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Dissolution or reconstitution of firm – Taxability Revamped

Section 45(4) of the Income Tax Act, 1961 (IT Act) provides that profits or gains arising from the transfer of capital assets by way of distribution of said assets on the dissolution of a firm or otherwise are chargeable to tax as income of the firm. The taxability is in the previous year to which the transfer takes place.

The applicability of this Section has been under the scanner for various situations from the perspective of whether the term ‘or otherwise’ encompasses such situations. The instances of such situations would cover the distribution of capital assets taking place during the existence of the partnership firm, assets of the firm getting transferred to the retiring partner or where subsisting partners of the firm transfer assets in favor of the retiring partner. The Landmark Bombay High Court ruling1 accorded wide scope to the words ‘otherwise’ and thereby concluded that situations mentioned above trigger provisions of Section 45(4) of the IT Act.

Another area of dispute pertained to the aspect as to whether consideration (an amount equal to their capital balance or asset equivalent to capital balance) paid to the retiring partners is nothing but their share of interest in the firm and therefore, no capital gain tax is leviable. The Supreme Court2 had given a favorable view on this issue, but some adverse decisions renewed the debate.

Issue sought to be addressed by Finance Bill

The Memorandum to Finance Bill 2021 noted that there is uncertainty regarding the applicability of section 45(4) to a situation where assets are revalued or self-generated assets recorded in the books of accounts and also when payment is made to retiring partner in excess of his capital contribution/ balance.

Amendment by Finance Bill 2021

The Finance Bill 2021, presented on 1 February 2021, proposed certain amendments in the IT Act to address the concern in this regard by substituting section 45(4) and inserting new section 45(4A). However, the Finance Act 2021, as assented to by the President on 28 March 2021 (hereinafter referred to as ‘the Finance Act’), presented significant amendments to the proposals introduced earlier. The Finance Act has introduced two-fold amendments in this regard –

  1. on the transfer of property or stock in trade by the firm on reconstitution or dissolution and
  2. on the transfer of right by the partner on reconstitution of the firm

These amendments are discussed hereunder:

i) Insertion of section 9B: Income on receipt of a capital asset or stock in trade by a partner from the firm

The newly introduced Section provides for taxability in the hands of the firm where a partner receives any stockin- trade or capital asset from such entity in connection with dissolution or reconstitution. The fair market value (FMV) of the stock in trade or the capital asset shall be deemed as full value of consideration while computing business profits/capital gains in the hands of the firm.
Reconstitution shall cover the below –

  1. Retirement/death of one or more partners; or
  2. Admission of new partners, provided at least one existing partner continues: or
  3. Change in respective profits shares of all or some of the partners.

To summarize, section 9B covers taxability in the hands of the firm under both circumstances, i.e., reconstitution as well as dissolution. The taxability of gains from transfer stock-in-trade/capital asset is encapsulated below:

  • FMV of stock-in-trade on the date of receipt by the partner shall be taxable as business income under section 28 of the IT Act (with due consideration to the legit business expenditure incurred).
  • Determination of income taxable on the transfer of capital asset would be subject to the mode of computation as per section 48 of the IT Act and factors such as nature of the capital asset, period of holding, cost of acquisition, full value of consideration

ii) Substitution of section 45(4) of IT Act: Transfer of right by the partner on reconstitution:

The substituted Section provides that profits and gains arising from receipt of a capital asset or money by a partner from a firm in connection with the reconstitution of the firm shall be deemed to be the income of the firm under the head ‘Capital Gains’ in the year in which the partner receives such capital asset or money or both.

The profit and gains are to be computed in accordance with the following formula:

A = B + C - D

A = Income chargeable to tax under this provision as the income of the firm under the head capital gains;

B = Value of money received by partner on the date of such receipt;

C = FMV of the capital asset received by the partner on the date of such receipt; and

D = Balance in the capital account (represented in any manner) of the partner in the books of accounts of the firm at the time of reconstitution.

Where the value of A is negative, profits and gains shall be deemed to be nil.

Furthermore, for computation of the balance in the capital account, an increase on account of revaluation of any asset, self-generated goodwill, or other self-generated asset shall not be taken into account.

The amended Section aims at taxing the firm for the entire surplus received by the partner over and above the capital balance (without considering any revaluation to assets).

The amendments overrule the judicial precedents3 wherein it has been held that what the partner receives at the time of retirement/reconstitution is his own share of interest in the firm and thus not a transfer liable to tax.

Interplay of Section 9B and Section 45(4) of IT Act

  • Applicability

    From the above, it is clear that the firm would be assessed under section 9B for its own income and under Section 45(4) for the income arising to partner thereof. Explanation 2 to Section 45(4) clarifies that provisions of the said Section shall apply in the specific case (as covered under the Section) in addition to Section 9B of the IT Act.

  • Elimination of double taxation

    Section 48 has been amended to deal with double taxation due to capital gains tax arising under Section 45(4) (i.e., to the extent income taxed under section 45(4) shall be reduced from the full value of consideration of the capital asset being transferred by the firm while computing gains under section 9B of the IT Act).

Our Comments

With the rationalization of the corporate tax rates and providing individuals with an alternate tax regime, the government's objective seems to plug all the tax leakages due to loopholes in any provisions of the IT Act. The aim also seems to rationalize the provisions for bringing requisite certainty on taxability in various situations. This is evident from the amendments brought in the context of taxability of ‘slump sale’ and ‘entitlement of depreciation on Goodwill.’

While the government had promised no retro tax, these provisions are proposed to be applicable from the financial year 2020-21. Considering the same, if the taxable event as per section 9B and section 45(4) has occurred during the period 1 April 2020 till date, the same shall be taxable in the hands of the firm.

1. A.N. Naik Associates 265 ITR 346 – subsequently followed in many rulings
2. Mohanbhai & Pamabhai 165 ITR 166
3. National Company - 105 taxmann.com 255 (Madras High Court), Electroplast Engineers - 104 taxmann.com 444 (Bombay High Court) and Dynamic Enterprises 359 ITR 83 (Karn) [FB]

Tax Street March 2021