Section 45(3) – Capital Gains on Asset Contribution to Firm

Section 45(3) of the Income-tax Act, 1961 provides for the taxation of capital gains arising when a person transfers a capital asset to a firm, Limited Liability Partnership (LLP), Association of Persons (AOP), or Body of Individuals (BOI)—other than a company or co-operative society—in which he is or becomes a partner or member. Such a transfer, when made by way of capital contribution or otherwise, is treated as a taxable transfer in the hands of the individual contributor.

Table of Contents

1. Definition of “Firm”, “Partner” and “Partnership”
2. Contribution of Capital Asset to Firm/LLP/BOI/AOP by Partner/Member [Section 45(3)]

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The capital gains implications of transactions involving partners/members and firms/LLPs/AOPs/BOIs are covered in sections 45(3), 45(4), 9B and section 48(iii).

1. Definition of “Firm”, “Partner” and “Partnership”

Section 2(23) of the Act defines the terms “firm”, “partner” and “partnership” as under –

(23)(i) “firm” shall have the meaning assigned to it in the Indian Partnership Act, 1932, and shall include a limited liability partnership as defined in the Limited Liability Partnership Act, 2008;

(ii) “partner” shall have the meaning assigned to it in the Indian Partnership Act, 1932, and shall include —

(a) any person who, being a minor, has been admitted to the benefits of partnership; and

(b) a partner of a limited liability partnership as defined in the Limited Liability Partnership Act, 2008;

(iii) “partnership” shall have the meaning assigned to it in the Indian Partnership Act, 1932 (9 of 1932), and shall include a limited liability partnership as defined in the Limited Liability Partnership Act, 2008 (6 of 2009);

Thus, the term “firm” includes Limited Liability Partnership as defined in the Limited Liability Partnership Act, 2008.

The definition of “firm” in section 2(23)(i) covers –

• “Firm” as defined in section 4 of the Indian Partnership Act, 1932 (also known as “traditional partnership” or “general partnership”); and
•  “Limited Liability Partnership” as defined in the LLP Act, 2008

Thus, the word “firm” for the purposes of section 9B, Section 45(3), 45(4) and 48(iii) will cover both the “traditional partnership” or “general partnership” and Limited Liability Partnership

The definition of “partner” in section 2(23)(ii) covers –

• Definition of “partner” in the context of a traditional partnership firm/general partnership firm;
• Definition of partner holding out
• Minor admitted to the benefits of partnership; and
• Definition of “partner” in the context of a Limited Liability Partnership

The above definitions of partner will apply for the purposes of sections 9B, Section 45(3), 45(4) and 48(iii).

1.1 “Firm” as Defined in Section 4 of the Indian Partnership Act, 1932 (Also Known as “Traditional Partnership” or “General Partnership”)

Section 4 of the Indian Partnership Act, 1932 defines “partnership”, “partner”, “firm” and “firm name” as under –

4. Definition of “Partnership”, “partner”, “firm” and “firm name” –

“Partnership” is the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all. Persons who have entered into partnership with one another are called individually “partners” and collectively “a firm”, and the name under which their business is carried on is called the “firm name”.

1.2 “Limited Liability Partnership” as Defined in the LLP Act, 2008

Section 2(1)(n) of the Limited Liability Partnership Act, 2008 defines the term “limited liability partnership”. Accordingly, a “limited liability partnership” means a partnership formed and registered under the Limited Liability Partnership Act, 2008.

In other words, only an LLP formed and registered under the LLP Act, 2008 (Indian LLP) shall be regarded as “firm” for section 2(23)(i) purposes. A foreign LLP (i.e., an LLP formed and/or registered outside India) shall not be regarded as “firm” for section 2(23)(i) purposes.

Section 3 of the LLP Act, 2008 provides as under –

(1) A limited liability partnership is a body corporate formed and incorporated under this Act and is a legal entity separate from that of its partners.

(2) A limited liability partnership shall have perpetual succession.

(3) Any change in the partners of a limited liability partnership shall not affect the existence, rights or liabilities of the limited liability partnership.

1.3 Definition of ‘Partner’ in the Context of a Traditional Partnership Firm/General Partnership Firm

Section 4 of the Indian Partnership Act, 1932 defines “partnership”, “partner”, “firm” and “firm name” as under –

4. Definition of “Partnership”, “partner”, “firm” and “firm name” –

“Partnership” is the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all. Persons who have entered into partnership with one another are called individually “partners” and collectively “a firm”, and the name under which their business is carried on is called the “firm name”.

1.4 ‘Partner by Holding Out’ is Not a ‘Partner’ for the Purposes of the Act

Section 28 of the Indian Partnership Act, 1932 provides that “Anyone who by words spoken or written or by conduct represents himself or knowingly permits himself to be represented, to be a partner in a firm, is liable as a partner in that firm to anyone who has on the faith of any such representation given credit to the firm, whether the person representing himself or represented to be a partner does or does not know that the representation has reached the person so giving credit.” The “partner by holding out” by virtue of section 28 is liable as a partner but is not a partner within the meaning of section 4.

1.5 Minor Admitted to the Benefits of Partnership

As per the provisions of the Indian Partnership Act, 1932 –

• A minor cannot be a “partner” in a general partnership firm/traditional partnership firm.
• He can only be “admitted to the benefits of partnership” in a general partnership firm/traditional partnership firm in terms of section 30 of the Indian Partnership Act, 1932.

A “minor admitted to benefits of partnership” is not a ‘partner’ within the meaning of section 4 of the Indian Partnership Act, 1932. He becomes a ‘partner’ only when he elects to become a partner by giving public notice at any time within six months of his attaining majority, or of his obtaining knowledge that he had been admitted to the benefits of partnership. If he fails to give such public notice, he shall become a partner in the firm on the expiry of the said six months. However, by a legal fiction in sub-clause (a) of clause (22) of Section 2 of the PBPT Act, (Prohibition of Benami Property Transactions Act, 1988)  a minor admitted to the benefits of partnership is deemed to be a ‘partner’ in a general partnership firm/traditional partnership firm for the purposes of PBPT Act.

There is no provision in the LLP Act, 2008 which provides for admitting minor to the benefits of partnership in an LLP.

1.6 Definition of ‘Partner’ in the Context of a Limited Liability Partnership

In terms of section 2(23), the term ‘partner’ shall include a partner of a limited liability partnership formed and registered under the Limited Liability Partnership Act, 2008.

Clause (q) of sub-section (1) of section 2 of the said Act defines “partner” as follows –

(q)“partner”, in relation to a limited liability partnership, means any person who becomes a partner in the limited liability partnership in accordance with the limited liability partnership agreement;

Clause (q) of sub-section (1) of section 2 of the said Act defines the term “limited liability partnership agreement” to mean any written agreement between the partners of the limited liability partnership or between the limited liability partnership and its partners which determines the mutual rights and duties of the partners and their rights and duties in relation to that limited liability partnership.

While a traditional partnership firm need not be evidenced by a written agreement/partnership deed, the agreement between partners of an LLP must be in writing in terms of clauses (o) and (q) of sub-section (1) of section 2 of the Limited Liability Partnership Act, 2008. However, it may be noted that if a traditional partnership firm is not evidenced by a partnership deed, then, it will be assessed as ‘AOP’ and not as ‘firm’. [Section 184 of the Act].

2. Contribution of Capital Asset to Firm/LLP/BOI/AOP by Partner/Member [Section 45(3)]

The ingredients of section 45(3) of the Act are as follows –

(i) There is a transfer of capital asset;

(ii) Such transfer is by a person to a firm or AOP or BOI (not being a company or a co-operative society) in which he is or becomes a partner or member;

(iii) Such transfer is by way of capital contribution or otherwise; and

(iv) If conditions (i) to (iii) are satisfied,

• • the profits or gains arising from such transfer shall be chargeable to tax as his income of the previous year in which such transfer takes place; and
  • For the purposes of section 45, the amount recorded in the books of account of the firm, association or body as the value of the capital asset shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of the capital asset.
  • As per the provisions of sec. 17(1)(b) of the Registration Act, 1908 in the case of a sale of immovable property worth ₹ 100/- or above, no title passes to the transferee unless a conveyance is executed and registered under the Registration Act. 1908. However the Madras High Court in the case of R.M. Ramanathan Chettiar v. Controller of Estate Duty [1975] 99 ITR 410 (Mad.) held that no document of transfer is necessary when the partner brings into the partnership firm some of his assets with an intention to treat the same as partnership assets even though the assets so brought in consist of immovable properties. In arriving at this conclusion favourable to the assessee the Madras High Court referred to an earlier decision rendered by the Madras High Court in the case of Chief Controlling Revenue Authority v. Chidambaram AIR 1970 Mad 5 wherein the earlier Bench took the same view that no document is necessary when a partner brings into the partnership some of his assets with an intention to treat the same as partnership assets, that by virtue of section 14 of Partnership Act, property could be thrown into the partnership stock without any formal document, so as to make it the property of the firm. This view was taken by various High Courts on earlier occasions – two such instances being the one taken by the Full Bench of the Calcutta High Court in the case of Prem Raj Brahmin v. Bhani Ram Brahmin, AIR 1946 ILR 1 Cal. 191 [FB] and the Patna High Court in the case of Firm Ram Sahay Mall Rameshwar Dayal v. Bishwanath Prasad, AIR 1963 Patna 221. In fact, this view has been followed for tax purposes in ascertaining the hands in which the income from the property has to be assessed in different contexts as in CIT v. Hind Construction Ltd. [1972] 83 ITR 211 (SC) and CIT v. Amber Corpn. [1981] 5 Taxman 56 (Raj). The Delhi High Court in the case of Addl. CIT v. Manjeet Engineering Industries [1984] 18 Taxman 235 (Delhi) also came to the same conclusion as that of the Madras High Court in R.M. Ramanathan Chettiar’s case (supra) that no document of transfer is necessary when a partner brings into partnership some of his assets to treat the same as partnership assets even though the assets brought in consist of immovable properties. The Delhi High Court in this case reviewed a number of decisions on this point before arriving at a decision favourable to the assessee.
  • It is to be noted that the Supreme Court dismissed the Department’s special leave petition against the judgment of the Delhi High Court in the case of Manjeet Engineering Industries (supra) on 10.09.1990 [CIT v. Manjeet Engineering Industries S.L.P. (Civil) Nos. 8904-13 of 1984.]
  • The Andhra Pradesh High Court in the case of CIT v. A.V. Bhanoji Rao [1983] 12 Taxman 349 (AP) also came to the same conclusion as that of the Madras High Court in R.M. Ramanathan Chettiar’s case (supra) that no document registered or otherwise was needed for transferring even an immovable property to a firm by the partner as capital contribution. A Full Bench of the Lahore High Court in the case of Ajudhia Pershad v. Shamsunder AIR 1947 Lah. 13 held that the interest of a partner in partnership assets comprising of movable and immovable property would be treated as movable property. Relying on it, the Full Bench of the Andhra High Court in the case of A. Narayanappa v. B. Krishnappa AIR 1959 AP 380 at page 384 observed that the interest of a partner in partnership assets cannot be regarded as a right of interest in immovable property within the meaning of Sec.17(1)(b) of the Registration Act, 1908. The Rajasthan High Court in the case of Amber Corporation (supra) observed at page 32 that even if a property contributed by one partner be an immovable property, no document, registered or otherwise, is required for transferring the property to the partnership. At this juncture, decision rendered by the Madras High Court at a later point of time in the case of CIT v. T.M.B. Mohamed Abdul Khader [1984] 16 Taxman 413 (Mad.) may be noted. In this case the assessee, a partner in a firm made a declaration to the effect that certain property owned by him individually would thereafter be the property of the firm and the assessee’s account in the firm was then credited with the amount of consideration agreed upon which was much higher than the book value of the property but the transfer was not effected through a registered document. The Madras Court, without noticing the earlier decision given in the case of R.M. Ramanathan Chettiar’s case (supra) and without referring to any of the earlier decisions given by various courts, held that in the absence of a registered document, there was no valid transfer of property from the assessee to the partnership and as such, no liability to capital gains tax arose. This decision rendered by the Madras High Court is therefore a decision given per incuriam (i.e., given without noticing the earlier decision of the Madras High Court) and therefore would not be a binding precedent and may be confined to the facts of the case arising in that decision. This decision need not stand in the way of taking a stand that no registration is required when the partner brings immovable property into the business as his contribution. The provisions of section 14 of the Indian Partnership Act, 1932 also stipulate that the property can be originally brought into the stock of the firm or may be acquired by purchase or otherwise by or for the firm or for the purposes and in the course of business of the firm. Therefore, nothing would prevent the partners of a firm which has been in existence for a few years and carrying on business, from transferring the immovable property standing in their name to the name of the firm without attracting the provisions of section 17(1)(b) of the Registration Act, 1908. In other words, the transfer of immovable property can be made by the partners even after it had been in existence for quite a few years. Therefore, when an immovable property is contributed as capital by a partner by crediting his capital account and debiting his asset account, such pooling would convert the proprietary property as firm’s property by operation of the partnership law, though it is not registered because there is no conveyance requiring registration. A partnership deed recording the fact of pooling is registrable only as a partnership deed. Though stamp duty would be attracted, if such partner brings the property to the firm by way of sale, the contribution of the same as capital is different from such sale The decisions given by the Madras High Court in the cases of CIT v. S. Rajamani and Thangarajan Industries [2000] 241 ITR 668 (Mad.) and CIT v. Dadha & Co. [1983] 14 Taxman 219 (Mad.) are not applicable as in these cases it was held by the High Court that the registered document is required during the subsistence of the firm where the transaction involves immovable property and when there is transfer of immovable property by the firm to the partners, document in writing was required. It was held that in the absence of any document in writing the property did not get transferred in the name of the partners. The Madras High Court in the case of CIT v. Palaniappa Enterprises [1984] 19 Taxman 417 (Mad.) held that there cannot be a partition of firm’s property by the partner as though it were a co-owned property. Likewise, the Bombay High Court in the case of CIT v. J.M. Mehta & Brothers [1995] 79 Taxman 409 (Bom.) also held that there cannot be a division of the properties purchased in the name of the firm between the partners by mere entries in the books during subsistence of the partnership and when the property is sold, capital gains are assessable only in the hands of the firm despite any such division.
  • With regard to the value to be adopted, there is no stipulation that only the market value has to be adopted by the partners when they transfer the properties in the name of the firm because after the amendment to section 45(3) of the Act with effect from 01-04-1988 by the Finance Act, 1987 it is now expressly provided that the amount recorded in the books of account of the firm would be the full value of the consideration received or accruing as a result of transfer of capital assets for the purposes of section 48 of the Act.

Illustration 1 – X, Y and Z are partners in a firm. Y transfers a building owned by him to the firm. The market value of the building on the date of transfer (20-10-2017) is ₹ 8,00,000. His account in the firm’s books is credited by ₹ 6,00,000 and building account is debited by the same amount. He had purchased the building on 1-4-2001 for ₹ 2,00,000.

In this case, Y will be subject to tax on capital gains (long-term) for the year ended 31-3-2018, i.e., assessment year 2018-19. The capital gains will be computed as under –

Taxable long-term capital gain for the assessment year 2018-19                    56,000

Illustration 2 – Mr. Tiwari a partner in the firm of M/s. ABC & Co. made a declaration on 2-4-2017 to the effect that certain of his own immovable property will thereafter be the property of the firm. The consideration agreed to was ₹ 18,00,000 against his acquisition cost of ₹ 4,00,000 on 10-05-2001.

The declaration was followed by book entries by which Mr. Tiwari’s account in the firm was credited with a sum of ₹ 18,00,000 while a corresponding debit was given to the asset account. Is Mr. Tiwari liable to tax on capital gains?

Section 45(3) provides that profits or gains arising from the transfer of a capital asset by a person to a firm in which he is or becomes a partner, by way of capital contribution or otherwise, shall be chargeable to tax as his income of the previous year in which such transfer takes place. On a combined reading of sections 2(47)(v) and Section 45(3) of the Act it is clear that Mr Tiwari is liable to pay tax on capital gains on transfer of the immovable property to the firm although the transfer has not been registered. The amount recorded in the books shall be deemed to be the full value of consideration arising as a result of transfer.

2.1 Amount Recorded in Books Does Not Mean Partner’s Capital Account Should be Credited

When a partner contributes a capital asset into the firm the amount recorded in the books shall be taken as the sale consideration. The credit for the contribution need not necessarily be in the capital account of the contributing partner. [Mafatlal Holdings Ltd. v. Addl. CIT [2004] 85 TTJ (Mum. – Trib.) 821].

2.2 Where Capital Contribution is Stock-in-trade of the Firm

Where the goods are transferred to the capital account of the firm being the regular stock-in-trade of the assessee, the position is different. In such a case, it would be covered by the exception provided in section 2(14)(i) and, thus, no capital gain will arise at the time of contribution of stock in trade as capital contribution. [Prakash Chand Daddha v. ITO [1983] 17 TTJ (Jp. – Trib.) 230].

2.3 Where Transaction Covered by Section 45(3) is International Transaction, Capital Gains Will be Computed Based on ALP

In case of a transaction covered by section 45(3) [capital contribution by partner to firm in the form of capital assets] which satisfies the definition of ‘international transaction’ in section 92F, the full value of consideration for calculating capital gains will not be the amount credited to partner in the books of the firm but the ALP for transfer of capital assets to firm as determined under section 92C. Canoro Resources Ltd. In re [2009] 180 Taxman 220 (AAR – New Delhi)

2.4 Where the Assessee-Proprietor Transfers Assets to Firm and Within 3 Months the Assets are Revalued and Firm Converted into Pvt. Ltd. Co.

Where the assessee-proprietor transferred his assets to a partnership firm constituted on 1-4-2011 and subsequently assets of firm were revalued and firm was converted into a private limited company on or about 29-06-2011, the Tribunal held that the assessment of capital gains in assessee’s hands had to be done on the basis of value of assets as on 1-4-2011 when partnership firm was constituted and not on the basis of revalued value of assets as sought to be done by the Revenue. The Tribunal also rejected Revenue’s contention was that assets were actually revalued before 1-4-2011 and value of assets was much higher on 1-4-2011 than what was shown in deed of partnership. The High Court held that for the purpose of computing capital gains under section 45(3) of the Act, value of assets recorded in books of firm on date of transfer would be deemed to be full value of consideration received or accrued as a result of transfer and therefore, order passed by the Tribunal was justified. The Supreme Court dismissed the Special leave petition filed by the Revenue against the impugned order of the High Court. [Principal CIT v. Dr. D. Ramamurthy [2019] 103 taxmann.com 24/261 Taxman 560 (SC)]

2.5 Capital Contribution in the Form of Land Which was Treated as Stock-in-trade

Where partners of the assessee-firm made capital contribution in the form of land which was treated as stock-in-trade, provisions of section 45(3) would not apply rather the case would be governed by the provisions of sections 28 to 43A and, thus, the Assessing Officer was entitled to examine reasonableness of payments made to partners for their contribution of land in terms of section 40A(2)(a) of the Act. [Asstt. CIT v. Karuna Estates & Developers [2018] 92 taxmann.com 282/170 ITD 249 (Visakha. – Trib.)]

2.6 Where Land Brought in by Partners as Current Assets and Also Treated as Such by the Firm

Section 45(3) is applicable only in respect of a capital asset; thus, where a land was brought in a firm by partners as current assets and firm had also accounted for it as a current asset, the provisions of section 45(3) of the Act would not be applicable [ITO v. Orchid Griha Nirman (P.) Ltd. [2016] 74 taxmann.com 187/161 ITD 818 (Kol. – Trib.)]