Tax on the Distribution of assets to partners

My firm recently went through dissolution and I am not sure about the liability of the assets finally distributed. While wondering about such a question, I laid my eyes on this blog giving information on the tax on the distribution of assets to partners. So let us hop into this article for getting answers to all your questions as well. The Finance Act, 2021 has made some significant changes in respect of the taxation of distribution of capital assets, shares in the stock exchange, or money by a Partnership Firm on its dissolution or reconstitution.

Capital Gain Tax on Distribution of Assets to Partners

Section 45(4) of the Income Tax Act, 1961 (hereinafter referred to as “the Act”) imposes capital gains tax in the hands of a Partnership Firm at the time of distribution of assets on the dissolution of the Firm or “otherwise”. To calculate capital gains, the Fair Market Value (“FMV”) of the asset on the date of transfer/distribution by the Firm is taken to be the full consideration received by the Firm.

At the heart of the dispute is the term “otherwise”. In various cases, the question arose as to whether “otherwise” would cover the case of a partner’s retirement from the Firm, when the Firm continues to exist without dissolution even after such retirement.

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Digging into the Pre-Amendment Period

Section 45(4) of the Income Tax Act, 1961 provided for the tax liability on capital gains on the distribution of capital assets on winding up of a firm or otherwise in the year in which the said transfer took place and the fair market value of the asset on the date of such the transfer was considered consideration under Section 48. The applicability of Section 45(4) in the case of distribution of capital assets other than the liquidation of the company has been discussed in several courts decided that Section 45(4) only triggers the case of company dissolution and not in other cases of company restoration.

Highlights of Finance Amendment Bill, 2021

The following are the highlights of Finance Amendment Bill, 2021:

• Insertion of a new section 9B in the Income Tax Act, 1961 which provides for the liability to income tax on the distribution of capital assets or shares on the stock exchange by a firm to its partner on its dissolution or renewal.
• Replacement of existing section 45(4) of the Income Tax Act, 1961 by new section 45(4).
• The above changes are effective from April 1, 2021, and will therefore be applicable for AY 2021-22 relevant to the financial year 2020-21.

Pre-requisites of Section 45

Section 45(4) shall be applied if the following conditions are met:

• There is a certain defined person
• A specified entity as defined
• Designated person receives
  • Any capital asset, or
  • Money, or
  • Both
• The income mentioned in (c) is from the previous year
• The confirmation referred to in (c) is from a specific entity
• The receipt is in connection with the reconstitution of a specific entity.

Taxation under Section 9B is Allowed

It is clarified that the provisions of section 45(4) shall apply in addition to the provisions of section 9B and where a particular person receives a capital asset from a particular entity in connection with the reconstitution of such particular entity, the provisions of both sections may operate independently (Explanation 2).

What Judiciary has to say on Section 45(4) of the Income Tax Act, 1961!

In the case of A. N. Naik Associates, the Bombay High Court held that the word “otherwise” will not only cover cases of dissolution but also cases of departure of a partner from a partnership where such partner acquires a capital asset from the partnership.

Section 45, sub-section 4, therefore, deals not only with cases similar to the dissolution of the company but also with cases of the reestablishment of the company as a result of the retirement of a partner. In this case, the taxpayer (assessee) was a partnership firm formed by family members and during the recovery, various assets belonging to the firm was handed over to the outgoing partners through a family arrangement. A similar opinion was taken by the Tribunal in another case, where the partners of the company took out real estate and invested it in a new partnership firm. The old company did not disappear.

The word “otherwise” was still held to include such a situation where the capital assets of the firm are distributed to its partners other than on dissolution of the firm. Therefore, while construing the term “otherwise”, courts have held that whenever a partnership firm distributes any capital assets to a partner on retirement, capital gains tax in the hands of the firm must be imposed on such transfer.

However, the courts also took a different view. In the case of the National Company, the taxpayer (assessor) was a partnership firm whose partners were family members. At the time of the retirement of two partners, they acquired part of the real estate of the company.

The Madras High Court held that Section 45(4) will not affect the retirement of a partner. It also held that the receipt of cash or assets by a departing partner does not constitute consideration received by the partner in place of relinquishing his interest in partnership assets. The Court drew strength for this argument from various judgments of the Hon’ble Supreme Court. The remuneration received by the retired partner is only the partner’s share of the partnership that he receives in money or property. The Court distinguished A. N. Naik Associates case on facts.

Observation on Judicial Interpretation done by Judiciary

As can be seen from the above-mentioned cases, there was a long-term dispute about the taxation of capital gains according to Section 45 (4), when capital assets are distributed by a firm to a departing partner. Different courts have interpreted the term “otherwise” differently, causing much uncertainty. It is high time that this matter was laid to rest by providing legal certainty and legal certainty. The upcoming budget offers an opportunity to end this dispute through an appropriate amendment/clarification of the scope of the term “otherwise”. We hope the government will take a wise step in the right direction.

Final words

Since there was uncertainty regarding the applicability of the provisions of former Section 45(4) to a situation where assets are overvalued or self-generated assets are accounted for in the books of accounts and the payment to a partner or member is greater than his capital contribution, an attempt was made to resolve this uncertainty dissipate by substituting the said section 45(4) and inserting a new section 9B in the Income Tax Act, 1961.