If any partner does not agree to sell a firm’s property, whether the same can be considered as an encumbrance for capital gain computation?

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If any partner does not agree to sell a firm’s property, whether the same can be considered as an encumbrance for capital gain computation?

If any partner does not agree to sell a firm’s property, whether the same can be considered as an encumbrance for capital gain computation?

Issue before the Mumbai bench was:

Whether if any partner does not agree to sell a firm’s property, the same can be considered as an encumbrance, for which the compensation paid is to be considered as expense incurred wholly and exclusively for the purpose of sale of capital asset. YES is the answer.

Facts of the case

The assessee was owner of the plot located in Mumbai which was converted from capital asset to stock in trade on 18-2-2006. The said property was sold during the year under consideration giving rise to capital gains as well business profits. The impugned property was originally owned by one Mr.Percy Maurice Pereira, vendor. Assessee entered into an agreement for purchase of the impugned property with the vendor. As on the date of agreement the impugned property was subject matter of suit filed by the brother of the vendor before HC, which fact was acknowledged by both the parties in the preamble to the said agreement. The impugned property was agreed to be purchased for a sale consideration of Rs 2.5 Lakhs and an amount of Rs.10,000 thereof was paid to the vendor on the date of agreement itself. The title deeds were examined by the purchaser/assessee and apparently due to the suit pending before HC the property could not be conveyed to the purchaser/assessee. Nevertheless both parties continued to hold the impugned agreement and vide the vendor’s letter, the vendor confirmed that the time for completion of the sale was extended until such time the suit was finalized or settled in favour of the vendor. That apart the assessee paid monies to the vendor from time to time, being the sale consideration, as requested by the vendor and the total amount paid in this regard was Rs.21950 including the amount of Rs.10000 paid at the time of execution of the agreement. Further the assessee also made an attempt to help the vendor to defend the suit in favour of the vendor. Assessee filed Suit before the HC. Finally HC passed decree in favour of the assessee holding that there was a valid and subsistent agreement and the vendor was directed to do all acts so as to effectively convey the property to the assessee. Further the assessee was also directed to pay an amount of Rs. 1.6 crores in addition to the amounts already paid to the vendor and the decree was to operate as conveyance of the property on payment of the said amount. Accordingly, the payments were made to the vendor and the conveyance deed was executed on 20-2-2006. Thus, the assessee converted the said impugned property into his stock in trade in February 2006 and sold the same in the following financial year relevant to the A.Y. under consideration. On completion of the sale, the assessee computed capital gains up to February 2006 and business profits for the period thereafter. The capital gains were offered to tax for the A.Y. under consideration following the provisions of Sec. 45(2).

In computing capital gains, the assessee adopted the FMV of the impugned property on 1-4-81 as it’s cost of acquisition on the ground that the right title in the property was available to them since 1973 owing to the subsistence of the above discussed agreement. That apart the assessee also paid an amount of Rs.54 lakhs to one of it’s retiring partner Smt. Sushila Kothari, owing to the deed of retirement of partnership dated 21-12-2005. The assessee claimed that the said amount was paid to her as compensation to remove the encumbrance on the impugned property that she was creating hurdles to dispose of the property and therefore the payment of Rs. 54 lakhs should be treated as expenditure incurred in relation to the transfer of the impugned property and it would go to reduce the taxable capital gains arising on sale of the impugned property. As against the above claim of the assessee, A.O. held that the rights in the impugned property passed on to the assessee only on account of the consent terms filed before HC and the consequent decree passed by HC directing the vendor to convey the property. In this regard A.O. observed that even though there was a valid and subsisting agreement with the vendor in respect of the impugned property, the sale took place only on payment of the amount agreed upon in the consent terms to the vendor and handing over the possession of the property to the assessee by executing the conveyance deed by the vendor. The A.O. further noted that the agreement of sale was neither decisive nor conclusive as to the date of sale and the injunction order passed by HC restraining the vendor from alienating the property was no evidence to establish the rights of the assessee in the impugned property. Further AO also stated that the fact of registering the sale agreement with the Sub Registrar was also not indicative of establishing the Revenue’s rights therein by observing that the title of the property was transferred on execution/performance of the contract and not by mere registration of sale deed. In essence, AO held that the assessee owned the property only in F.Y. relevant to A.Y.2006-07 and therefore the asset was owned by him for a period of less than 36 months as on the date of it’s transfer by the assessee and therefore the capital gains arising from the impugned transaction are to be taxed as short term capital gains. As a consequence the A.O. also disallowed assessee’s claim for deduction u/s 54 EC towards investment in specified bonds. The AO also declined payment of Rs. 54 lakhs made to clear such encumbrance but for which the sale could not have taken place and accordingly disallowed the assessee’s claim to deduct the same from taxable capital gains. CIT(A) allowed assessee’s claim of long term capital gains, however, he declined payment of Rs. 54 lakhs made to remove the encumbrance.

Having heard the matter, the Tribunal held that,

++ assessee sold one property during the year and offered long term capital gain after claiming exemption u/s 54EC and claimed deduction of Rs. 54,00,000/- on account of compensation for encumbrance but the AO held that asset is short term capital asset. Hence, exemption u/s 54EC will not be allowed. The AO also disallowed the claim of compensation for encumbrance. The CIT(A) held that asset is long term capital gains and date of acquisition is 19.7.1981 instead of 9.7.1973 claimed by the assessee. Therefore, fair market value of 1.4.1981 will not be allowed, but confirmed the addition of Rs. 54,00,000/-. We find that as per agreement of sale deed executed on 7.3.1973 which has been duly registered with the Sub-registrar of Assurance, Mumbai under S-2489/82 in the name of the assessee, the assessee has acquired right in the property from the date of agreement to sale dt. 7.3.1973. We also find that on 24.1.1983 assessee obtained an order and injunction against the vendor preventing the vendor from alienating, encumbering, transferring parting with the possession of the suit property. The order of the Court clearly evidences that the court accepted assessee’s claim, right title and interest in the property conferred upon vide agreement dated 1973. In view of the above, it is clear that right of assessee in the property is existed since from 1973. Clause 2(a) of Consent Term in the Suit no. 889 of 1980 before Bombay High Court also clarifies that agreement of 1973 was valid;

++ we do not find any infirmity in the action of CIT(A) for treating capital gains as long term capital gains. However, he has allowed indexation from 19.7.1981 in place of date of acquisition of property in the year 1973. Since the property was acquired vide agreement of sale deed executed on 7.3.1973 which was duly registered with the Sub-registrar, we direct the AO to allow indexation by taking fair market value as on 1.4.1981. As per Sec. 2(29A) and 2(42A) holding period will be counted from the date from which assessee held the asset i.e. when right in capital asset was vested to assessee which is from the date of allotment or agreement for sale. It does not require that property should be conveyed. Even if the land was purchased, but not conveyed in the name of the assessee it will not affect the holding period of asset. Our view is duly supported by the decisions of the Punjab & Haryana HC in the case of Madhukaul 2014-TIOL-316-HC-P&H-ITand Vinod Kumar Jain 2010-TIOL-706-HC-P&H-IT . As the property was acquired before 1.4.1981, we direct the AO to take fair market value of property as on 1.4.1981 as per provisions of Sec. 55(2) for the purpose of indexation while computing long term capital gains. With regard to declining assessee’s claim of payment for removal of encumbrances amounting to Rs. 54 lakhs, we find that one Partner, Smt. Sushila Devi created problems for the on issue of property. Therefore, vide Deed of Retirement of Partnership dt. 21.12.2005, assessee resolved the problem by paying Rs. 54 lakhs in addition to her capital in the firm for the settlement of her claims in the capital as per clause no. 2 on page no. 3 of Deed of Retirement of Partnership dt. 21.12.2005, profits and assets of partnership firm which comprised the property at Bandra as only property;

++ as per Sec. 48 if the expenditure is incurred wholly and exclusively in connection with transfer of capital asset, in that situation expenditure is allowable. The above condition is satisfied in present case because one can sell the property only when the property is free from encumbrance. In the instant case, in a firm, if any partner disagrees to sell the property, the firm cannot sell the property which it is intending to sell. In other words, if any partner does not agree to sell for any reasons, then, there is an encumbrance for selling the property. To sort out such a problem and to make property, which is intended to be sold, without any encumbrance, it is necessary to settle the difference between the partners by either convincing the partner for selling the property or to retire the said partner by paying his dues and claim. Thus, the assessee firm in order to clear the encumbrance on property has paid Smt. Sushila Devi Rs. 54 lakhs in addition to credit balance in her capital. Only after that assessee been able to file the consent term before the Hon’ble High Court on same day i.e. 21.12.2005. otherwise neither consent term will be filed nor assessee before court gets the property conveyance. Hence, it is paid wholly and exclusively for the purpose of sale of capital asset. In view of the above, there is no justification in the order of lower authorities for enhancing capital gains by not allowing deduction of Rs.54 lakhs paid to partner to remove encumbrance. In the result, appeal of revenue is dismissed, whereas appeal of assessee and cross-objection is allowed in part

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