Sections 2(47) and 45(4) – Capital gains – Where retiring partners were paid sums on reconstitution of assessee-partnership firm in proportion to their share in partnership business / asset, no transfer of assets having taken place, no capital gains would arise

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Principal CIT vs. Electroplast Engineers; [2019] 104 taxmann.com 444 (Bom)

Date of order: 26^th March, 2019

A.Y.: 2010-11

Sections 2(47) and 45(4) – Capital gains – Where retiring partners were paid sums on reconstitution of assessee-partnership firm in proportion to their share in partnership business / asset, no transfer of assets having taken place, no capital gains would arise

Under a Deed of Retirement cum Reconstitution of the Partnership, the original two partners retired from the firm and three new partners redistributed their share. Goodwill was evaluated and the retiring partners were paid a certain sum for their share of goodwill in proportion to their share in the partnership. The assessee-partnership firm filed return of income. The A.O. was of the opinion that the goodwill credited by the assessee-partnership firm to its retiring partners was capital gain arising on distribution of the capital asset by way of dissolution of the firm or otherwise. Thus, the assessee-partnership firm had to pay short-term capital gain tax in terms of section 45(4) of the Income-tax Act, 1961.

The Commissioner (Appeals) agreed with the contention of the assessee-partnership firm that there was neither dissolution of the firm nor was the firm discontinued. He held that the rights and interests in the assets of the firm were transferred to the new members and in this manner amounted to transfer of capital asset. Thus, section 45(4) would apply. The Tribunal held that section 45(4) would apply only in a case where there has been dissolution of the firm and, thus, the conditions required for applying section 45(4) were not satisfied.

On appeal by the Revenue, the Bombay High Court upheld the decision of the Tribunal and held as under:

“i)   As per the provision of section 45(4), profits or gains arising from transfer of capital asset by way of distribution of capital asset on dissolution of firm or otherwise shall be chargeable to tax as income of the firm. For the application of this provision, thus, transfer of capital asset is necessary.

ii)   In the case of CIT vs. Dynamic Enterprises [2014] 223 Taxman 331/[2013] 40 taxmann.com 318/359 ITR 83, the full bench of the Karnataka High Court has held that after the retirement of the partners, the partnership continued and the business was also carried on by the remaining partners. There was, thus, no dissolution of the firm and there was no distribution of capital asset. What was given to the retiring partners was money representing the value of their share in the partnership. No capital asset was transferred on the date of retirement. 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.

iii)   In the instant case, admittedly, there was no transfer of capital asset upon reconstitution of the firm. All that happened was that the firm’s assets were evaluated and the retiring partners were paid their share of the partnership asset. There was clearly no transfer of capital asset.”