Dissolution or Reconstitution of Partnership Firm to attract Income Tax

 

Income Tax Act – 1961 is refined every year so as to filter the tools of tax evasions & avoidance. One such prevailing loophole was with regard to retirement of a partner from the firm after revaluation of the Assets or by recording self generated goodwill or other assets in the firm. Finance Act-2021 has filtered this tax avoidance tool used by firm, Association of person (AOP) or Body of individuals (BOI) by inserting section 9B, substituting section 45(4) and inserting section 48(iii). Let us know more about it.

Provision prior to amendment & the Loophole:

Any profit or gains arising on distribution of capital assets to a Partner on dissolution or otherwise was liable for Capital Gains tax in hands of the firm/AOP/BOI. As per the word used in section, the tax implication used to arise in case of dissolution or otherwise. The expression “Otherwise” used in section 45(4) was the cause of litigation as to whether it included “Retirement” of a partner or not. It was always contended by the partner that section 45(4) is applicable only in a case of “Dissolution” of firm & not on retirement. There were 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 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 was no express provision 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) was not specifically covering the situation of “Reconstitution” & was often used as a tool of tax planning, tax avoidance or tax evasion. This loophole is now plugged by adding two new sections [section 9B & 45(4)].

New Amendment by Finance Act – 2021:

Before understanding the amendment, it is important to understand that when a partner retires from the firm and obtains money or property from the firm, there are two transactions.

1. First one,  qua the partner and
2. Second one, transfer of money or property by the firm.

The former transaction is dealt with in section 45(4) and the later in section 9B. New Section 45(4) now provides for taxation if the partner receives the “capital assets” or “money“ at the time of reconstitutions whereas Section 9B covers situation where the partner receives capital assets or stock in trade at the time of reconstitutions or dissolution.

Provision of Section 9B:

1. Newly introduced section 9B provides for taxation in the hands of the firm if any partner receives capital assets or stock in trade or both at the time of reconstitution or dissolution.
2. Section 9B provides that receipt by the partner shall be deemed to be “transfer” and the profits on such deemed transfer shall be treated as income of the firm to be chargeable as “Business Income” if stock in trade is transferred or chargeable as “Capital Gains” if the capital assets is transferred.
3. Fair Market Value (FMV) of the capital asset or stock in trade on the date of receipt by the partner person shall be relevant for computing the amount of profit in such cases.
4. The section applies only if the partner receives any capital asset or stock in trade. The provision does not apply to receipt of money by the specified person. It is covered by section 45(4).
5. Income Tax rate of such capital gain will depend on the nature & holding period of capital asset.
6. A conversion of a partnership firm under Chapter XXI of the Companies Act, 2013 may not result in reconstitution of the specified entity. Similarly, conversion of a firm into LLP may also not be regarded as reconstitution of the specified entity.
7. Mere reconstitution does not trigger applicability of section 9B, unless it is accompanied by receipt of capital asset or stock in trade by a specified person.

Provision of New Section 45(4):

Section 45(4) is applicable if the capital assets or money or both is given by the firm to the partner on reconstitution of the firm. Any profits arising from such transfer shall be chargeable to income-tax as income of the firm under the head “Capital gains” in the year in which such money or capital asset were received by the partner. The method of calculation of profit u/s 45(4) is required to be determined in accordance with the following formula:

A = B+C-D

Where,

A = income of the firm chargeable as “Capital gains” Income;

[However, if the value of ‘A’ turns out to be negative, it shall be taken as zero].

B = Value of any money received by the partner;

C = FMV of the capital asset received by the partner and

D = Amount of balance in the capital account of the partner in the books of accounts of the firm at the time of its reconstitution. [To be considered without taking into account the amount of revaluation/self-generated goodwill/ self-generated asset].

It may be noted that section 45(4) shall operate in addition to the provisions of section 9B and when a capital asset is received by a partner then the provisions of both the sections may operate independently. The provision applies when a partner “receives” money or capital assets. Hence, mere reconstitution will not trigger tax under section 45(4) unless it is accompanied by “receipt” of any money or capital asset by the partner.

Double Taxation:

To avoid the rigour of double taxation U/s 9B as well U/s 45(4), consequential amendment is also done in section 48 wherein it is provided that the amount of cost of acquisition of capital assets will include the amount of capital gain chargeable to tax u/s 45(4). The CBDT has been authorised to prescribe the manner of computation in such case. It is expected that the CBDT will shortly issue the suitable guidelines for avoiding the rigour of double taxation.

 

Taxpayers must carefully note that above provisions are made effective from FY 2020-21 & so any reconstitution of firm/AOP/BOI on or after 1st April, 2020 will be subject to taxation accordingly.

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