If no Assets transferred by Partnership firm to Retiring Partner than Section 45(4) shall not apply

What is section 45(4) of the Income Tax Act?

Section 45(4) deals with a distribution of capital assets on the dissolution of a firm or other association of persons or body of individuals or otherwise. If in the course of such distribution of capital asset there is a transfer of a capital asset by the firm in favour of a person and it results in profits or gains to the firm, then the said profits or gains shall be chargeable to tax as income of the firm and again for computing such income, Section 48 is attracted. In other words, in the process of a dissolution of a firm, if a capital asset is transferred to a partner which results in profits or gains, then that income is chargeable at the hands of the firm under this provision. In order to attract sub-section (4) of Section 45, the condition precedent is as follows:

(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; and

(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.

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. Then only the profits or gains arising from such transfer is liable to tax under Section 45(4) of the Act.

Fact and Issue of the case

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 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. 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. No capital asset was transferred on the date of retirement under the deed of retirement deed dated 01.04.1994. In the 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 tax for the profits or gains which did not accrue to them would not arise.

Observation of the Tribunal

In the instant case, the partnership firm did not transfer any right in the capital asset in favour of the retiring partner. The partnership firm did not cease to hold the property and consequently, its right to the property is not extinguished. Conversely, the retiring partner did not acquire any right in the property as no property was transferred in their favour. The Division Bench in Gurunath’s case (supra) did not appreciate this distinguishing factor and by wrong application of the law laid down by the Bombay High Court held the assessee in that case is also liable to pay capital gains tax under Section 45(4). Therefore, the said judgment does not lay down the correct law.

The court added that several other aspects of Section 45(4) was addressed in the course of the arguments by both sides which are not relevant to adjudicate the present issue, as in the present case there is no distribution of assets and hence, one of the condition precedent for invoking Section 45(4) does not exist and hence Section 45(4) is not attracted to the facts of this case.

Even if the retirement is assumed to be covered within the ambit of expression ‘otherwise’ Section 45(4) will not apply to retirement where only money value of the partner’s interest in the firm is paid to the outgoing partner and no specific asset is distributed or transferred to the outgoing partner, because the firm continues to own the asset and for Section 45(4) to attract, the firm should cease to be the owner of the asset. In the present case, the assets of the firm continued to be owned by the same firm and the outgoing partners are not taken away any asset in its physical form. Being so, in our opinion, Section 45(4) of the Act could not be applied. Accordingly, the court dismissed the ground of the appeal taken by the revenue.