S. 45(4): Full Bench High Court Explains Law On Taxability Of Capital Gains In Hands Of Firm

CIT vs. M/s Dynamic Enterprises (Karnataka High Court – Full Bench)

S. 45(4) does not apply if the retiring partner takes only money
towards the value of his share and there is no distribution of capital assets among the partners

The assessee partnership firm was constituted on 09.01.1985 with Anurag Jain and Nirmal Kumar Dugar as its partners. On 13.04.1987, Nirmal Kumar Dugar retired from partnership and L.P. Jain entered the partnership and contributed capital for purchase of land to construct a housing complex. The assessee-firm purchased land for a consideration of Rs.2.5 lakhs. Another reconstitution took place on 1.7.1991 by which L.P. Jain retired from the firm and Pushpa Jain and Shree Jain were inducted as partners. Later, on 28.04.1993, five partners belonging to the Khemka Group were inducted. Prior to the induction of the Khemka Group, the assets of the firm were revalued. The three old partners retired through deed of retirement dated 01.04.1994 and received the enhanced value of the property in FY 1994-95. The AO held that the introduction of the Khemka Group and the retirement of the old partners was a device adopted to transfer the immovable property and to evade capital gains tax and stamp duty. He assessed the firm on capital gains. This was upheld by the CIT(A) though reversed the Tribunal. The Tribunal held that as the land continued to remain with the assessee-firm, there was no transfer u/s 2(47) and that the retiring partners had merely withdrawn the amounts standing to their credit in the capital account. On appeal by the department to the High Court, it was felt that there was a conflict between Mangalore Ganesh Beedi Works 265 ITR 658 and Gurunath Talkies 328 ITR 59 and the issue was referred to the Full Bench. HELD by the Full Bench:

(i) S. 45(4) deals with a distribution of capital assets on the dissolution of a firm or other AOP or BOI or otherwise and provides that if in the course of such distribution of capital asset there is a transfer of a capital asset by the firm, the firm shall be chargeable to tax on capital gains. In order to attract s. 45(4), the conditions precedent are (1) there should be a distribution of capital assets of a firm; (2) such distribution should result in transfer of a capital asset by firm in favour of the partner; (3) on account of the transfer there should be a profit or gain derived by the firm and (4) such distribution should be on dissolution of the firm or otherwise. In other words, the capital asset of the firm should be transferred in favour of a partner, resulting in firm ceasing to have any interest in the capital asset transferred and the partners should acquire exclusive interest in the capital asset. On facts, the partnership firm purchased the property and it was not in the name of any partner. No partner brought that capital asset as capital contribution into the firm. Also, there was no dissolution of the firm because the firm continued to exist even after the retirement of some partners. What was given to the retiring partners is cash representing the value of their share in the partnership. No capital asset was transferred on the date of retirement. In the absence of distribution of a capital asset and in the absence of transfer of capital asset in favour of the retiring partners, no profit or gain arose in the hands of the partnership firm and so the question of the firm being assessed u/s 45(4) would not arise;

(ii) The department’s argument that the transaction by which the five incoming partners brought money into the firm and the three erstwhile partners retired by taking money (leaving the capital asset in the firm) is a device adopted to evade payment of profits or gains is not acceptable because it proceeds on the premise that the immovable property belongs to the erstwhile partners and that after the retirement the erstwhile partners have taken cash and given the property to the incoming partners. The property belongs to the partnership firm and not to the partners. The partners only had a share in the partnership asset when they retired and took their share in cash, they were not relinquishing their interest in the immovable property. What they relinquished is their share in the partnership.Therefore, there is no transfer of a capital asset and no capital gains or profit arises (Ganesh Beedi Works 265 ITR 658 approved; Gurunath Talkies 328 ITR 59 reversed; Narayanappa vs. Bhaskara Krishnappa AIR 1966 SC 1300, Malbar Fisheries Co 120 ITR 49 (SC), Sunil Siddharthbhai 156 ITR 509 (SC), A.N. Naik Associate 265 ITR 346 (Bom) referred)