ORDER Sushma Chowla, Judicial Member
1. Both the appeals filed by the revenue in the case of two partners of same partnership firm are against separate orders of CIT (A) relating to the same Assessment Year 1994-95 against the order under Section 143(3) read with Section 147 of the I.T. Act, 1961. The assessees in both the appeals have independently filed cross-objections against the reopening of the assessment under the provisions of Section 147 of the IT. Act. Both the appeals by the revenue and the cross-objections raised by the assessee though relating to separate assessees are on same issue, were heard together and are being disposed off by this consolidated order for the sake of convenience.
2 Shri R.N. Parbat/Dilip Sharma, Departmental Representatives appeared for the revenue and Shri Vijay Patil/Vishwas Mahindale, learned Counsel appeared for the assessee and put forward their rival submissions.
3. In both the appeals, the issue raised by the Revenue is under:
On the facts and in the circumstances of the case and in law the Ld. CIT(A) erred in deleting the addition of Rs. 10,65.863- (in the case of Shri Deviprasad L. Dave) Rs. 10,43,658/- (in the case of Smt. Paru D. Dave) being the amount of short term capital gains assessed in the hands of the assessee on account of assessee’s assignment and relinquishment of rights in the firm’s assets on the reconstitution of the firm.
4. The brief facts of the case are that both the assessees were partners in the firm M/s. Rakhal Corporation having equal shares in the profits of the business. The said firm owned a factory premises, book value of which was shown at Rs. 79,452/- upto 31.03.1993. No depreciation was claimed on the said factory premises by the firm. On 15.04.1993, the said factory premises were revalued at Rs. 23.00 Lakhs on the basis of a Valuation Report of a Registered Valuer. The difference in value was credited equally to the capital accounts of both the partners i.e., Rs. l1,10,274/- each. On 29.04.1993, the partnership firm was reconstituted and five new partners of Shah Group were admitted. Because of the reconstitution of the partnership firm, the total profit sharing ratio of the old partners were reduced to 5% i.e., 3% of Shri D.L. Dave (HUF) and 2% of Smt. Paru Dave. As per the terms of the partnership, the capital of the firm was fixed at Rs. 1.00 Lakh, which was required to be contributed by the partners in their profit sharing ratio. Subsequently, the old partners withdrew a total sum of Rs. 18,53,700/- from their respective capital accounts. In the case of both the assessees, the Return of Income was accepted by way of intimation under Section 143(1)(a) of the I.T. Act. During the course of assessment in the case of the firm M/s. Rakhal Corporation, the difference in revaluation of factory premises of Rs. 22,20,548/- was treated as short-term capital gains. On appeal the CIT(A) deleted the addition the hands of the firm by observing that “there is no doubt a case for bringing this amount to tax in the hands of the partners since they have divested themselves of valuable rights and an asset handed over the same to the new partners. But looking to the firm itself, it cannot be said that the firm has earned any income out of this transaction”. Based on the above said observation of CIT(A) the assessment in the case of both the partners was reopened under Section 147 of the I.T. Act. The Assessing Officer observing that by admitting new partners in the partnership firm and retaining only 5% share, the original partners have extinguished their rights in the partnership property and assets, being factory premises, for a consideration of Rs. 23.00 Lakhs being the revaluation amount. Accordingly a sum of Rs. 10,65,863/- was computed as short term capital gain on sale of factory premises being the proportionate gain on surrender of its right in the partnership assets. It was observed by the Assessing Officer that in view of the consideration received the assessee had assigned and relinquished his/her rights in the partnership firm’s assets.
5. Before the CIT(A), it was contended that during the subsistence of the partnership, a partner does not have any right over the property and the property is that of the firm. It was also contended by the assessee that there was no transfer of any right in the property as the revaluation, reconstitution and withdrawal of capital do not constitute any transfer and therefore, there was no liability to any capital gains. The CIT(A) during the course of appeallate proceedings observed that the firm had revalued the factory shed and had credited the difference in the partners capital account prior to the process of introducing new partners. Even after the introduction of new partners and reduction in the share of old partners, the asset concerned remained in the hands of the firm and the assessees could not have claimed any right or interest over the said property. The CIT(A) further observed that revaluation by itself does not generate any income. Reliance was placed on the decision of Hon’ble Supreme Court reported in 83 ITR 212 for the proposition that revaluation being a mere book entry, does not generate any income, Further it was also observed by the CIT(A) that it has been held in a number of cases that a partner has no interest in any assets of the partnership during taxed the capital gains on revalued value of factory premises. It was further clarified by the learned AR that the provisions of Section 45(4) of the Act are also not applicable as it talks of distribution of assets on dissolution of partnership firm and not on reduction of share of partners. For the proposition that the reduction in share ratio amounts to transfer or not, reliance was placed by the learned AR on the decision of Hon’ble Kerala High Court in CIT v. Kunnamkulam Mill Board 257 ITR 544. The learned AR for the assessee further clarified that the ratio laid down by the Hon’ble Supreme Court in CGT v. Chhotalal Mohanlal 166 ITR 124 was under the Gift Tax Act and the connotation of transfer under Gift Tax Act and under Income Tax Act are different. The learned AR relied on the decision of Hon’ble Supreme Court reported in Jagatram Ahuja v. CGT 246 ITR 609 for the proposition that on reduction of share in partnership firm no Gift Tax is attracted. Reliance was placed on various decisions for the proposition that whether on reconstitution or retirement of a partner there is relinquishment of any right in the property of the firm.
6. We have heard the rival submissions and perused the records. Both the assessees before us were partners in the partnership firm M/s. Rakhal Corporation with 50% share of each. The partnership firm owned a factory building which was shown at cost in the balance sheet from year to year and no depreciation was being claimed on the said factory building. On 01.04.1993 i.e., the start of Accounting Year, the WDV of the said factory building was reflected at Rs. 79,452/-. During the year under consideration, the said factory building was revalued at Rs. 23.00 Lakhs and the difference on account of revaluation of asset amounting to Rs. 22,20,548/- was credited to the respective partners account on the date of revaluation i.e., 15.04.1993. On 29.04.1993 the firm was reconstituted by the admission of five new partners who inducted a sum of Rs. 34.00 Lakhs by way of capital contribution and loan and advances in the partnership firm. The shares of the old partners from 100% was reduced to 5%. Subsequently, both the partners had withdrawn a sum of Rs. 9,65,100/- by Shri Deviprasad L. Dave (HUF) and Rs. 9,35,000/- by Smt. Paru Dave. The said consideration received by the individual partners was treated as assignment and relinquishment of their respective shares in the partnership on assets in favour of the new partners admitted to the reconstituted firm and the transaction amounts to transfer within the meaning of Section 2(47) of the I.T. Act. The gain arising from the transaction was held to be liable to be tax as capital gains under Section 45 of the I.T. Act.
7. The issue for our adjudication is whether short term capital gain arises on surrender of rights in the revalued partnership assets. Partnership firm constituted of its partners is governed by the provisions of Partnership Act. The partnership firm is not a legal entity and property of the partnership vests in its partners in as much as all the partners have an interest in the partnership property The provisions of the Partnership Act clearly provide that a property which is brought in by the partners on the formation of partnership or acquired in the course of business of partnership, becomes the property of the firm. The partners of a partnership firm are entitled to a share in the profits of the business to the extent of their share ratio During the subsistence of partnership no partner has any assigned right or share in the partnership property. During the continuance of the partnership the partners have only a right in the profits of the partnership and no partner can deal with any portion of the partnership property as his own during the continuance of the partnership firm.
8. Their Lordships of Hon’ble Supreme Court in S.V. Chandra Pandian and Ors. v. S.V. Sivalinga Nadar and Ors. 212 ITR 592 had held that as under:
…The above provisions make it clear that regardless of the character of the property brought in by the partners on the constitution of the partnership, such property shall become the properly of the firm and an individual partner shall only be entitled to his share of profits, if any, accruing to the partnership from the realization of this property and upon dissolution of the partnership to a share in the money representing the value of the property. It is well-settled that the firm is not a legal entity, it has no legal existence, it is merely a compendious name and hence the partnership property would vest in all the partners of the firm. Accordingly, each and every partner of the firm would have an interest in the property or asset of the firm but during its subsistence no partner can deal with any portion of the property as belonging to him, nor can he assign his interest in any specific item thereof to anyone.
On a true reading of the award as a whole, there was no doubt that it essentially dealt with the distribution of the surplus properties bringing to the dissolved firms. The award, therefore, did not require consideration under Section 17(1) of the Registration Act’.
9. Their Lordships of Hon’ble Supreme Court in Addanki Narayanappa v. Bhaskar Krishnappa had held as under:
…During the subsistence of the partnership, however, no partner can deal with any portion of the property as his own. Nor can he assign his interest, in a specific item of the partnership property to anyone. His right is to obtain such profits, if any, as fall to his share from time to time and upon the dissolution of the firm to a share in the assets of the firm which remain after satisfying the liabilities….
10. As the partners have no right in the assets of the partnership firm, there was no transfer of any right in the said property on reconstitution / retirement of a partner. Their Lordships of Hon’ble Supreme Court in Addl. CIT v. Mohanbhai Pamabhai 165 ITR 166 had held that when a partner retired from the firm and received a share of amount calculated on the value of net partnership assets including goodwill of the firm, there was no transfer of interest of the partner in the goodwill and no part of the amount received by him would be assessable as capital gains under Section 45 of the I.T. Act. Similar view was taken by the Hon’ble Supreme Court in CIT v. R. Lingamallu Raghukumar 247 ITR 801. In case any asset/property is allocated to a partner in proportion to his share in the profits of the firm, there is no partition or transfer taking place nor there is any relinquishment of interest of other partners in the allocated property, in the sense of transfer or extinguishment of interest as envisaged under Section 17 of the Registration Act. Thus, when dissolution of partnership firm takes place and residue is distributed amongst the partners after settlement of amounts, there is no transfer or relinquishment of interest as envisaged under Section 17 of the Registration Act. This view was held by the Hon’ble Supreme Court in S.V. Chandra Pandian and Ors. v. S.V. Shivalinga Nadar and Ors. (supra). The Income Tax Act has brought in by way of an amendment to Section 45 of the I.T. Act that on dissolution of partnership firm provisions of Section 45(4) of the Act shall be applicable which treats the dissolution of a partnership as deemed transfer of assets from the partnership firm to its partners.
11. In a partnership amongst partners, each and every partner of the firm has an interest in each and every property of the partnership firm. Till the accounts are settled and the residue/surplus is not distributed amongst the partners, no partner can claim any share in such assets of the partnership firm. Each partner is entitled to its share of profits in the partnership firm but the entitlement of right in the assets/property of the partnership firm arises only on dissolution.
12. The other issue to be considered is whether there is a relinquishment of a right in the property of the firm on reconstitution of partnership firm. The partner of a partnership firm has only an interest in the property during the subsistence of the partnership firm. There is no relinquishment of any right in the partnership property on reconstitution/retirement of a partner.
13. Their Lordship of Kerala High Court in CIT v. Kunnamkulam Mill Board (supra) had held that ownership of property does not change on change in the constitution of firm. As long as there is no distribution for the simple reason the firms total reconstitution, there is no transfer of capital assets.
In the facts of the case before Kerala High Court, there was reconstitution of assets of the firm wherein the assets were revalued on mutual agreement of the partners. The difference in the revalued amounts was credited to the respective capital accounts of the partners. There was reconstitution of partnership firm with introduction of two partners for a short time and thereafter the original five partners retired and the business was carried on in partnership by the surviving two partners It was held that in such cases of reconstitution, the ownership of the property does not change with the change in the constitution of the firm and accordingly there is no transfer of capital asset. It was further held that.
if a partner retires, he does not transfer any right in the immovable property in favour of the surviving partner because he had no right with respect to the properties of the firm.
The learned DR had relied on the decision of Hon’ble Supreme Court in Shree Narayana Chandrika Trust v. CGT (supra), wherein the chargeability to gift tax on reconstitution of firm was considered. This is not a issue before us and the principle laid down by Hon’ble Supreme Court is not applicable to the issue before us. Similar was the view taken by the Hon’ble Supreme Court in CGT v. Chhotalal Mohanlal (supra).
14. In the facts before us the partnership asset was revalued by the partners at the start of the year and the difference on account of revaluation of asset was credited to the partners account. The revaluation of partnership assets was anterior to the introduction of new partners. Revaluation of assets by partnership firm does not attract Capital Gains. The revaluation of assets of partnership and the credit of revalued amount to the Capital account of partners in their respective share ratio does not entail any transfer as defined under Section 2(47) of the IT, Act. The introduction of new partners to a partnership firm owning immovable assets and consequent reduction in the share ratio of present partners does not entail any relinquishment of their rights in the partnership property. On introduction of new partners, there is realignment of share ratio interse between the partners only to the extent of sharing the profits or losses, if any of the partnership business. When any new partner is introduced into an existing partnership firm, the profit sharing ratios undergo a change, which does not amount to transfer as defined under Section 2(47) of the Act, as there is no change in the ownership of assets by the partnership firm. As during the subsistence of the partnership firm, the partners have no defined share in the assets of the partnership and thus on realignment of profit sharing ratio, on introduction of new partners, there is no relinquishment of any nonexistent share in the partnership assets as the asset remained with the firm. Such an arrangement is not covered by the provisions of Section 45(4) of the Act, which covers the case of dissolution of partnership firm. Accordingly, no capital gains arises on such relinquishment of share ratio in the partnership firm. We confirm the order of CIT(A) and dismiss the grounds of appeal raised by the Revenue.
15. The cross-objections filed by the assessees are against the reopening of assessment under Section 147 of the I.T. Act. The Learned AR for the assessee had stated that the grounds in cross-objections are not pressed and hence the same are dismissed as not pressed.
16. In the result, the appeals being ITA No. 2583/Mum/1999 and ITA No. 5008/Mum/2002 filed by the revenue are dismissed and the cross-objections filed by the assessees being CO No. 245/Mum/2003 and CO No. 72/Mum/2004 are also dismissed.
Order pronounced on the 22nd day of December, 2006.