Understanding Capital Gains | A Comprehensive Guide and FAQs

No, When incoming partner brings cash into the firm as his contribution, no capital gains is charged in his hands, because there is no transfer of any asset within the meaning of Section 2(47) of the IT Act. The asset in the firm remains the property of the firm. Profit sharing ratio does not fall by introduction of cash. Even though definition of ‘property’ mentioned in Section 2(14)(a) was amended by inserting an Explanation thereunder by the Finance Act, 2012, so as to include in the definition of property, rights in or in relation to an Indian company but there was no change so as to include in that definition rights in or in relation to, a partnership firm.

Now yes. Prior to amendment by Finance Act, 1987 w.e.f. 01-04-1988, the decision of Hon’ble Apex Court in CIT v. Kartikey V Sarabhai³ was being followed. In this case, it was held that there is transfer when assessee-partner brings his capital asset into partnership as capital contribution since assessee’s exclusive interest in capital asset is reduced to shared interest. As no consideration is received by partner within meaning of section 48, or no profit or gain accrued to him in commercial sense, no capital gain chargeable under section 45 will arise even though contribution made by assessee in firm amounts to transfer under section 2(47) read with section 45 of the Act. The only exception when section 48 can be invoked is where the transfer of an asset to the firm is a device or ruse for converting asset into money.⁴ The above decision of Hon’ble Apex Court was followed in following cases.⁵

Where a partner brings asset in the firm on his entry, even though it is a transfer, but section 45 cannot be invoked [prior to insertion of section 45(3) by Finance Act, 1987 w.e.f.  01-04-1988]. It is because no consideration is received by the partner and no profit and gains arose to him⁶, and therefore, section 52 cannot be invoked⁷, except in cases where assessee adopts a device such as first transferring personal assets at enhanced value in the firm constituted with 6 persons who brought in cash as their capital and the assessee withdrew cash and subsequently also dissolved the firm, charge of capital gains can be sustained.⁸  It is also not essential that the asset should be registered in the name of the firm when brought into the firm by the partner.⁹

The above view that no capital gains can be charged if incoming partner brings some asset into the firm was nullified by the insertion of sub-section (3) in section 45 by Finance Act, 1987 w.e.f. 01-04-1988 according to which the profit and gains arising from transfer of capital asset by a person to a firm (for becoming a partner) or to an AOP or BOI (other than a company or co-operative society) by way of capital contribution or otherwise shall be chargeable to tax as his income of the previous year in which such transfer takes place and for the purposes of section 48, the amount recorded in the books of account of the firm/AOP/BOI as the value of the capital asset shall be deemed to be the full value of consideration received or accruing as a result of the transfer of the capital asset. Therefore, transfer by the incoming partner or existing partner of his capital asset either as his capital contribution or otherwise is now brought into the net of capital gains.

The order of the CIT u/s 263 could not be upheld where he set aside the order of the AO for the AY 1981-82 by holding that section 45(3) can be invoked on entry of the partner into the firm by bringing asset.¹⁰

If there was no evidence to show that something more than apparent consideration was in fact paid by assessee, it could not be said that assessee had understated consideration or that consideration actually received by assessee was more than what was declared or disclosed.¹¹

Yes. Where immovable property is transferred by a partner to firm as a capital contribution and registration does not take place by paying stamp duty, case would be covered under section 45(3)¹², and the value of capital asset recorded in books of account of firm would be considered as full value of consideration for purpose of computing capital gain.¹³

But where transfer of land as a part of capital contribution to partnership firm takes place in the year 2008 and land in question was not transferred in the name of firm and no amount was credited by firm in account of assessee as a consideration for land in question during assessment year 2009-10, no capital gains can be charged in that year.¹⁴ But where assessee contributed land, valued as per books, at cost of ` 7.81 crores in AY 2004-05, contribution of assessee became 88 per cent of total capital but he was assigned only 5 per cent profit sharing in the firm, it was found that entire transaction of contribution to partnership was a sham and was an attempt to devise a method to avoid capital gain tax on transfer of land to firm. The capital gains would be charged in the hands of the partner bringing land into firm.¹⁵

No. Section 45(3) is applicable only in cases of transfer/contribution of capital asset by the partner into the firm but where partner contributed a current asset in the business of the firm and on receipt of such asset, the firm also accounted for it as current asset and not as capital asset, section 45(3) will not be applicable.¹⁶

Now transfer of stock-in-trade by the partner into the firm will be taxed u/s 43CA. Finance Act, 2013 w.e.f. 01-04-2014 inserted section 43CA providing for taxation of difference between cost of acquisition of land or building or both and stamp duty valuation of such land or building transferred by an assessee other than as capital asset to the firm as profit and gains under the head ‘business income’ and stamp duty valuation will be deemed as full value of consideration received on such transfer to which section 50C would apply and where date of agreement and date of conveyance are different, then the stamp duty valuation on the date of agreement will be treated as full value of consideration.

There are two aspects of the issue. When the incoming partner brought in capital asset into the firm, section 45(3) would be triggered and capital gains liabilities would arise on the incoming partner and the value of the capital asset, so introduced, and recorded in the books of the firm will become the full value of consideration. The computation of capital gains will be carried out in accordance with section 48. In the second stage after capital asset so brought in becomes the asset of the firm and is disposed off by it, capital gains would arise on the firm and sale consideration coupled with section 50C will be the full value of consideration and value of the capital asset recorded in the books of the firm will be the cost of acquisition.¹⁷

No. Profit or gain would arise only when transfer has been made at a price which is more than cost price and difference between cost price and amount at which transfer has taken place can be charged under section 45(3). In a case where the cost price recorded in the books of the partner and that recorded in the books of the transferee is the same, no liability to capital gains would arise u/s 45(3).¹⁸

In a case where transferor is incoming partner and brings with him unquoted equity shares, then for computing capital gains in his hands, FMV of the shares calculated in the prescribed manner will be FVC. However, as per Section 45(3), the value of the shares recorded in the books of the firm, for which credit is given to the incoming partner, will be deemed as FVC. Thus, there is conflict between Section 45(3) and Section 50CA. In case of conflict between deeming provision of Section 45(3) and deeming provision u/s 50CA. Section 45(3) will prevail, as there cannot be superimposition of another deeming fiction u/s 50CA over deeming fiction created by Section 45(3). Therefore, for working out capital gains in the hands of incoming partner, FVC will be the value of shares recorded in the books of the firm. COA will be either the cost to the incoming partner or cost as per Section 49(4), where Section 56(2)(vii)/(viia)/(x) may be invoked.

No. On revaluation of a current asset and then its transfer to fixed assets, a revaluation reserve account in the books was created by the assessee and the value of asset was enhanced and credited to Revaluation Reserve Account or to partners account¹⁹  and debited to the said asset Account. It was held that transfer of an asset from current to fixed after revaluation does not give rise to any receipt or accrual of income to the assessee. It is not necessary that every reserve has to be routed through profit and loss account. “Process of revaluation of stock by itself cannot bring in any real profit as held in following cases.²⁰ Moreover, what is taxable under the income-tax law is only real income.²¹ The Courts have held that there is no principle by which the stock-in-trade can be valued at market price so as to bring to tax the notional profits which might in future be realized as a result of the sale of the stock-in-trade.²²

Yes. It can be. Where partner had transferred a capital asset to the firm at a value which is higher than stamp duty valuation or fair market value, then partner will be liable to capital gains u/s 45(3) on the difference between cost of acquisition to the partner and the value at which it was transferred to the firm. If the firm records the same value in the books as its cost of acquisition, then the firm may be disallowed a part of expenditure u/s 40A(2)(a), if in the opinion of the AO, expenditure incurred by it is more than SDV/FMV.²³

Yes. Where the partner transfers a capital asset to the firm at value which is less than FMV/SDV, then he will be charged u/s 45(3) for capital gains on the difference between its cost of acquisition and value recorded in the books of the firm being value less than FMV/SDV. The firm will also be charged u/s 56(2)(x) on the deemed income being difference between the value recorded in the books and FMV/SDV of that asset. However, provisions of section 56(2)(x) will not be applicable in case of transfer of an asset by the partner to the firm, if it is stock-in-trade. In that case, section 43CA may be invoked.

No. Where an assessee, a partner in a partnership firm transferred his land as capital contribution and claimed long-term capital loss on said transfer, the Assessing Officer, observing that stamp duty value of land was much higher as compared to consideration received by assessee, invoked provisions of section 50C and made additions for long-term capital gain, it was held that since case of assessee fell under scope of section 45(3) which itself is a deeming section and provided for deeming consideration to be adopted for computation of capital gains under section 48, Section 50C could not be extended to compute deemed full value of consideration accruing as a result of such transfer for computation of capital gain.²⁴

The purpose of insertion of section 45(3) is to deal with cases of transfer between partnership firm and partners and in such cases, the Act provides for computation mechanism of capital gain and also provides for consideration to be adopted for the purpose of determination of full value of consideration. Since the Act itself provides for deeming consideration to be adopted for the purpose of section 48, another deeming fiction provided by way of section 50C cannot be extended to compute deemed full value of consideration as a result of transfer of capital asset by partner in a firm as a capital contribution²⁵. Therefore, Section 45(3) makes it clear that for the purpose of section 48, the amount recorded in the books of account of a firm shall be deemed to be full value of consideration received or accruing as a result of transfer of a capital asset. The Assessing Officer cannot import another deeming fiction created for the purpose of determination of full value of consideration as a result of transfer of a capital asset.  It is held in CIT v. Mother India Refrigeration Industries (P.) Ltd.²⁶ that

“the legal fictions are created only for some definite purpose, and these must be limited to that purpose and should not be extended beyond that legitimate field.”

For the proposition that another deeming fiction cannot be imported in the deeming fiction already invoked, reference may be made to the following authorities²⁷

Section 45(3) is applicable when there is a  transfer of capital asset by a person to a firm, may be by way of capital contribution or otherwise. Additional capital contribution by a partner in a firm may affect profit sharing ratio or may be violation of partnership deed. Therefore, transfer in some cases may not be by way of capital contribution but by way of a separate credit to the partner or as current assets. This may be held as current account as different from capital account. Therefore, the expression ‘otherwise’ would cover all those cases where transfer of capital asset by the partner to the firm is not treated by the partnership firm as capital contribution.

No. From the provisions of section 45(1), (3), (4) and section 2(31) of Income-tax Act, the identity of the firm as well as that of the partners for taxability of income are separate and distinct. They are independently taxable on income arising from their activities. If there is a transfer effected by a firm of capital assets i.e., property held by the firm, the capital gain tax arises in the hands of the firm and not in the hands of the partners and vice versa. Section 45(3) which was inserted by the Finance Act, 1987, with effect from 01-04-1988, deals with a person who transfers a capital asset to a firm as a capital contribution and becomes a partner of a firm. The income so derived is liable to be taxed at the hands of such member or partner. On the other hand, sub-section (4) of section 45 deals with profits or gains arising from the transfer of a capital asset by way of distribution of capital assets on the dissolution of a firm chargeable to tax as the income of the firm. When the inducted partners became partners in the firm and the firm continued to own assets, but the erstwhile partners withdrew the money brought in by the incoming partners as drawings, they did not retire from the partnership firm and continued to be the partners of the firm. However, their share got reduced to the extent allotted to the inducted partners. As the property was not owned by existing partners, it was owned and continued to be owned by the firm, it cannot be said that

“they transferred any part of the asset in favour of incoming/existing partners and any amount represented the consideration received for such transfer and as such it is liable for payment of capital gains under section 45(1)”.²⁸

The Courts have held that assets remain in the name of the firm at the time of entry of a new partner, or at the time of retirement of an existing partner. The profit-sharing ratio of the existing partners is reduced when a new partner enters and is increased when an existing partner retires. It also results in decrease or increase in the right to share in the properties of the firm of the partners in the newly constituted firm. The view of the department that there will be deemed gift or deemed income u/s 56(2) in the hands of beneficiary is not sustainable as there is no transfer of any asset when there is transfer of money only. Notional increase or decrease in the right to share in the assets of the firm will not give rise to any income chargeable u/s 56(2)(x)/56(2)(vii) or (viia). The expression used in these sections is “when any person receives”, which denotes an actual receipt of money, movable or immovable property and not notional receipt. The expression can be compared with Section 48 which uses the expression “received or accruing”. This has been explained by the court as consideration actually received and not something suspected or deemed.²⁹ Thus, in brief-

(i) Realignment of shares when new partners enter: When there is realignment of shares when new partners are inducted in the firm, there is no liability to capital gains as no transfer of any asset is involved as assets remained with firm³⁰.