Legal Provisions on Reconstitution of a firm and its Tax Impact

1. Sec 45(1) of the Act states as follows:

Any profits or gains arising from the transfer of a capital asset effected in the previous year shall, save as otherwise provided in sections 54, 54B, 54D, 54E, 54EA, 54EB, 54F, 54G and 54H be chargeable to income-tax under the head "Capital gains", and shall be deemed to be the income of the previous year in which the transfer took place.

2. Sec 45 of the Act states as follows:

[(4) Notwithstanding anything contained in sub-section (1), where a specified person receives during the previous year any money or capital asset or both from a specified entity in connection with the reconstitution of such specified entity, then any profits or gains arising from such receipt by the specified person shall be chargeable to income-tax as income of such specified entity under the head "Capital gains" and shall be deemed to be the income of such specified entity of the previous year in which such money or capital asset or both were received by the specified person, and notwithstanding anything to the contrary contained in this Act, such profits or gains shall be determined in accordance with the following formula, namely:

A = B+C-D

Where,

• A = income chargeable to income-tax under this sub-section as income of the specified entity under the head "Capital gains";
• B = value of any money received by the specified person from the specified entity on the date of such receipt;
• C = the amount of fair market value of the capital asset received by the specified person from the specified entity on the date of such receipt; and
• D = the amount of balance in the capital account (represented in any manner) of the specified person in the books of account of the specified entity at the time of its reconstitution:

Provided that if the value of "A" in the above formula is negative, its value shall be deemed to be zero:

Provided further that the balance in the capital account of the specified person in the books of account of the specified entity is to be calculated without taking into account the increase in the capital account of the specified person due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset.

Explanation 1.- For the purposes of this sub-section,-

(i) the expressions "reconstitution of the specified entity", "specified entity" and "specified person" shall have the meanings respectively assigned to them in section 9B;

(ii) "self-generated goodwill" and "self-generated asset" mean goodwill or asset, as the case may be, which has been acquired without incurring any cost for purchase or which has been generated during the course of the business or profession.

Explanation 2.-For the removal of doubts, it is clarified that when a capital asset is received by a specified person from a specified entity in connection with the reconstitution of such specified entity, the provisions of this sub-section shall operate in addition to the provisions of section 9B and the taxation under the said provisions thereof shall be worked out independently.]]

3. Sec 9B of the Act states as follows:

(1) Where a specified person receives during the previous year any capital asset or stock in trade or both from a specified entity in connection with the dissolution or reconstitution of such specified entity, then the specified entity shall be deemed to have transferred such capital asset or stock in trade or both, as the case may be, to the specified person in the year in which such capital asset or stock in trade or both are received by the specified person.

(2) Any profits and gains arising from such deemed transfer of capital asset or stock in trade or both, as the case may be, by the specified entity shall be-

(i) deemed to be the income of such specified entity of the previous year in which such capital asset or stock in trade or both were received by the specified person; and

(ii) chargeable to income-tax as income of such specified entity under the head "Profits and gains of business or profession" or under the head "Capital gains", in accordance with the provisions of this Act.

3.1 The primary conditions specified in sec 9B of the Act are -

a. Any capital asset or stock in trade is received by a specified person i.e. the partner of LLP from the specified entity i.e. the partnership firm

b. Such receipt is in connection with the dissolution or reconstitution of the specified entity

"reconstitution of the specified entity" means, where-

(a) one or more of its partners or members, as the case may be, of such specified entity ceases to be partners or members; or…………………………

3.2 It can be seen that there are two main conditions to be complied with in order to bring a transaction within the scope of provisions of sec 9B of the Act i.e.

• receipt of capital asset or stock in trade
• there should be re-constitution of the entity

In a case; where there is a re-constitution of the LLP and the retiring partners do not receive any asset or stock-in-trade from the LLP; then deeming provisions of sec 9B shall not be applicable to this case.

3.3 If the outgoing partners receive money from the LLP; deeming provision u/s 45(4) shall operate and taxability in this case shall be determined as per the deeming provisions of sec 45(4) of the Act which states as follows:

[(4) Notwithstanding anything contained in sub-section (1), where a specified person receives during the previous year any money or capital asset or both from a specified entity in connection with the reconstitution of such specified entity, then any profits or gains arising from such receipt by the specified person shall be chargeable to income-tax as income of such specified entity under the head "Capital gains" and shall be deemed to be the income of such specified entity of the previous year in which such money or capital asset or both were received by the specified person, and notwithstanding anything to the contrary contained in this Act, such profits or gains shall be determined in accordance with the following formula, namely:-

A = B + C - D

Where,

• A = income chargeable to income-tax under this sub­section as income of the specified entity under the head "Capital gains";
• B = value of any money received by the specified person from the specified entity on the date of such receipt;
• C = the amount of fair market value of the capital asset received by the specified person from the specified entity on the date of such receipt; and
• D = the amount of balance in the capital account (represented in any manner) of the specified person in the books of account of the specified entity at the time of its reconstitution:

Provided that if the value of "A" in the above formula is negative, its value shall be deemed to be zero:

Provided further that the balance in the capital account of the specified person in the books of account of the specified entity is to be calculated without taking into account the increase in the capital account of the specified person due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset.

Explanation 1. For the purposes of this sub-section,-

(i) the expressions "reconstitution of the specified entity", "specified entity" and "specified person" shall have the meanings respectively assigned to them in section 9B;

(ii) "self-generated goodwill" and "self-generated asset" mean goodwill or asset, as the case may be, which has been acquired without incurring any cost for purchase or which has been generated during the course of the business or profession.

3.4 Explanation 2.-For the removal of doubts, it is clarified that when a capital asset is received by a specified person from a specified entity in connection with the reconstitution of such specified entity, the provisions of this sub-section shall operate in addition to the provisions of section 9B and the taxation under the said provisions thereof shall be worked out independently.]

3.5 Thus profits and gain arising to the outgoing partners on account of such receipt shall be chargeable to tax as income of LLP and shall be calculated as follows:

When the fair valued asset of the LLP will be finally sold; then as per clause (iii) of sec 48 of the Act - if money or capital asset had been received by the outgoing partner A then the amount charged to tax u/s 45(4) of the Act which is attributable to the capital asset being now transferred by LLP calculated as per Rule 8AB of the Income Tax Rules shall be reduced from the sale consideration.