Finance Act, 2021, amended tax provisions relating to dissolution and reconstitution of a partnership firm / LLP / AOP/ BOI (“Specified Entity”) and correspondingly in the hands of a partner of a partnership firm/LLP or member of AOP/ BOI (“Specified Person”).
In a legal parlance, dissolution of a Specified Entity shall refer to the stage of liquidation through which such Specified Entity is brought to an end and the assets & property of the concerned entity are redistributed amongst the Specified Person(s) of a Specified Entity, once all dues are settled. Further Reconstitution of Firm refers to the stage where new Specified Person is admitted and / or Specified Person is retired and / or Expulsion of a Specified Person and / or Insolvency of a Specified Person and / or Death of a Specified Person and / or change in profit sharing ratio amongst the Specified Person(s).
Section 45(4) of the Income Tax Act, 1961 (“ITA”) provided for applicability of capital gains tax in the hands of such Specified Entity, upon any distribution of capital assets at the time of dissolution or otherwise of a Specified Entity to a Specified Person. For the calculation of capital gains in the hands of Specified Entity, the fair market value (“FMV”) of such capital asset so distributed was considered to be deemed as consideration and the cost of Acquisition of such capital asset so distributed was available as a deduction.
However, there were cases where, instead of a capital asset, money or any other assets (other than capital asset) were distributed to the Specified Person at time of dissolution or reconstitution of the Specified Entity. Further, in various cases such money/ any other assets so distributed were in excess of the credit balance of capital account of such Specified Person(s) on account of revaluation of self generated assets such as goodwill. Additionally, interpretation of the term ‘or otherwise’ led to various interpretations which led to litigations.
Various judicial precedents[1] have held that the provisions of section 45(4) of the ITA were not applicable if the asset so distributed was not a capital asset.
Further, it was also held in various cases that, if the Specified Person’s capital account had been revalued prior to distribution of money/ other assets, then such distribution was not taxable in the hands the recipient of such money/ other assets (i.e. the Specified Person).
In order to address the above, vide Finance Act, 2021, amendment has been made in sub-section (4) of section 45 of the ITA and a new section 9B has been inserted in the ITA, which are clarificatory in nature. The aforesaid amendments are retroactive in nature and summaries of the amendments are as under:
- New Section 9B of the ITA provides that in the event of dissolution or reconstitution, if Specified Entity transfers capital assets or stock-in-trade or both to Specified Person(s), any profits arising from such transfer shall be deemed to be income of such Specified Entity. Nature of taxation would be under the head capital gains, if capital assets are transferred or under the head profit and loss of business or profession, if stock in trade are transferred. Fair value of consideration of capital asset or stock-in-trade or both as received by the Specified Person shall be deemed to be full value of consideration in the books of the Specified Person.
- Sub-section 4 to Section 45 of the ITA is amended to provide for taxation in the hands of Specified Entity. In the event of reconstitution of the Specified Entity, where any monetary consideration or capital asset or both are received by such Specified Person, any profit made on such receipt (i.e. excess of consideration over and above balance in Specified Person’s capital account in the Specified Entity) shall be chargeable to tax as Capital gains. Further, it is expressly provided that in computing the balance in the Specified Person’s capital in the books of the Specified Entity, any increase on account of revaluation of any asset or due to self-generated goodwill or self-generated asset shall not be taken into account.
- In order to mitigate any double taxation in the hands of Specified Entity upon simultaneous application of section 9B and substituted section 45(4), section 48 of the ITA has been amended to allow reduction of gains attributable to the capital asset transferred by the Specified Entity in computing income under section 45(4) in the hands of Specified Person. The manner of computing such gains attributable to capital asset shall be prescribed by the Government seperately.
Key observations from the aforesaid amendments:
Event based interplay: The amendment made under section 9B of the ITA provides for events of reconstitution or dissolution of Specified Entity whereas the amendment made under section 45(4) of the ITA only provides for event of reconstitution of a Specified Entity. Accordingly, in the event of dissolution of a Specified Entity, provisions of section 45(4) of the ITA shall not get triggered.
Benefit based interplay: Section 9B of the ITA refers to transfer of capital assets or stock-in-trade or both, whereas section 45(4) of the ITA refers to transfer of capital assets or monetary considerations or both. Accordingly, in the event of dissolution of Specified Entity, transfer of monetary consideration in excess of credit balance of Specified Person’s account is directly taxed in the hands of Specified Person and it does not attract any capital gains in the hands of Specified Entity. Similarly, in the event of reconstitution of Specified Entity, profit on transfer of stock-in-trade would be taxable in the hands of Specified Entity itself and no further taxes would be imposed in the hands of Specified Person.
Further, since definition of Capital Asset u/s 2(14) of the ITA[2] specifically excludes assets like personal effects and agriculture land under the scope of capital assets. The effect of transfer of such excluded assets to the Specified Person upon reconstitution / dissolution is not specified and accordingly, may invite various interpretations which may increase the scope of tax litigations, if implemented.
The above amendment plugs the loophole in the erstwhile taxation regime which had limited applicability and various judicial interpretations. Further, the erstwhile prevailing practice (specially adopted in real estate industry) of transferring capital assets at cost to the Specified Person, is now no longer outside of taxation regime. In effect, the amendment fixes the loophole in the taxation regime and provides full proof mechanism to tax any arrangement distribution at the time of dissolution / reconstitution of the partnership firm / LLP/ AOP/ BOI.
For detailed discussion on the above subject, please feel free to connect at contact@devadhaaantu.in
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[1] Addl CIT Vs Mohanbhai Pamabhai [1987] 165 ITR 166 (SC); CIT Vs R.L. Raghukumar [2001] 247 ITR 801 (SC): 166 CTR 398 (SC); Jagatram Ahuja Vs CGT [2000] 246 ITR 609 (SC) : 164 CTR 1 (SC)
