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Money paid to Retiring Partners on Retirement is not taxable in Firm’s Hands
20 December 20...
 The Assessing Officer (AO) contended that there is
transfer of property from the old firm to the new firm. The
AO furthe...


The Division Bench felt that there was a conflict
between the propositions of law laid down in the above
two decisions....
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Money paid to Retiring Partners on Retirement is not taxable in firm’s hands

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The Karnataka High Court in the case of Dynamic Enterprises (the taxpayer) held that the firm shall not be liable to capital gains tax under Section 45(4) of the Income-tax Act, 1961 (the Act) on account of payment of money to the retiring partner, not involving distribution of any asset. In order to attract capital gains tax under Section 45(4) of the Act, there should be an absolute cessation of right in property of the firm, as a result of which the retiring partners should hold an absolute title to property so relinquished by the firm. If this condition is absent, there could be no application of Section 45(4) of the Act.

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Money paid to Retiring Partners on Retirement is not taxable in firm’s hands

  1. 1. KPMG FLASH NEWS KPMG IN INDIA Money paid to Retiring Partners on Retirement is not taxable in Firm’s Hands 20 December 2013  Background Recently, the Karnataka High Court in the case of 1 Dynamic Enterprises (the taxpayer) held that the firm shall not be liable to capital gains tax under Section 45(4) of the Income-tax Act, 1961 (the Act) on account of payment of money to the retiring partner, not involving distribution of any asset. In order to attract capital gains tax under Section 45(4) of the Act, there should be an absolute cessation of right in property of the firm, as a result of which the retiring partners should hold an absolute title to property so relinquished by the firm. If this condition is absent, there could be no application of Section 45(4) of the Act.  The taxpayer consisting of three partners (existing partners) was reconstituted during 1993 and five new partners were introduced in the taxpayer.  Prior to the reconstitution, the assets of the taxpayer were revalued as per the report of the registered valuer on 28 March 1993 and the difference between the revalued amount and the book value was credited in the capital account of the existing partners in the profit sharing ratio. Facts of the case  The existing partners retired from the taxpayer with effect from 1 April 1994 and the balance standing to the credit of their respective capital accounts was paid to them.  The taxpayer is a partnership firm engaged in the real estate business.  The taxpayer came in to existence on 9 January 1985. _________________ 1 CIT v. Dynamic Enterprises (ITA No. 1414/2006) – Taxsutra.com © 2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  2. 2.  The Assessing Officer (AO) contended that there is transfer of property from the old firm to the new firm. The AO further contended that the introduction of new partners and the retirement of existing partners was a device to transfer the immovable property and to evade capital gains tax as well as stamp duty. Therefore, he held that the capital gains tax is liable to be paid by the taxpayer.  The Commissioner of Income-tax (Appeals) [CIT(A)] held that the reconstitution of firm has taken place on 1 April 1994 i.e., nearly one year after the new partners were inducted in the firm and accepted the genuineness of the old firm as well as the new firm; but it held it as a colourable device to evade payment of tax.  The Income-tax Appellate Tribunal (the Tribunal) held that the reconstituted firm cannot be termed as a transferor even for arguments sake. The process of transfer requires a person who has a right in an asset and then such a right will be either sold, exchanged or relinquished to another person. In the given case, the taxpayer has not transferred any right in immovable properties. Therefore, there is no transfer and the firm is not liable to pay capital gains tax.  Therefore, the firm is not liable to pay any capital gains tax. Tax department’s contentions  The new partners brought money into the firm as their capital contribution, and the existing partners received the money and relinquished their interest in the capital asset in favour of the new partners. Thus, there was transfer of the capital asset, which results in capital gain liable to tax under Section 45(4) of the Act.  The transaction falls within the ambit of the word ‘otherwise’ in Section 45(4) of the Act.  Notwithstanding the above, it is a device adopted by the partners to evade payment of profits or gains and hence, is taxable. Constitution of Full Bench  The Division Bench of the High Court referred to the following two decisions: 2  In the case of Gurunath Talkies , it was held that in view of the series of transactions, such as reconstitution of the firm twice; once in July, 1994 and another in December, 1994, and the entire assets retained in the hands of the newly added two partners, results in transfer of assets of the firm, in the sense that the assets of the firm as had been held by the erstwhile partners is transferred to the newly added two partners, though all along the assets of the firm continued in the hands of the firm. Therefore, it was held that there is transfer of capital assets within the meaning of Section 2(47) of the Act.  Issues before the High Court In the case of Mangalore Ganesh Beedi 3 Works , it was held that though the firm stood dissolved on 5 December 1987, for a limited purpose of winding up the affairs of the firm, it continued till its assets and business were sold as a going concern on 20 November 1994. Therefore, the firm continued to hold the properties as owner till 20 November 1994. In those circumstances, there was no distribution of capital assets of the firm despite its dissolution and the firm could not have been made liable for paying capital gains tax in terms of Section 45(4) of the Act.  Whether the firm should be made liable to pay capital gains, when a retiring partner takes only the money towards the value of his share, even when there is no distribution of capital asset/assets among the partners under Section 45(4) of the Act?  Whether the retiring partner would be liable to pay tax on the capital gains? Taxpayer’s contentions  In order to attract Section 45(4) of the Act, dissolution of the firm and distribution of the capital asset are the conditions precedent. Also, the outgoing partners should acquire interest in such a capital asset and consequently the firm should cease to have any interest in the capital asset so distributed. The profit or gain arising from such a transfer of a capital asset is taxable under Section 45(4) of the Act.  In the current case, the amounts standing on credit of capital accounts is paid to the retiring partners and hence, there is no transfer of asset to the retiring partner. ______________ 2 3 CIT v. Gurunath Talkies [2010] 328 ITR 59 (Kar) CIT v. Mangalore Ganesh Beedi Works [2004] 265 ITR 658 (Kar) © 2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  3. 3.  The Division Bench felt that there was a conflict between the propositions of law laid down in the above two decisions. In order to resolve the said conflict, this matter was referred to the Full Bench.  It was held that the division bench decided Gurunath’s case following the Bombay High Court 4 ruling in the case of A.N. Naik Associates , without considering the distinguishing factor that A.N. Naik Associates case involved transfer of assets of the partnership in favour of the retiring partner. However, in Gurunath’s case there was no transfer of assets of the partnership, and therefore, the Gurunath’s case does not lay down correct law.  In the present case, there was no distribution of assets and hence, one of the condition precedent for invoking Section 45(4) of the Act did not exist and hence, Section 45(4) of the Act was not attracted to the facts of the case.  Therefore, the question of the firm being assessed under Section 45(4) of the Act and charging them tax for the profits or gains which did not accrue to them would not arise.  The second issue was not answered as the same did not arise for consideration in the appeal. High Court’s ruling  In order to attract sub-section (4) of Section 45, the following conditions need to be fulfilled :    On account of the transfer there should be a profit or gain derived by the firm and   Such distribution should result in the transfer of a capital asset by the firm in favour of the partner   There should be a distribution of capital assets of the firm Such distribution should be on dissolution of the firm or otherwise. Section 45(4) of the Act, requires that the capital asset of the firm should be transferred in favour of a partner, resulting in the firm ceasing to have any interest in the capital asset transferred and the partners should acquire exclusive interest in the capital asset. In other words, the interest the firm has in the capital asset should be extinguished and the partners in whose favour the transfer is made should acquire that interest. Only then the profits or gains arising from such transfers are liable to tax under Section 45(4) of the Act. Five partners brought in cash when the firm was reconstituted on 28 April 1993. Nearly a year thereafter, the existing three partners took their share in the partnership asset and went out of the partnership. However, even after the retirement of three partners, the partnership continued to exist and the business was carried on by the remaining five partners. There was no dissolution of the firm or at any rate there was no distribution of capital asset on 1 April 1994.  The retiring partners were given the value of their share in the partnership and no capital asset was transferred.  When the existing partners took cash and retired, they were not relinquishing their interest in the immovable property of the firm, but they relinquished their share in the partnership. The full bench decision settles the controversy about taxability of the amount paid to retiring partner, without distribution of capital assets, in the hands of the firm under Section 45(4) of the Act. The question whether the retiring partner was liable to capital gains tax for the amount received on retirement, is left unanswered. However, this matter was decided by the Supreme Court in the case of 5 Mohanbhai Pamabhai wherein it was held that when the partner retired from the firm, there was no transfer of interest of any of the taxpayers in the asset of the firm and no part of the amount received by any of the taxpayers was assessable to capital gains tax under Section 45 of the Act. Therefore, it seems that the amount paid to the retiring partner should neither be taxable in the hands of the firm nor in hands of the partner. In the absence of distribution of the capital asset, no profit or gain arose in the hands of the partnership firm.  Our comments ______________ 4 5 CIT v. A.N. Naik Associates [2004] 265 ITR 346 (Bom) CIT v. Mohanbhai Pamabhai [1987] 165 ITR 166 (SC) © 2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  4. 4. www.kpmg.com/in Ahmedabad Safal Profitaire B4 3rd Floor, Corporate Road, Opp. Auda Garden, Prahlad Nagar Ahmedabad – 380 015 Tel: +91 79 4040 2200 Fax: +91 79 4040 2244 Hyderabad 8-2-618/2 Reliance Humsafar, 4th Floor Road No.11, Banjara Hills Hyderabad 500 034 Tel: +91 40 3046 5000 Fax: +91 40 3046 5299 Bangalore Maruthi Info-Tech Centre 11-12/1, Inner Ring Road Koramangala, Bangalore 560 071 Tel: +91 80 3980 6000 Fax: +91 80 3980 6999 Kochi 4/F, Palal Towers M. G. Road, Ravipuram, Kochi 682 016 Tel: +91 484 302 7000 Fax: +91 484 302 7001 Chandigarh SCO 22-23 (Ist Floor) Sector 8C, Madhya Marg Chandigarh 160 009 Tel: +91 172 393 5777/781 Fax: +91 172 393 5780 Chennai No.10, Mahatma Gandhi Road Nungambakkam Chennai 600 034 Tel: +91 44 3914 5000 Fax: +91 44 3914 5999 Delhi Building No.10, 8th Floor DLF Cyber City, Phase II Gurgaon, Haryana 122 002 Tel: +91 124 307 4000 Fax: +91 124 254 9101 Kolkata Infinity Benchmark, Plot No. G-1 10th Floor, Block – EP & GP, Sector V Salt Lake City, Kolkata 700 091 Tel: +91 33 44034000 Fax: +91 33 44034199 Mumbai Lodha Excelus, Apollo Mills N. M. Joshi Marg Mahalaxmi, Mumbai 400 011 Tel: +91 22 3989 6000 Fax: +91 22 3983 6000 Pune 703, Godrej Castlemaine Bund Garden Pune 411 001 Tel: +91 20 3050 4000 Fax: +91 20 3050 4010 The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. © 2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. © 2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International The KPMG name, logo and “cutting through complexity“ are registered Cooperative (“KPMG International”), a Swiss entity. All rights reserved. trademarks of KPMG International Cooperative (“KPMG International”), a Swiss entity.

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