By TIOL News Service

BANGALORE, NOV 14, 2013: THE sole issue before the Full Bench of the HC is - Whether when a retiring partner takes only money towards the value of his share and there is no distribution of capital assets among the partners, even then it can be said that there is transfer of capital assets and the partnership firm is liable to capital gains u/s 45(4). And the verdict goes against the Revenue.

Facts of the case

The assessee, M/s.Dynamic Enterprises, is a partnership firm which came into existence on 09.01.1985 with Sri Anurag Jain and Sri Nirmal Kumar Dugar as its partners. The firm was engaged in the business of buying landed properties, constructions of buildings thereon, construction of industrial sheds, commercial complexes etc. On 13.04.1987, the firm was reconstituted by which Sri Nirmal Kumar Dugar retired from the partnership and L.P. Jain (father of Anurag Jain) entered the partnership as he showed his willingness to contribute capital for purchase of land to construct housing complex. The firm purchased land under a registered sale deed dated 13.5.1987 for a consideration of Rs.2,50,000/-. Another reconstitution took place on 1.7.1991 by which Sri L.P.Jain retired from the firm and Smt. Pushpa Jain and Smt. Shree Jain were inducted as partners. The firm was reconstituted and five partners belonging to Khemka Group were inducted into the firm by a deed dated 28.04.1993. Before the reconstitution, the assets of the firm were revalued as per the report of the registered valuer on 28.03.1993. The three old partners retired through deed of retirement dated 01.04.1994. The old partners received the enhanced value of property in financial year 1994-95. As per the Assessing Officer there was transfer of property from old firm to the new firm on 01.04.1994. Hence, it was a transfer within the meaning of Section 2(47) of the I.T.Act. Accordingly, notice under Section 148 was issued on 27.03.2002. In reply to the said notice, the assessee-firm contended that it had paid the amount to the retiring partners standing on credit side in respect of capital accounts. There was no transfer of asset and therefore, they were not liable to pay any capital gains tax.

The Assessing Officer held that the land was purchased when the firm was having two partners, namely, Shri Anurag Jan and Shri L.P.Jain. The firm had done no business all through its existence. The receipt of rents and commission for assessment year 1994-95 were found as bogus. The immovable property was not utilized to earn paltry sums during the existence of the firm. The new partners were introduced and the old partners retired. This was a device adopted to transfer the immovable property. The incoming partners tried to evade capital gains tax as well as stamp duty and therefore, he held the capital gains tax was liable to be paid by the firm. In appeal, the appellate authority affirmed the said order. The appellate authority held that the reconstitution of firm had taken place on 01.04.1994 i.e., nearly one year after the members of the Khemka family were introduced as partners. Therefore, it accepted the genuineness of the old firm as well as the new firm but it held it was a colourable device to evade payment of tax.

On appeal, the Tribunal held that reconstitution of the firm has taken place on 01.04.1994 i.e., nearly one year after the members of the Khemka family were introduced as partners. The difference between the value determined on account of the revaluation and the book value was credited in the capital account of the partners in the profit share ratio on reconstitution of the firm as on 01.04.1994. The retiring partners had withdrawn their capital as standing in the books of accounts of the firm. As per Section 45 of the Income Tax Act, profit and gains arising from the transfer of a capital asset was chargeable under the head “capital gains”. Hence to levy capital gains tax there should be an asset and there should be transfer in respect of that asset. The word ‘transfer’ is defined in Section 2(47) of the I.T. Act. As per this definition, transfer includes sale, exchange or relinquishment of the asset. It also includes extinguishment of any rights in the asset. Hence to complete the process of transfer there should be a person who is having a right in an asset and then such right is either sold, exchanged or relinquished to another person. In the instant case, the firm was reconstituted as on 01.04.1994 to continue the same business. The firm had not relinquished any right in the land. The land was being owned by the firm. The return filed by the firm for the assessment year 1995- 1996 was of the reconstituted firm and not of the old firm and therefore, there was no transfer as on 01.04.1994 by the reconstituted firm. The Revenue had charged capital gains tax in the hands of the reconstituted firm. Relying on the judgments of several High Courts as well as the Supreme Courts it held that the reconstituted firm cannot be termed as a transferor even for the arguments sake. There was no transfer and the firm was not liable to pay capital gains tax.

On appeal, the Larger Bench of the High Court held that,

++ under the provisions of the Partnership Act, 1932, the firm is not recognized as a legal entity. A Partnership Firm is not a distinct legal entity apart from the partners constituting it. In law the Firm as such has no separate rights of its own in the Partnership Assets. When one talks of firm’s property or the firm’s assets all that is meant is property or assets in which all partners have a joint or common interest. The Whole concept of partnership is to embark upon a joint venture and for that purpose to bring in as capital money or even property including immovable property. Once that is done, whatever is brought in would cease to be the exclusive property of the person who brought it in. It would be the trading asset of the partnership in which all the partners would have interest in proportion to their share. The property of the firm includes all property and rights and interests in property originally brought into the stock of the firm, or acquired, by purchase or otherwise, by or for the firm, or for the purposes and in the course of the business of the firm, and includes also the goodwill of the business. Property and rights and interest in property acquired with money belonging to the firm are deemed to have been acquired for the firm. When a partner brings in his personal asset into a partnership firm as his contribution to its capital, an asset which originally was subject to the entire ownership of the partner becomes now subject to the rights of other partners in it. When his personal asset merges into the capital of the partnership firm a corresponding credit entry is made in the partner's capital account in the books of the partnership firm, but that entry is made merely for the purpose of adjusting the rights of the partners inter-se when the partnership is dissolved or the partner retires. His right during the subsistence of the partnership is to get his share of profits from time to time as may be agreed upon among the partners and after the dissolution of the partnership or with his retirement from the partnership, of the value of his share in the net partnership assets as on the date of dissolution or retirement after a deduction of liabilities and other prior charges. Dissolution of a firm must, in point of time, be anterior to the actual distribution. Division or allotment of the assets that takes place after making accounts and discharging the debts and liabilities due by the Firm. The distribution, division, or allotment of assets of the erstwhile partners, is not done by the dissolved firm. It is the partners who own jointly or in common the assets of the partnership and, 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 partners and there is no question of any extinguishment of the firm’s rights in the partnership;

++ however, the Income Tax Act recognizes the firm as a distinct assessable legal entity apart from its partners. Sub-sections (3) and (4) of Section 45 were introduced by Finance Act, 1987, which came into effect from 01.04.1988. In sub-section (3) what is sought to be taxed is the profits or gains arising from the transfer of a capital asset by a person to a firm or other association of persons or body of individuals. After such transfer, he is or becomes a partner or member, by way of capital contribution or otherwise. Then the said capital contribution shall be chargeable to tax as his income of the previous year in which such transfer takes place and, for the purposes of section 48, 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. When a partner brings in his personal asset into a partnership firm as his contribution to its capital, an asset which was originally exclusively belonging to him, becomes the trading asset of the firm, in which all partners acquire interest in proportion to their respective share in the firm. His right during the subsistence of the partnership is to get his share of profits from time to time as agreed upon among the partners. On dissolution of the firm or on retirement from the firm to get the value of his share in the net partnership asset as on the date of dissolution or retirement. Therefore, this is a case of a partner bringing capital asset to a partnership firm as his capital contribution;

++ Sub-section (4) of Section 45 deals with a distribution of capital assets on the dissolution of a firm or other association of persons or body of individuals or otherwise. If in the course of such distribution of capital asset there is a transfer of a capital asset by the firm in favour of a person and it results in profits or gains to the firm, then the said profits or gains shall be chargeable to tax as income of the firm and again for computing such income, Section 48 is attracted. In other words, in the process of a dissolution of a firm, if a capital asset is transferred to a partner which results in profits or gains, then that income is chargeable at the hands of the firm under this provision. Therefore, in order to attract Section 45(4) of the Act, the capital asset of the firm should be transferred in favour of a partner, resulting in firm ceasing to have any interest in the capital asset transferred and the partners should acquire exclusive interest in the capital asset. In other words, the interest the firm has in the capital asset should be extinguished and the partners in whose favour the transfer is made should acquire that interest. Then only the profits or gains arising from such transfer is liable to tax under Section 45(4) of the Act;

++ in the instant case, the partnership firm had purchased the property under a registered sale deed in the name of the firm. The property did not stand in the name of any individual partners. No individual partners brought that capital asset as capital contribution into the firm. Five partners brought in cash by way of capital when the firm was reconstituted on 28.04.1993. Nearly a year thereafter on 01.04.1994 by way of retirement, the erstwhile three partners took their share in the partnership asset and went out of the partnership. After the retirement of three partners, the partnership continued to exist and the business was carried on by the remaining five partners. There was no dissolution of the firm or at any rate there was no distribution of capital asset on 01.04.1994 when three partners retired from the partnership firm. What was given to the retiring partners is cash representing the value of their share in the partnership. No capital asset was transferred on the date of retirement under the deed of retirement deed dated 01.04.1994. In the absence of distribution of capital asset and in the absence of transfer of capital asset in favour of the retiring partners, no profit or gain arose in the hands of the partnership firm. Therefore, the question of the firm being assessed under Section 45(4) and charging them tax for the profits or gains which did not accrue to them would not arise;

++ in the instant case, the partnership firm did not transfer any right in the capital asset in favour of the retiring partner. The partnership firm did not cease to hold the property and consequently, its right to the property is not extinguished. Conversely, the retiring partner did not acquire any right in the property as no property was transferred in their favour. The Division Bench in Gurunath’s case did not appreciate this distinguishing factor and by wrong application of the law laid down by the Bombay High Court held the assessee in that case is also liable to pay capital gains tax under Section 45(4). Therefore, the said judgment does not lay down the correct law;

++ we would like to add that several other aspects of Section 45(4) was addressed in the course of the arguments by both sides which are not relevant to adjudicate the present issue, as in the present case there is no distribution of assets and hence, one of the condition precedent for invoking Section 45(4) does not exist and hence Section 45(4) is not attracted to the facts of this case;

++ in so far as the substantial question of law “whether the retiring partner would be liable to pay capital gain” is concerned, the said question does not arise for consideration in the appeal as the only question which arose for consideration was, whether the firm is liable to pay capital gain tax. Therefore, the said question of law is not answered.

(See 2013-TIOL-891-HC-KAR-IT-LB)