Taxation of Capital Gains

Transactions Between a Firm and its Partners or between an AOP/BOI and its Members

Section 45(4) of the Income Tax Act, 1961

Topics covered in this article are as follows:

1. Money or Capital Asset or Both received by Partner/Member on Reconstitution of Firm/LLP/AOP/BOl [Section 45(4)]

   1.1 Condition (i): A specified person receives any capital asset or money or both

   1.2 Meaning of receipt of money or capital asset or both

      1.2.1 Receipt of capital asset being shares and securities

      1.2.2 Receipt of capital asset being movable property like jewellery/ artistic work/bullion

      1.2.3 Receipt of capital asset being immovable property

   1.3 How to apply section 45(4) if say stock-in-trade is also received by partner/member in addition to money or capital asset or both

   1.4 Condition (ii): Money or capital asset or both is received from specified entity

   1.5 Conditions (iii) and (iv): Receipt must be during the previous year in connection with the reconstitution of firm/LLP/AOP/BOI

   1.6 In connection with the reconstitution

   1.7 Condition (v): Increase in the capital account of partner due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset

   1.8  Capital gains resulting under sub-section (4) if only money is paid to partner/member – Whether LTCG or STCG?

2. Income on receipt of capital asset or stock-in-trade by specified person from specified entity [Section 9B]

   2.1 Dissolution of firm

   2.2 Conversion of firm/LLP into company under Chapter XXI provisions of Companies Act, 2013 (earlier Part IX of Companies Act, 1956) is not “dissolution of firm/LLP”

   2.3 Computation of capital gains under section 9B on dissolution/reconstitution of the specified entity

3. In case of reconstitution of Firm/LLP/AOP/BOl, which provision will apply when and how?

1. Money or Capital Asset or Both received by Partner/Member on Reconstitution of Firm/LLP/AOP/BOl [Section 45(4)]

New sub-section (4) of section 45 shall apply if the following conditions are satisfied:

• Condition (i): A specified person [Para 6B.4-1 a of Taxmann’s Taxation of Capital Gains [10^th Edition | 2021]] receives any capital asset [see section 2(14) of the Act] or money or both. [see Para 6B.5-1 of supra]
• Condition (ii): He receives it from specified entity [see Para 6B.4-lb of supra]
• Condition (iii): Such receipt [Para 6B.5-2 of supra] takes place during the previous year in question which must be 2020-21 or any subsequent previous year [see Para 6B.5-3 of supra]
• Condition (iv): Such receipt [Para 6B.5-3 of supra] takes place during the previous year in connection with the reconstitution of the specified entity [see Para 6B.5-4 of supra]
• Condition (v): There has been an 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 [Para 6B.5-5 of supra]. If not, then computation provisions of section 45(4) will result in zero capital gains at least where settlement is only by money alone.

If all the above conditions are satisfied, then:

• Any profits or gains arising from receipt of such money or capital asset or both by the specified person (partner/member) shall be chargeable to income-tax as income of such specified entity (firm/ AOP/BOI) under the head “Capital gains”;
• Such capital gains 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
• Such capital gains shall be computed by the formula A=B+C-D
  • A=Income taxable as capital gains of the specified entity (If A is negative, firm cannot avail set-off of capital asset. If A in negative, it shall be deemed to be zero)
  • B=Money received by specified person (e.g., partner) from specified entity (firm/LLP)
  • C= Fair Market Value of received capital asset received by specified person on the date of such receipt
  • D= the amount of balance in the capital account of the specified person in the books of account of the specified entity. 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.
  • ‘D’ in the above formula is nothing but Adjusted Capital Account Balance or ACAB
• It would appear that the resulting capital gains from money or capital asset or both received by retiring partner from firm shall be classified as short-term or long-term depending on the whether partner has been with firm for 36 months or more
• Explanation 2 below new substituted sub-section (4) of section 45 clarifies that when a capital asset is received by a specified person from a specified entity in connection with reconstitution of such specified entity, the provisions of this sub-section shall operate in addition to the provisions of section 9B and the taxation under the said provisions thereof shall be worked out independently. In other words, separate independent of computation of capital gains will take place under section 9B taking the FMV as full value of consideration and deducting from it expenses incurred for transfer, cost of acquisition/improvement (or indexed cost as the case may be) and capital gains computed under section 45(4) attributable to capital asset as computed under Rules notified under section 48(m).

1.1 Condition (i): A specified person receives any capital asset or money or both

Note the following:

• There must be receipt of any capital asset or money or both by a specified person.
• That said, section 45(4) does not say that, in order for its provisions to apply, the receipt by specified person from specified entity should be only of money or capital asset or both. Section 45(4) will equally apply to a situation where money, capital asset and stock-in-trade is given, or money and stock-in-trade is given to retiring partner/member. Only that, in these situations, section 45(4) will be applied by excluding the stock-in-trade component of the package given to partner. In such situation, the ACAB will be compared with the money and/or capital assets components of the package of settlement given to retiring particular stock-in- trade component is relevant only for section 9B and not for section 45(4). Receipt must be in connection with the reconstitution of Erm/AOP/BOI.6B.5-2 Meaning of receipt of money or capital asset or both

1.2 Meaning of receipt of money or capital asset or both

Words and Phrases Legally Defined (Third Edition) defines ‘Receive’ as under:

… Prima facie, as a matter of ordinary English language, I think “received” means actually get into their hands.’ (Per Harvey J in Pilcher v. Logan (1914) 15 SR (NSW) 24 at 27)

The Compact Oxford Dictionary gyves the following definitions of ‘receive’.

Receive

verb 1. be given, presented with, or paid. 2. accept or take delivery of.

1.2.1 Receipt of capital asset being shares and securities – it appears that the date of receipt of credit of listed shares and securities in demat account is the date of receipt for listed shares and securities. Unlisted shares are not in demat form. So, transfer of these shares is effected by executing the share transfer deed and delivering the share certificate along with the transfer deed to the transferee. The transferee signs the transfer deed and lodges it with the investee company along with the share certificate. After verifying the documents and following the prescribed legal procedure, the investee company registers the transfer in favour of the transferee. A question arises – at what point of time can shares be said to be received by the transferee? – whether at the time of delivery of transfer deed and share certificate to transferee? Or when the investee company registers the transfer in favour of the transferee? It seems that as per the plain and ordinary meaning of the word ‘receive’ the shares can be said to be received when the transferee receives the duly executed transfer deed and the relevant share certificate. In Howrah Trading Co. Ltd. CIT\ 1959] 29 Comp. Cas. 282 (SC), it was held that when the transaction is completed by entry of the transferee’s name in the register of members, transfer relates back to the date the transfer was first made. This decision also seems to support the above view.

1.2.2 Receipt of capital asset being movable property like jewellery/ artistic work/bullion – In case of jewellery [as defined in Explanation to sub-clause (ii) of section 2(14)], archaeological collections, drawings, paintings, sculpture or works of art, bullion, date of receipt will be the date on which delivery (actual or constructive) is taken by the recipient or his agent.

1.2.3 Receipt of capital asset being immovable property – Question arises – which date should be taken as the date of receipt of immovable property – date of receiving possession or date of registration?

It appears that date of receipt of possession of immovable property is the date of receipt and not the date of signing the deed or registration thereof. This view appears to be appropriate because the Supreme Court has defined ownership as ownership in de facto sense rather than de jure sense. In a landmark judgment in Mysore Minerals Ltd v. CYT [1999] 106 Taxman 166, the Supreme Court held that to claim depreciation, it is not necessary that the assessee should be the registered owner of the assets. Exclusive possession rights, to exclude others from enjoyment of assets, right to retain possession and defend the same are some of the characteristics of ownership which would entitle the assessee to depreciation under section 32 (so long as it was used for carrying on business or profession). In Tata Electric Companies (AOP) v. Jt. C7T [ITA No. 2330/Mum./2001] (17-10-2006) (unreported), the Tribunal considered the issue of ‘ownership’ of asset for claiming depreciation under section 32 of the Act in the light of various Apex Court decisions on the subject and beautifully extracted the law in this regard at para 21 of the Order:

‘… the substantial de facto ownership of an asset is to be looked into, rather than examining the religious de jure ownership of the asset.      In a case where the transfer of property was contemplated by an agreement and thereafter, the physical delivery of the property was handed over and the property was used for the business of the assessee and thereafter, even if delayed, the transaction was concluded by executing the relevant conveyance and documents, then in such circumstances, the ownership of the asset must be considered as having been transferred from the date of actual delivery of the asset. … in such circumstances, where the contract has been lawfully executed, …. the validity of the registered documents goes back to the date of de facto transfer of ownership of the asset. This liberal principle has been upheld by the Supreme Court….’

Taking a cue from the above decisions, it may be opined that date of receipt of possession of immovable property is the date of receipt and not the date of signing the deed or registration thereof.

This view is also consistent with ordinary meaning of ‘receive’ as above. Also, the triggering event in section 9B & section 45(4) is not “transfer of capital asset” like in sub-section (1) but “receipt of capital asset”.

1.3 How to apply section 45(4) if say stock-in-trade is also received by partner/member in addition to money or capital asset or both

The applicability of section 45(4) is not precluded that if the pay-out of settlement of retiring partner’s capital account balance has components of stock-in-trade or assets which are neither stock-in-trade nor capital assets (e.g., rural agricultural land in India) or both in addition to money and/or capital assets. The other components of settlement apart from money and capital assets will be ignored for section 45(4) purposes and capital gains under section 45(4) will be computed only with reference to money and capital asset components. Business income from the stock- in-trade component will be computed with reference to FMV of the stock-in-trade in accordance with section 9B. If any rural agricultural land in India owned by firm is given to retiring partner, it will neither result in capital gains nor business income in firm’s hands.

1.4 Condition (ii): Money or capital asset or both is received from specified entity

Section 45(4) comes into play only if money or capital asset or both is received by specified person from specified entity only and from no other person.

The following points are noteworthy here:

• Section 45(4) is attracted only when retiring partner receives capital asset or money from the firm/LLP.
• If retiring partner receives only stock-in-trade section 45(4) will not apply. Only section 9B will apply.
• However, if retiring partner receives stock-in-trade in addition to money or capital asset or both, section 45(4) will apply to money and/or capital asset component of the package.
• If he receives any capital asset or money from other partners privately from their personal funds and they don’t debit it to firm/ LLP, then, section 45(4) is not attracted. The taxability in retiring partner’s hands, however, is not ruled out.
• Section 45(4) will also not be attracted where firm is transferred to a company and retiring partner receives shares or money of new company.
• It appears that section 45(4) will not be attracted if retiring partner’s balance is parked in a loan account or payable account and then the firm/LLP is converted into a company under Chapter XXI of the Companies Act, 2013 and then the company pays off the loan/payable account. The reason is mere reconstitution of entity does not trigger section 45(4) unless the retiring partner receives money or capital asset or both from the firm/LLP.

1.5 Conditions (iii) and (iv): Receipt must be during the previous year in connection with the reconstitution of firm/LLP/AOP/Bol

Such receipt must take place during the previous year in question which must be 2020-21 or any subsequent previous year. This is because new substituted clause (4) of section 45 is effective from assessment year 2021-22 only. Also, such receipt must take place during the previous year in connection with the reconstitution of the specified entity.

1.6 In connection with the reconstitution

What if capital asset approximating the credit balance is given to a partner and is treated as drawings by debit to capital account and in the next financial year, they draw up a deed of reconstitution giving recitals to the effect that partner has overdrawn and is unable to bring in capital and therefore it is mutually agreed that he will retire with effect from

…. date and the            asset drawn by him as drawings on …. be treated as full and final settlement of dues payable to him qua partner of the firm? Such a case would clearly not be receipt “at the time of reconstitution” which words were there in the Finance Bill, 2021. At time of passage of Finance Bill, 2021 in Lok Sabha, the words “at the time of” have been replaced with the words “in connection with the reconstitution”. A similar amendment of substituting “at the time of ” with “in connection with” was made by Finance Act, 2005 in section 35DDA. The effect was explained in the Notes on Clauses on the Finance Bill, 2005 as in order to make the section applicable to payments in connection with employee’s voluntary retirement either in the year of retirement or in any subsequent year. Taking a cue from the above Notes on clauses on an identical change in wordings in the past, one can take a view that, even after the change in wordings, section 45(4) will not apply to drawings by partners in the financial years preceding the financial year in which the reconstitution takes place. A view can be taken that section 45(4) will only apply to receipt of asset by partner in the year in which reconstitution takes place or in any subsequent year.

1.7 Condition (v): Increase in the capital account of partner due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset

If there is no increase in the capital account of partner due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset, then section 45(4) will result in Nil capital gains.

1.8 Capital gains resulting under sub-section (4) if only money is paid to partner/member – Whether LTCG or STCG?

If capital asset is given to partner/member, it is not difficult to decide whether resulting capital gain in hands of firm is short-term or long-term.

Question arises what if only money is paid to partner/member at the time of reconstitution or dissolution of firm / LLP/AOP/BOI? In that case, if computation under sub-section (4) results in capital gains in the hands of firm, it will be treated as short-term if partner/member has been with the firm/LLP/AOP/BOI for 36 months or less. Where it is treated as short-term, it would be taxed at slab rates.

The resulting capital gains would be treated as long-term capital gains if retiring partner has been partner with the firm for more than 36 months.

2. Income on receipt of capital asset or stock-in-trade by specified person from specified entity [Section 9B]

The ingredients of section 9B are as follows:

1. Specified person receives during the previous year any capital asset or stock-in-trade or both
2. Receipt is from a specified entity
3. Receipt is in connection with the dissolution or reconstitution of such specified entity

If above ingredients are satisfied, then the following consequences follow:

• Specified entity shall be deemed to have transferred such capital asset or stock-in-trade or both to the specified person in the year in which capital asset or stock-in-trade or both is received by specified person;
• Any profits and gains from such deemed transfer of stock-in- trade shall be deemed as income of such specified entity in the previous year in which it is received by the specified person and will be taxable under the head Profits and Gains from Business or Profession;
• Any profits and gains from such deemed transfer of capital asset shall be deemed as income of such specified entity in the previous year in which it is received by the specified person and will be taxable under the head Capital gains;
• FMV of stock-in-trade as on date of receipt by specified person shall be deemed to be the full value of consideration accruing or received as a result of such deemed transfer;
• FMV of capital asset as on date of receipt by specified person shall be deemed to be the full value of consideration accruing or received as a result of such deemed transfer; and
• Removal of difficulties Guidelines may be issued by CBDT for the purposes of section 9B and section 45(4). These Guidelines are binding on assessee and Department and should be applied.

The following judicial rulings are relevant:

• In CIT Dadha & Co. [1983] 142 ITR 792 (Mad.) it was held that where a firm owns certain properties, a registered document will be necessary to transfer firm’s interest in such properties in favour of partners and mere book entries will not be sufficient to effect such transfer. Thus, where such property is sold after effecting such book entries, and no registered document is executed for transferring such properties to partners, capital gains arising from sale of properties by partners would be assessable only in the hands of the firm and not in the hands of the partners.
• An assessee transferred immovable properties by means of registered documents. The assessee denied the liability to capital gains tax on the reasoning that the properties were transferred already in favour of one of the partners of the firm who retired earlier. The court held transfer of asset in favour of the partner previously by means of book entry is not proved by any other evidence. The court held that there is no tangible material in the form of conveyance deed executed by the firm for transfer of capital asset that could be taken by the Assessing Officer for the purpose of deciding the capital gains tax. Section 2(47)(v) and (vi) inserted w.e.f. 1-4-1988 have enlarged the meaning of the term ‘transfer’ yet unless there is an evidence to satisfy the conditions contained therein, a mere book entry would not be sufficient for transfer of capital asset in favour of the transferee. [ CIT C. C. Transport & Co. [2007] 292 ITR 663 (Ker.)].
• It has been held that mere entries in the books of a partnership firm cannot convert partnership property into individual property of its partners. Even an agreement entered into by the partners treating the firm’s property as individual property would not have such effect unless the agreement was followed by a deed of conveyance known to law. [CIT Bharati Engg. Corpn. [1989] 46 Taxman 80/180 ITR 32 (Punj. & Har.)].
• The transfer of property to an existing partner by mere adjustment of book entries otherwise than in connection with dissolution of the partnership or retirement of the partner from the partnership, not accompanied by a duly registered deed of conveyance, constitutes no transfer. [CIT Kedarnath Poddar & Co. [1995] 127 CTR (Cal.) 58; S.V. Chandrapandian v. S.V. Sivalinga Nadar [1995] 212 ITR 592 (SC) and N Khadervali Saheb v. N Gudu Sahib [2003] 261 ITR 1 (SC)].

2.1 Dissolution of firm

The term dissolution is not defined in section 9B. Section 39 of the Indian Partnership Act defines “dissolution of firm” as under:

“39. Dissolution of firm – The dissolution of partnership between all the partners of a firm is called “dissolution of the firm”

Thus, dissolution of firm is distinguished from dissolution of partnership. In dissolution of partnership, the relationship comes to an end between some partners only. Dissolution of partnership happens when there is retirement or death of one or more partners. Dissolution of firm means relationship of partnership between all the partners of the firm ceases.

Section 63 of the Limited Liability Partnership Act, 2008 provides that “The winding up of a limited liability partnership may be either voluntary or by the Tribunal and limited liability partnership, so wound up may be dissolved.”

A dissolution brings the partnership to an end [CIT v. Pigot Chapman & Co. [1982] 9 Taxman 7 (SC); CITv. Omprakash Premchand & Co. [1996] 86 Taxman 376 (MP)]. It has been held that:

1. when there are only two partners constituting the partnership firm, on the death of one of them, the firm is deemed to be dissolved despite the existence of a clause which says otherwise [Mohd Laiquiddin Kamala Devi Misra (2010) 1 SCR 873 (SC)]. [If firm pays off the legal representatives of deceased partner, then section 9B is triggered. If remaining partner pays off from his personal funds, section 9B will not be triggered].
2. when upon retirement of a partner from partnership of two partners, the assets were taken over by one partner who continued the business as a proprietor, there was a dissolution of the firm [ITO Om Namah Shivay Builders & Developers (2011) 43 SOT 397 (Mum.) cited in ITO v. Alta Inter Chem Industries [2013] 32 taxmann.com 138 (Ahd – Trib)]. (In this case, section 9B will not be triggered though a dissolution of firm takes place as the pay-outs to other partners is made by the remaining partner who takes over all assets of the firm and turns the firm into his sole proprietorship concern. Section 9B(1) expresses itself to be applicable “where any specified person receives during the previous year any capital asset or stock-in-trade or both from a specified entity in connection with the dissolution or reconstitution of such specified entity”)

2.2 Conversion of firm/LLP into company under Chapter XXI provisions of Companies Act, 2013 (earlier Part IX of Companies Act, 1956) is not “dissolution of firm/LLP”

In ACIT v. Unity Care and Health Services [2006] 103 ITD 53 (Bang.) the ITAT held that conversion of firm into company under Chapter XXI provisions of Companies Act, 2013 (earlier Part IX of Companies Act, 1956) is not “dissolution of firm”. The ITAT held that “There is no dissolution of the firm. The persons who were either to register under the partnership Act are now registered under the Companies Act”.

2.3 Computation of capital gains under section 9B on dissolution/reconstitution of the specified entity

 The rate at which such capital gain shall be charged to tax will be depend on the nature of capital asset transferred and period for which such asset is held by the specified entity.

3. In case of reconstitution of Firm/LLP/AOP/BOl, which provision will apply when and how?

The provisions will apply as under:

• If retiring partner receives entire dues in money, only section 45(4) will apply. Provisions of sections 9B and 48(m) will have no application.
• If retiring partner receives a capital asset only from a firm in full settlement of all his dues, section 45(4) should be applied first to calculate taxable capital gains accruing to retiring partner on transfer of his share which instead of being taxed in his hands will be taxed as capital gains of the firm. Then capital gains of the firm will have to be worked out under section 9B. The FMV of capital asset given will be full value of consideration to the firm. From it, deduct (I) expenses incurred wholly and exclusively in connection with transfer, (II) cost of acquisition/improvement or indexed cost of acquisition or improvement, as the case may be and (III) capital gains taxable u/s 45(4). The result will be capital gains u/s 9B.
• If retiring partner receives only stock-in-trade, only section 9B shall apply.

Say retiring partner’s capital account balance (dues receivable from firm) is Rs. 100. Self-generated Goodwill credit in accounts is Rs. 5. Revaluation surplus credit is say 20.

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