The assessee was a partnership firm engaged in the business of buying landed properties, constructions of buildings thereon, construction of industrial sheds, commercial complexes etc. It had purchased the property under a registered sale deed in the name of the firm.
The firm was reconstituted. Five partners brought in cash by way of capital contribution. Before the reconstitution, the assets of the firm were revalued as per the report of the registered valuer on 28.03.1993. Nearly a year thereafter, the erstwhile three partners retired through deed of retirement and had withdrawn their capital as standing in books of account of the firm. The old partners received the enhanced value of property in FY 1994-95.
The AO held that there was a transfer of property from old firm to reconstitute firm and that incoming partners tried to evade capital gain tax as well as stamp duty. The AO held that firm was liable to pay capital gain tax. On appeal, the CIT (Appeals) affirmed the order of the AO on the ground that it is a colourable device to evade payment of tax.
On further appeal, the ITAT held that since firm had not relinquished any right in property as property was being owned by the firm, there was no transfer by the reconstituted firm and the firm was not liable to capital gain tax.
Revenue filed appeal to HC, and following substantial questions of law was framed:
“When a retiring partner takes only the money towards the value of his share, whether the firm should be made liable to pay capital gains even when there is no distribution of capital asset/assets among the partners under Section 45(4) of the I.T. Act?”
The HC observed that in order to attract Section 45(4), the following conditions should be satisfied:
(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.
(4) Such distribution should be on dissolution of the firm or otherwise.
The HC held that in order to attract Section 45(4) of the Act, 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. 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. If this condition is satisfied, then the profits or gains arising from transfer is liable to tax under Section 45(4) of the Act.
The HC observed that in the instant case, the partnership firm had purchased the property under a registered sale deed in the name of the firm. The property did not stand in the name of any individual partners. No individual partners had brought that capital asset as capital contribution into the firm. Five partners brought in cash by way of capital, when the firm was reconstituted on 28.04.1993. Nearly a year thereafter on 01.04.1994 by way of retirement, the erstwhile three partners took their share in the partnership asset and went out of the partnership. After the retirement of three partners, the partnership continued to exist and the business was carried on by the remaining five partners. The HC held that there was no dissolution of the firm or at any rate there was no distribution of capital asset on 01.04.1994, when three partners retired from the partnership firm. What was given to the retiring partners is cash representing the value of their share in the partnership.
The HC held that “In absence of distribution of 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. Therefore, the question of the firm being assessed under Section 45 (4) and charging them tax for the profits or gains which did not accrue to them would not arise”.