26 May 2014
When a firm created at will is dissolved by mutual agreement between the partners, will the distribution of capital assets to the partners by the firm constitute a transfer consequently levying capital gains tax on the transaction?
27 May 2014
Yes it is required and the firm has to value the properties of the firm at market value and calculate the capital gains as the provisions of section 45(4) shall be applicable. The following is to be considered
Issue for consideration : 1.1 S. 45(4) of the Income-tax Act provides for taxation of the deemed capital gains arising on distribution of capital assets in the course of dissolution. The essential requirements for at-tracting this provision is that there is a dissolution, and that in the course of such dissolution, capital assets are distributed. 1.2 The said S. 45(4) reads as : "The profits or gains arising from the transfer of a capital asset by way of distribution of capital assets on the dissolution of a firm or other association of persons or body of individuals (not being a company or a co-operative society) or otherwise, shall be chargeable to tax as the income of the firm, association or body, of the previous year in which the said transfer takes place, and for the purposes of S. 48, the fair market value of the asset on the date of such transfer shall be deemed to be the full value of the consideration received or accruing as result of the transfer." 1.3 Ordinarily, capital gains arise on transfer of a capital asset. ‘Transfer is considered to be ‘sine qua non’ of capital gains. The term ‘transfer’ is defined by S. 2(47) of the Act, which reads as under : " ‘transfer’, in relation to a capital asset, includes : (i) the sale, exchange or relinquishment of the asset; or (ii) the extinguishments of any rights therein; or (iii) the compulsory acquisition thereof under any law; or (iv) in a case where the asset is converted by the owner thereof into, or is treated by him as, stock-in-trade of a business carried on by him, such conversion or treatment; or (v) any transaction involving the allowing of the possession of any immovable property to be taken or retained in part performance of a contract of the nature referred to in S. 53A of the Transfer of Property Act, 1882 (4 of 1882); or (vi) any transaction (whether by way of becoming a member of, or acquiring shares in, a co-operative society, company or other association of persons or by way of any agreement or any arrangement or in any other manner whatsoever) which has the effect of transferring or enabling the enjoyment of, any immovable property; Explanation : For the purposes of sub-clauses (v) and (vi), ‘immovable property’ shall have the same meaning as in clause (Id) of the S. 269UA". 1.4 From a bare reading of the above provisions, it is seen that the distribution of capital asset in the course of dissolution is not specifically included in the definition of the term ‘transfer’. Instead, a direct charge is sought to be created by introducing a deeming fiction in the form of S. 45(4) for bringing to tax the deemed capital gains on such distribution. It is this act of bypassing the provision of S. 2(47) by the Legislature that has become the subject matter of an interesting controversy whereunder a possibility of rendering S. 45(4) nugatory is being debated. 1.5 One view of the matter is that S. 45(4) is a charging Section that brings in an effective charge in the circumstances provided therein, independent of S. 2(47). This view is supported by the decisions of the Karnataka and the Goa Bench of the Bombay High Court. The other view of the matter holds that without a specific amendment in S. 2(47) amending the definition of ‘transfer’, S. 45(4) has no independent application. This view is supported by a decision of the Madhya Pradesh High Court. 2. Moped and Machines’ case : 2.1 The issue first arose for consideration of the Madhya Pradesh High Court in the case of CIT v. Moped and Machines, 281 ITR 52 (MP). The assessee in that case was a partnership firm that consisted of two partners. One of the partners expired on April 19, 1990. In the course of assessment proceedings for the A.Y. 1991-92, the assessee firm was asked that since the firm stood dissolved after the death of one of the partners, why the tax on the capital gains should not be imposed on it. Eventually, the Assessing Officer applied provisions of S. 45(4) for including the deemed capital gains in the hands of the firm. 2.2 Being aggrieved, the assessee preferred an appeal before the CIT(A). It was contended before him that S. 45(4) of the Act would not apply unless the gains had arisen from the transfer of the capital asset within the meaning of S. 2(47) of the Act. It was also contended that the Finance Act, 1987, by which S. 45(4) was inserted, did not amend the definition of transfer as contained in S. 2(47), so as to include the distribution of capital asset on dissolution of a firm. It was also highlighted that the distribution of assets of a dissolved firm to the partners did not constitute a sale, exchange, relinquishment of asset or the extinguishment of any right therein, and therefore, it did not fall within the definition of ‘transfer’, and as there was no ‘transfer’ as is envisaged u/s.2(47), there would be no capital gains. The CIT(A) appreciating the contentions came to hold that levy of capital gains did not meet the test of the basic requirement, namely, ‘transfer’. He also held that no capital gains tax can be levied on an entity which was non-existent. In the Revenue’s appeal before the Tribunal, the Tribunal found that the issue was squarely covered in favour of the assessee by the decision of the Income-tax Appellate Tribunal, Jabalpur Bench, in the case of Asst. CIT v. Thermoflics India, 60 ITD 554. Following the same, the Tribunal held that there was no transfer of asset on the dissolution of the firm. 2.3 The Revenue referred the following question of law for consideration of the Madhya Pradesh High Court : "Whether the Tribunal was justified in holding that in the absence of any corresponding amendment in the definition of S. 2(47), there does not arise any liability of capital gains on the firm on the death of one of the partners, thereby deleting the addition of Rs.3,40,198 made by the Assessing Officer ?" 2.4 The Revenue submitted that the Tribunal and the CIT(A) had erred by holding that there had been no transfer in the case at hand and that the definition clause, namely, S. 2(47) did not cover the act of distribution of capital asset on dissolution. It was also submitted that the CIT(A) had erred in law by expressing the view that no capital gains could be levied on the firm which was not-existent. 2.5 For the assessee, the submissions that were advanced before the CIT(A) were reiterated and it was also contended that in the absence of distribution of assets, S. 45(4) of the Act was not attracted. 2.6 The Madhya Pradesh High Court upholding the decision of the Tribunal observed that there was no transfer of capital assets within the meaning of the term as defined u/s.2(47), and in the circumstances, provisions of S. 45(4) were not applicable to the facts of the case. In view of the aforesaid pronouncement of law, the Court was inclined to hold that there was no transfer of assets as per S. 45(4) of the Act, that there could not be a transfer as contemplated u/s.2(47) of the Act on dissolution in the circumstances specified in S. 45(4). 3. Suvardhan’s case : 3.1 The issue once again came up before the Karnataka High Court recently in the case of Suvardhan v. CIT, 287 ITR 404. The assessee in that case was a registered firm which came into existence by way of partnership deed dated July 23, 1986. The partnership consisted of three persons. On July 1, 1988, one of the partners retired and the other two continued the partnership in terms of the partnership deed dated October 17, 1988. A survey was conducted in the business premises of the assessee. It came to light that the firm had been dissolved and the business had been taken over by one of the partners, Smt. Anuradha Maruthi Gokarn. It was also noticed that the partnership was dissolved on April 1, 1992, and the assets and liabilities had been taken over by the said lady. The Assessing Officer proposed to apply S. 45(4) of the Act. Notice was issued. The assessee filed a nil return. Thereafter, the Assessing Officer concluded the assessment u/s.144 of the Act charging capital gains in the hands of the firm in respect of the assets transferred by the firm. The appeal filed by the assessee stood dismissed by the CIT(A). The assessee’s appeal to the Tribunal was also rejected by it. 3.2 At the instance of the assessee, the Tribunal referred the following question of law for consideration of the Karnataka High Court : "Whether, on the facts and in the circumstances of the case, the Tribunal was justified in coming to the conclusion that the assessee-firm was liable to capital gains u/s.45(4), on the ground that there was transfer or distribution of capital assets on the dissolution of the partnership firm ?" 3.3 On behalf of the assessee-firm, attention of the Court was invited to S. 45(4) and S. 2(47) of the Act to contend that the order of the Tribunal required reconsideration. It was contended that both the provisions were required to be read together and that on such a combined reading it was clear that the case on hand was a case of ‘no transfer’. 3.4 For Revenue, the submissions made before the Tribunal were reiterated in support of the order of the Assessing Officer. 3.5 The Court observed that the admitted facts revealed a dissolution of the firm; that the dissolution deed showed that the retiring partner had no objection whatsoever in continuation of business in the same name, either as a sole proprietrix or in any other manner as the other partner thought fit; that the other partner in terms of the materials placed on record had taken over the entire assets and liabilities of the partnership firm. 3.6 The Court further observed that a reading of S. 45(4) showed that the profits or gains arising from the transfer of capital assets by way of distribution of capital assets on the dissolution of a firm was chargeable to tax as the income of the firm, in the light of the fact that a transfer had taken place. The Court also took notice of the assessee’s contention that the term ‘transfer’ had been defined u/s.2(47) of the Act and that if S. 2(47) was read with S. 45(4), there was no transfer at all, and in any case if there was any transfer, it was not by the assessee, but by the retiring partner. 3.7 For considering the issue on hand, the Court was inclined to notice S. 47 of the Act. It noted that S. 47 was a special provision which would define the transactions not regarded as transfer and a reading of the said S. 47 of the Act showed that several transactions were considered as ‘no-transfer’ for the purpose of S. 45 of the Act. It noted S. 47(ii), prior to its deletion read as : "any distribution of capital assets on the dissolution of a firm, body of individuals or other association of persons."; that the said provision was omitted by the Finance Act, 1987 with effect from April 1, 1988; that therefore, any transaction resulting in distribution on dissolution of a firm had to be considered as ‘transfer’ in terms of S. 47; that on omission of clause (ii) of S. 47, it could not be said that S. 45 was inapplicable to the facts in the case on hand. 3.8 The Karnataka High Court further distinguished the judgement of the Madhya Pradesh High Court in CIT v. Moped and Machines, 281 ITR 52 relied upon by the assessee by observing that in the said judgement, there was no reference to omission of clause (ii) of S. 47 as it stood prior to April 1, 1988; that in the said judgement, what was considered was the provisions of S. 45(4) and S. 2(47), as it stood then; that therefore, the said judgement would not be applicable to the issue involved in the case on hand; that on the other hand, the decision of the Bombay High Court in the case of CIT v. A.N. Naik Associates, 265 ITR 346 was found to be applicable, as in the said decision, the Bombay High Court had noticed the effect of the omission of the said clause (ii) of S. 47 by the Act of 1987. 3.9 The Karnataka High Court, in respectful agreement with the judgement of the Bombay High Court, noted that when the Parliament in its wisdom had chosen to remove a provision which provided for the cases of ‘no transfer’, there was no need for any further amendment to S. 2(47) of the Act. The Court accordingly held that despite no amendment to S. 2(47), in the light of removal of clause (ii) to S. 47, the transaction was liable to capital gains tax at the hands of the authorities. 4. Observations : 4.1 Profits or gains arising from the transfer of a capital asset by way of distribution of capital assets, in the course of dissolution of a firm, were not chargeable to capital gains tax, for the reason that such distribution was not considered to be a ‘transfer’ for the purposes of computation of capital gains. This position in law was laid down by the Supreme Court in the cases of CIT v. Dewas Cine Corpn., 68 ITR 240 and Malabar Fisheries Co. v. CIT, 120 ITR 49 (SC). In addition, such an understanding had a legislative acceptance in the form of S. 47(ii) of the Act, which provided that any distribution of capital assets on the dissolution of the firm, etc. would not be regarded as a transfer. 4.2 This settled position was upset by introduction of S. 45(4) and deletion of S. 47(ii) with effect from 1-4-1988 i.e., A.Y. 1988-89 onwards. The reasons for the introduction of the new Section and for disturbing the settled position is explained by Circular No. 495, dated 22-9-1987, vide para 24.3. It was felt that the route of dissolution was used in a scheme of tax avoidance, which enabled the participants of the scheme to transfer assets from one hand to another hand without payment of legitimate tax. 4.3 The Section since its introduction has been the subject matter of intense debate and discussion, as it threw open a large number of complex and unresolved issues including : (a) S. 2(47) of the Act which defines the term ‘transfer’ has not been amended to provide specifically for inclusion of the case of distribution of assets on dissolution. In view of that, a doubt has arisen relating to the enforceability of S. 45(4). (b) The Section covers the cases of dissolution ‘or otherwise’. In view of that, a doubt has arisen about the applicability of S. 45(4) in cases of retirement and withdrawal of assets. (c) The profits or gains are deemed to have arisen in the previous year in which the transfer takes place. The identification of the year of transfer becomes an issue in cases where the year of distribution happens to be different than the year of dissolution. (d) The term ‘distribution’ is a legal and accounting concept which has given rise to a debate as to whether the Section will apply in a case where all the assets are taken away by one of the partners. An issue also has arisen as to whether the sale of capital assets to a partner could be treated as distribution of assets or not. (e) A doubt has arisen about the entity in whose hands the deemed capital gain could be taxable, i.e., whether the gain would be taxed in the hands of the firm or in the hands of the group of partners as the firm has been dissolved and ceases to continue. (f) Whether the provisions of S. 45(4) apply to the cases of dissolution by operation of law, for example, dissolution on death or insolvency of a partner where no tax avoidance is intended at all. Though issues are several, the subject matter of discussion here is restricted to the one that is arising out of the conflicting decisions of the Court discussed here, on the subject of the legislative need to have amended the provisions of S. 2(47) for roping in the transactions of distribution in the course of dissolution. 4.4 Transactions of introduction and withdrawal of assets into and from a firm by partners and distribution of assets on dissolution, which are not regarded as transfers under general law, have been the subject of controversy in tax laws for the last several decades. Since distribution of assets of a firm amongst its partners on dissolution of a firm was not regarded as a transfer, on account of various decisions of the Supreme Court, there was a need to amend the definition of ‘transfer’ as contained in S. 2(47) by specifically roping in the case of distribution of assets in the course of dissolution. Since the same has not yet been amended to cover specifically the case of dissolution of a firm, the debate about the validity of the amendment is raging. 4.5 The decision of the MP High Court highlights that the amendment has not materially changed the legal position. It explains that the legislature should have simultaneously amended the definition of ‘transfer’ u/s.2(47) and ‘income’ u/s.2(24). Since no such amendments have been made, it is believed that the ratio of the Supreme Court decision in Malabar Fisheries’ case still applies, and that there is no ‘transfer’ which gives rise to capital gains. 4.6 As against that, the Karnataka and Bombay High Courts hold that S. 45(4) is introduced mainly with a view to nullify the decisions of the Supreme Court. It is pointed out that the other view, if accepted, would render S. 45(4) nugatory and the purpose of enactment by the Legislature would be nullified. It is believed that the decisions of the Supreme Court, on the subject, do not hold good anymore. It is further said that S. 45 is a charging Section, and is a complete code within itself. The capital gains arising on distribution of capital assets on dissolution can be computed and subjected to tax u/s.45 itself, and therefore there was no legislative necessity to have amended either S. 2(47) or S. 2(24) to enlarge the definition of the terms ‘transfer’ and ‘income’. 4.7 The Pune Bench of the ITAT, in the case of Kothari Vora Associates v. ACIT, 57 ITD 171, has considered this issue in detail. The assessee in that case claimed that S. 45(4) was inoperative in view of the Supreme Court decision in the case of Malabar Fisheries Co. 120 ITR 49, and that there was no liability to tax in the absence of a specific provision in S. 2(47) of the Act. Applying the principles of mischief rule supplied by Heydon’s case, 3 Co. Rep.7a, and discussed by the Supreme Court in the case of Dr. Baliram Waman Hiray v. Mr. Justice B. Lentin, 176 ITR 1, the Tribunal found that S. 45(4) was brought on the statute book to remedy the mischief and advance the case of the Revenue. There was avoidance of capital gains tax on transfer of capital assets on dissolution of a firm, and in order to remedy the situation, S. 45(4) was inserted. The interpretation of this provision should be harmonious, so as to advance the remedy and suppress the mischief. The Tribunal therefore held that the principles laid down in the case of Malabar Fisheries Co. were no longer applicable. The Tribunal felt that there was no necessity for corresponding amendment to S. 2(47) and S. 2(24), as S. 45 was a charging Section and a complete code in itself, and therefore it was not necessary to go to S. 2(47) or S. 2(24) to decide whether the distribution of capital assets on dissolution of a firm was chargeable to tax or not. A similar view is taken in the cases of Suvardhan, 67 ITD 104 (Bang.), Swamy Studio, 66 ITD 276 (Mad.) and Singla Rice & General Mills, 82 ITD 778 (Del.). It is that decision of the Bangalore Tribunal in Suvardhan’s case that has been approved by the Karnataka High Court, which has been the subject matter of discussion here. 4.8 A similar issue was considered by the Jabalpur Bench of the ITAT in the case of Thermoflics India, 60 ITD 554. In this case, on the expiry of one partner, the second partner retired from the firm on the same date and the remaining third partner took over all the assets and liabilities of the firm. The Tribunal in that case considered the amendments brought about to the definition of ‘transfer’ by insertion of clauses (v) and (vi) to S. 2(47) with effect from A.Y. 1988-89. It concluded that the definition of the word ‘transfer’ as per S. 2(47) did not cover the case of distribution of assets among partners on the dissolution of a firm. The Tribunal therefore concluded that the provisions of S. 45(4) did not apply unless the definition of the word ‘transfer’ in S. 2(47) was amended or modified to cover the cases of distribution of assets on dissolution of a firm. It is this decision of the Jabalpur Tribunal in the Thermoflics’ case that has been approved by the MP High Court in Moped & Machines’ case, which has been the subject matter of discussion here. 4.9 The Bombay High Court was concerned with the issue on hand in the case of A. N. Naik & Associates, 265 ITR 346, in the context of retirement. In that case, the Court observed that the Act of 1987 brought on the statute book a new Ss.(4) in S. 45 of the Act, whose effect was that the profits or gains arising from the transfer of a capital asset by a firm to a partner on dissolution or otherwise would be chargeable as the firm’s income in the previous year in which the transfer took place. It further observed that before the introduction of Ss.(4), clause (ii) of S. 47 provided that the distribution of capital assets on the dissolution of a firm, etc. was not regarded as transfer, however, the Finance Act, 1987, with effect from April 1, 1988 omitted that clause, instead of amending S. 2(47), the effect of which was that distribution of capital assets on the dissolution of a firm would be regarded as transfer. 4.10 It is clearly evident that the High Courts of Bombay and Karnataka have decided the issue on hand by mainly relying on the fact of deletion of S. 47(ii), perhaps on the understanding that even in the times before its deletion there was a ‘transfer’ on such dissolution but such transfer was saved from the liability to capital gains tax only because of the saving provided by sub-clause (ii) of S. 47. We respectfully beg to differ with this understanding inasmuch as it is the clear position in law that there are several cases of transfer which cannot be regarded as ‘transfer’ within the meaning of term as defined u/s.2(47) independent of S. 47 and that the effect of S. 47 is that it seeks to define some of them by specifically excluding them for removal of doubts. It has never been the case that a transaction for it being excluded from the provisions of S. 2(47) has to be the one which is specifically excluded therefrom by S. 47. At the same time, we note that this aspect of the matter was not considered explicitly by the MP High Court, though the same was considered by the Tribunal. Again, the Karnataka High Court, in deciding the issue by relying heavily on the omission of said sub-clause (ii) of S. 47, perhaps has erroneously observed that the MP High Court was concerned with the case which had the benefit of the said sub-clause, which we respectfully submit was not the case inasmuch as the Court in that case was concerned with the A.Y. 1991-92 and the Karnataka High Court was concerned with A.Y. 1992-93, the years for which the benefit of the said sub-clause had ceased to be available. 4.11 The issue remains unresolved as is evident by the conflicting decisions of the Courts on the subject and is sure to haunt the corridors of the Court. However, the better view appears that S. 45(4) is a charging Section, as the same is introduced for plugging the mischief as is noted by the Bombay High Court. However this still leaves the fate of those cases open where the dissolution is not effected for tax evasion, but has taken place per force of law. It is desirable, in view of the conflicting judicial views clearly conveying that there is a scope for two genuinely divergent views, that the Government wakes up and takes necessary action to clarify its intentions by specifically amending the law. 4.12 Normally, in cases of firms consisting of more than two partners, the death or insolvency of a partner would result in dissolution of the firm as per the provisions of the said Act. However, there would be no dissolution in a case where the partners have agreed to continue the partnership and the business even after death or insolvency, on certain terms and conditions. On compliance of such terms, the firm will be said to have continued. In such cases, there is a consensus of opinion that the provisions of S. 45(4) will not apply. 4.13 Cases which create real difficulty are the cases of partnership consisting of two partners only. It is in such cases that a difficulty arises, where one of the partners dies or is declared insolvent or retires. In such cases, the firm shall stand automatically dissolved on death or insolvency or on retirement by operation of the law. In such cases of severe hardships, the recent decision of the Madras High Court in the case of CIT v. Vijaya Metal Industries, 256 ITR 540, provides a major breakthrough. In that case, the assessee partnership consisted of two partners, which was dissolved on death of one of the partners. The business of the partnership firm was continued by the surviving partner with the assets of the partnership firm. The Income-tax Department applied the provisions of S. 45(4) and brought to tax the deemed capital gain by holding that the transfer took place on dissolution of the firm. The Tribunal held that though the dissolution of firm took place by operation of law, it was not followed by transfer of capital assets by way of distribution of such assets. The Madras High Court confirmed the decision of the Tribunal. 4.14 The decision in the case of Vijaya Metal Industries provides a much needed relief. With this, one thing is certain that the dissolution by itself will not result in distribution of assets of the firm. The distribution will take place only on taking of a positive action by the parties concerned for distributing the assets. Till such time, the assets may be treated as jointly held by the parties. This by itself is a big relief for the assessees who are caught unaware. It is also certain that it is possible to defer the year of taxation to the year in which the distribution takes place. This will enable an assessee to comprehend the impact of S. 45(4) and plan for the same. In view of the above, a new possibility has emerged whereunder the surviving partner can successfully join hands with the legal heirs of the deceased partner, in partnership and continue the business with the assets of the erstwhile firm. In such a case, the above-referred decision will help in contending that the assets of the erstwhile firm are not distributed amongst the parties entitled to it and till such time no liability to tax by virtue of S. 45(4) will arise.
28 May 2014
Thank You so much sir for the detailed explanation but as we have Malabar Fisheries from the SC and Moped and Machines from MP HC, cant we rely on their decisions as the decision to be taken relates to a firm in MP and whenever there is such a conflicting situation, the benefit of doubt is given to the assessee?
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