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February 8, 2021

Partner getting more cash or assets than capital balance will be liable to Tax During Dissolution or Change in Constitution

by CA Shivam Jaiswal in Income Tax

Partner getting more cash or assets than capital balance will be liable to Tax During Dissolution or Change in Constitution

Finance Minister Nirmala Sitharaman proposed many new measures in the Budget 2021 to prop up the declining economy amid the Covid-19 pandemic and boost spending across sectors. Budget 2021 focused on the seven pillars for reviving the economy – Health and Wellbeing, Physical and Financial Capital and Infrastructure, Inclusive Development for Aspirational India, Reinvigorating Human Capital, Innovation and R&D, and Minimum Government Maximum Governance. Several direct taxes and indirect taxes amendments were also proposed. Let us learn more about the clarifications that were brought about for Capital Gains on Dissolution or Reconstitution of a firm in Budget 2021 in this article.

What do you mean by Dissolution or Reconstitution of a firm?

The partnership is an agreement between two or more persons for sharing the profits of a business carried on by all or any one of them acting for all. Any change in the existing agreement is known as reconstitution of the partnership firm. Thus, the existing agreement ends and a new agreement is formed with the changed relationship among the members of the partnership firm and its composition.Reconstitution of a partnership firm takes place whenever there is a change in the profit-sharing ratio among the partners, admission of a new partner, retirement of a partner and death or insolvency of a partner.

Dissolution of a firm amounts to a complete closure of the business. When any of the partners dies, retires or become insolvent and if the remaining partners discontinue the business of the firm, then it is a dissolution of firm. On dissolution of the firm, the business of the firm ceases to exist since its affairs are would up by selling the assets and by paying the liabilities and discharging the claims of the partners.

What were the income tax provisions on Dissolution of a firm prior to Budget 2021?

  • Normally in the case of Dissolution of Firm, the firm itself will be dissolved, its business will be shut down and its assets will be realised or transferred to its Partners in proportion of their capital account.
  • Prior to amendment vide Finance Act 1987, the said transaction of ‘transferring of assets by the firm to partners” is not regarded as a transfer by virtue of sec.47(ii) and the said provision was misused largely to avoid capital gain on transfer of capital assets by way of seller and buyer of property entering into Partnership and capital assets purported to transferred is brought in the books of firm and subsequently the firm will be dissolved and the capital asset will be transferred to its partner i.e., intended seller.
  • In order remove the above loophole sec.47(ii) was removed and sec.45(4) was inserted to tax the gain on Capital Assets transferred to partner in the hands of the firm.

What were the income tax provisions on Reconstitution of a firm prior to Budget 2021?

  • On reconstitution of firm, firms account will be drawn as on the date of reconstitution which will result in revaluation of its assets and valuation of goodwill and same will be credited to the existing partners’ capital account.
  • If a Retiring partner is allotted a capital asset of a firm as a consideration for retirement, then 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 chargeableto tax as the income of the firm
  • When Retiring partner is paid by way of cash in accordance with balance lying in his capital a/c, there is no transfer of capital assets by the firm and hence there is no tax liability in the hands of the firm.
  • When a retiring partner receives amount lying in his capital a/c, it is nothing but his share in the net assets of the Partnership firm and it involve no transfer of rights to the continuing partners and hence there is no gain which is taxable in retiring partners hands.

What was changed by Budget 2021?

It has been proposed in Budget 2021 that where a partner/member receives any money or other asset at the time of dissolution or reconstitution of the firm/AOP/BOI which is more than the balance appearing in the capital account (without considering revaluation), the profits or gains arising from such receipt shall be chargeable under the head ‘capital gains’ as income of such firm, AOP or BOI of the previous year in which such money or other asset was received by the specified person.

Capital Balance will be before the effect of the effect of revaluation of capital asset or self-generated goodwill. Self-generated assets means asset which is acquired without incurring any purchase cost or which has been generated during the course of business/profession.

This amendment will take effect from 1st April, 2021.

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