Pursuant to the amendment vide Finance Act 2021, in relation to reconstitution or dissolution of Firm / LLP / AOP / BOI (‘Specified Entity’), a revised mechanism of taxation impact on distribution of capital assets or stock in trade to partners / members (‘Specified Person’), upon such reconstitution and dissolution have been prescribed under the provisions of the Income Tax Act, 1961 (‘the ITA’).
Briefly, any profits on distribution of capital assets or stock in trade or both to Specified Person shall be considered as deemed income in the hands of Specified Entity and taxable under the head ‘Capital Gains’ in case of distribution of capital asset and under the head of ‘Profits and Gains of Business or Profession’ in case of distribution of stock-in-trade u/s 9B of the ITA. Here, fair market value of capital assets or stock in trade is considered to be full value of consideration.
Further, in the event of reconstitution of the Specified Entity, where monetary consideration or capital asset or both are received by the Specified Person(s), any profit made on such receipt shall be taxable in the hands of Specified Entity u/s 45(4) of the ITA.
Further, Circular No. 21 of 2021 dated July 2, 2021 (‘the Circular’) has been issued in this regard to clarify the aforesaid amendment. According to the Circular, in the event of reconstitution of the Specified Entity, the provisions of section 45(4) of the ITA shall operate in addition to the provision of section 9B of the ITA. Taxation under the said provisions shall be worked out independently.
Thus, in order to avoid double taxation upon simultaneous application of section 9B and section 45(4) of the ITA, section 48 of the ITA has been amended to provide for mechanism to determine the capital gains u/s 45(4) of the ITA which shall be allowed as deduction while computing capital gains in the hands of Specified Entity in the event of subsequent distributions to Specified Person. Further, section 48(iii) of the ITA provides that if any money or capital asset is received by Specified Person from a Specified Entity, then the amount chargeable to income-tax as income of such Specified Entity u/s 45(4) of the ITA, which is attributable to the capital asset being transferred by such Specified Entity shall be calculated as per newly inserted Rule 8AB under the Income Tax Rules, 1962 (’the Rules’) vide a notification no. 76/2021 dated July 2, 2021 (‘Attribution of income u/s 45(4) of the ITA’).
Accordingly, the amount taxed under section 45(4) of the ITA is required to be attributed to the remaining Capital Assets of the Specified Entity, so that when such remaining capital assets are transferred / sold by the Specified Entity in future, section 48(iii) of the ITA provides that the amount of capital gains under section 45(4) of the ITA as attributed to the remaining Capital Assets gets reduced from the full value of the future sale consideration and to that extent, Specified Entity does not pay tax again on the same amount. The attrition is required to be given effect to only for the purposes of section 45(4) of the ITA.
Further, provisions of section 48 of the ITA applies only to the capital assets which are not forming part of the block of assets. Thus, in order to give effect to the provisions of Section 48 to the assets forming part of the block of assets, the Circular further clarifies that the provisions of the Rule shall extend to transfer of assets forming part of block of assets. Accordingly, in such cases as well, attrition would be required to be made. Accordingly, at the time of future sale of such remaining assets forming part of block of assets, net value of consideration as determined under Rule 8AB of the Rule, shall be considered for reduction from the written down value of the block of assets under sub-clause (c ) of clause (6) of section 43 of the ITA or for calculation of capital gains u/s 50 of the ITA, as the case may be.
Determination of period of holding of assets distributed by Specified Entity to Specified Person:
Further, sub rule (5) to Rule 8AA of the Rules has been inserted to provide for determining the period of holding of the Capital Assets and the corresponding nature of Capital gains chargeable u/s 45(4).
Accordingly, the nature of capital gains computed under section 45(4) upon distribution of CA on reconstitution has been prescribed under Subrule (5) of Rule 8AA of the IT Rules as under:
Short term Capital Gains:
- Capital Asset which is short term capital asset at the time of taxation under section 45(4) of the IT Act; or
- Capital asset forming part of block of assets; or
- Capital asset being self-generated asset / goodwill.
Long term Capital Gains: Any other capital asset not covered above and is long term capital asset at the time of taxation of capital gains under section 45(4).
Mechanism to determine Attribution of income u/s 45(4) of the ITA:
The capital gains computed under section 45(4) of the ITA to be attributed to the remaining capital assets of the Specified Entity under Rule 8AB of the Rules are as under:
Where capital gain relates to revaluation of any capital asset or valuation of self-generated asset / goodwill of Specified Entity,
Capital Gains u/s 45(4) of the ITA | X (Multiplied) | Increase in value of such capital asset due to revaluation Aggregate of increase in, or recognition of value of all assets because of revaluation |
No such attribution is required where capital gain relates only to capital asset received by the Specified Person from the Specified Entity and where capital gains does not relate to any of the above cases.
Further, it has been specifically provided that revaluation or valuation (as the case may be) does not entitle the Specified Entity to claim depreciation on increase in value of such capital asset or recognition of self-generated asset/goodwill. Further, Specified Entity is required to furnish details of such attribution in the Form No. 5C. This Form is to be furnished electronically on or before the due date of filing income tax return.
In a nut shell:
As explained above, the detailed rules and clarificatory guidelines have been issued in respect of the amended provisions in relation to the reconstitution of the Specified Entity. However, it is interesting to see how implication of the above provisions are applied. As the implications would differ on a case-to-case basis, the amendment might adversely affect any arrangement that results into reconstitution of the Specified Entity. In such case, the flexibility available with the Firm / LLP structure, may get disturbed. Few such questions that may be required to be looked into are as under:
- Whether provisions of GAAR would be applicable,
- If it is proved that the partner overdraws the capital account, in which case, Specified Person’s capital account would be negative and accordingly, provisions of section 45(4) may not apply?
- If the dissolution takes place immediately after reconstitution of Specified Entity?
- Whether provisions of section 50C (in case of immovable properties), section 50CA (in case of shares of unlisted company), would be applicable if transfer takes place at value lower than stamp duty valuation?
- Whether provisions of Section 56(2)(x) of the ITA would be applicable on the distribution upon dissolution and / or reconstitution of Specified Entity?
As the amended provisions are introduced to fix the erstwhile loopholes, but it also results in uncertain tax issues. It would be interesting to see how law around these provisions evolve over a period of time and whether such complexities result in further tax litigations.
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