Whether where partnership deed itself makes it clear that immovable property is being contributed as an item of capital as objective of firm is to carry on business in real estate, such asset can be considered as a stock in trade - YES: HC

THE issues before the Bench are - Whether where the partnership deed itself makes it clear that the property is being contributed as an item of capital as the objective of the firm is to carry on the business in real estate, such an asset can be considered as a stock in trade and Whether the market value of the property has to be taken into consideration for determining the value of property, which is allotted to the respective partners on dissolution. And the verdict goes in favour of the Revenue.

Facts of the case

The assessee-firm was constituted through a partnership deed and comprised of three partners S, R and A. Before the constitution of the firm, the mother, S, and two sons, R and A, had equal shares, in an item of immovable property, being a house. Another item was an open land, in which two brothers had equal shares. Both the properties were pooled into assets of the firm towards the respective shares of the partners. The firm was dissolved and on dissolution, the entire house was allotted to the share of S, whereas the entire landed property was allotted to the share of R. A appears to have been allotted either cash component, or other properties.

In the returns filed by the firm, the values of various properties were shown. The Income Tax Officer (ITO), took the value of the house at Rs.17,67,678/- by determining the annual lease value at Rs.1,60,698/- and multiplying the same, 11 times. The difference of tax together with interest under Section 139B and an additional interest under Section 217 were levied.

In appeal, Commissioner affirmed the order of AO. In second appeal, Tribunal also dismissed the appeal.

The assessee filed reference application and the following questions were referred to the High Court:

1. Whether on the facts and in the circumstances of the case and on cumulative consideration of all relevant factors and in existence it could be said that the parties never intended to carry on any business and whether the nature of partnership by a deed dated 07.04.1986 was for extraneous purpose other than carrying on business?

2. Whether on the facts and in circumstances of the case, the Tribunal is correct in its conclusion that there can be a firm in existence both in form and substance and it is immaterial whether the object of the firm was to carry on business in real estate or for any other purpose?

3. Whether on the facts and in the circumstances of the case the immovable properties bearing Municipal No.7-8-757/1/F Godown Road, Nizamabad and Plot No.3 and 4, Yellamma Nizamabad are capital asset or stock in trade of partnership?

Assessee submitted that the very act of the I.T.O. in determining the value of the house as against the value shown in the return was contrary to law. It was submitted that the firm was brought into existence only as a device to readjust the shares in the immovable properties held by the family members and it could not be treated as a firm within the meaning of the Partnership Act. It was contended that the very fact that it stood dissolved within one year and that hardly any activity was undertaken, would demonstrate that it was a nominal entity and was not intended to be an agency to carry on business. It was further argued that the ITO ought not to have levied interest under Section 217 of the Act or at any rate, he ought to have waived it in the given facts and circumstances of the case.

Revenue contended that, once the firm was brought into existence, through a registered document and certain profits were also posted in the profit and loss account, it could not be treated as a nominal entity. It was submitted that whatever may be the value furnished by an assessee about an item, which is part of stock in trade, the determination of market value becomes relevant, particularly when the firm is dissolved and the business activity is discontinued.

Having heard the parties, the Court held that,

++ as a result of dissolution of the firm, redistribution of the properties took place in a manner, different from the one, in which they were held before the constitution of the firm. That, in turn, attracted imposition of gift tax. The matter landed before this Court in the form of R.C.No.160 of 2000 at the instance of the assessee herein. The assessee did not dispute the existence of firm. The plea, on the other hand, was that the dissolution of the firm does not bring about any transfer of property, and thereby, the occasion to levy the gift tax, does not arise. Having acknowledged the existence of firm in that case, the assessee cannot plead to the contrary, in this case. Therefore, questions 1 and 2 are answered against the assessee;

++ coming to the third question, the controversy is as to whether the house, which was brought into the pool of assets of the firm, can be treated as stock in trade, and if so, the value thereof. In the income tax returns, the value thereof was shown as Rs.6,73,000/-. It is a matter of record that the house was given on rent to a Nationalised Bank and it was fetching a rent of about Rs.16,000/-, per month. In the order passed by him, the ITO determined the value of the property at Rs.17,67,678/-. This figure was arrived at by the process of capitalisation i.e. firstly by determining the annual leases valued at Rs.1,60,698/- and then multiplying it 11 times. No serious doubt is expressed as to the formula adopted by the ITO. The objection is mostly about the very process of treating it as a stock in trade;

++ Tribunal has undertaken extensive discussion in its order about this aspect. It was observed that in the partnership deed itself, the partners made it clear that the property is being contributed as an item of capital. It was also observed that the identified objective of the firm is to carry on the business in real estate and in the activity of that nature, an item of immovable property can certainly be a stock in trade. We are in agreement with the observation made by the Tribunal. Counsel for the assessee is not able to convince us to take a different view;

++ the manner, in which the value of an asset, which forms part of stock in trade of a firm must be arrived at, is explained by the Supreme Court in A.L.A. Firms case. Broadly stated, the principle is that (a) the value can be determined on the basis of cost or market value and the assessee will have option to choose between lesser of them, provided the business or trade is being continued; (b) in case the firm is dissolved or the business activity is discontinued, the market value alone becomes relevant;

++ G.R.Ramachari and Co.{(1961) 41 ITR 142 (Mad)} holds that the principle of valuing the closing stock of a business at cost or market price at the option of the assessee is a principle that would hold good only so long as there is a continuing business and that where a business is discontinued, whether on account of dissolution or closure or otherwise by the assessee, then the profits cannot be ascertained except by taking the closing stock at market value;

++ this was followed by the Supreme Court in the subsequent judgments, including Shakthi Trading Co. v. C.I.T. 250 ITR 871;

++ whatever may have been the liberty of an assessee to choose between the cost and market value of an asset, whichever is beneficial to him; that liberty stands taken away when the firm is dissolved, or the business activity is discontinued. For the purpose of determining the value of property, which is allotted to the respective partners on dissolution, it is only the market value that becomes relevant; and that exactly was taken into account, in the instant case;

++ we, therefore, answer the third question also against the assessee and in favour of the Department;

++ last of the submission made by the counsel for the assessee is about the waiver of interest levied under Section 217 of the Act. It is true that Rule 40 of the Income Tax Rules (for short the Rules), provides for the waiver of such interest levied under Section 217 of the Act, under various circumstances enumerated under Clauses 1 to 5, of the Rules, as stood then. It is also true that, no business in its true sense has taken place, in this case, and the survival of the firm itself was less than one year and it may be a case falling under Clause (5) of Rule 40 of the Rules. This, however, can be appreciated, if only the assessee files an application in this behalf. We leave that aspect open.