Reconstitution of partnership Firm now liable for Income Tax

Tax planning by way of revaluation of assets or by recording self generated goodwill or other assets in the firm was one of the biggest tools of tax planning or tax avoidance. Finance Bill – 2021 has now placed a ban on this tool by making an amendment w.e.f. 01/04/2020.

At present, any profit or gains arising on distribution of capital assets to a Partner of a firm on dissolution or otherwise attracts Capital Gains tax in hands of the firm [Present Section 45(4)]. This provision is also applicable to Association of Persons (AOP) or Body of Individuals (BOI) as well. As per the word used in section, the tax implication arises in case of dissolution or otherwise. The expression “Otherwise” used in section 45(4) is the cause of litigation as to whether it includes “Retirement” of a partner or not. It is always contended by the partner that section 45(4) is applicable only in a case of “Dissolution” of firm & not on retirement. There are divergent views of the court as to whether the term ‘’or otherwise” covers the retirement of a partner from a firm. Some courts have ruled that there is no taxability in the hands of firms if the retiring partners get extra amount at the time of retirement if the firm continues even after retirement. Few courts have ruled that the retiring partner will be liable to pay capital gains tax on receipt of money exceeding capital account balance. Further, there is no express provision at present as to whether revaluation of asset or self generated goodwill or any other self generated asset is to be taken into account for calculating capital account balance of Partner.

 In short, present section 45(4) is not specifically covering the situation of “Reconstitution”. As a result of all above, it was used as a tool of tax planning, tax avoidance or tax evasion. This loophole is now proposed to be plugged by proposing altogether two new sections 45(4) & 45(4A) in the Income Tax Act-1961. Both these sections are proposed to be effective from FY 2020-21 & so any reconstitution of firm/AOP/BOI on or after 1st April, 2020 will be subject to taxation accordingly.

New Amendment Proposed by Finance Bill – 2021:

New Section 45(4) is proposed to replaced old section 45(4) so as to provide for taxation if the partner receives the “capital assets” at the time of reconstitutions whereas Section 45(4A) is proposed to be introduced so as to cover situation where the partner receives money or other assets (other than capital assets) at the time of reconstitutions.

New Section 45(4):

1. The proposed amendment provides that capital gains tax would be chargeable to tax in hands of firm on receipt of capital asset by a Partner on dissolution or reconstitution.
2. The fair market value of such capital assets as is given to the partner shall be taken as the sale consideration (full value consideration) for computing capital gain in the hands of the firm.

New Section 45(4A):

1. It provides for taxation in the hands of the firm if the partner receives money or other assets on dissolution or reconstitution.
2. The proposed amendment provides that capital gains tax would be chargeable to tax in hands of a firm on receipt of money or other assets by a Partner which is in excess of his capital account balance at the time of dissolution or reconstitution.
3. For the purposes of 45(4A), value of money or Fair Market Value (FMV) of the assets shall be taken as sale consideration (Full Value Consideration) for computing capital gain in the hands of the firm.
4. As far as the cost of acquisition of assets is concerned, it is provided that capital account balance of the partner shall be deemed as the Cost of Acquisition for computing capital gain. The capital account balance of the Partner shall be calculated without taking into account any increase due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset.
5. Consequential amendment is also proposed in section 48 of the Act to provide that the amount already offered for taxation u/s 45(4A) will be eligible for deduction whenever such assets are sold subsequently. This is to be done in the manner to be prescribed later by the CBDT. This is to mitigate the double taxation which may arise later.

There are still some lacuna & loopholes in the new proposed sections. It may be filtered during the course of discussion & passage of Bill in the Parliament. This new section is sure to plug the loopholes in the existing system of taxation for partnership firms.

For ease of reference and understanding the new section 45(4) as well as section 45(4A) and section 48 alongwith explanatory memorandum thereto is reproduced hereunder:

Amendment of section 45:

New Proposed Section 45(4) reads as under:

(4) Notwithstanding anything contained in sub-section (1), where a specified person receives during the previous year any capital asset at the time of dissolution or reconstitution of the specified  entity,  which  represents  the  balance  in  his  capital account in the books of accounts of such specified entity at the time of its dissolution or reconstitution, then any profits or gains arising from receipt of such capital asset by the specified person shall be chargeable to income-tax as income of such specified entity under the head “Capital gains” and shall be deemed to be the income of such specified entity  of the previous year in which such  capital  asset  was  received  by  the  specified  person  and notwithstanding anything to the contrary contained in this Act, for the purposes of section 48,––

(a) fair market value of the capital asset on the date of such  receipt  shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of such capital asset; and

(b) the cost of acquisition of the capital asset shall be determined in accordance with the provisions of this Chapter:

Provided that the balance in the capital account of the specified person in the books of account of the specified entity is to be calculated without taking into account increase in the capital account of the specified person due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset.

New Proposed Section 45(4A) reads as under:

Notwithstanding anything contained in sub-section (1), where a specified person receives during the previous year any money or other asset at the time of dissolution or reconstitution of the specified entity, which is in excess of the balance in his capital account in the books of accounts of such specified entity at the time of its dissolution or reconstitution, then any profits or gains arising from receipt of such money or other asset by the specified person shall be chargeable to income- -tax as income of such specified entity under the head “Capital gains” and shall be deemed to be the income of such specified entity of the previous year in which such money or other asset was received by the specified person and notwithstanding anything to the contrary contained in this Act, for the purposes of section 48,––

(a) value of any money or the fair market value of other asset on the date of such receipt shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of such capital asset;  and

(b) the balance in the capital account of the specified person in the books of accounts of the specified entity at the time of its dissolution or reconstitution shall be deemed to be the cost of acquisition:

Provided that the balance in the capital account of the specified person in the books of account of the specified entity is to be calculated without taking into account increase in the capital account of the specified person due to revaluation of any asset or due to self-generated or any other self-generated asset.

Explanation: For the purpose of this sub-section, the expressions “specified entity”, “self-generated goodwill”, “self-generated asset” and “specified person” shall have the meaning respectively assigned to them in sub-section (4).

Explanatory Memorandum to section 45(4):

Clause 14 of the Bill seeks to amend section 45 of the Income-tax Act relating to Capital gains.

The aforesaid section inter alia, provides that any profits or gains arising from the transfer of a capital asset shall be chargeable to income-tax under the head “Capital gains” and shall be deemed to be the income of the previous year in which such transfer took place. Further, sub-section (4) of the said section, provides that the profits or gains arising from the transfer of a capital asset by way of distribution of capital assets on the dissolution of a firm or other association of persons or body of individuals (not being a company or a co- operative society) or otherwise, shall be chargeable to tax as the income of the firm, association or body, of the previous year in which the said transfer takes place.

It is proposed to insert sub-clause (1B) so as to provide that notwithstanding anything contained in sub-section (1), where any person receives at any time during any previous year any amount under a unit linked insurance policy, to which exemption under clause (10D) of section 10 does not apply on account of the applicability of the fourth and fifth proviso thereof, including the amount allocated by way of bonus on such policy, then, any profits or gains arising from receipt of such amount by such person shall be chargeable to income-tax under the head “Capital gains” and shall be deemed to be the income of such person of the previous year in which such amount was received and the income taxable shall be calculated in such manner as may be provided by rules.

It is further proposed to substitute sub-section (4) in the said section so as to provide that where a specified person receives during the previous year any capital asset at the time of its dissolution or reconstitution of the specified entity, which represents the balance in his capital account in the books of accounts of such specified entity at the time of dissolution or reconstitution, then any profits or gains arising from receipt of such capital asset by the specified person shall be chargeable to income-tax as income of such specified entity under the head “Capital gains” and shall be deemed to be the income of such specified entity of the previous year in which such capital asset was received by the specified person.

It is also proposed to amend the section to provide that fair market value of the capital asset on the date of such receipt shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of such capital asset.

It is also proposed to amend the section to provide that the cost of acquisition of the capital asset shall be determined in accordance with the provisions of this Chapter.

It is also proposed to amend the section to provide that the balance in the capital account of the specified person in the books of account of the specified entity is to be calculated without taking into account increase in the capital account of the specified person due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset.

It is also proposed to amend the section to define the expressions “self-generated goodwill” and “self-generated assets”, “specified entity” and “specified person”.

It is also proposed to insert sub-section (4A) in the said section so as to provide that where a specified person receives during the previous year any money or other asset at the time of dissolution or reconstitution of the specified entity, which is in excess of the balance in his capital account in the books of accounts of such specified entity at the time of its dissolution or reconstitution, then any profits or gains arising from receipt of such money or other asset by the specified person shall be chargeable to income-tax as income of such specified entity under the head “Capital gains” and shall be deemed to be the income of such specified entity of the previous year in which such money or other asset was received by the specified person.

It is also proposed to amend the section to provide that value of any money or the fair market value of other asset on the date of such receipt shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of such capital asset.

It is also proposed to amend the section to provide that the balance in the capital account of the specified person in the books of accounts of the specified entity at the time of its dissolution or reconstitution shall be deemed to be the cost of acquisition and the balance in the capital account of the specified person in the books of account of the specified entity is to be calculated without taking into account increase in the capital account of the specified person due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset.

It is also proposed to amend the section to provide that for the purpose of this sub-section, the expressions “specified entity”, “self-generated goodwill”, “self-generated asset” and “specified person” shall have the meaning assigned to them in sub-section (4) of the Act.

These amendments will take effect from 1st April, 2021 and will, accordingly, apply in relation to the assessment year 2021-2022 and subsequent assessment years.

Amendment of section 48:

16. In section 48 of the Income-tax Act,  after clause (ii) the following clause shall be inserted, namely:

“(iii) in case of specified entity referred to in sub-section (4A) of section 45, the amount included in the total income of such specified entity under sub-section (4A) of  section 45 which is attributable to the capital asset being transferred, calculated in the prescribed manner:”.

Explanatory Memorandum to section 48:

Clause 16 of the Bill seeks to amend section 48 of the Income-tax Act relating to mode of computation for income chargeable under the head capital gains.

The section inter alia, provides for computation of capital gains arising out of transfer of a capital asset by deducting from the full value consideration received or accruing as a result of such transfer, the amounts of expenditure incurred wholly and exclusively for such transfer and cost of acquisition as well as cost of any improvement thereto.

It is proposed to insert clause (iii) in the said section so as to provide in case of specified entity referred to in sub-section (4A) of section 45, the amount included in the total income of such specified entity under sub-section (4A) of section 45 which is attributable to the capital asset being transferred, calculated in the prescribed manner, shall be reduced from full value of consideration received or accruing as a result of transfer of the capital asset.

This amendment shall come into effect from the 1st day of April, 2021 and shall accordingly apply to assessment year 2021-2022 and subsequent assessment years.