[Opinion] Impact of Secs. 9B & 45(4) on Asset Distribution in Partnership Firms

Authored by V. K. Subramani – CA

Table of Contents

1. Mansukh Dyeing & Printing Mills case

2. Contentions of the Revenue

3. Decision of the tribunal

4. Decision of the Apex Court

5. Application of Section 9B

6. Application of Section 45(4) (new)

7. Analysis of apex court decision

8. Impact of Section 9B and Section 45(4)

Provisions of income-tax law undergo change at regular intervals with multiple underlying objectives sought to be achieved. The changes per se are for the intended purpose and when it is not so, the legislature again revisits the provision to set right the lacuna, if any. Recently, the Supreme Court in CIT v. Mansukh Dyeing & Printing Mills [2022] 145 taxmann.com 151 rendered a decision in respect of a scenario which was prior to insertion of section 9B and substitution of section 45(4) by the Finance Act, 2021. This refresher takes note of the apex court decision and how the legal amendments made in the recent times would operate in the backdrop of the said apex court decision.

1. Mansukh Dyeing & Printing Mills case

The assessee being a partnership firm consisted of 4 partners was engaged in the business of dyeing, printing, processing, manufacturing and trade in clothing. All the four partners are relatives being brothers. Based on the family settlement, one of the existing partners having 25% share in the firm reduced his share to 12% and the balance 13% was distributed to 3 new partners. Subsequently, the partner who reduced his profit-sharing ratio and two other partners retired from the firm. Thus, the firm consisted of only one brother and other 3 (new) partners. After a short gap of time, the firm was again reconstituted with admission of 4 partners of which one was a company. In the reconstituted partnership deed one erstwhile partner (brother) and one of the partners who was admitted in the earlier reconstitution decided to withdraw a part of their capital.

The partnership firm revalued the assets and an amount of Rs.17.34 crores (surplus) was credited to the accounts of the partners in their profit-sharing ratio. It may be noted that the revaluation benefitted one old partner and three partners who were admitted in the first reconstitution besides 4 partners who were inducted in the second reconstitution of the firm. The two existing partners viz. the original partner (brother who continued in the firm) and one partner who was admitted in the first reconstitution withdrew amounts from the partnership firm. Thus, the issue litigated was that the partners got the benefit of significant amounts by way of credit to their capital account.

Factually, four partners who joined in the second re-constitution referred above contributed in aggregate Rs.11.50 lakhs and got benefit of revaluation aggregating to Rs.7.97 crores being credited to their account.

The assessee-firm filed its ITR for the previous year relevant to the assessment year 1993-94 in which the second re-constitution of the firm was made (i.e. 01.01.1993) by declaring income of Rs.3.19 lakhs. Subsequently, reassessment proceedings were initiated and the income was reassessed at Rs.2.55 crores. Addition of Rs.17.35 crore was made towards short-term capital gain under section 45(4) of the Act attributable to revaluation gains credited to capital account of all the partners.

2. Contentions of the Revenue

According to the tax officer, the assessee revalued land and building from Rs.21.13 lakhs to Rs.17.56 crores thereby increasing the value of assets to the extent of Rs.17.35 crores. The amounts credited to the partners’ capital account was treated as ‘transfer’ and liable for capital gains tax under section 45(4) of the Act. Since the building so revalued was a depreciable asset in the hands of the firm, the resultant capital gain was assessed as short-term capital gain under section 50 of the Act.

The CIT (Appeals) upheld the assessment and held that it is a clear case of distribution of assets of the firm to the partners who have also withdrawn their amounts subsequently. To the extent that the values were assigned to each partner, the partnership firm has relinquished its interest in the assets and therefore it is liable to tax under section 45(4). The CIT (Appeals) relied on CIT v. A.N.Naik Associates [2004] 136 Taxman 107/265 ITR 346/187 CTR 162 (Bom.). The claim of the assessee that the decision of CIT v. Texspin Engg & Mfg. Works [2003] 129 Taxman 1/[2003] 263 ITR 345/180 CTR 497 (Bom.) was not applied by drawing a distinction of its rationale to the facts of the case.

3. Decision of the tribunal

The tribunal relied on the decision in the case of CIT v. Hind Construction Ltd [1972] 4 SCC 460 and allowed the appeal stating that the revaluation of assets and crediting the capital account of the partners did not involve any ‘transfer’. It held that the decision of A.N.Naik Associates (supra) is not applicable and the decision of Texspin Engg & Mfg. Works (supra) shall be applied. The High Court too, dismissed the appeal preferred by the Revenue.

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4. Decision of the Apex Court

The apex court took note of section 45(4) (prior to its substitution by the Finance Act, 2021) and held that the object and purpose of section 45(4) when it was inserted by the Finance Act, 1987 was to plug a loophole and correspondingly section 2(47)(ii) was omitted. Earlier, transfer of capital asset was exempted from the definition of transfer which helped the taxpayers to avoid capital gains tax by revaluing the assets and transferring the same at the time of dissolution.

As regards the reliance of the assessee on Hind Construction Ltd (supra) the apex court observed that the decision relates to time period before the insertion of section 45(4) by the Finance Act, 1987 and at that point of time the word ‘otherwise’ appearing in section 45(4) was absent. Therefore, in Hind Construction Ltd’s case (supra) it had no occasion to consider the amended section 45(4) which contained the word ‘otherwise’.

It took note of the observations of the Bombay High Court in the case of A.N.Naik Associates (supra) with regard to meaning of the term ‘otherwise’ wherein it was held that the word ‘otherwise’ used in section 45(4) takes into its sweep not only the cases of dissolution but also cases of subsisting partners of a partnership transferring the assets in favour of a retiring partner.

The apex court adverting to the facts of the case held that the revalued amounts were credited to the account of the partners in their profit-sharing ratio and it can be said that it is in effect distribution of assets to the partners. It held that section 45(4) (erstwhile) will apply to the facts of the case. The apex court accordingly held that the decision of the Bombay High Court A.N.Naik Associates (supra) would apply and the decision was rendered by upholding the action of the Assessing Officer.

5. Application of Section 9B

Section 9B inserted by the Finance Act, 2021 applicable from the assessment year 2022-23 says that where a ‘specified person’ receives any capital asset or stock in trade or both in connection with the dissolution or reconstitution of a specified entity, it is liable to tax in the hands of the specified entity viz. firm, AOP or BOI.

Any profits and gains arising from transfer of a capital asset shall be chargeable to tax under the head ‘Capital gains’ and in the case of any profit arising from transfer of stock-in-trade shall be chargeable to tax as income under the head ‘Profits and gains of business or profession’. The fair market value of capital asset and stock in trade shall be deemed to be the full value of consideration for the purpose of ascertaining the income or gain, as the case may be. The key expression is ‘receives during the previous year’. Thus, if an agreement is made and the capital asset or stock in trade is not received by the partner or member, section 9B would not apply.

6. Application of Section 45(4) (new)

Where a specified person (partner or member of firm or AOP or BOI as the case may be) receives any money or capital asset or both from the specified entity then any profits and gains arising from such receipt is chargeable to tax in the hands of the firm or AOP or BOI, as the case may be. However, the income chargeable to income-tax would be the amount received in excess of the balance in capital account of the recipient partner. A formula is also prescribed for computing the amount liable to tax.

It is worth noting that the further proviso to section 45(4) says that the balance in the capital account shall be ascertained without taking into account any increase due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset.

7. Analysis of apex court decision

The apex court has taken note of the fact that the firm in Mansukh Dyeing & Printing Mills case (supra) resorted to revaluation of assets which resulted in surplus to the extent of Rs.17.34 crores credited to partners’ capital account. The amount withdrawn by the partners was roughly Rs.20 to Rs.25 lakhs. It did not take note of the fact that the partners did not benefit equal to revaluation amount and have only drawn hardly 1.5% of the revalued amount.

A partnership firm or its partners at their sweet will and pleasure can resort to revaluation of assets of the firm. There is no legal procedure or hurdle to moderate such exercise. Thus, merely because an accounting entry is made in the books of the firm for giving effect to revaluation would lead to imposition of tax is akin to taxing hypothetical gain and imposing tax on such gain, seems to be a tough decision.

The firm nor the partners have benefited by revaluation exercise because of credit to the capital account of the partners. At the most, the balance sheet of the firm after revaluation may indicate its true or nearer to its present networth. However, it cannot necessarily result in such surplus as the revaluation is only an estimate, being a matter of opinion. There is a withdrawal of Rs.25 lakhs by the partners post-revaluation which is indirectly a transfer of asset (cash) to the respective partners. Such amount to the extent exceeds original capital account of the partners could have been subjected to tax. However, taxing the entire amount credited to the capital accounts of partners’ by the firm when such gain is not actual and being notional/hypothetical, seems to be harsh.

8. Impact of Section 9B and Section 45(4)

If the same facts as are prevailing in Mansukh Dyeing’s & Printing Mills case (supra) are adopted after the insertion of section 9B and section 45(4), it would lead us to the following conclusions:

(i) Section 9B and section 45(4) would apply only when the specified person (partner or member) receives money or capital asset or stock in trade. A revaluation exercise as such would not make the firm liable to tax when no consideration or benefit is received by the partner/ member as a result of such revaluation;

(ii) Revaluation of asset and credit to partners’ capital account cannot be called as transfer as the firm continues to own the asset as before. The definition of transfer is inclusive but still when the subject matter is immovable property (land and building) the ownership would not change in the absence of a registered conveyance deed or document. Therefore, the revaluation of asset and credit to partners’ capital account in the present-day context would not trigger both section 9B and section 45(4);

(iii) Crediting the partners’ capital account upon revaluation of assets cannot be called as distribution of assets since the assets continue to remain with the firm and the firm being the collective expression representing all the partners, continues to hold the assets as before;

(iv) Revaluation of capital assets is not to be considered for the purpose of section 45(4) (new) while reckoning the capital of the partners in view of further proviso to section 45(4);

(v) The excess of money received over capital contribution by a partner(s) is liable to tax in the hands of the firm. Thus, in this case the excess of Rs.25 lakhs over the amount standing to the credit of the respective partners would only be liable to tax in the hands of the firm;

(vi) Change in constitution of the firm carried out twice will not have any impact in the hands of the firm by applying section 9B unless the partners’ exiting the firm received capital asset or stock in trade from the firm;

(vii) Introduction of sections 9B and 45(4) provide clarity as regards the moment for triggering those provisions and effectively block distribution of capital assets to partners being tax free. It is altogether a different matter that the attribution principle given in rule 8AB read with section 48(iii) contribute to complicate the applicability of those provisions.

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