1. Background
- Section 45(4) of the Income Tax Act, 1961 (hereinafter referred to
as the Act) deals with computation of income from capital gains arising by
way of distribution of capital assets on dissolution or
otherwise of firm/AOP/BOI (other than company and
co-operative society).Prior to the introduction of this Section, it was a
settled legal position that, assets of the firm belonged to the partners.
And therefore no gain shall arise on account of transfer of such assets to
the partners upon dissolution or reconstitution. With a view to curb such
tax avoidance through routing of assets from firm to partners, the Finance
Act, 1987 inserted a new sub-section 4 of Section 45 of the Act.
- As
per Section 45 (4)
- 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 and, for the purposes of section 48, the fair
market value of the asset on the date of such transfer shall be deemed to
be the full value of the consideration received or accruing as a result of
the transfer.
2. Application of Section 45(4)
- there shall be a transfer by way
of distribution.
- transfer should be by way of distribution upon “dissolution or otherwise”
- the
transferor shall be the firm/AOP/BOI(not being a company or co-operative
society
- the
transferee shall be the partner/member
- the underlying transferred asset should be a capital asset (defined u/s 2(14))
- FMV of
the asset as on the date of such transfer shall be deemed to be the full
value of consideration
- Profit
or gains arising from such transfer shall be chargeable to tax as income
of the Firm/AOP/BOI (Transferor)
- Profits/Gains arising out of the transfer shall be charged as STCG/LTCG
3. Analysis
A further analysis
to the section can be drawn in light of the clarifications issued by various
courts/legislative authorities:
a. Significance
of the term “otherwise”
There were
controversies whether this section covers only a transfer on dissolution or
also a transfer during the subsistence of a firm. However it was settled by
various courts that, even when a firm is in existence and there is a transfer
of capital asset to retiring partner, it comes within the expression “Otherwise”. Hence, Section 45(4) will be
applicable even in case of reconstitution of firm.
It was clarified in
CIT vs A.N.Naik Associates (2004) 265 ITR 346 (Bombay) by the Honorable High
Court of Bombay that the expression “otherwise” has to be read with the words
“transfer of capital assets by way of distribution of capital assets.
This was further
upheld by the Honorable High Court of Madras in the case of National Company vs
The Assistant Commissioner of Income Tax (2019).
b. Distribution
in specie
The distribution
shall be “Distribution in specie” and “not distribution of sale proceeds”.
Distribution of capital assets should be the actual transfer of such asset.
Distribution connotes actual distribution and not something which is Notional.
Following
transactions shall not be regarded as
transfer by way of distribution:
i. Receipt of amount in excess of the capital
balances in the partners’ capital account
Partnership Firm
ABC sold capital asset for Rs.50 crore. The sale proceeds were equally
distributed to the partners at the time of dissolution. Consequently each
partner received Rs.10 crore over and above their respective capital balances.
This is a case of distribution of sale proceeds to
partner and not a case of “Distribution in specie”. Hence, the transaction
cannot be regarded as transfer for the purpose of Section 45(4).
In Prashant S.
Joshi Vs. The Income Tax Office and Ors., reported in 2010 324 ITR 154 (Bom),
it was held that excess amount paid to partners over and above their capital
balances shall not be regarded as transfer within the meaning of Section 45(4)
ii. Revaluation
of capital assets in the books of accounts and crediting the capital accounts
of the partners on such revaluation cannot be regarded as transfer as this is
not a case of “Distribution in specie”.
Partnership Firm
ABC at the time of retirement of partner A, revalued all the capital assets of
the firm. Profit arising on account of such revaluation was credited to the
capital accounts of all the partners in equal ratio.
Mere revaluation of capital assets by crediting the
capital balances of partners cannot be regarded as transfer as this is not a
case of Distribution in specie. This is a case of Notional sale. Hence, the
transaction cannot be regarded as transfer for the purpose of Section 45(4).
In CIT vs
Kunnamkulam Mill Board [2002] 257 ITR 544, Honorable High Court of Kerala held
that on retirement of the partner of the firm, crediting of revaluation profits
to the retiring partners’ account cannot be regarded as transfer within the
meaning of Section 45(4).
4. Illustrations
a. ABC & Co, a
partnership firm transferred building with WDV of Rs.10 lacs to Mr.A at the
time of his retirement. Fair Market Value of the Building as on the date of
transfer is Rs.15 lacs. Capital balance of Mr.A as on that date is Rs.8 lacs.
Application of 45(4)
- Section
45(4) is applicable on transfer of capital asset to partner in case of
reconstitution of partnership firm.
- FMV of
the asset as on the date of such transfer shall be deemed to be the full
value of consideration - Rs.15 lacs
- Cost of
Acquisition shall be its book value as on the date of transfer- Rs.10
lacs.
- Benefit
of indexation is not available in case of depreciable asset.
- Gain on
transfer shall be Short Term Capital Gain (STCG)
Sale consideration - Rs.15 lacs
Less: Cost of acquisition Rs.10 lcas
Short Term Capital Gain Rs.5 lacs
b. Details of
partnership firm XYZ & Co as at 31st December 2018 (date of dissolution)
Application of 45(4)
For the purpose of
capital gain, assets taken over shall be segregated into 3 categories
● Non depreciable
asset
● Depreciable asset
● Non capital asset
- Not within the purview of Section 45(4)
Note:
i. Agreed
value is irrelevant for the purpose of Section 45(4)
ii. Stock
in Hand is not a Capital asset as defined under Section 2(14)
iii. Cost
of improvement is not considered for the purpose of above calculation
iv. Indexed
cost of acquisition is arrived by applying the CII Rates
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