it is imperative to understand that when a partner disassociates from the partnership firm and obtains money or property from the firm, there are two transactions. One, qua the partner and two, transfer of property by the firm to the partner. The former transaction is dealt with in section 45(4) and the latter in section 9B.

It is important to note that in the original Finance Bill introduced on 1st February 2021, the proposals were in the form of substitution of section 45(4), insertion of section 45(4A) and insertion of section 48(iii). Subsequently, those proposals were amended and have been finally inserted as section 9B, section 45(4) and section 48(iii), which are explained in the following paragraphs:

1.2 Section 9B and Section 48(iii)

1.2.1 Preconditions for Applicability

Section 9B applies if ALL of the following conditions are satisfied:

(a) There is a specified person as defined

(b) There is a specified entity as defined

(c) The specified person receives

(i) any capital asset, or

(ii) stock in trade, or

(iii) both

(d) The receipt referred to in (c) is during previous year

(e) The receipt referred to in (c) is from a specified entity

(f) The receipt is in connection with the dissolution or reconstitution of specified entity.

[section 9B(1)]

1.2.2 Implications

If ALL of the aforesaid conditions are satisfied, the following implications arise:

(a) It shall be deemed that

(i) the specified entity has transferred such capital asset or stock in trade or both;

(ii) the transfer is to the specified person;

(iii) the transfer is in the year in which the capital asset or stock in trade are received by the specified person. [section 9B(1)]

(“deemed transfer”)

(b) (i) Profits and gains arising on deemed transfer shall be deemed to be the income of such specified entity [section 9B(2)(i)];

(ii) Such income shall be deemed to be of the previous year in which capital asset or stock-in-trade are received by the specified person [section 9B(2)(i)];

(iii) The income shall be chargeable to tax as income of the specified entity under the head “profits and gains of business or profession” or under “capital gains” in accordance with the provisions of the Act [section 9B(2)(ii)];

(iv) FMV of the capital asset or stock in trade on the date of receipt by specified person shall be deemed to be full value of consideration for the specified entity [section 9B(3)].

It appears that by virtue of section 48(iii), the computation of capital gains above shall be reduced by the gains taxed under section 45(4) [section 48(iii)].

1.2.3 Resolution of Difficulty

If any difficulty arises in giving effect to the provisions of this section and section 45(4), the CBDT may, with the approval of the Central Government, issue guidelines for the purposes of removing the difficulty. Every such guideline issued by the CBDT shall, as soon as may be after it is issued, be laid before each House of Parliament, and shall, be binding on the income-tax authorities and on the assessee [section 9B(4)/(5)].

1.3 Definitions

For the above purposes, the various terms have been defined as follows:

1.3.1 “Specified entity”

means

(a) a firm; or

(b) other AOP; or

(c) BOI

but excludes a company or a cooperative society.

1.3.2 “Specified person”

essentially means a person, who is a partner or member of a specified entity in any previous year.

1.3.3 “Reconstitution of the specified entity”

means, a case where,

(a) one or more partners or members of such specified entity cease to be its partner or member; or

(b) one or more new partners or members are admitted in such specified entity in such circumstances that one or more of the partners or members of the specified entity, before the change, continue as partner(s) or member(s) after the change; or

(c) all the partners or members of such specified entity continue with a change in their respective share or in the shares of some of them.

1.4 Analysis and Issues

Section 9B is a deeming provision, enabling taxation of certain income in the hands of specified entity. It is not a computation provision. For computation, the provisions of profits and gains of business or profession or capital gains will apply.

The section applies with effect from assessment year 2021-22. It, therefore, impacts transactions entered into in financial year 2020-21, including those before the introduction of the provision in the Finance Bill 2021.

1.4.1 Specified Person

“Specified person” means any one of the following

(a) a person who is a partner of a firm

(b) a member of any AOP

(c) a member of any BOI

The term “partner” includes a minor who has been admitted to the benefits of partnership (section 2(23)(ii)].

The definition covers any person who is a partner or member. Hence, it covers all partners/members such as companies, cooperative societies, etc. and whether resident or non-resident.

A deceased partner ceases to be a partner of the firm and if his share is paid to his legal heirs, then on a plain reading, it could be argued that the asset received by the legal heirs cannot be said to be received by a specified person.

1.4.2 Specified Entity

“Specified entity” means a firm or other association of persons or body of individuals (not being a company or a cooperative society).

“Firm” includes a limited liability partnership as defined in a Limited Liability Partnership Act, 2008 [section 2(23)(i)] Hence, a partner in an LLP is also a specified person.

A joint venture/consortium, whether consisting of non-resident members or otherwise, may or may not be regarded as an AOP. Also see CBDT Circular No. 7/2016 dt. 7-3-2016.

It appears that the provision will apply even if the specified entity is taxed on presumptive basis under section 44AD.

1.4.3 Reconstitution of the Specified Entity

The term “reconstitution of specified entity” has been artificially defined for the purposes of section 9B. The definition has three clauses. The term is explained with the help of following illustrations:

Suppose, A, B, C and D are partners of a partnership firm X Co., having equal share in profit/loss.

(a) If A (or any of the partner) retires, X Co. is considered to be reconstituted under clause (a).

(b) If E joins as a partner and A, B, C, D continue as partners.

X Co. will be considered as reconstituted under clause (b) since E has joined and old partners remain.

(c) IF E, F join and none of the existing partners continue to remain as partner.

The requirement of clause (b) is that new partner should join and atleast one or more of the old partners (being A, B, C, D) should continue. In this case, none of the existing partners continues. Hence, there is no reconstitution under clause (b). However, as per clause (a), there is a reconstitution even if one partner retires. Hence, due to retirement of old partners, the event would be considered as reconstitution under clause (a), although not under clause (b).

(d) There is a change in profit sharing ratio (PSR) from equal to A-30%; B-20%; C-30%; D- 20%.

Yes, the change in PSR will constitute reconstitution under clause (c), since all partners are continuing and there is change in PSR of all of them.

(e) There is a change in PSR from equal to A-30%; B-20%; C-25%; D- 25%.

The PSR of only A&B has changed where PSR of C&D has remained same. The wordings used in clause (c) are “a change in their respective share or in the shares of some of them”. Thus, even if there is a change in PSR of only some of the partners, it would still constitute reconstitution.

(f) A retires and new PSR is B-33%, C-33%, D-34%.

It would not be reconstitution under clause (c) since all the existing partners are not continuing; however, it would constitute reconstitution under clause (a), since an existing partner ceases to exist as a partner.

(g) If E admitted and the PSR changes from equal to A-20%; B-20%; C-20%; D-20%; E-20%.

Since all the partners continue, and there is change is PSR, clause (c) applies. It can also be said to be reconstitution under clause (b).

A conversion of a partnership firm under Chapter XXI of the Companies Act, 2013 may not result in reconstitution of the specified entity. Similarly, conversion of a firm into LLP may also not be regarded as reconstitution of the specified entity.

There is a reconstitution when there is a change in the share or shares of the partners or members. It is not clarified whether the term “share” covers share in profit only or does it cover share in losses also, with share in profit remaining the same. A mere reconstitution does not trigger applicability of section 9B, unless it is accompanied by receipt of capital asset or stock in trade by a specified person.

1.4.4 Dissolution

A dissolution brings the partnership to an end [CIT v. Pigot Champan & Co. [1982] 9 Taxman 7/135 ITR 620 (SC); CIT v. Omprakash Premchand & Co. (1996) 86 Taxman 376/[1997] 227 ITR 590 (MP).

The term “dissolution” also covers dissolution of LLP within the meaning of Chapter XIII of the LLP Act, 2008.

It has been held that

(a) when there are only two partners constituting the partnership firm, on the death of one of them, the firm is deemed to be dissolved despite the existence of a clause which says otherwise [Mohd. Laiquiddin v. Kamala Devi Misra, (2010) 1 SCR 873 (SC)].

(b) when upon retirement of a partner from partnership of two partners, the assets were taken over by one partner who continued the business as a proprietor, there was a dissolution of the firm [ITO v. Om Namah Shivay Builders & Developers, (2011) 43 SOT 397 (Mum.) cited in ITO v. Alta Inter Chem Industries, [2013] 32 taxmann.com 138/[2012] 20 ITR (Trib.) 103 (Ahd.-Trib.)].

1.4.5 Receives

The provision applies when a specified person ‘receives’ a capital asset or stock in trade.

Any change in share of a partner results in reconstitution of the specified entity. However, mere reconstitution will not trigger tax under section 9B unless it is accompanied by a specified person “receiving” any capital asset or stock in trade.

To illustrate, A and B are partners in a firm sharing profits and losses equally. Suppose, they decide to change the profit sharing ratio to 60:40 and pursuant to the change in share, A brings in additional Rs.50 lakhs as capital as a result of which the total capital of the partnership firm is Rs.250 lakhs. In such circumstances, although there is a reconstitution of the specified entity, no capital asset or stock in trade is received by a specified person and hence, tax under section 9B is not triggered.

1.4.6 Capital Asset or Stock-in-Trade

The section applies only if the specified person receives any capital asset or stock in trade. The character as capital asset or stock in trade should be as in the hands of the specified entity and not the specified person.

The term “capital asset” is defined in section 2(14). The definition applies unless the context otherwise requires. However, it appears that an asset which is not capital asset within the meaning of section 2(14) is not a capital asset for the purposes of section 9B. To illustrate, agricultural land which is not a capital asset under section 2(14) cannot be regarded as a capital asset for the purposes of section 9B and the transfer of such an asset will not result in any tax implication under section 9B. On the other hand, all capital assets (whether movable or immovable or actionable or claim, etc.) are covered by the expression capital asset.

Capital asset would also include a running business (J. K. Trust v. CIT [1957] 32 ITR 535 (SC); CIT v. Krishna Warriar, AIR 1965 SC 59; PNB Finance Ltd. v. CIT, [2001] 117 Taxman 586/252 ITR 491 (Delhi); CIT v. F. X. Periera & Sons (Travancore) (P.) Ltd., [1991] 55 Taxman 242/[1990] 184 ITR 461 (Ker.)] and hence, if a specified person receives a running business of the specified entity, it could be said that he has received a capital asset.

The provision does not apply to receipt of money by the specified person. It is covered by section 45(4)

1.4.7 In Connection with

The section applies when a specified person receives a capital asset or stock in trade “in connection with … dissolution or reconstitution of the specified entity”. The term “in connection with” is judicially explained in other contexts on follows:

(a) The expression “in connection with” is the widest amplitude [Renusagar Power Company Ltd. v. General Electric Company, AIR 1985 SC 1156; CIT v. Shakuntala Kantilal, [1991] 58 Taxman 106/190 ITR 56 (Bom).

(b) ‘In connection with’ includes matters occurring prior to as well as subsequent to or consequent upon so long as they are related to the principal thing [Ashok Kumar v. State of Haryana AIR 2010 SC 2839; Stumpp, Schuele & Somappa Ltd. v. CIT [1992] 61 Taxman 278/[1991] 190 ITR 152 (Kar).

(c) ‘In connection with’, as defined in the Law Lexicon, Vol. 1, 1975 Edition, page 248-II, must be considered to imply a substantial or direct connection [Oceanic Contractor Inc. v. ITO [1990] 33 ITD 213 (Bom)] and not a fanciful or highly problematic connection [Basudev v. Rex AIR 1949 (All.)(FB) cited in ONGC as representative assessee of Alberta Research Council v. JCIT (2010) 41 SOT 525 (Delhi)].

On a plain reading, if a specified person receives a capital asset or stock in trade which is not in connection with dissolution or reconstitution of the specified entity, section 9B should not be applicable.

1.4.8 Deemed Transfer

The receipt of stock-in-trade or capital asset by a specified person from a specified entity is deemed to be a transfer. This is done to overrule various judicial rulings including the following, which held that the distribution, division or allotment of assets by a partnership firm upon dissolution or reconstitution is nothing but a mutual adjustment of rights between the partners:

(a) CIT v. Dewas Cine Corporation, [1968] 68 ITR 240 (SC) (adjustment of the rights of the partners in a dissolved firm is not a transfer).

(b) Malabar Fisheries Co. v. CIT, [1979] 120 ITR 49/2 Taxman 409 (SC) [the consequence of the distribution, division or allotment of assets by the partnership which follows 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)].

There does not appear to be any provision deeming any profits and gains to arise on the transfer.

1.4.9 Year of Transfer

The capital asset or stock in trade is deemed to be transferred in the year in which the capital asset or stock in trade is received by the specified person.

1.4.10 Year of Taxation of Income

The profits and gains arising from the deemed transfer shall be deemed to be the income of such specified entity of the previous year in which the capital asset or stock in trade is received by the specified person. The use of the term ‘receives’ suggests that the method of accounting followed by specified entity or specified person is not relevant.

If the reconstitution and receipt by specified person are in different previous years with the receipt following the reconstitution, on a literal reading, the tax will be in the year of receipt on the firm, as reconstituted.

1.4.11 Manner of Computation of Income

The profits and gains arising from deemed transfer of stock in trade shall be chargeable to income tax under the head “profits and gains of business or profession”.

The profits and gains arising from deemed transfer of capital asset shall be chargeable to income tax under the head “capital gains”.

In both cases, the profits and gains are chargeable to income-tax under the head business income or capital gains “in accordance with the provisions of the Act”. The term “in accordance with” means “in a manner conforming with” [ITC Ltd. v. CCE, AIR 2005 SC 1370] or “not contrary to” or “in conflict with” CIT v. Anjum M.H. Ghaswala [2001] 119 Taxman 352/252 ITR 1 (SC)1. Thus, the computation of income and charge to income tax should be in conformity with or not contrary to or in conflict with the provisions of the Act. To illustrate, if the specified person has received a capital asset, the capital gains in the hands of the specified entity should be computed in accordance with all the provisions from section 45 to section 55A, except to the extent a provision is superseded by section 9B or is in conflict with section 9B. In view of this, it appears that the specified entity should be entitled to

(a) compute the gains under section 48;

(b) substitute fair market value of the asset as on 01.04.2001 as cost of acquisition;

(c) avail of indexation benefit under second proviso to section 48;

and so on.

Further, the capital gains so computed should be allowed to be set off and carry forward (in case of a loss) under sections 70, 71 and 74.

Likewise,

(a) the income under the head “profits and gains on business or profession” should be computed in the manner provided in sections 28 to 44DB.

(b) the net amount of profits or gains or business or profession including the profits and gains arising upon deemed transfer of stock in trade should be allowed to be set off and carry forward under section 70 to section 72.

1.4.12 Modification in Computation on Account of Section 48(iii)

Section 48 provides for mode of computation of capital gains. Broadly, the section provides that capital gains shall be computed as follows:

Full value of consideration received or accruing as a result of a transfer of the capital asset

Less: Expenditure incurred wholly and exclusively in connection with such transfer [clause (i)]

Less: The cost of acquisition of the asset and any cost of improvement thereto [clause (ii)]

Further, clause (iii) has been inserted by the Finance Act, 2021 in section 48 to provide that if any money or capital asset is received by a specified person from a specified entity, then the amount chargeable to income-tax as income of such specified entity under section 45(4), which is attributable to the capital asset being transferred by the specified entity, shall be calculated in the prescribed manner and shall be allowed as a deduction in computing capital gains.

In the above connection, the Explanatory Memorandum at the time of introduction of Finance Bill 2021 on 1st March 2021 stated as follows:

“Consequential amendment is also proposed in section 48 of the Act to provide that in case of specified entity, the amount included in the total income of such specified entity under sub-section (4A) of section 45 which is attributable to the capital asset being transferred, shall be reduced from the full value of the consideration to compute income charged under the head “capital gains”. This is to be calculated in the manner to be prescribed later. This is to mitigate the double taxation which may have happened but for this provision in a situation where an asset which was revalued and for which income under the proposed sub-section (4A) of section 45 of the Act was brought to tax is transferred subsequently by the specified entity.”

While the scheme of taxation as finally enacted by the Finance Act 2021 is different from the scheme as proposed initially, it appears that the intention behind insertion of section 48(iii) has remained the same.

The language of the provision is not very clear. However, having regard to the Explanatory Memorandum, it appears as follows:

(a) Section 48(iii) is applicable to computation for the purpose of section 9B.

(b) The amount of income under section 45(4) will have to be bifurcated into the amount attributable to receipt of money by the specified person and the amount attributable to receipt of capital asset.

(c) The Act is silent as to the manner in which the income under section 45(4) shall be bifurcated into the amount of income attributable to receipt of money and the amount of income attributable to receipt of capital asset. Section 48(iii) states that the amount attributable to receipt of capital asset shall be calculated in the prescribed manner.

(d) The amount so calculated shall be deducted while computing capital gains under section 9B in the hands of specified entity.

To illustrate, suppose the capital gains calculated under section 9B on a standalone basis is Rs.2 crores; suppose the amount of capital gains taxable under section 45(4) and calculated in the prescribed manner under section 48(iii) is Rs.1.8 crores. In this case, the final capital gains chargeable under section 9B read with section 48 shall be Rs.20 lakhs (Rs.2 crores less Rs.1.8 crores).

The computation of capital gain under section 9B read with section 48(iii) shall be as follows:

Particular Amount
Full value of consideration received or accrued (FMV of capital asset) xxx
Less:
(a) Expenditure incurred wholly and exclusively in connection with transfer; (xxx)
(b) Cost of acquisition/indexed cost of acquisition; (xxx)
(c) Cost of improvement/indexed cost of improvement; and (xxx)
(d) The amount chargeable to tax as income of specified entity under section 45(4) which is attributable to capital asset being transferred by the said entity [section 48(iii)]. (xxx)
Income taxable under the head capital gains (before exemption under section 54EC, etc.) xxx

It appears that the attribution under section 48(iii) has to be done capital asset wise in order to ensure that appropriate deduction is available while computing capital gains on the capital asset, as required by section 9B.

The arguments in support of the aforesaid interpretation that section 48(iii) provides for additional deduction in computation under section 9B are as follows:

(a) As mentioned above, section 48 provides for mode of computation of capital gains. Hence, when clause (iii) is inserted in section 48, it is to provide additional deduction in computation of capital gains. Now, individual asset wise capital gains have to be computed only in the scheme of taxation under section 9B and not under section 45(4). In the circumstance, section 48(iii) can apply only in relation to computation under section 9B and not in section 45(4).

(b) Further, paraphrasing section 48(iii),

(i) the provision applies when any money or capital asset is received by a specified person from a specified entity referred to in section 45(4); and

(ii) if the provision is applicable, then the deduction shall be equal to the amount chargeable “under that sub-section” [that is section 45(4)] which is attributable to the capital asset transfered by the specified entity; the amount attributable shall be calculated in the prescribed manner.

Thus, section 45(4) is used in section 48(iii) for the limited purpose of,

(i) determining whether section 48(iii) applies or not (as precondition for applicability); and

(ii) quantifying the amount of the deduction (as computation provision).

However, section 45(4) is not used in section 48(iii) for modifying the income computed under it. In other words, the measure of deduction is the amount of tax under section 45(4) but it is not by itself a deduction for section 45(4).

1.4.13 Profits and Gains

Section 9B(2) provides that profits and gains arising from deemed transfer shall be deemed to be income and chargeable to income tax. Thus, on a literal reading, section 9B(2) applies only if profits and gains arise from deemed transfer. However, there is no provision to provide that “profits and gains” are also deemed to have arisen. Now, profits and gains have to be understood in a commercial sense [Madras Industrial Investment Corporation Ltd. v. CIT [1997] 225 ITR 802/91 Taxman 340 (SC); Calcutta Company Ltd. v. CIT [1959] 37 ITR 1 (SC), AIR 1959 SC 1165; Sunil Siddharthbhai v. CIT [1985] 23 Taxman 14w/156 ITR 509 (SC); CIT v. Bai Shirinbai K. Kooka [1962] 46 ITR 86 (SC); Badridas Daga v. CIT [1958] 34 ITR 10 (SC)]. It is a moot point whether paying off a partner upon reconstitution or dissolution results in profits and gains in a commercial sense to the specified entity.

It has been held that profits and gains should be understood as including losses. Section 45(4) states that the income chargeable under the said section cannot result in a loss [see proviso to section 45(4)]. However, no similar provision is found in section 9B and hence, it appears that the computation of income under section 9B could result in a loss.

1.4.14 Amount of Consideration

The FMV of the capital asset or stock-in-trade shall be deemed to be the full value of consideration received as result of the deemed transfer of the capital asset/stock-in-trade.

The term “fair market value” has been defined in section 2(22B). However, it applies only to a capital asset. It appears that the definition sets out the general principle of computation of FMV and hence, the principle laid down in section 2(22B)(i) would apply to valuation of stock-in-trade also.

In case a partner takes over the running business of a firm upon its dissolution, the FMV of running business (including intangible assets) will have to be calculated.

1.4.15 Sections 50C, 50CA and 43CA are not Applicable

Section 9B(3) provides that the FMV of the capital asset or stock-in-trade received by the specified person shall be deemed to be the full value of the consideration received or accruing as a result of the deemed transfer of the capital asset or stock-in-trade by the specified entity. It appears that so far as consideration is concerned, the said provision is a self-contained exhaustive provision and it cannot be substituted by the stamp duty value in section 43CA or section 50C as the case may be. Likewise, the FMV cannot be substituted by the consideration computed under section 50CA. The arguments in support of this proposition are as follows:

(a) Section 9B(3) states that the FMV shall be regarded as consideration “for the purposes of this section”. Now, there is no computation directly under section 9B. As pointed out in section 9B(2)(ii), the computation is to be done under the head “business income” or “capital gains”. Hence, when section 9B(3) states “for the purposes of this section”, it obviously means for the purposes of computation under the head “profits and gains of business or profession” or “capital gains”. Having provided that the FMV will apply for the purposes of computation under the said heads, it is evident that it should apply to all the provisions in the said headings, including section 43CA or section 50C or section 50CA. Any contrary interpretation will result in a conflict between section 9B(3) and section 50C, etc. which ought to be avoided by holding that the FMV under section 9B(3) will prevail.

(b) Section 50C applies only in a case where the consideration received or accruing as a result of transfer by an assessee of a capital asset is less than stamp duty value. Hence, section 50C applies only where

(i) consideration is received or accruing; and

(ii) there is a transfer.

It could be argued that in a case of a retirement or dissolution, there is mere settlement of account and no consideration actually accrues or arises to the specified entity.

Further, in a case of dissolution there is no transfer by the partnership firm. In fact, it is precisely to overcome the fact that there is no transfer and no consideration that section 9B deems a transfer and deems FMV as consideration. In such circumstances, it could be argued that the preconditions for applicability of section 50C are not satisfied in case of a deemed transfer of capital asset covered by section 9B.

(c) Section 50C states that stamp duty value shall be deemed to be the full value of consideration received or accruing as a result of such transfer. Now, section 9B(3) also provides that the FMV of the asset shall be deemed to be the full value of consideration accruing or arising as a result of the transfer. Thus, both the sections provide for a “deemed consideration”. It appears that the deemed consideration under the specific provision section 9B cannot be substituted by the deemed consideration under section 50C.

Likewise, it appears that section 50CA and section 43CA are not applicable in a situation covered by section 9B.

1.4.16 Rate of Tax

The rate at which such capital gain shall be charged to tax will depend on the nature of capital asset transferred and period for which such asset is held by the specified entity. Hence, the capital gains may be liable to concessional tax rate as provided in section 111A or section 112 or section 112A, as the case may be, subject to fulfilment of conditions specified therein.

1.4.17 Cost of Acquisition in the Hands of the Specified Person

The law is silent as to the cost of acquisition of capital asset or stock in trade in the hands of the specified person. This results in ambiguity for the recipient. To illustrate,

(a) A retiring partner is given shares worth Rs.2.6 crore whose original cost is Rs.1 crore.

(b) The capital balance of the retiring partner in the books of the partnership firm is Rs.1.5 crore.

(c) The firm pays tax of say Rs.30 lakhs.

In the above case, what is the cost for the partner:

Is it

(a) Rs.1 crore?

(b) Rs.1.5 crore?

(c) Rs.2.6 crore?

(d) Rs.2.9 crore?

Some of the judgments under the pre amended law are summarized below:

(a) upon partition of a HUF, if a property is allotted to a coparcener, the cost to him would be the cost at which the property was valued at the partition [Kalooram Govindram v. CIT, [1965] 57 ITR 335 (SC); Raj Narain Agarwala v. CIT [1970] 75 ITR 1 (Delhi)].

(b) while dividing the properties between the various partners, the arbitrators valued them and after distributing them they made adjustments in the shares by directing the partner receiving property of a higher value to pay actual monetary compensation to the partner receiving property of lower value. In such a case, the actual cost of the property to the assessee should be considered to be price valued by arbitrator and not what it was to the original firm, at the time of its acquisition [Matrumal Dhanna Lal v. ITO [1972] 86 ITR 497 (All)].

A reasonable interpretation should be that the specified person ought to be regarded as having paid the fair market value of the asset received by him, that is, Rs.2.6 crores in the aforesaid illustration, especially when the firm itself is assessed on the same value.

However, where a firm is dissolved and partner takes over the business, it appears that it will be a case of succession under section 170. In such a case, if section 49(1)(iii)(a) applies, then notwithstanding the payment of tax by specified entity on FMV of asset, the cost in hands of specified person could be the cost to the previous owner.

Section 54EC provides for exemption to capital gains arising from transfer of a long term capital asset being land or building. It is pertinent that the section requires investment of capital gains and not consideration. If the capital asset received by the specified person is land or building and is a long term asset, it could argued that capital gains under section 9B should be regarded as arising from transfer of a long term asset and accordingly, the specified entity ought to be regarded as entitled to benefit under section 54EC.

1.4.18 Impact on WDV of Block of Assets

The capital asset may be depreciable or non-depreciable. In case of depreciable asset, the law is silent as to the impact of such receipt by specified person on the written down value of the block of assets in the hands of specified entity under section 43(6).

1.5 Section 45(4)

1.5.1 Pre-conditions for Applicability

Section 45(4) applies if the following conditions are satisfied:

(a) There is a specified person as defined

(b) There is a specified entity as defined

(c) The specified person receives

(i) any capital asset, or

(ii) money, or

(iii) both

(d) The receipt referred to in (c) is during previous year

(e) The receipt referred to in (c) is from a specified entity

(f) The receipt is in connection with the reconstitution of specified entity.

1.5.2 Implications

If all the aforesaid conditions are satisfied, the following implications arise under section 45(4):

(a) Any profits or gains arising from such receipts by the specified person shall be chargeable to income-tax as income of such specified entity under the head “Capital gains”.

(b) The profits and gains shall be deemed to be the income of such specified entity of the previous year in which such money or capital asset were received by the specified person.

(c) Such profits or gains shall be determined in accordance with the following formula, namely:

A = B+C-D

Where,

A = income of the specified entity chargeable under the head “Capital gains”;

However, if the value of ‘A’ in the above formula is negative, ‘A’ shall be deemed to be zero:

B = value of any money received by the specified person from the specified entity on the date of such receipt;

C = the amount of fair market value of the capital asset received by the specified person from the specified entity on the date of such receipt; and

D = the, amount of balance in the capital account (represented in any manner) of the specified person in the books of accounts of the specified entity at the time of its reconstitution:

For the purpose of D, the balance in the capital account of the specified person is to be calculated without taking into account the increase in the said account due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset [proviso to section 45(4)].

1.5.3 Irrelevant Factor

The section is applicable notwithstanding anything contained in section 45(1).

1.5.4 Taxation under Section 9B is Permitted

It is clarified that the provisions of section 45(4) shall operate in addition to the provisions of section 9B and when a capital asset is received by a specified person from a specified entity in connection with the reconstitution of such specified entity, the provisions of both the sections may operate independently (Explanation 2).

1.5.5 Definitions

For the above purposes, the following expressions shall have the meanings assigned to them in section 9B:

(a) reconstitution of the specified entity

(b) “specified entity”

(c) “specified person”

“self-generated goodwill” means goodwill which has been acquired without incurring any cost for purchase or which has been generated during the course of the business or profession [Explanation 1(ii)].

“self-generated asset” means an asset which has been acquired without incurring any cost for purchase or which has been generated during the course of the business or profession [Explanation 1(ii)].

1.6  Analysis and Issues

1.6.1 Section 45(4) overrides section 45(1)

Section 45(4) starts with the expression “notwithstanding anything contained in sub-section (1)”. Thus, it overrides section 45(1). In other words, if there is any conflict or inconsistency between section 45(1) and section 45(4), the latter provision will prevail.

There is no amendment in the definition of ‘income’ in section 2(24). This is perhaps, because section 2(24)(vi) already provides that income shall include capital gains chargeable under section 45 [which section would include section 45(4)].

The section applies with effect from assessment year 2021-22. It, therefore, impacts transactions entered into in financial year 2020-21, including those before the introduction of the provision in the Finance Bill 2021 (for interest on account of shortfall in advance tax, please see para 1.4.7).

1.6.2  Receives

The provision applies when a specified person “receives” money or capital asset. Hence, mere reconstitution will not trigger tax under section 45(4) unless it is accompanied by a specified person “receiving” any money or capital asset.

1.6.3 Money or Capital Asset

The section applies only if the specified person receives money or capital asset.

1.6.4 Capital Asset

It appears that the character as capital asset should be in the hands of the specified entity and not the specified person.

1.6.5 In Connection with

The section applies when a specified person receives money or capital asset “in connection with” reconstitution of a specified entity. On a plain reading, if a specified person receives money or capital asset which is not in connection with reconstitution of the specified entity, section 45(4) should not be applicable. To illustrate, any withdrawal by a partner in the normal course of continuation of the partnership business, without in connection with the reconstitution of the partnership, will not be covered by section 45(4).

1.6.6 No Deemed Transfer/Consideration

The receipt of money by the specified person is deemed to be income of the specified entity. Unlike section 9B,

(a) the receipt is not deemed to be transfer by the specified entity, although the income will be chargeable under the head capital gains;

(b) there is no deemed consideration.

A possible reason is that the scheme of taxation under section 45(4) overrides section 45(1) and provides its own formula for computation, ignoring provisions such as section 48.

1.6.7 Profits or Gains

Section 45(4) provides that profits or gains arising from receipt of money shall be chargeable to income-tax. Thus, on a literal reading, section 45(4) applies only if profits or gains arise from receipt of money. However, there is no provision to provide that “profits or gains” are also deemed to have arisen. It is a moot point whether a partner receiving his own share in the partnership can be said that profits and gains have arisen to him in a commercial sense.

1.6.8 Year of Taxation of Income

The profits and gains arising from receipt of money by the specified person shall be deemed to be income of the specified entity of the previous year in which such money or capital asset is received by the specified person.

1.6.9 Computation of Fair Market Value

The component C in the formula requires taking into consideration FMV of the capital asset received by the specified person.

The term fair market value is defined in section 2(22B)

_______________

*Sections 9B, 45(1B), 45(4), 47, 48, 49, 50, 50B, 54GB and 55.

  1. The Authors acknowledge the inputs by Taxmann’s editorial team in interpreting these provisions.
  2. For the purpose of: Section 245D(4) of the Income-tax Act, 1961.

Disclaimer: The content/information published on the website is only for general information of the user and shall not be construed as legal advice. While the Taxmann has exercised reasonable efforts to ensure the veracity of information/content published, Taxmann shall be under no liability in any manner whatsoever for incorrect information, if any.

4 thoughts on “All About ‘Dissolution and Reconstitution Tax’ on Partnership Firm”

  1. Very good article.
    However, I could not understand the logic behind taxing a specified entity in deeming fiction u/s. 45(4).
    In one of the case matter, a partner retires from firm and got an amount excess of his capital credit balance. He got it because there is some assets in the firm which got price rise and his share is credited in his account.
    Here, literally, the partner is getting the money and the firm is paying the tax
    Please elaborate on this

  2. In case the retiring partner overdrawn and made payment to the partnership on retirement what is the legal position?

  3. Can you explain what shall be the applicable provision if all he existing partners retire and get money in return. As far as i believe the provisions of section 45(4) shall be applicable.
    Need some clarification regarding the same

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