The Finance Bill, 2021 proposed to amend the section 45(4) of the Income Tax Act, 1961 (“Act”) to provide that receipt of a capital asset, money or any other asset by a partner at the time of dissolution or reconstitution of a firm, shall be taxed as capital gains in the hands of the firm. This provision is also applicable to Association of Persons (AOP) or Body of Individuals (BOI). The amendment proposes to substitute the sub-section (4) with a new provision in place of the extant provision.
The expression ‘otherwise’ used in section 45(4) is the cause of litigation in interpreting whether it includes ‘retirement’ of a partner. As per section 45(4), capital gains tax is charged on a firm for transferring a capital asset and in the distribution of the capital assets, during the dissolution of the firm or otherwise.
Disputes involving whether capital gains taxes are leviable on sums paid or assets distributed to retiring partners is a subject matter of litigation for several decades now. The point of dispute between the assessee and the income tax department is whether a firm is liable to pay capital gains tax in case of transfer of assets to the retiring partners while other partners continue with the firm.
It was always contended by the assessee that Section 45(4) of the Act would apply only in a case of “dissolution” of firm. It would not apply to the retirement of partners where the firm had not been dissolved. The retiring partners were allotted properties to the extent of the credit balance in the capital account and did not receive any consideration for the transfer of their interests in the firm.
On the other hand, it was the view of the department that when there is a dissolution or “otherwise” of a partnership firm, resulting in the transfer of assets to the partners, section 45(4) of the Act would apply.
There were divergent views of the Courts on the issue. While Madras High Court in National Company vs. ACIT (TCA. No. 365 & 366 of 2009 dated April 08, 2019) held that the allotment of immovable property by a firm to its retiring partners towards their share in the partnership firm does not attract section 45(4), the Bombay High Court in the case of CIT vs. A.N.Naik and Others [2004] 265 ITR 346 (Bombay) has taken a contrary view to hold that when there is a dissolution or “otherwise” of a partnership firm, resulting in the transfer of assets to the partners, section 45(4) of the Act would apply.
Transfer of capital asset to partner/member on the dissolution of the firm/AOP/BOI taxable as capital gains
It has been proposed that where a partner/member receives any money or other asset at the time of dissolution or reconstitution of the firm/AOP/BOI which is more than the balance appearing in the capital account (without considering revaluation), the profits or gains arising from such receipt shall be chargeable under the head ‘capital gains’ as income of such firm, AOP or BOI of the previous year in which such money or other asset was received by the specified person.
Rationalisation of provision of transfer of capital asset to partner on dissolution or reconstitution
The existing provisions of section 45 of the Act inter alia, provides that any profits or gains arising from the transfer of a capital asset shall be chargeable to income-tax under the head Capital gains and shall be deemed to be the income of the previous year in which such transfer takes place. Further sub-section (4) of the said section, provides that 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 such firm or other association of persons or body of individuals of the previous year in which the said transfer takes place. Further, the fair market value of the asset on the date of such transfer shall be deemed to be the full value of the consideration for the purposes of section 48.
In this regard, it has been noticed that there is uncertainty regarding the applicability of provisions of aforesaid sub-section to a situation where assets are revalued or self-generated assets are recorded in the books of accounts and payment is made to partner or member which is in excess of his capital contribution.
Hence, it is proposed to substitute the existing sub-section (4) of section 45 of the Act with a new sub-section (4) and also insert a new sub-section (4A) to this section.
New proposed sub-section (4) of section 45 of the Act applies in a case where a specified person who receives during the previous year any capital asset at the time of dissolution or reconstitution of the specified entity. The capital asset represents the balance in the capital account of such specified person in the books of the specified entity at the time of its dissolution or reconstitution. In this situation, the profit and gains arising from the receipt of such capital asset by the specified person shall be chargeable to income-tax as income of the 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 the capital asset was received by the specified person. For the purposes of section 48 of the Act, the fair market value of the capital asset on the date of such receipt shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of the capital asset. 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 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.
New proposed section sub-section (4A) of section 45 of the Act applies in a case where a specified person receives during the previous year any money or other asset at the time of dissolution or reconstitution of the specified entity. The money or other asset is required to be in excess of the balance in the capital account of such specified person in the books of accounts of the specified entity at the time of its dissolution or reconstitution. In this situation, the profits or gains arising from the receipt of such money or other asset by the specified person shall be chargeable to income-tax as income of the 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 the money or other asset was received by the specified person.
For the purposes of section 48 of the Act,
(i) value of the money or the fair market value of other asset on the date of such receipt shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of the capital asset; and
(ii) the balance in the capital account of the specified person in the books of accounts of the specified entity at the time of its dissolution or reconstitution shall be deemed to be the cost of acquisition.
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 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.
For the purposes of these two sub-sections,-
“specified person” is proposed to be defined as a person who is partner of a firm or member of other association of persons or body of individuals (not being a company or a cooperative society), in any previous year;
“specified entity” is proposed to be defined as a firm or other association of persons or body of individuals (not being a company or a cooperative society); and
“self-generated goodwill” and “self–generated assets” are proposed to be defined as 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.
Consequential amendment is also proposed in section 48 of the Act to provide that in case of specified entity, the amount included in the total income of such specified entity under sub-section (4A) of section 45 which is attributable to the capital asset being transferred, shall be reduced from the full value of the consideration to compute income charged under the head ―capital gains‖. This is to be calculated in the manner to be prescribed later. This is to mitigate the double taxation which may have happened but for this provision in a situation where an asset which was revalued and for which income under the proposed sub-section (4A) of section 45 of the Act was brought to tax is transferred subsequently by the specified entity.
These amendments will be effective from the 1st April, 2021 and will accordingly apply to the assessment year 2021-22 and subsequent assessment years.
To give effect to the proposed amendments, Finance Bill, 2021 vide Clauses 14 and 16 proposed to amend section 45 and section 48 of the Income Tax Act, 1961 as detailed below-
Amendment of section 45.
14. In section 45 of the Income-tax Act,––
(a) after sub-section (1A), the following sub-section shall be inserted, namely:––
‘(1B) Notwithstanding anything contained in sub-section (1), where any person receives at any time during any previous year any amount under a unit linked insurance policy, to which exemption under clause (10D) of section 10 does not apply on account of the applicability of the fourth and fifth proviso thereof, including the amount allocated by way of bonus on such policy, then, any profits or gains arising from receipt of such amount by such person shall be chargeable to income-tax under the head "Capital gains" and shall be deemed to be the income of such person of the previous year in which such amount was received and the income taxable shall be calculated in such manner as may be prescribed.’;
(b) for sub-section (4), the following sub-sections shall be substituted, namely:–
‘(4) Notwithstanding anything contained in sub-section (1), where a specified person receives during the previous year any capital asset at the time of dissolution or reconstitution of the specified entity, which represents the balance in his capital account in the books of accounts of such specified entity at the time of its dissolution or reconstitution, then any profits or gains arising from receipt of such capital asset 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 capital asset was received by the specified person and notwithstanding anything to the contrary contained in this Act, for the purposes of section 48,––
(a) fair market value of the capital asset on the date of such receipt shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of such capital asset; and
(b) the cost of acquisition of the capital asset shall be determined in accordance with the provisions of this Chapter:
Provided 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 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.
Amended Provisions Explained:
Clause 14 of the Bill seeks to amend section 45 of the Income-tax Act relating to Capital gains.
The aforesaid section inter alia, provides that any profits or gains arising from the transfer of a capital asset shall be chargeable to income-tax under the head “Capital gains” and shall be deemed to be the income of the previous year in which such transfer took place. Further, sub-section (4) of the said section, provides that 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.
It is proposed to insert sub-clause (1B) so as to provide that notwithstanding anything contained in sub-section (1), where any person receives at any time during any previous year any amount under a unit linked insurance policy, to which exemption under clause (10D) of section 10 does not apply on account of the applicability of the fourth and fifth proviso thereof, including the amount allocated by way of bonus on such policy, then, any profits or gains arising from receipt of such amount by such person shall be chargeable to income-tax under the head "Capital gains" and shall be deemed to be the income of such person of the previous year in which such amount was received and the income taxable shall be calculated in such manner as may be provided by rules.
It is further proposed to substitute sub-section (4) in the said section so as to provide that where a specified person receives during the previous year any capital asset at the time of its dissolution or reconstitution of the specified entity, which represents the balance in his capital account in the books of accounts of such specified entity at the time of dissolution or reconstitution, then any profits or gains arising from receipt of such capital asset 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 capital asset was received by the specified person.
It is also proposed to amend the section to provide that fair market value of the capital asset on the date of such receipt shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of such capital asset.
It is also proposed to amend the section to provide that the cost of acquisition of the capital asset shall be determined in accordance with the provisions of this Chapter.
It is also proposed to amend the section to provide 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 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.
It is also proposed to amend the section to define the expressions “self-generated goodwill” and “self-generated assets”, “specified entity” and “specified person”.
It is also proposed to insert sub-section (4A) in the said section so as to provide that where a specified person receives during the previous year any money or other asset at the time of dissolution or reconstitution of the specified entity, which is in excess of the balance in his capital account in the books of accounts of such specified entity at the time of its dissolution or reconstitution, then any profits or gains arising from receipt of such money or other asset 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 other asset was received by the specified person.
It is also proposed to amend the section to provide that value of any money or the fair market value of other asset on the date of such receipt shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of such capital asset.
It is also proposed to amend the section to provide that the balance in the capital account of the specified person in the books of accounts of the specified entity at the time of its dissolution or reconstitution shall be deemed to be the cost of acquisition and 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 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.
It is also proposed to amend the section to provide that for the purpose of this sub-section, the expressions “specified entity”, “self-generated goodwill”, “self-generated asset” and "specified person" shall have the meaning assigned to them in sub-section (4) of the Act.
These amendments will take effect from 1st April, 2021 and will, accordingly, apply in relation to the assessment year 2021-2022 and subsequent assessment years.
Amendment of section 48.
16. In section 48 of the Income-tax Act, after clause (ii) the following clause shall be inserted, namely: ──
“(iii) in case of specified entity referred to in sub-section (4A) of section 45, the amount included in the total income of such specified entity under sub-section (4A) of section 45 which is attributable to the capital asset being transferred, calculated in the prescribed manner:”.
Amended Provision Explained
Clause 16 of the Bill seeks to amend section 48 of the Income-tax Act relating to mode of computation for income chargeable under the head capital gains.
The section inter alia, provides for computation of capital gains arising out of transfer of a capital asset by deducting from the full value consideration received or accruing as a result of such transfer, the amounts of expenditure incurred wholly and exclusively for such transfer and cost of acquisition as well as cost of any improvement thereto.
It is proposed to insert clause (iii) in the said section so as to provide in case of specified entity referred to in sub-section (4A) of section 45, the amount included in the total income of such specified entity under sub-section (4A) of section 45 which is attributable to the capital asset being transferred, calculated in the prescribed manner, shall be reduced from full value of consideration received or accruing as a result of transfer of the capital asset.
This amendment shall come into effect from the 1st day of April, 2021 and shall accordingly apply to assessment year 2021-2022 and subsequent assessment years.
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