Fixed asset revaluation results in a taxable credit to the partner capital account: SC
Facts and Issue
The respondent assessee, a partnership firm, originally had four partners—all brothers—who were active in the clothing manufacturing, processing, and trading industries. According to the Family Settlement dated 02.05.1991 one of the existing partners, Shri M.H. Doshi, who had a 25% profit share in the company, had his share reduced to 12% and three new partners, Smt. Ranjan Doshi (11%), Shri Prakash Doshi (1%) and Shri Rajeev Doshi (1%), were admitted to the partnership to take over his remaining 13% share. It appears that thereafter, Shri M.H. Doshi, Shri Manohar Doshi and Shri V.H. Doshi retired from the partnership and reconstituted the partnership firm consisted of the partners namely, viz., Shri Hasmukhlal H. Doshi, Smt. Rajan H. Doshi, Shri Prakash H. Doshi & Shri Rajiv H. Doshi.
That on 01.11.1992, the firm was again reconstituted and three more partners, namely, viz., Smt. Vaishali Shah (18%), Smt. Bhavna Doshi (9%), Smt. Rupal Doshi (9%) and M/s. Ranjana Textile Pvt. Ltd. (10%) were admitted as partners. The contribution of new partners was as under:- Vaishali Shah – Rs. 4.50 lakhs M/s. Ranjana Textiles Pvt. Ltd. – Rs. 2.50 lakhs Bhavna Doshi – Rs. 2.25 lakhs Rupal Doshi – Rs. 2.25 lakhs
Two partners, Hasmukh H. Doshi and Smt. Ranjan Doshi, elected to remove some of their money, which was noted in the reconstructed partnership document.
The firm’s assets were revalued on January 1, 1993, and a sum of Rs. 17.34 crores was credited to the accounts of the partners in accordance with their profit-sharing ratio. Two of the original partners, Shri Hasmukhlal H. Doshi and Smt. Ranjan Doshi, withdrew between 20 and 25 lakhs rupees in capital. As a result, the Revenue claims that the new partners benefited right away from the credit of the revaluation amount to their capital accounts,
with Smt. Vaishali Shah receiving RS 3.12 crores (she contributed RS 4.50 lakhs),
Smt. Bhavna Doshi receiving RS 1.56 crores (she contributed RS 2.25 lakhs),
Smt. Rupal Doshi receiving RS 1.56 crores (she contributed RS 2.25 lakhs), and
M/s. Ranjana Textiles receiving Rs. 1.73 crores (she contributed RS 2.50 lakhs)
In relation to the pertinent assessment years, the respondent submitted its Return of Income. The Return of Income for the A.Y. 1993–1994 was submitted for Rs. 3,18,760. According to Section 143(1) of the Income Tax Act of 1961, the same was approved. But soon after, the notification under Section 148 of the Income Tax Act was sent, reopening the assessment in accordance with Section 147 of the Income Tax Act. The assessment was revised in accordance with Sections 143(3) and 147, which resulted in a total income determination of Rs. 2,55,19,490. Under Section 45(4) of the Income Tax Act, an addition of Rs. 17,34,86,772/- was made to the short-term capital gain amount. For A.Y. 1994–1995, a similar addition was made.
Observation by the court
The Commissioner of Income Tax (Appeals) [CIT(A)] by order dated 30.07.2004 confirmed the addition on account of Short-Term Capital Gains and held that there is a clear distribution of assets as partners have also withdrawn amounts from the capital account. CIT(A) also observed that value of the assets of the firm which commonly belonged to all the partners of the partnership have been irrevocably transferred in their profit-sharing ratio to each partner. The partnership has effectively given up its interest in the assets to the extent that the value has been assigned to each member, and this giving up can only be described as a transfer through relinquishment. The CIT(A) consequently concludes that the requirements of Section 45(4) have been met, and the assets, to the extent that their value was dispersed, would be considered income from capital gains in the hands of the assessee firm. Additionally, the CIT (A) noted that as the transfer of the revalued assets occurred in the previous year, the liability for capital gains arises in the A.Y. 1993-1994.The CIT(A) distinguished the decision of the Bombay High Court in the case of Commissioner of Income-Tax Mumbai Vs. Texspin Engg. and Mfg. Works, Mumbai, (2003) 263 ITR 345 and relied on the ruling of the Bombay High Court in Commissioner of Income Tax Vs. A.N. Naik Associates and Ors., (2004) 265 ITR 346 (Bom). (Bom.).
In a case involving an appeal filed by the assessee, the ITAT, by judgement and order dated October 26, 2006, and relying on this Court’s ruling in Commissioner of Income Tax, West Bengal vs. Hind Construction Ltd., (1972) 4 SCC 460, granted the appeal and overturned the A.O.’s addition to short-term capital gains by noting that, as noted and held by this Court in the aforementioned decision, revaluation of the assets The Bombay High Court’s ruling in the case of A.N. Naik Associates and Ors. (supra) shall not be relevant, according to the ITAT’s observation, which was upheld by the court.
In this instance, the partnership firm’s assets were revalued on January 1, 1993, to increase their value by an amount equal to Rs. 17.34 crores (applicable to the assessment years of 1993–1994), and the revalued amount was credited to the accounts of the partners in their profit-sharing ratio. It can be said that the credit of the asset revaluation amount to the capital accounts of the partners represents an effective distribution of the assets valued at Rs. 17.34 crores to the partners, and that over the years, some new partners were added by the introduction of small amounts of capital ranging from Rs. 2.5 to 4.5 lakhs, and that these new partners were given significant credits to their capital accounts immediately upon joining the partnership. Some of the partners actually withdrew the amount that had been credited to their capital accounts. Therefore, the assets so revalued and the credit into the capital accounts of the respective partners can be said to be “transfer” and which fall in the category of “OTHERWISE” and therefore, the provision of Section 45(4) inserted by Finance Act, 1987 w.e.f. 01 .04.1988 shall be applicable.
Concerning the reliance on the court’s decision in Hind Construction Ltd. (supra), it is important to note that the decision was made before Section 45(4) of the Income Tax Act, which was added by the Finance Act of 1987. Additionally, Section 45(4) did not contain the word “OTHERWISE” in the earlier regime. Therefore, this Court had no occasion to analyse the amended/inserted Section 45(4) of the Income Tax Act and the word used “OTHERWISE” in the case of Hind Construction Ltd. (supra). Under the circumstances, for the purpose of interpretation of newly inserted Section 45(4), the decision of this Court in the case of Hind Construction Ltd. (supra) shall not be applicable and/or the same shall not be of any assistance to the assessee. As such, we are in complete agreement with the view taken by the Bombay High Court in the case of A.N. Naik Associates and Ors., (supra). We affirm the view taken by the Bombay High Court in the above decision.
The court has ruled against the assessee and in favour of the AO. The Court stated that the contested decision and order issued by the High Court and the ITAT are invalid as the amount credited on revaluation to the capital accounts of the partners is a clear distribution of assets as partners have also withdrawn amounts from the capital account, it is also been observed that value of the assets of the firm which commonly belonged to all the partners of the partnership have been irrevocably transferred in their profit-sharing ratio to each partner and thus transfer of the revalued assets occurred in the previous year, the liability for capital gains arises in the A.Y.994_2014_5_1501_39976_Judgement_24-Nov-2022