The Commr Of Income Tax vs M/S Dynamic Enterprise

The transaction falls within the ambit of the word

"otherwise" in Section 45(4) of the Act. Even otherwise it is a

devise adopted by the partners to evade payment of profits or

gains and taxable.

9. Per contra, the learned counsel for the assessee

contended that in order to attract Section 45(4), the

condition precedent is that there should be a dissolution of

the firm and distribution of capital asset in which the

outgoing partners should acquire interest in the capital asset

and consequently the firm should cease to have any interest 10

in the capital asset so transferred. The profit or gain arising

from such transfer of a capital asset is taxable, under

Section 45(4) of the Act, which is not the case on hand.

10. It is in this background we have to notice the

conflicting judgments of this Court, which resulted in this

reference and resolve the conflict.

CONFLICTING JUDGMENTS

11. Before the Division Bench reliance was placed

on the judgment of this Court in the case of Commissioner

of Income Tax and Another Vs. Gurunath Talkies

reported in (2010) 328 ITR 59. This Court in paras 24 to

28 has made the following observations:

"24. In this view of the matter we answer the first question in the affirmative in favour of the Revenue holding that there was a transfer of capital asset attracting the capital gain transaction in terms of s.45(4) of the Act. 11

25. The second question is answered in the negative in favour of the Revenue and against the assessee holding that the judgments which were noticed by the Tribunal were in the context of the law as it existed prior to its amendment in the year 1987. Finance Act of 1987 having expressly and with definite purpose brought about the amendment to IT Act reintroducing sub-ss. (3) and (4) to s. 45 of the Act, the Tribunal should have examined the appeal before it merely by applying the statutory provisions as it prevailed during the accounting period relevant to the assessment year 1994-95 and not merely by following the principles, the ratio of the judgment of the Supreme Court which had been rendered slightly in a different context. Though Mr.Shankaranarayana Rao, learned counsel for the assessee would submit that the assessee had not indulged in any suppression or mis- representation and that the transactions were genuine and has been clearly disclosed in the return and therefore in the situation never warranted a levy of penalty as it was proposed in the assessment order and also does not warrant levy of interest, as a consequence of this appeal 12

being allowed, it automatically restores the levy of interest; we are afraid that the Tribunal having not looked into this aspect and having merely examined merits of the appeal before it as to there being loss and there being gain and as this question is now answered against the assessee, there is no scope for us to independently examine the question of levy of interest. It remains.

26. However, we notice the question of penalty is an independent proceeding and it is open to the assessee to urge such defence as is available to the assessee in an appropriate proceeding rather than to elicit a finding in this appeal.

27. Mr.Rao has brought to our notice that in respect of judgment of the Bombay High Court in A.N.Naik's case (supra)and also the judgment of our High Court in Suvardhan's case (supra) SLPs have been preferred by the assessee and leave has been granted to appeal and appeals are pending.

28. May be the position is that but on that premise we do not think we should keep this appeal 13

pending without answering the questions raised in this appeal as the law which governs the field has been applied and questions are answered herein. There is no question of postponing the decision in this appeal any further."

12. Then the Division Bench noticed the judgment of

this Court in the case of Commissioner of Income Tax Vs.

Mangalore Ganesh Beedi Works reported in (2004) 265

ITR 658 held at para-20 as under:

"20. In view of the above statutory provisions and the law laid down by the Supreme Court it appears reasonable to hold that though the firm stood dissolved on 5th December 1987, for a limited purpose of winding up of the affairs of the firm, it continued till its assets and business were sold as a going concern on 20th November 1994. Therefore, the firm continued to hold the properties as owner till 20th November 1994. For the foregoing reasons, we hold that there was no distribution of capital assets of the firm despite its dissolution and, therefore, the firm could 14

not have been made liable for paying capital gains tax in terms of s.45(4) of the Act."

13. In Gurunath's case (supra), this Court held in

view of the series of transactions such as reconstitution of

firm twice; once in July, 1994 and another in December,

1994 and the entire assets retained in the hands of the

newly added two partners, results in transfer of assets of the

firm in the sense that the assets of the firm as had been held

by the erstwhile partners is transferred to the newly added

two partners though all along the assets of the firm

continued in the hands of the firm. Therefore, it was held

that there is transfer of capital assets within the meaning of

Section 2(47).

14. In Mangalore Ganesh Beedi Works's case

(supra), after the dissolution of the firm, its business was

continued by association of persons comprised of all the

erstwhile 13 partners by using the assets as well as the

name of the dissolved firm. Therefore, till the date of 15

dissolution, the name "Mangalore Ganesh Beedi Works" was

of the partnership firm. Whereas, after the dissolution, it

became the name of the association of persons comprised of

all the erstwhile partners of the dissolved firm. In that

context it was held though the firm stood dissolved on

December 5th 1987, for a limited purpose of winding up of

the affairs of the firm, it continued till its assets and

business were sold as a going concern on November 20th

1994. Therefore, the firm continued to hold the properties

as owner till November 20th 1994. In those circumstances,

there was no distribution of capital assets of the firm despite

its dissolution and therefore the firm could not have been

made liable for paying capital gains tax in terms of Section

45(4) of the Act. It is in this background, we have to resolve

the conflict between these two decisions.

STATUTORY PROVISIONS

15. In the instant case, the assessee is sought to be

taxed under Section 45(4) of the Act on the ground that there 16

is a transfer of the properties of the partnership firm. Section

45(1), (3) and (4) of the Income Tax Act reads as under:

"45. Capital Gains.- [(1)] 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.

xxx xxx xxx

(2) xxxx

[(3) The profits or gains arising from the transfer of a capital asset by a person to a firm or other association of persons or body of individuals (not being a company or a co-operative society) in which he is or becomes a partner or member, by way of capital contribution or otherwise, shall be chargeable to tax as his income of the previous year in which such transfer takes place and, for the purposes of section 48, the amount recorded 17

in the books of account of the firm, association or body as the value of the capital asset shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of the capital asset.

(4) 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 section 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]"

16. The word 'transfer' has been defined in Section

2(47) of the Act as under:-

"Transfer", in relation to a capital asset, includes,- 18

(i) the sale, exchange or relinquishment of the asset; or

(ii) the extinguishment 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]

[(iva) the maturity or redemption of a zero coupon bond; 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 section 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 19

shares in, or 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 purpose of sub-clauses (v) and (vi), "immovable property" shall have the same meaning as in clause (d) of section 269UA;]"

17. Section 14 of the Indian Partnership Act, 1932

deals with the property of the firm, which reads as under:-

"14. The property of the firm - Subject to contract between the partners, the property of the firm includes all property and rights and interests in property originally brought into the stock of the firm, or acquired, by purchase or otherwise, by or for the firm, or for the purposes and in the course of the business of the firm, and includes also the goodwill of the business. 20

Unless the contrary intention appears, property and rights and interest in property acquired with money belonging to the firm are deemed to have been acquired for the firm."

18. The Apex Court in the case of Narayanappa vs.

Bhaskara Krishnappa reported in AIR 1966 SC 1300

dealing with the concept of partnership held as under:-

"The Whole concept of partnership is to embark upon a joint venture and for that purpose to bring in as capital money or even property including immovable property. Once that is done, whatever is brought in would cease to be the exclusive property of the person who brought it in. It would be the trading asset of the partnership in which all the partners would have interest in proportion to their share. The person who brought it in would, therefore, not be able to claim or exercise any exclusive right over any property which he has brought in, much less over any other partnership property. He would not be able to exercise his right even to the extent of his share in the partnership. His right during the 21

subsistence of the partnership is to get his share of profits from time to time as may be agreed upon among the partners and after the dissolution of the partnership or with his retirement from the partnership, of the value of his share in the net partnership assets as on the date of dissolution or retirement after a deduction of liabilities and other prior charges."

19. The Supreme Court in the case of Malbar

Fisheries Co. vs. CIT reported in (1979) 120 ITR 49

explaining the position of a partnership under the

Partnership Act as well as Income Tax Act held as under:-

"A Partnership Firm under the Indian Partnership Act, 1932, is not a distinct legal entity apart from the partners constituting it and equally in law the Firm as such has no separate rights of its own in the Partnership Assets and when one talks of firm's property or the firm's assets all that is meant is property or assets in which all partners have a joint or common interest. It can not, therefore, be said that, upon 22

dissolution, the firm's rights in the partnership assets are extinguished. It is the partners who own jointly or in common the assets of the partnership and, therefore, the consequence of the distribution, division or allotment of assets to the partners which flows upon dissolution after discharge of liabilities is nothing but a mutual adjustment of rights between partners and there is no question of any extinguishment of the firm's rights in the partnership assets amounting to a transfer of assets within the meaning of sec.2(47) of the IT Act, 1961. There is no transfer of assets involved even in the sense of any extinguishment of the firm's rights in the partnership assets when distribution takes place upon dissolution.

In order to attract S.34(3)(b) it is necessary that the sale or transfer of asset must be by the assessee to a person. Dissolution of a firm must, in point of time, be anterior to the actual distribution, division or allotment of the assets that takes place after making accounts and discharging the debts and liabilities due by the Firm. Upon dissolution the firm ceases to exist; then follows the making up of accounts, then the discharge of debts and liabilities and thereupon 23

distribution, division or allotment of assets takes place inter se between the erstwhile partners by way of mutual adjustment of rights between them. The distribution, division, or allotment of assets of the erstwhile partners, it not done by the dissolved firm."

20. The Apex Court in the case of Sunil

Siddharthbhai vs. Commissioner of Income Tax,

Ahmedabad reported in (1985) Vol. 156 ITR 509 (SC) at

pages 518, 519, 520 and 522 held as under:-

"When a partner brings in his personal asset into a partnership firm as his contribution to its capital, an asset which originally was subject to the entire ownership of the partner becomes now subject to the rights of other partners in it. It is not an interest which can be evaluated immediately. It is an interest which is subject to the operation of future transactions of the partnership, and it may diminish in value depending on accumulating liabilities and losses with a fall in the prosperity of the partnership 24

firm. The evaluation of a partner's interest takes place only when there is a dissolution of the firm or upon his retirement from it. It has some times been said, and we think erroneously, that the right of a partner to a share in the assets of the partnership firm arises upon dissolution of the firm or upon the partner retiring from the firm. We think it necessary to state that what is envisaged here is merely the right to realise the interest and receive its value. What is realised is the interest, which the partner enjoys in the assets during the subsistence of the partnership firm by virtue of his status as a partner and in accordance with the terms of the partnership agreement.

What the partner gets upon dissolution or upon retirement is the realisation of a pre- existing right or interest. It is nothing strange in the law that a right or interest should exist in praesenti but its realisation or exercise should be postponed. Therefore, what was the exclusive interest of a partner in his personal asset is, upon its introduction into the partnership firm as his share to the partnership capital, transformed into an interest shared with the other partners in that asset. Qua that asset, there is a shared interest. 25

During the subsistence of the partnership, the value of the interest of each partner qua that asset cannot be isolated or carved out from the value of the partner's interest in the totality of the partnership assets. And in regard to the latter, the value will be represented by his share in the net assets on the dissolution of the firm or upon the partner's retirement.

What is the profit or gain which can be said to accrue or arise to the assessee when he makes over his personal asset to the partnership firm as his contribution to its capital? The consideration, as we have observed, is the right of a partner during the subsistence of the partnership to get his share of profits from time to time and after the dissolution of the partnership or with his retirement from the partnership to receive the value of the share in the net partnership assets as on the date of dissolution or retirement after a deduction of liabilities and prior charges. When his personal asset merges into the capital of the partnership firm a corresponding credit entry is made in the partner's capital account in the books of the partnership firm, but that entry is made merely for the purpose of adjusting the rights of 26

the partners inter-se when the partnership is dissolved or the partner retires. It evidences no debt due by the firm to the partner. Indeed, the capital represented by the notional entry to the credit of the partner's account may be completely wiped out by losses which may be subsequently incurred by the firm, even in the very accounting year in which the capital account is credited. Having regard to the nature and quality of the consideration which the partner may be said to acquire on introducing his personal asset into the partnership firm as his contribution to its capital it cannot be said that any income or gain arises or accrues to the assessee in the true commercial sense which a business man would understand as real income or gain."

21. Under the provisions of the Partnership Act,

1932, the firm is not recognized as a legal entity. A

Partnership Firm is not a distinct legal entity apart from

the partners constituting it. In law the Firm as such has

no separate rights of its own in the Partnership Assets.

When one talks of firm's property or the firm's assets all 27

that is meant is property or assets in which all partners

have a joint or common interest. The Whole concept of

partnership is to embark upon a joint venture and for

that purpose to bring in as capital money or even property

including immovable property. Once that is done,

whatever is brought in would cease to be the exclusive

property of the person who brought it in. It would be the

trading asset of the partnership in which all the partners

would have interest in proportion to their share. The

property of the firm includes all property and rights and

interests in property originally brought into the stock of

the firm, or acquired, by purchase or otherwise, by or for

the firm, or for the purposes and in the course of the

business of the firm, and includes also the goodwill of the

business. Property and rights and interest in property

acquired with money belonging to the firm are deemed to

have been acquired for the firm. When a partner brings in

his personal asset into a partnership firm as his

contribution to its capital, an asset which originally was 28

subject to the entire ownership of the partner becomes

now subject to the rights of other partners in it. When his

personal asset merges into the capital of the partnership

firm a corresponding credit entry is made in the partner's

capital account in the books of the partnership firm, but

that entry is made merely for the purpose of adjusting the

rights of the partners inter-se when the partnership is

dissolved or the partner retires. His right during the

subsistence of the partnership is to get his share of profits

from time to time as may be agreed upon among the

partners and after the dissolution of the partnership or

with his retirement from the partnership, of the value of

his share in the net partnership assets as on the date of

dissolution or retirement after a deduction of liabilities

and other prior charges. Dissolution of a firm must, in

point of time, be anterior to the actual distribution.

Division or allotment of the assets that takes place after

making accounts and discharging the debts and liabilities

due by the Firm. The distribution, division, or allotment 29

of assets of the erstwhile partners, is not done by the

dissolved firm. It is the partners who own jointly or in

common the assets of the partnership and, therefore, the

consequence of the distribution, division or allotment of

assets to the partners which flows upon dissolution after

discharge of liabilities is nothing but a mutual adjustment

of rights between partners and there is no question of any

extinguishment of the firm's rights in the partnership.

22. However, the Income Tax Act recognizes the

firm as a distinct assessable legal entity apart from its

partners. Sub-sections (3) and (4) of Section 45 were

introduced by Finance Act, 1987, which came into effect

from 01.04.1988. In sub-section (3) what is sought to be

taxed is the profits or gains arising from the transfer of a

capital asset by a person to a firm or other association of

persons or body of individuals. After such transfer, he is

or becomes a partner or member, by way of capital

contribution or otherwise. Then the said capital 30

contribution shall be chargeable to tax as his income of

the previous year in which such transfer takes place and,

for the purposes of section 48, the amount recorded in

the books of account of the firm, association or body as

the value of the capital asset shall be deemed to be the

full value of the consideration received or accruing as a

result of the transfer of the capital asset. When a partner

brings in his personal asset into a partnership firm as his

contribution to its capital, an asset which was originally

exclusively belonging to him, becomes the trading asset of

the firm, in which all partners acquire interest in

proportion to their respective share in the firm. His right

during the subsistence of the partnership is to get his

share of profits from time to time as agreed upon among

the partners. On dissolution of the firm or on retirement

from the firm to get the value of his share in the net

partnership asset as on the date of dissolution or

retirement. Therefore, this is a case of a partner bringing 31

capital asset to a partnership firm as his capital

contribution.

23. Sub-section (4) of Section 45 deals with a

distribution of capital assets on the dissolution of a firm or

other association of persons or body of individuals or

otherwise. If in the course of such distribution of capital

asset there is a transfer of a capital asset by the firm in

favour of a person and it results in profits or gains to the

firm, then the said profits or gains shall be chargeable to tax

as income of the firm and again for computing such income,

Section 48 is attracted. In other words, in the process of a

dissolution of a firm, if a capital asset is transferred to a

partner which results in profits or gains, then that income is

chargeable at the hands of the firm under this provision. In

order to attract sub-section (4) of Section 45, the condition

precedent is,

(1) There should be a distribution of capital assets of a firm; (2) Such distribution should result in transfer of a capital asset by firm in favour of the partner; and 32

(3) On account of the transfer there should be a profit or gain derived by the firm.

(4) Such distribution should be on dissolution of the firm or otherwise.

24. Therefore, in order to attract Section 45(4) of the

Act, the capital asset of the firm should be transferred in

favour of a partner, resulting in firm ceasing to have any

interest in the capital asset transferred and the partners

should acquire exclusive interest in the capital asset. In

other words, the interest the firm has in the capital asset

should be extinguished and the partners in whose favour the

transfer is made should acquire that interest. Then only the

profits or gains arising from such transfer is liable to tax

under Section 45(4) of the Act.

25. In the instant case, the partnership firm had

purchased the property under a registered sale deed in the

name of the firm. The property did not stand in the name of

any individual partners. No individual partners brought that

capital asset as capital contribution into the firm. Five 33

partners brought in cash by way of capital when the firm

was reconstituted on 28.04.1993. Nearly a year thereafter on

01.04.1994 by way of retirement, the erstwhile three

partners took their share in the partnership asset and went

out of the partnership. After the retirement of three

partners, the partnership continued to exist and the

business was carried on by the remaining five partners.

There was no dissolution of the firm or at any rate there was

no distribution of capital asset on 01.04.1994 when three

partners retired from the partnership firm. What was given

to the retiring partners is cash representing the value of their

share in the partnership. No capital asset was transferred

on the date of retirement under the deed of retirement deed

dated 01.04.1994. In the absence of distribution of capital

asset and in the absence of transfer of capital asset in favour

of the retiring partners, no profit or gain arose in the hands

of the partnership firm. Therefore, the question of the firm

being assessed under Section 45(4) and charging them tax 34

for the profits or gains which did not accrue to them would

not arise.

26. It was contended on behalf of the revenue that

five incoming partners brought money into the firm. Three

erstwhile partners who retired from the partners on

01.04.1994 took money and left the property to the incoming

partners. It is a device adopted by these partners in order to

evade payment of profits or gains. As rightly held by this

Court in Gurunath's case (supra) it is taxable. This

argument proceeds on the premise that the immovable

property belongs to the erstwhile partners and that after the

retirement the erstwhile partners have taken cash and given

the property to the incoming partners. The property belongs

to the partnership firm. It did not belong to the partners.

The partners only had a share in the partnership asset.

When the five partners came into the partnership and

brought cash by way of capital contribution to the extent of

their contribution, they were entitled to the proportionate 35

share in the interest in the partnership firm. When the

retiring partners took cash and retired, they were not

relinquishing their interest in the immovable property. What

they relinquished is their share in the partnership.

Therefore, there is no transfer of a capital asset, as such, no

capital gains or profit arises in the facts of this case. In that

view of the matter, Section 45(4) has no application to the

facts of this case.

27. In Gurunath's case (supra), the Division Bench

of this Court followed the judgment of the Bombay High

Court in the case Commissioner of Income Tax Vs.

A.N.Naik Associate - (2004) 265 ITR 346 (BOMBAY). In

Naik's case, the asset of the partnership firm was

transferred to a retiring partner by way of a deed of

retirement. A memorandum of family settlement was entered

into and the business of those firms as set out therein was

distributed in terms of the family settlement as the party

desired that various matters consisting the business and 36

assets thereto be divided separately and partitioned. The

term has also provided that such of those assets or liabilities

belonging to or due from any of the firms allotted, the parties

thereto in the schedule annexed shall be transferred or

assigned irrevocably and possession made over and all such

documents, deeds, declarations, affidavits, petitions, letters

and alike as are reasonably required by the party entitled to

such transfer would be effected. It is based on this

document and subsequent deeds of retirement of

partnership that the order of assessment was made holding

that the assesses are liable for tax on capital gains.

28. In that context, the Bombay High Court held

that when the assets of the partnership is transferred to a

retiring partner, the partnership which is assessable to tax

ceases to have a right or its right in the property stands

extinguished in favour of the partner to whom it is

transferred. If so read, it will further the object and the

purpose and intent of the amendment of Section 45. Once 37

that be the case, the transfer of assets of the partnership to

the retiring partners would amount to the transfer of capital

assets in the nature of capital gains and business profits

which is chargeable to tax under Section 45(4) of the Income

Tax Act. In that context, it was held the word "otherwise"

takes into its sweep not only cases of dissolution but also

cases of subsisting partners of a partnership, transferring

assets in favour of a retiring partner. It is in this context the

Bombay High Court held that Section 45(4) was attracted.

Therefore, to attract Section 45(4) there should be a transfer

of a capital asset from the firm to the retiring partners, by

which the firms ceases to have any right in the property

which is so transferred. In other words, its right to the

property should stand extinguished and the retiring partners

acquires absolute title to the property.

29. In the instant case, the partnership firm did not

transfer any right in the capital asset in favour of the retiring

partner. The partnership firm did not cease to hold the 38

property and consequently, its right to the property is not

extinguished. Conversely, the retiring partner did not

acquire any right in the property as no property was

transferred in their favour. The Division Bench in

Gurunath's case (supra) did not appreciate this

distinguishing factor and by wrong application of the law laid

down by the Bombay High Court held the assessee in that

case is also liable to pay capital gains tax under Section

45(4). Therefore, the said judgment does not lay down the

correct law.

30. We would like to add that several other aspects

of Section 45(4) was addressed in the course of the

arguments by both sides which are not relevant to

adjudicate the present issue, as in the present case there is

no distribution of assets and hence, one of the condition

precedent for invoking Section 45(4) does not exist and

hence Section 45(4) is not attracted to the facts of this case. 39

ANSWER

31. The reference is answered as

under:

"When a retiring partner takes only money towards the value of his share and when there is no distribution of capital asset/assets among the partners there is no transfer of a capital asset and consequently no profits or gains is payable under Section 45(4) of the Income Tax Act?"

32. In so far as the substantial question of law

"whether the retiring partner would be liable to pay capital

gain" is concerned, the said question does not arise for

consideration in the appeal as the only question which arose

for consideration was, whether the firm is liable to pay

capital gain tax. Therefore, the said question of law is not

answered.

33. For the aforesaid reasons, we pass the

following: 40

ORDER

(i) The substantial question of law is answered in

favour of the assessee and against the revenue.

(ii) Consequently, the appeal stands dismissed.

(iii) No costs.

Sd/-

JUDGE

Sd/-

JUDGE

Sd/-

JUDGE

JT/BMM/-