By TIOL News Service

MUMBAI, APR 04, 2019: THE ISSUE BEFORE THE DIVISION BENCH IS - Whether any profit/gain taxable u/s 45(4) can be said to have arisen in hands of partnership firm upon mere retirement of partners, in absence of distribution of capital asset in favour of retiring partners. NO IS THE VERRDICT.

Facts of the case:

The assessee is a partnership firm engaged in manufacturing of tube light fittings and other lighting accessories for over 13 years. During the relevant year, constitution of the firm underwent a change under a Deed of Reconstitution of partnership and three new partners were admitted. Later on, another Deed of Retirement cum Reconstitution of the partnership was executed by which the original two partners retired from the firm and the remaining three partners redistributed their share in a partnership firm. The partnership created a goodwill account and a sum of Rs. 3.75 Crores was credited in the books of the firm in the said account. The retiring parters were paid sums of Rs. 2.97 Crores and 77.27 Lakhs respectively in proportion of their shares in the partnership business. During the course of assessment, the AO was of the opinion that in terms of section 45(4), the firm had to pay short term capital gain tax on such amounts. The AO further opined that the goodwill credited by the firm of Rs. 3.75 Crores was nothing but the capital gain arising on distribution of the capital asset by way of "dissolution of the firm or otherwise".

On appeal, the CIT(A) agreed with the contention of assessee that there was neither dissolution of the firm nor the firm was discontinued. He, however, held that the rights and interests in assets of the firm were transferred to the new members and in this manner there was transfer of capital asset. He was further of the opinion that Section 45(4) would apply in the present case which would cover even a case of transfer of capital asset otherwise than by dissolution of the firm. On further appeal, the Tribunal was of the opinion that the conditions required for applying section 45(4) were not satisfied in the present case.

High Court held:

++ as per the provision of Section 45(4), profits or gains arising from transfer of capital asset by way of distribution of capital asset on dissolution of firm or otherwise shall be chargeable to tax as income of the firm. For application of this provision, thus, transfer of capital asset is necessary. Provisions of Section 45(4) came up for consideration before this Court in the case of A. N. Naik Associates, where there was reorganization of the partnership in quick succession. The Court therein held that such reorganization would not amount to dissolution of the firm. The question in such background was whether Section 45(4) would apply in case there has been transfer of capital asset. The Court therein referred to legislative changes and observed that when the asset is transferred to the partner, that falls within the expression "otherwise" and the rights of the other partners in that asset of the partnership are extinguished. It was held that transfer of assets of the partnership of the retiring partners would amount to transfer of capital assets;

++ the decision of the Court in the case of A. N. Naik Associates was considered by the Karnataka High Court in the Full Bench Judgment in the case of Dynamic Enterprises. The question considered by the court was when retiring partner takes only money towards value of his share, whether the firm should be made liable to pay capital gains even when there is no distribution of capital asset among the partners u/s 45(4). The Court therefore held that after retirement of partners, the partnership continued and the business was also carried on by the remaining partners. There was thus no dissolution of the firm and there was no distribution of capital asset. What is given to the retiring partners was money representing the value of their share in the partnership. No capital asset was transferred on the date of retirement. In absence of distribution of capital asset and in absence of transfer of capital asset in favour of retiring partners, no profit of gain arose in the hands of partnership firm. In the result, there is no error in the view of Tribunal.

(See 2019-TIOL-755-HC-MUM-IT)