Whether section 56(2)(x) of the IT Act apply on ‘Interest in partnership firm’ ?

Recently Bengaluru bench of Income Tax Appellate Tribunal (‘the ITAT’) in case of Buckeye Trust (‘Taxpayer’) passed a decision against the Taxpayer noting that the “interest in partnership firm” falls in the category of “shares”and the same is covered by the provisions of explanation (d) of section 56(2)(vii) of the Income Tax Act 1961 (‘the IT Act’). 

The Taxpayer is a private discretionary trust and was established under the provisions of Indian Trust Act, 1882 vide settlement deed January 23, 2018 executed between Mr. Anand Nadathur, being the Settlor and Vervain Management Private Limited, being the Trustee. The settlor settled his investments into partnership firms and equity shares in an unlisted company amounting to INR  669,27,63,437 to the trust out of natural love and affection.

During the scrutiny assessment, the assessing officer (‘AO’) accepted the return of income submitted by the Taxpayer. In order to examine the settlement receipt amounting to INR INR 669,27,63,437 as received by the Taxpayer under the provisions of the IT Act, the Principal Commissioner of Income Tax (‘PCIT’) initiated reassessment and called for assessment records and examined the proceedings. It took a view that the order passed by AO is erroneous and prejudicial to the interest of revenue.

In justification of the settlement by settlor as aforesaid, the Taxpayer made submission as under:

• The contribution by settlor into the Trust was made for the benefit of beneficiaries. This obligation constitutes a promise by the trustee to the settlor that the contribution / corpus / funds would be distributed as intended by the settlor. And the said promise fits in the phrase “promise to do something” and “at the desire of promisor” appearing in section 2(d) of the Indian Contract Act 1872. Hence the promise given by the trust to the settlor is the consideration.
• Receipt by the Trust is essentially receipt by the relatives being the beneficiary and thus clearly immune from the applicability of section 56(2)(x) and some part of the contribution constitutes receipts by the settlor himself which cannot constitute income based on the basic fundamental principle that no one can earn income from himself.
• Reference was made to following case laws:
  • CGT vs K. Nagammal [1997] 226 ITR 598 (Kerala) whereby it was held that the word “consideration” as found in the definition of the term “gift” in the Gift-tax Act would carry meaning assigned to it in section 2(d) of the Indian Contract Act, 1872.
  • Keshub Mahindra v CGT [1968] 70 ITR 1 (Bom HC) whereby it was stated that the term “consideration” cannot get confined to money alone. The term “consideration” is that which creates a contractual relationship between the promiser and promise in regards to that performance of promise and in regards to which the parties to the agreement or contract get related to each other. It is more than elementary that the law in regards to consideration tells us that consideration may be relating to a party other than promiser and promise illustratively for the benefit of a minor.

Based on the submission as above, PCIT noted as under:

1. From the reading of the Trust deed it was observed that the Trust has not been created or established solely for the benefit of the relatives of the individual but also other persons, charity can be added.
2. Accordingly, Trust has power to add beneficiaries who may not get covered under section 56(2)(x) of the IT Act.
3. The Taxpayer in its reply explained that the trust deed is entered for the benefit of the family. However, one of the clause whereby power to the Trustees to add any person or class of persons (whether or not in existence or ascertained) or Charity to the class of Beneficiaries. Thus, PCIT noted that the benefits are not restricted to the relatives only.
4. In the present case the trust has received an amount of Rs.669,27,63,437/- in the form of interest in partnership firms/shares settled by the settlor in favor of the Trust. The said interest in partnership firms/investment in unlisted shares are accounted under the head Trust Fund’ and under the head of investment in the financial statement.

Accordingly, PCIT applied section 56(2)(x) of the IT Act on the said receipts from settlor into the Trust.

Aggrieved by the order of PCIT, the Taxpayer has filed an appeal to the ITAT.

Following arguments were made by the Taxpayer :

• The transactions involved in this case are out of the purview of section 56(2)(x) of the Act. As the trust has been established exclusively for the family members covered in the definition of relative. Further, the money received by the trust is not without consideration as the same has been received in fiduciary capacity. Accordingly, the property which is transferred by the settlor is out of the purview of the expression “shares and Securities”. The property is managed by Trust via trustees and does not have any right to enjoy the receipt as owner. Provisions of section 56(2)(x) are not applicable for genuine transactions.
• Even if it is presumed that the case of the assessee falls in the rigors of section 56(2)(x) of the Act, then as per the definition of “property” as given in section 56(2)(x) of the Act, the interest in partnership firm are not covered in that definition. Ld. Counsel next contended that expression “shares” used in the definition of “property” as explanation (d) to section 56(2)(Vii) of the Act.
• Even if it is presumed that it is covered in the definition of “property” then the amount received by the assessee cannot be said to be an amount received without consideration.

After analysing the arguments on behalf of the Taxpayer and revenue, ITAT’s observation are as under:

1. The Settlor’s interest in partnership firms were revalued by crediting the partnership account and such interest was transferred to Trust as settlement amount. Since the Taxpayer has been introduced as partner in the partnership firms, and that too without any capital contribution, capital account of the assessee has been credited with an amount of Rs 669.27Crore, as evident from the above facts. Therefore, it was the abundant duty of the AO to examine the valuation of shares of partnership firms, adopted by the settlor for crediting the capital account of assessee in those firms and the taxability of the same in the hands of the firms and vice versa, which the AO has not done in this case.
2. It is settled position of law that tax planning is permissible if it is done within the four corners of law but tax evasion is not permissible.
3. If apparent is not real then the courts have power to lift the veil and to see through the transaction as held by the Hon’ble Apex Court in Vodafone case. In this case arrangement of affairs have been done in such a manner that one partner has been made retired and the retirement benefits have been devolved in the favor of third parties and family members.
4. It is abundantly clear that the benefit of the amount received was not restricted to the family members and hence the view of the AO is not plausible view therefore the PCIT is correct in law in holding the order as prejudicial to the interest of revenue.
5. Expression “property” has two ingredients i.e “shares and securities”. In our understanding these terms are not similar in view of the following differences. Shares can be used more broadly to mean a part or portion of something. Securities, encompasses a broader range of financial instruments and includes shares, bonds, debentures, mutual funds, and other investment products. Securities can be traded on various financial markets, including stock exchanges, bond markets, and over-the-counter (OTC) markets.
6. It is settled position of law that words should not be overly restricted; their meaning can be shaped by the context in which they are used. Legal texts, contracts, or laws often define words, but if a specific definition is not provided, courts or authorities may interpret the word according to its common usage or the broader context. Therefore we have to take the common meaning of word “share”.
7. ITAT made reference to various judicial pronouncement, summary of such judgements is as under:
   1. Shares of a partner in partnership firm are generally termed as “Interest in partnership firm”, which refers to not only the proportion of ownership, rather also include their right to participate in the management of the firm as held by the Apex Court in the case of Raman Chettiar;[1]
   2. In case of K. Rukmani Ammal v. K. Balakrishnan[2] the court observed that a partner’s interest in a partnership firm is a species of movable property and can be transferred.
   3. Hon’ble Supreme Court in case S. Gurunarayana v. S. Narasimhulu[3] held that a partner’s interest in a partnership firm is not merely a financial interest but also includes their right to participate in the management of the firm.
   4. Hon’ble Supreme Court in case Sudhir Gopi v. Usha Gopi[4] held that a partner’s interest in a partnership firm is a valuable right and can be the subject matter of a partition suit.

Based on above observations, ITAT rejected the contentions of the Taxpayer that interest in partnership firm is out of the purview of section 56(2)(x) of the IT Act.

[1] CIT Vs Raman Chettiar 57 ITR 232(SC).

[2] K. Rukmani Ammal v. K. Balakrishnan (1973) 91 ITR 631 (Madras High Court)

[3] S. Gurunarayana v. S. Narasimhulu (2004) 7 SCC 472 (Supreme Court of India)

[4] Sudhir Gopi v. Usha Gopi (2018) 14 SCC 452 (Supreme Court of India)

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