Is there a transfer of assets on conversion of proprietary business into partnership firm?

Capital gain is the profit one earns on the sale of an asset like stocks, bonds or real estate. It results in capital gain when the selling price of an asset exceeds its purchase price. It is the difference between the selling price (higher) and cost price (lower) of the asset. Capital loss arises when the cost price is higher than the selling price. The sale of capital assets may lead to capital gains and these gains may attract tax under the Income Tax Act.

Section 45 of Income Tax Act, 1961 provides that any profits or gains arising from the transfer of a capital asset effected in the previous year will be chargeable to income-tax under the head ‘Capital Gains’. Such capital gains will be deemed to be the income of the previous year in which the transfer took place.

Let us refer to the case of CIT v. H. Rajan and H. Kannan (1999), where the main issue under consideration was whether there is a transfer of assets on conversion of proprietary business into partnership firm?

Facts of the Case:

• Damodaran Nair was carrying on business as an individual till March 31, 1967.
• On April 1, 1967, he converted the individual business into a partnership business in which he admitted two of his nephews as partners giving them 1/4^th share each.
• The Income-tax Officer was of the view that there was transfer of the assets for less than the market value and the business being of a transporter, the Income-tax Officer valued the buses at Rs. 3 lakhs as against the book value of Rs. 2,46,260 and taxed the difference of Rs. 53,740 as capital gains.
• He also added Rs. 1 lakh to this figure as representing the value of the route permit.
• The Appellate Assistant Commissioner reduced the quantum of the capital gains but the Tribunal, on a further appeal by the assessee came to the conclusion that on conversion of individual business into a partnership it did not result in any transfer as envisaged by Section 45 read with Section 2(47) of the Income-tax Act.
• It accordingly directed the amount of capital gains to be deleted. On a reference application being filed, the aforesaid question of law was referred.
• The High Court vide its judgment under appeal came to the conclusion that there was no transfer of assets and, therefore, no capital gains could be levied.
• Aggrieved with the order of High Court, Revenue approached the Supreme Court (SC).

Reference by SC to an older case

• In Sunil Siddharthbhai v. CIT, SC had to consider a similar question.
• In that case also a partner had introduced capital assets into the firm and the question arose whether that amounted to there being a transfer of capital assets and, secondly, whether there were any capital gains which had resulted from this transfer.
• It was held by SC that as the exclusive interest of a partner in personal asset was reduced and the said asset becoming an asset of the firm in which the other partners got an interest, there was a transfer of interest in law.
• It was, however, held that for such a transfer no consideration was received within the meaning of Section 48 and, therefore, no profit or gain had accrued to the transferor for the purposes of Section 45 of the Act.
• Therefore, there was no capital gains which could be taxed.

Observations of SC w.r.t the current case

• According to SC, the position in the present case was similar to the case of Sunil Siddharthbhai v. CIT.
• The exclusive business of the assessee was imparted with a character of a partnership business with induction of two nephews of the assessee.
• This certainly would mean that there was a transfer of part of the assets at least by the assessee in favour of his two nephews.
• But as held by this court in Sunil Siddharthbhai’s case, the transfer did not result in yielding any profit or gain to the assessee which could be subjected to tax under Section 45 of the Act.
• The question as framed by the Tribunal dealt with only one aspect, namely, whether there was a transfer of the assets in the assessee’s case and though the High Court has held that there was no liability under Section 45, having come to the conclusion that there was no transfer, the question of law as framed did not bring out this aspect of the case specifically.
• SC, therefore, frame an additional question. The original question would be regarded as question No. 1 and additional question would be that if the answer to question No. 1 is in the negative, then would such a transfer result in there being any gains or profit taxable under Section 45 of the Act?

Conclusion by SC

In so far as the first question, SC held that the exclusive business of the assessee was imparted with a character of a partnership business with induction of two nephews of the assessee, which was a transfer of the assets under section 2(47) by the assessee in favour of his nephews. However, for the second question, SC concluded that such a transfer did not yield any profits or gains to the assessee which could be subjected to tax under section 45. For this, the Court followed its decision in Sunil Siddharthbhai v. CIT [1985].

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