By Subash Agarwal, Advocate
According to section 45(4) gains arising from deemed distribution of capital assets on the dissolution of a firm or otherwise is chargeable to capital gains tax and for the purpose of section 48, FMV of assets on the date of dissolution etc. is deemed to be the full value of the consideration received.
This provision was brought on the statue book to block a devise resorted to by the assessees to transfer capital assets through the medium of firms without paying any capital gains tax, particularly, by bringing in new partner(s) and after a while, dissolving the firm and handing over high valued assets at book value to the newly inducted partners, thereby, evading capital gains tax.
Though the term “dissolution of a firm” is vividly mentioned in the provision but at the same time, there is an omnibus term used i.e., “otherwise”. The purpose of this write-up is to examine whether the “reconstitution” of partnerships are also covered under the sweep of the general term “otherwise”.
Often, revenue’s contention is that “reconstitution” of a partnership is also a specie of transfer referred to in section 45(4) and the same is covered by the term “otherwise”. As such, FMV of the assets given to the retiring partners shall be taken as deemed sale consideration for the purpose of computation of capital gains in the firm’s hands.
The mischief of sec 45(4) is applied even where there is induction of new partners on the plea that a right on existing assets is created in favour of the incoming partners, which are appearing at the book value in the accounts but their market value is considerably higher. In this regard, Kerala High Court judgement in the case of CIT vs. Kunnamkulam Mill Board 257 ITR 544 is worth taking note of.
In this case, the Hon’ble Court held that in a case of this nature what happens is that with the admission of new partners, the right of the existing partners were reduced and that a right was created in favour of the newly inducted partners. But the ownership of the property did not change even with the change in the constitution of the firm.
Likewise, if a partner retires, he does not transfer any right in the immovable property in favour of the surviving partner because he has no specific right with respect of the properties of the firm.
More recently, in the case of Prashant S. Joshi vs. ITO 324 ITR 154 (Bom.), same view as in the case of Kunnamkulam Mill’s case was taken.
However, a contrary view has been taken by the Bombay High Court in the case of CIT vs. A.N. Naik Associates 265 ITR 346. In this case, there was handing over of assets of the partnership to the retiring partners. In that context, it was held that section 45(4) will apply, where there is transfer of assets to the retiring partners (see para 21 of the judgement). In this case, even Kunnamkulam Mills’ case (supra) was also considered at para 15 and the same was distinguished and it was observed that in Kunaamkulam’s case, assets were not allotted to the partners.
Another interesting case was before the Hon’ble Karnataka High Court in the case of CIT vs. Gurunath Talkies 328 ITR 59 (Karn.) where there were four partners. There was reconstitution of partnership. Two new partners were inducted. There was again reconstitution of the firm. The Old partners retired leaving the assets of the firm with newly inducted partners. The Court held that there was transfer of assets of the firm after considering the objects of the introduction of section 45(4).
Thus, the application of mischief of sec 45(4) on reconstitution of firms depends on facts and circumstances of a case.