Section 45(4) Of Income Tax Act Applicable To Cases Of Subsisting Partners Of A Partnership Transferring The Assets In Favour Of A Retiring Partner: Supreme Court

A Supreme Court bench comprising Justices M.R. Shah and M.M. Sundresh held that Section 45(4) of the Income Tax Act was applicable to not only the cases of dissolution but also cases of subsisting partners of a partnership, transferring the assets in favour of a retiring partner.

The respondent assessee, a partnership firm originally consisted of four partners (all brothers) engaging in the business of Dyeing and Printing, Processing, Manufacturing, and Trading in Clothing. Under the family settlement, one of the brother's shares was reduced and three new partners were admitted. Subsequently, three of the brothers retired and reconstituted a new firm with three other partners. In the new partnership, two of the partners decided to withdraw their capital. The partnership firm (assessee in the case) filed its Return of Income for the relevant assessment years. Thereafter, the assessment was reopened under Section 147 of the Income Tax Act by issuance of the notice under Section 148. As per the Assessing Officer (A.O.), the assessee revalued the land and building and enhanced the valuation thereby increasing the value of the assets. Therefore the revaluing of the assets, and subsequently crediting it to the respective partners' capital accounts constituted transfer, which was liable to capital gains tax under Section 45(4) of the Income Tax Act. The Commissioner of Income Tax (Appeals) [CIT(A)] confirmed the addition on account of Short-Term Capital Gains and held that there was a clear distribution of assets as partners had also withdrawn amounts from the capital account.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 had been irrevocably transferred in their profit-sharing ratio to each partner. To the extent that the value has been assigned to each partner, the partnership had effectively relinquished its interest in the assets and such relinquishment could only be termed as transfer by relinquishment. Therefore, according to the CIT(A), conditions of Section 45(4) were satisfied and therefore, the assets to the extent of their value distributed were deemed as income by capital gains in the hands of the assessee firm.

In an appeal preferred by the assessee, the ITAT allowed the appeal and set aside the addition made by the A.O. towards Short Term Capital Gains by observing revaluation of the assets and crediting to partners' account did not involve any transfer. Thereafter, High Court dismissed the appeals preferred by the Revenue. Thus, the Revenue approached the Supreme Court.

The primary question posed for the consideration before the Court was regarding the applicability of Section 45(4) of the Income Tax Act.

Section 45(4) provides that –

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 chargeable to tax as the income of the firm, association or body, of the previous year in which the said transfer takes place and for the purposes of section 48, the fair market value of the asset on the date of such transfer shall be deemed to be the full value of the consideration received or accruing as a result of the transfer.

The court noted that earlier, omission of Clause (ii) of Section 2(47) and Section 47(ii) exempted the transform by way of distribution of capital assets from the ambit of the definition of "transfer". The same helped the assessee in avoiding the levy of capital gains tax by revaluing the assets and then transferring and distributing the same at the time of dissolution. The said loophole came to be plucked by insertion of Section 45(4) and omission of Section 2(47)(ii).

The court stated that the submission on behalf of the assessee was that unless there was a dissolution of the partnership firm, and there was only transfer of the amount on revaluation to the capital accounts of the respective partners, Section 45(4) of the Income Tax Act shall not be applicable. It added–

"However, in view of the amended Section 45(4) of the Income Tax Act inserted vide Finance Act, 1987, by which, "OR OTHERWISE" is specifically added, the aforesaid submission on behalf of the assessee has no substance. After detailed analysis of Section 45(4), it is observed and held that the word "OTHERWISE" used in Section 45(4) takes into its sweep not only the cases of dissolution but also cases of subsisting partners of a partnership, transferring the assets in favour of a retiring partner."

In the present case, the bench noted that the amount was available to the partners for withdrawal. Therefore, the assets so revalued and the credit into the capital accounts of the respective partners was "transfer" and fell in the category of "OTHERWISE". Therefore, the provision of Section 45(4) wasapplicable.

Therefore, the judgements of the High Court and that of the ITAT were held as unsustainable and accordingly quashed and set aside. The order passed by the Assessing Officer was restored. 

CASE TITLE: The Commissioner of Income Tax v. M/s. Mansukh Dyeing and Printing Mills

Citation : 2022 LiveLaw (SC) 991

For Appellant(s) Mr. Rupesh Kumar, Adv. Mr. Raj Bahadur Yadav, AOR

For Respondent(s) Mr. Kaustubh Shukla, Adv. Ms. Nancy Shamim Adv Lakshmeesh S Kamat Adv Ms. Isha Vatsa Adv Mr. Parijat Kishore Adv Mr. Rahul Shyam Bhandari Adv Mr. Konark Tyagi Adv Mr. Ankur Kashyap Adv Mr. Hasan Murtuza Adv Mr. Abhay Singh Adv. Smiriti Ahuja Adv Mr. Vinodh Kanna B. AOR

Headnotes

Income Tax Act 1961- Section 45(4) - Section 45(4) applicable to not only the cases of dissolution but also cases of subsisting partners of a partnership, transferring the assets in favour of a retiring partner.

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