Tax Implications On Reconstituion Of Partnership Firm By: Avani Maheshwari
Tax Implications On Reconstituion Of Partnership Firm
Authored By: Avani Maheshwari
Kirit P.
Mehta School Of Law, Mumbai.
ABSTRACT
There
has been a never-ending saga on the disputes involving capital gains to be
levied on the money/assets paid to
the partners getting retired for a several years now. With an objective to bring some clarity,
the government introduced
Section 45(4) under the Income
Tax Act, 1961.
The said section
provides that capital
gains should be taxed in the hands
of the specified entity. There
are no accurate answers on the above issue and the courts have passed several judgements. The taxation on the exit of a
partner was specifically excluded till financial year 1987-88.1 In order to prevent misuse of the
exemption, Section 45(4) was introduced by the
Income Tax Act, 1961 in the year 1987.2 The issue was very contentious and thus the legislature introduced some amendments which
redesigned the entire scheme of taxation in case of reconstitution of a firm.
Key Words: Taxation,
Reconstitution, Retirement, Finance
Act, exemption, capital
gains.
1 The transaction was not considered as a transfer
under Section 47(ii) of the Income
Tax Act, 1961.
2 Introduced in the Finance
Bill of 1987.
INTRODUCTION
Taxation
in case a Partners retires from a firm has been a contentious issue for a very long time. There have been various
judgements on the issue and conflicting as well. For a very long time,
there was no capital gains tax on distribution as assets on dissolution
of partnership firm. As a result of which, individuals used to convert
the assets of their firm into individual assets either upon dissolution or retirement contending that capital gains tax is
not payable.
To overcome this tax planning exercise, the legislature introduced Section
45(4) which imposed capital gains in
the hands of the partnership firm. However, the same resulted in a lot of
litigation as a result of which there was an amendment under Section 45(4) to
resolve the issues. Through Finance Act, 2021 the
legislature redesigned the entire scheme through introduction of Section 9B. The article critically analyses the
changes and some open issues. The
legislature introduced Section 45(3) along with Section 45(4) to solve the
misuse of provisions and deleted the erstwhile section 47(ii) to bring clarity.
The changed provisions starts with a non-obstante clause
and thus, the provisions will override if there is anything contrary to the
provision provided in the income tax Act. Through this amendment, the legislature has favored the view that on retirement of partner, there
is a transfer of right and thus capital
gains tax should be levied with respect to the same. The new provisions have clarified
that revaluation of assets should not be included while
computing gains.
RESEARCH QUESTIONS
1. Whether there is a transfer from the retiring
partner to the continuing partners
when a certain amount is paid to the
retiring partner by the firm.
2. Whether there is a transfer of capital asset to the retiring partner
by the firm when a certain asset is allocated to the retiring
partner by such firm.
3. Whether there is a transfer of capital asset by a partner to the firm when the partner contributes a personal asset to the firm.
ANALYSIS OF THE PROVISIONS THROUGH JUDICIAL DECISIONS
In the matter of Mohanbhai
Pamabhai3, it was held by the Gujarat High court that there does not
exist any extinguishment by the retiring partner towards the continuing
partners, hence there cannot be any
transfer4. Even if there is a transfer, there is no consideration
since the retiring partner is realizing his share in the net assets of the firm and thus such an amount is not consideration in lieu of the said
transfer. The partner is just realizing his share and settling his rights.
The said judgement was affirmed by the
Supreme court.
In the matter of Tribhuvandas G
Patel5, it was held by the High court that the question whether a particular transaction upon
retirement would result in releasing of interest in favour of continuing partners
would depend upon the mode of retirement. If the retiring
partner agrees to take lumpsum in consideration of
relinquishing his share instead of taking his share on the basis of notion sale, the transaction would come within the ambit of transfer. Such a transaction would be subjected to tax. The court came to this conclusion
without analysing the facts of Gujarat High court’s decision
in Mohanbhai’s case (supra).
So, until the above judgement by the Bombay
High court, the view was that
there would be no transfer when
partners settle their rights. Since, in this case the partner was paid an
amount in excess to his balance in
the capital account and there existed a deed which extinguished his rights and claims towards the continuing
partners , it was inferred by the Bombay High court that excess amount received was subject to tax. Further, it was
pointed by the court that if the retiring
partner assigns his interest by a deed then the transaction would be a transfer
wherein the partner has stated that
he has no further claims against the co-partners. It was further rejected by the court that dissolution and
retirement are the same as pleaded by the assessee. The said judgement was reversed by the Supreme Court.
Thus,
it is clear that there are two different views in relation to tax implications
of amount received by the retiring
partner.
3 Addl. CIT v. Mohanbhai Pamabhai
(1987) 165 ITR 166 (SC)
4 Section 2(47) of the Income Tax Act, 1961.
5 CIT v. Tribhuvandas G.
Patel, (1999) 236 ITR 515 (SC)
In
the matter of Commissioner of Income Tax
vs AN Naik Associated & Anr6, the phrase ‘otherwise’ was interpreted to cover
retirement as against simple interpretation which covers only dissolution within it’s ambit. It is pertinent to note that
the court in this particular case considered whether
asset allocation on retirement comes within the ambit of Section 45(4) and not whether the said transaction amounts
to transfer against the consideration received by the partner on the said retirement. Accordingly, the Bombay High
court held that allocation of capital
asset to the retiring partner is taxable in the hands of the firm. If the
section were to be interpreted to
cover only ‘dissolution’ then the entire purpose of the provision goes into
drain. The above judgement
was subsequently upheld
by CIT v. Nathan
and Co.7
However, the same High court in Madras has taken a different view in the
case of National Company v. ACIT8, wherein they held that immovable
property distributed to retiring partner
would not come within the ambit of Section 45(4) of the Act. Thus there
is no capital gains because consideration is being paid to partners
in lieu of their interest in the firm. This view is contract to A.N. Naik case (supra).
They had relied upon some of the Supreme court judgements
which were based on the erstwhile provision of the Act before the amendment. Thus decision of Madras High court has restarted the entire controversy but it is yet to be seen whether
this decision would stand the etst of the time.
It is pertinent to note that the erstwhile provisions had a specific
provision in the form of Section
47(ii) stating that allocation of capital assets in case of dissolution of partnership would
not be a transfer. Thus, it would be out of the ambit of capital gains
tax. Section 45(3) and Section 45(4) was
introduced as a result of this.
In
the case of Sunil Sidharthbhai9, it was held by the Supreme court that capital gains tax is not leviable in case a partner at the time of his admission contributes his personal assets into
the firm’s asset. Due to the above judgement, certain taxpayers started
misusing the law to avoid the payment
of capital gains tax to the government. The government introduced Section 45(3) which stated that any contribution
in the form of capital assets made by a partner is subject to tax.
6 (2004) 265 ITR 346 (Bom)
7 TCA NO. 1458 of 2005.
8TCA. No. 365 & 366 of 2009 dated April 08, 2019
9 Sunil Sidharthbhai v. CIT (1985)
156 ITR 509
It is very common for companies to set up SPV for the purpose of making
investments into their parent companies
and in such situation this SPV is preferred as a partnership firm because there are tax benefits linked to it. Thus, it becomes very important to have clarity
on this subject.
RECENT CHANGES
INTRODUCED VIDE FINANCE
BILL, 2021
The Finance
Act, 2021 introduced a new provision as Section 9B. The aim of the new provision
is to tax when a specified person is allotted any capital asset or stock
in trade by the specified entity as a
result of dissolution or reconstitution. The tax liability falls on the
specified entity in the year in which the capital asset or stock in trade
is received by the specified person. Thus, Section 9B aims to cover only two
instances, namely the reconstitution and dissolution. Further, it is pertinent to note that the previous Section 45(4)
dealt only with dissolution and the
question of reconstitution was not very clear. However, in the matter of AK
Naik & Associates , it was held
by the High court of Bombay that Section 45(4) covers retirement under the ambit of “otherwise”. Section 9B has now made it clear
to that extent. It is important to note that Section 9B does not cover instances
where the specified
person receives money.
Implications under Section 45(4)
The
judgement of AK Naik is in a way implemented to make it clear that this new sub
section covers reconstitution. The
capital asset or money received by the specified person as a result of reconstitution of specified entity
is taxable under
this provision in the
hands of the specified entity. The specified entity has to pay
tax on the difference of amount lying in the capital account at the time of reconstitution and fair market
value of the capital asset and money
at the time of reconstitution. It is pertinent to note that the money
which is paid on dissolution is not covered within
the ambit of either
Section 9B or Section 45(4).
Upon
reading the new section, it is clear that the tax is to be paid by specified
entity on the amount being paid in
excess to the capital account balance. Hence, this new section is trying to tax the excess amount over the balance
in the capital account of the specified person. A question for consideration here is, what exactly is the specified
entity transferring/extinguishing to the specified
person so as to come
under the obligation to pay tax and that
too under the head of “capital gains”.
It is pertinent to note that the specified person
is ideally transferring his
rights in favour of the continuing partners. Has the legislature placed the taxation event wrongly under the
head ‘capital gains’. There is no clarity on this part.
Certain other issues arising from interpretation of Section 45(4) is it’s
applicability. The gains arising after distribution of capital asset or
stock in trade to the partner
would be deemed to be the income
of specified entity. The major objective
of Section 45(4)
is to levy tax on the excess
amount lying to the
credit of the capital account balance of the retiring partner.
Further, it is important to note that the term ‘money’ is not defined in
the Act. The provision states that
"if any person receives any money or
capital asset or both”. Thus, there arises a possibility of different interpretation of the term ‘money’. One interpretation can be that money would mean to include not only cash but
readily convertible assets as well such as stock in trade and other similar assets. On the other hand, the other
interpretation can be that since money was specifically spelt
out in the provision, all other kind of assets are not to be included specially when section 9B specifically deals with stock in trade.
Since the section
does not specifically include any other kind of liquid asset,
only money in the form of cash would be taxed in the hands of
the firm.
For the purpose of Section
45(4), there is ambiguity with respect to period of holding of capital asset that is should the period of holding be considered from the time capital was brought in by the partner in the firm or should be the
date from which the person became the partner in the firm. Classification of capital asset as
long term or short term is important to determine the tax rate
and this classification would depend upon the period of holding. There is not
much guidance on the same thus it is not possible
to determine the amount.
Section
45(4) covers cases of reconstitution only and this can become a cause of
litigation further since it is not expressly
mentioned. This issue may have large implications. Section 45(4) would be inapplicable in case a partner receives stock in trade. Further,
self-generated goodwill is excluded while computing the balance in the capital
account of the retiring partner.
CONCLUSION
The
changes brought by Finance Act in the year 2021 will resolve certain issues
which were a subject of litigation
in the past. Some issues have been resolved to a great extent. Having said that,
there are still certain open issues left that needs much needed clarity.
With respect to Issue 1, as far as the amounts received by the partner
are not in excess of the credit lying in their capital accounts,
there would not arise any tax implications. Tax implications will
only arise where there is a lumpsum payment or when there is a payment of excess
amount. BY making
an amendment and replacing the earlier sub-section, the legislative intent is clear. Thus, judgements like
Mohanbhai Pamabhai still holds good today since there is no amendment made to get the amounts received on retirement.
Accordingly, tax is to be paid by the
specified entity even in cases of retirement of partner since that falls within
the ambit of reconstitution. The
aspect which is remaining to be addressed is tax implication on allotment of money at the time of
dissolution as the same is not covered either under section 9B or Section
45(4).
With respect to Issue 2, ideally the tax implications should not depend
upon the type of consideration being
received by the retiring partner.
Thus, irrespective of the fact that whether
the partner has received capital asset or money, taxation should be same. However,
as mentioned above,
the Bombay High court in AK Naik case, held that allocation of capital asset
would be taxable in the hands of the firm under Section 45(4) since the term “otherwise” covers retirement
and the same has to be read with “transfer”. The above decision lays down a
good proposition and post amendment there
has been clarity
as the legislature has clearly
mentioned the tax implications in case of transfer of capital asset.
With respect to third
issue, the Supreme court in Sunil Siddharathbhai stated that there exists a transfer when a personal
asset is being contributed to the firm because the contributing partner
loses their exclusive right in the property, which they earlier had. However,
it was stated by the Supreme court that the amount recorded in the book firms may not represent
the correct value of
consideration. Thus, the legislature introduced Section 45(3) stating that the
said transaction would be considered
as transfer and consideration would be the amount being recorded in the firm’s books.