Is capital gain applicable on share of retiring partner?

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.

However, is capital gain applicable on share of retiring partner? A similar issue was raised in the case of Dr. Vithal V. Kamat Vs JCIT (ITAT Mumbai). Let us refer to the case to understand the same in detail.

Facts of the Case:

The assessee filed return of income declaring total income which was processed under section 143(1).
Thereafter, the case of the assessee was selected under scrutiny and statutory notices under section 143(2) of 142(1) were issued and duly served upon the assessee.
The assessee is an individual and is engaged in the business of hotel consultancy. During the year, the assessee derived income by way of salary from M/s Kamat Hotels India Pvt Ltd in the capacity of a director, income from business and income from other sources.
During the course of assessment proceedings, the AO noticed that assessee had credited a sum of Rs.45,67,74,730 under the head “Exempt income and receipt” in the capital account and accordingly the assessee was called upon to furnish the detail of the said amount.
The assessee had retired from the partnership M/s. Sports Field Construction in terms of deed of admission and retirement.
The assessee got his accounts audited under section 44AB and in the audit report filed along with the return of income, the auditors reported that assessee received upon his retirement from M/s. Sports Field Construction a partnership firm subject to takeover of debts and liabilities under the agreement net amount of Rs.45,67,74,731 which was not taxable and was taken to the capital account as shown in the balance sheet.
The assessee retired from the partnership and relinquished his rights, title and interest in the partnership properties.
The assessee’s account with the partnership was settled on his retirement and a sum of Rs.48.15 crore was received by him by way of retirement in full and final settlement of his account with the firm.
The assessee received Rs.46.65 crore directly and Rs.1.50 crores deposited in Escrow Account.

Observations of the AO

The AO brushed aside the submissions of the assessee and came to the conclusion that the money received by the assessee from the partnership concern after reducing payment to the club members was in consideration of transfer of right, title and interest in the properties and as such held the same to be taxable under section 45(1).
According to the AO the said gain was a long-term capital gain on the ground that the said right was acquired since 1992 and cost of acquisition is taken at nil because assessee was having debit balance of Rs.1,00,04,690 in the firm which showed that the amount introduced by the assessee for acquiring such rights stood withdrawn.
Accordingly, the AO held that the amount received as reduced by the payments due to members of Rs.1,01,86,000 was to be assessed as long-term capital gain.

Observations of Commissioner of Income Tax (Appeals) [CIT(A)]

The CIT(A) after taking into consideration the facts, contentions and submissions as made by the assessee during the course of assessment proceedings and also after considering the ratio laid down by various judicial forums allowed the appeal of the assessee on this issue by holding that the compensation received by the assessee upon retirement from the partnership firm as his share in the assets of the partnership firm was not liable to tax as there was no transfer of assets involved.

Aggrieved with the order of the CIT(A), the Revenue appealed before the ITAT.

Observations of ITAT on decisions by earlier cases

In the case of Addl. CIT vs. Mohanbhai Pamabhai (supra) the Supreme Court affirmed the decision of the Gujarat High Court as reported in (1973) 91 ITR 393 (Guj.) wherein the Bombay High Court had held that any money received by the partner upon retirement from the partnership firm as his share in the assets of the partnership concern was not a consideration for transfer of his interest in the partnership to the continuing partners and there is no transfer within the meaning of section 2(47) of the Act.

Supreme Court in the case of CIT v. Tribhuvandas G. Patel (supra) held that any amount paid to the partner upon his retirement towards his share in assets was not a transfer within the meaning of section 47(ii) and not liable to capital gain.

In the case of CIT v. Lingamallu Raghu Kumar (supra) the Supreme Court held that where the assessee received on retirement from the firm a sum more than what is due towards his capital and profit amount received was not assessable to capital gain as there was no transfer of any asset as contemplated in section 2(47) of the Act.

ITAT found merit in the alternative plea taken by the assessee that if the computational provision of capital gain as provided under section 48 breaks down, then the charging provision as provided under section 45 would also fail as held by the Supreme Court in the case of CIT vs. B.C. Srinivasa Setty (128 ITR 294).

The case of the assessee was squarely covered by the decisions of the Apex Court and in view of the ratio laid down in the above decisions by the Apex Court, ITAT was inclined to dismiss the appeal of the Revenue by upholding the order of CIT(A) on this ground.

In simple words, amount received on retirement from the firm more than what is due towards his capital and profit is not assessable to capital gain as there was no transfer of any asset as per the provisions of the Income Tax Act.

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