Partner vis-à-vis Capital Gain - Version 2.0

In our earlier version on the captioned subject matter, we have extensively dealt with taxation in the hands of the firm and the partners at the time of admission or dissolution and connected issues therein. We have framed four issues and tried to answer them with the help of judicial precedents on the subject. The article can be accessed here Partner vis-à-vis Capital Gains | SBS Blog. We strongly recommend to read the above article before proceeding to read the subject article.

For ready reference, the conclusion of the above article, the version 1.0 is as below[1]:

With the above in background, now, let us proceed to examine the recent changes to the above positions. The changes were initially made vide Finance Bill, 2021 to Section 45 of ITA. However, the changes proposed in Finance Bill, 2021 were not carried in toto when the Finance Act, 2021 was enacted. The changes proposed by Finance Bill and not carried out in Finance Act and vice-versa forms part of the annexure to this article.

From the annexure, it is evident that, Section 45(4) which is proposed to be replaced by Finance Bill, 2021 have been replaced with a different language in the Finance Act, 2021. Further, the new sub-section, which is proposed to be introduced by Finance Bill, 2021 vide (4A), was never found in the Finance Act, 2021. Further, a new section 9B was introduced in Finance Act, 2021, which was never found in the Finance Bill, 2021.

Amidst this, let us proceed to analyse the current position which was introduced vide Finance Act, 2021. Before proceeding further, we need to understand the difference between Section 9B and Section 45(4):

 

Implications under Section 9B:

• Section 9B has been introduced vide Finance Act, 2021. The new section aims to tax the specified entity when said entity allots any capital asset or stock in trade (for brevity ‘SIT’) to a specified person in connection with dissolution or reconstitution of the specified entity. The specified entity is required to pay tax in the year in which the specified person receives the capital asset or stock in trade.
• The specified entity is defined to mean a firm or other association of persons or body of individuals. A company and co-operative society have been specifically excluded. The phrase ‘reconstitution of specified entity’ has been defined to cover three instances, namely, in case of partnership, retirement of partners from partnership firm, admission of partner into partnership firm and change in profit sharing ratio. The phrase ‘specified person’ has been defined to mean a person who is a partner in any previous year. Accordingly, in case of retiring of partner, the retired partner, in case of admission, the new partner and in case of change in partner sharing ratio, all the partners would be falling under the definition of ‘specified person’.
• As stated above, Section 9B aims to cover two events, namely the dissolution or reconstitution. It is important to note that the earlier Section 45(4) was dealing only with dissolution and the question, whether reconstitution is covered under the said sub-section or not, was not clear. It was only in the matter of AN Naik & Associates[2], the Bombay High Court has held that retirement is also covered under the sub-section (4) under the ambit of ‘otherwise’. To this extent, the new Section 9B has made it clear that the reconstitution is also covered. Hence, receipt of any capital asset or stock in trade by retiring partner would be taxable under the appropriate head in the hands of firm. In other words, if the retired partner is allotted a capital asset, when he is retiring from the firm, the firm is required to pay tax under the head ‘capital gain’. In case, if stock in trade is allotted, then the same will be taxable under the head ‘profits and gains from business or profession’ (for brevity ‘PGBP’) in the hands of the firm. The firm is required to pay tax in the year in which the specified partner (in the above example, the retiring partner) receives the capital asset or stock in trade as the case may be.
• The next aspect is on the value on which the firm is required to pay tax. The section stipulates that the fair market value of capital asset or stock in trade on the date of receipt by specified person shall be deemed to be the full value of consideration. Hence, in case of capital asset, the firm is required to pay tax after adopting the mode of computation as per Section 48. The fair market value of capital asset on the date of its receipt by the specified partner shall be deemed to be the full value of consideration and the cost of acquisition and cost of improvement can be reduced to arrive the gain. In case of stock in trade, the profits have to be arrived after adopting the provisions of Section 29.
• It is important to note that Section 9B covers only, in case where the specified person, receives the capital asset or stock in trade. In case, if the specified partner receives money, then the said section is not applicable. Further, the old Section 45(4) is in a way introduced as new Section 9B except for the taxation of stock in trade, which was absent in the old Section 45(4). With this understanding of Section 9B, let us proceed to understand Section 45(4) in its new avatar.

Implications under Section 45(4):

• The said sub-section deals with taxation in the hands of specified entity when the specified person receives money or capital asset in the event of reconstitution of specified entity. For the purposes of this sub-section, the phrase ‘specified entity’, ‘specified person’ and ‘reconstitution of specified entity’ have the same meaning as laid down in Section 9B.
• As stated earlier, the said sub-section deals with taxation only in case of ‘reconstitution of specified entity’. Hence, for the instances of dissolution, the provisions of this sub-section shall not be applicable. The judgment of AN Naik & Others (supra) in a way is implemented by making it explicitly clear that the new sub-section covers reconstitution.
• Before proceeding to understand more about the new Section 45(4), it is important to also understand what new section is trying to achieve. On a reading of the new section, it is evident that the specified entity is made to pay tax on the amounts which are in excess of the capital account balances of the specified person. The capital account balances are the bare capitals and real accretions and the formula prescribed makes it sure that the revaluation profits and other similar increases in capital accounts are to be excluded. Hence, the new section is trying to tax the excess amount over the capital account balances to the specified person. A question that arises for consideration is, what is the specified entity foregoing/extinguishing/transferring to the specified person, so as to bring the specified entity under obligation to pay tax, especially under the head ‘capital gains’. Ideally, the specified person is transferring/extinguishing/foregoing his rights against another partners and for such, he is in receipt of capital asset or money and if he receives more amount that his capital account balance, he should be required to pay tax as gain accrues in his hands. Does the legislature intends to put this tax obligation in the hands of specified entity qua the new Section 45(4)? Or Is this taxation event wrongly placed under the head ‘capital gains’. There is no clarity in this aspect. It is important to note that the specified entity is paying and not receiving to be under obligation to tax except because of the obligation under Section 45(4).
• Keeping the above at the bay, let us proceed to examine other issues arising from interpretation of Section 45(4). To recap, the profits/gains arising from allotting of capital asset or stock in trade would be deemed to be income of the specified entity and the entity is required to pay tax on the same in terms of Section 9B. The role of Section 45(4) is not to tax the same transaction but to tax the excess amount over the capital account balances.
• The next aspect is determination of the excess amount over the capital account balances. The sub-section states that tax is payable B + C – D. The ‘B’ is defined to mean that value of money received by the specified person from the specified entity on the date of receipt. The ‘C’ is defined to mean the amount of fair market value of capital asset received by the specified person on the date of its receipt. The ‘D’ is defined to mean the balance in capital account (represented in any manner) of the specified person in books of account of specified entity at the time of its reconstitution. As stated earlier, the proviso to the said sub-section states that balance in the capital account is to be calculated without taking into account the increase in the capital account due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset.
• From the above, it is evident that the specified entity in the year in which the specified person receives money or capital asset as a result of reconstitution of the specified entity, has to pay tax on difference of the fair market value of capital asset and money and amount lying in the capital account of the specified person at the time of reconstitution. The capital account should be free from all the increases from revaluation of asset or self-generated good will or other self-generated asset. The difference, if positive, the same is taxable under the head ‘capital gains’ and if negative, ignored for the purposes of taxation. In other words, the law does not recognize any loss and taxes only the profit.
• The said sub-section is silent about the instances, where for example, the retiring partner is in receipt of stock in trade. It appears that eh same is not covered in the ambit of Section 45(4). However, the firm continue to be taxable under the head ‘profits and gains from business or profession’, since in such cases, the provisions of Section 9B are applicable. However, it is important to note that money paid on dissolution is not covered either under Section 9B or Section 45(4), since the former deals only with capital asset or stock in trade and the latter deals only with reconstitution.
• The below table gives a quick understanding on the obligations in different events and settlement thereof.

• Further, the phrase ‘money’ is neither defined under the Act nor under the Section 45(4). It simply states that ‘if any specified person receives any money or capital asset or both’. However, while computing the value in the formula provided, it states that ‘value of any money received by a specified person’. From the above, there is a possibility for interpreting the phrase ‘money’.
• One line of interpretation would be that the word ‘money’ cannot be interpreted to mean cash or amount paid through bank alone and include all other assets which can be readily convertible into money, namely stock in trade, debtors and other similar items. For example, let us say, the value of capital balance is Rs 150 and against to such amount, the partner is paid Rs 180. The said payment instead of happening entirely in cash, let us assume, has been made Rs 100 in cash (including bank), Rs 50 through transfer of debtors and stock in trade of Rs 30.
• In this scenario, if one considers amount received in cash as receipt of money, Rs 100 would be the value of money received by such person. However, such person actually has received Rs. 180 against the capital balance of Rs.150. Considering the intention behind the insertion of new section 45(4), one may argue that not alone cash/money but liquid assets should also be considered.
• However, one may argue that since ‘money’ was only specifically spelt out in Section 45(4), there cannot be inclusion of any other assets. This is especially when the Section 9B specifically talks about stock in trade and its absence in Section 45(4) cannot be read into. Also, on a similar footing, whenever the legislature wants to include the same, it has specifically mentioned such inclusion, for example as in the case of Section 56(2)(x).
• Further, in continuation to above, one may add another line of argument that in cases where the specified person is paid in other assets instead of money, the excess amount over the capital balance may be taxed in his hand instead of specified entity. This is also not clear and has to be answered in the coming days.
• In our view, the value of money stands only to be included, since the Section 45(4) does not ask to add other kind of liquid assets. The settlement in stock in trade would be captured under Section 9B and the settlement in debtors (as stated above) may be taxed in hands of the specified person instead of specified entity and the settlement in money is taxed in the hands of specified entity in terms of Section 45(4). The replacement of ‘capital asset’ with ‘other asset’ as appeared in the Finance Bill, 2021 would have made our lives much easier. May be, that is for the coming days. We need to await and see.
• Now, with the above understanding, let us take some case studies to dig further and to understand the practical aspects of the sections.

 

Case Studies:

• The above Section 9B and Section 45(4) have to be applied in the right manner. As stated earlier, Section 9B is applicable in a situation of receipt of capital asset or stock in trade when there is a reconstitution or dissolution of a specified entity. However, Section 45(4) is applicable in a situation of receipt of capital asset or money when there is a reconstitution of a specified entity. Undoubtedly, on a conjoint reading, lot of confusion would arise.
• In order to understand the above two sections, let us break the provisions into two parts. Part I is with regard to reconstitution of a specified entity and Part II with regards to dissolution of a specified entity.

 

Part I: Reconstitution of Specified Entity:

• As stated earlier, at the time reconstitution of a specified entity, both Section 9B as well as Section 45(4) would be applicable. Let us proceed to understand the operation of Section 9B and Section 45(4) at the time of reconstitution of specified entity.
• First, we shall proceed to understand the provisions of Section 9B at the time of reconstitution of a specified entity. Section 9B states that where any specified person receives any capital asset or stock in trade at the time of reconstitution (dissolution will be dealt in Part II) of any specified entity, such receipt of capital asset or stock in trade would be considered as transfer of capital asset or stock in trade by a specified entity in the normal course of a business.
• In other words, Section 9B requires that, in the above situation, income of a specified entity shall be computed as if such entity has transacted with outside person. Accordingly, specified entity is liable to pay tax on capital gains or business profits under Section 45 or Section 28 of the Act, as the case may be.
• With the above analysis, let us proceed to analyse the provisions of Section 45(4) at the time of reconstitution of a specified entity. Section 45(4) states that when any specified person receives any capital asset or money at the time of reconstitution from any specified entity, such receipt of capital asset or money would deemed to be considered as capital gains in the hands of specified entity.
• However, computation of capital gains under Section 9B is different from that of new Section 45(4). The computation mechanism under provisions of Section 9B is same as old Section 45(4) qua transfers of capital assets. Whereas new Section 45(4) has been enacted through the Finance Act, 2021 in order to tax the excess amounts over capital account balances (may be referred as to goodwill) of a specified person who retires from the specified entity.
• When any retiring person receives any consideration namely, capital asset or money in excess of the balance in the capital account of specified person, such excess amount would be considered as capital gains in the hands of specified entity under Section 45(4). Further, while computing the balance in the capital account, self-generated goodwill should not be considered.
• Let us understand the above provisions by way of an example. M/s ABC Firm has three partners, Mr A, Mr B and Mr C formed on January 01, 2021. The balance sheet of the firm as on 1^st July 2021 is as follows:

 

• During the year, Mr A wishes to retire from the firm. So, three partners agreed to revalue the assets as on the date for the purpose payment of capital balance to Mr A. The revaluation profits have been transferred to partners’ capital account. The balance sheet of the firm subsequent to the revaluation is as follows:

  

• As the capital balance of Mr A stood at Rs. 140, it has been agreed to pay the capital balance to Mr A in the following possible options:

From the above example, let us compute the tax payable under Section 9B and Section 45(4) under both the options.

Option – 1:

Computation under Section 9B:

• In this option, as retiring partner is receiving cash alone, provisions of Section 9B would not be applicable.
• However, as the capital asset being Land P and stock in trade have been transferred to third parties, income of the firm has to be computed under the normal provisions of the Act. As the land is held for a period less than 2 years, it would be considered as short-term capital asset.
• Accordingly, the specified entity would have paid tax on the gain of Rs 30 (100 – 70 being the cost of acquisition), assuming the margin on stock in trade is 50% and tax rate applicable at 25%, the profit that would be remaining for distribution is Rs 30, which would be transferred to resultant[4] partner’s capital account in the agreed proportion.

Computation of Capital Gains under Section 45(4):

• Now, let us proceed to compute the capital gains under Section 45(4). As stated earlier, for the purpose of computation of capital gains, the formula prescribed section 45(4) needs to be applied, A = B + C – D

 

• As evident from the table above, in Scenario 1, the capital balance appears as Rs 100 and in Scenario 2, Rs 110. The common thing in both the scenarios is removal of revaluation profit from the capital account balance. Since the capital account balance is Rs 140 and the profits arising from revaluation is Rs 40, the balance would be Rs 100. However, in Scenario 2, there is an extra balance of Rs 10 as against in Scenario 1. The rationale behind the extra balance of Rs 10 in Scenario 2 is explained as under.
• The guidelines issued by CBDT asks the capital gains arising from deemed transfer of capital assets (profits arising from transfer of stock in trade too) to the retiring partner to all the partners including the retiring partner. As stated above, the profits after tax of Rs 30 is to be distributed to all the partners including retiring partner. Hence, the capital account balance of Mr A would be Rs 110 [Rs 100 + Rs 10].
• However, the addition of Rs 10 appears to be reasonable only if it is assumed that the deemed transfer takes place prior to the retirement of partner. Let us say, in a case, where Mr A is agreed to be paid Rs 140 and the same is settled by way of allotting an asset after a period of 6 months, then distribution of profit to the retiring partner would look like putting the clock back. As of now, it is not clear, whether the guideline is applicable only in cases, where the settlement is done immediately prior to retirement. We need to wait and see the development in this connection.

Option 2:

Computation under Section 9B:

• In this option, as retiring partner is receiving capital asset and stock in trade, by invoking Section 9B, capital gains and PGBP has to be computed as per the normal provisions of the Act. Considering the same numbers as taken in Option 1, the profits after tax would be Rs 30.
• Subsequent to the payment of tax, net profit of Rs 30 would be transferred to resultant[5] partners account in the agreed proportion.

Computation of Capital Gains under Section 45(4):

• Now, we shall proceed to compute the capital gains under Section 45(4). As stated earlier, for the purpose of computation of capital gains, the formula prescribed Section 45(4) needs to be applied, A = B + C – D.

 

• Scenario 1 deals with taking the capital account balance only be removing the revaluation profit and not adding up the profit in terms of Section 9B. Whereas, Scenario 2 deals with the determination of capital account balance as per guidelines prescribed by CBDT. Under View 1, we have taken the view that the value of money includes all the amounts which are liquid in nature. Under View 2, we have taken the view that value of money is only the money received and not included other assets.
• From the above analysis, it can be concluded that Section 9B is nothing but combination of old Section 45(4) and Section 28. So, as regards to Section 9B there would not be any new additional burden on the taxpayer by the Finance Act, 2021.
• Now, let us proceed to analyse the additional burden on the taxpayer by virtue of new Section 45(4). As stated earlier, new Section 45(4) has been made in order to tax amount withdrawn by the specified person on reconstitution. In nutshell, new Section 45(4) is taxing the specified entity on revaluation of assets/recognition of self -generated assets/goodwill. In the above example, ABC has revalued assets to the extent of Rs 120 (Rs 30 on Land P, Rs 40 on Land Q and Rs 50 on Land R respectively). As the capital asset being Land P has been transferred to Mr A, it seems that an amount of income Rs 30 is doubly taxed in the hands of ABC. Once as a transfer of asset under Section 9B and second time under Section 45(4) being excess over capital account balance received by the partner.
• Hence, in order to mitigate effect of the double taxation, Section 48(iii) has been inserted so as to provided that income which is considered under Section 45(4) on account of revaluation of assets or recognition of assets shall be attributable to remaining assets of the specified entity and such amount has to be reduced while computing the capital gains of remaining assets when such assets have been transferred in future by the specified entity.
• In this regard, Rule 8AB has been notified for the purpose of computation of amount to be attributable to remaining assets of the specified entity. Rule 8AB provides the following procedure for attributing the amount to remaining assets:
• Where the income considered under Section 45(4) is related to revaluation of assets or recognition of self-generated goodwill or assets, such income has to be attributed to remaining assets of the specified entity in proportionate to the increase in the value of asset to total increase in the value of all assets (total assets means assets other than the capital asset received by the specified person).
• Where the income considered under Section 45(4) is not related to revaluation of assets or recognition of self-generated assets/goodwill, such income should not be attributed to other assets.
• Where the income considered under Section 45(4) is related to revaluation of capital asset received by the specified person alone, such income should not be attributed to other assets of the specified entity.
• Further, it has been provided through Rule 8AB, that income considered under Section 45(4) shall relate to revaluation of assets or recognition of self-generated assets only when such revaluation/recognition is based on the valuation report obtained from a registered valuer as defined under Rule 11U(g). It is further provided that no depreciation on account increase in the value of asset shall be allowed on account of revaluation or recognition of assets of the specified entity.
• Let us understand, the attribution of income under Rule 8AB from the above example discussed. ABC firm has revalued the assets at the time of retirement of Mr. A from the firm. Rule 8AB states that income considered under Section 45(4) shall be attributable to remaining assets of the specified entity:

  

• Given the above analysis, Section 48(iii) has been inserted to mitigate the effect of double taxation by virtue of Section 45(4). The profit of Rs 30[6] would be attributed to the remaining assets and same would be reduced from the full value of consideration while computing the capital gains when such asset is transferred by the specified entity in future.
• Further, while reading of Section 45(4) for the purpose of computation of capital gains, the question that arises is whether such capital gain is short-term or long term. As discussed earlier, Section 45(4) is taxing the revaluation profits of the assets of specified entity. Hence, determination of nature of capital gains should have to depend upon on nature of assets of the specified entity which are revalued. In this regard, a new sub-rule 5 has been inserted in Rule 8AA which state that:
• amount/part of it shall be deemed to be from transfer of short-term capital asset, if it is attributed to:
  1. capital asset which is short term capital asset at time of taxation of amount under Section 45(4).
  2. capital asset forming part of block of asset
  3. capital asset being self-generated asset/goodwill

• the amount or a part of it shall be deemed to be from transfer of long-term capital asset or assets, if it is attributed to capital asset which is not covered by above clause and is long term capital asset at the time of taxation of amount under Section 45(4).

Part II: Dissolution of Specified Entity:

• In Part I, the tax implications under Section 9B and Section 45(4) has been discussed when there is re-constitution of a specified entity. In Part II, let us try to understand the tax implications when there is a dissolution of firm.
• Before moving forward, let us understand the difference between re-constitution and dissolution of a specified entity. Reconstitution of a specified entity to mean retirement of one or more persons or admission of one or more partner along with the old partners or change in the profit sharing. Whereas dissolution of the specified entity to mean exit of all partners by way discontinue of the business of the specified entity.
• As stated earlier, Section 45(4) has been enacted to tax the revalued profits of the specified entity. However, at the time of dissolution of the entity, there would not be any such type of revaluation of assets and hence, Section 45(4) would not be warranted. Hence, at the time of dissolution of a specified entity, specified entity needs to be computed tax under Section 9B alone.
• Let us understand the effect of Section 9B, Section 45(4) and Section 48 (iii) in the following example. Mr X, Mr Y and Mr Z have decided to purchase land in their individual capacity and have purchased the same in the following manner:

 

• Now, if in the above example, instead of purchase of land in their individual capacities, three persons have decided to form a partnership firm for the purchase of lands. In such case, the following would be the situation:

  

• 18 months after the formation of firm, Mr Z has decided to retire from the firm, and they have agreed to transfer Land Z to Mr Z as final settlement of capital. The revalued prices of the land as on the date of retirement of Mr Z:

  

• As Mr Z is in receipt of capital asset at the time of reconstitution of the firm, Section 9B and Section 45(4) would come into play. In the first instance, capital gain under section 9B has to be computed in accordance with the provisions of the Act and FMV of such asset would be considered as full value of consideration and the tax at the rate of 25% would be Rs 200 [(1800-1000)*25%]
• Subsequent to the computation of net profits under Section 9B, such profits net-off of taxes has to be transferred to partner’s capital account in their capital ratio i.e. Rs 600 (800-200) has to be transferred to partner’s capital.

  

• Now, as Mr Z is receiving Land Z, capital gains under Section 45 (4) needs to be computed as under:

  

• Rule 8AB states that income considered under Section 45(4) shall be attributable to remaining assets of the specified entity. The attribution of income under Section 45(4) to remaining assets of the firm is as follows:

  

• Subsequently, after the three months of retirement of Mr Z, the remaining partner have decided to dissolve the firm and it has been agreed between them that Land X would be given to Mr X and Land Y would be given to Mr Y.
• As partner of firm has received capital asset at the time of dissolution of firm, capital gain needs to be computed having regard to Section 9B. FMV of such would be considered as full value of consideration. Further, income as considered under Section 45(4) at the time of retirement of Mr Z needs to be reduced from the full value of consideration as per Section 48(iii) read with Rule 8AB.

 

• Further, as there is no reconstitution of the firm, Section 45(4) would not be applicable. In this case, the firm has liable to pay a total tax of Rs 375 (Rs 200 and Rs 150 on retirement of Mr Z and Rs25 on dissolution of the firm) which is same as amount paid when such lands were purchased individually.

Conclusions – Post Amendment:

With the above in background, let us now, revisit the issues and conclusions arrived pre-amendment to analyse the current position.

(Any doubts/issues in the article can be directed to This email address is being protected from spambots. You need JavaScript enabled to view it.)

 

[1][1] For legends and other references, please visit the link shared above.

[2] [2004] 265 ITR 346 (Bom)

[3] As firm does not have enough cash balance, it would transfer Land P and stock in trade to third person to realise cash

 

[4] The issue, whether the profit has to be shared only to the resultant partners or all the partners including retiring partner is dealt at the time of dealing with Section 45(4).

[5] As discussed above.

[6] If the interpretation that the phrase ‘money’ includes other liquid assets, then the profit and attribution may vary.

[7] This is based on discussion we had for Scenario 1 in Option 1 for ‘Computation of Capital Gains under Section 45(4)’