T. C. A. Ramanujam looks at whether capital gains arise on dissolution of a firm
T. C. A. Ramanujam
In a series of judgments, the Supreme Court came down heavily on this view pointing out that there was no transfer involved when a partner brings in his capital assets into the firm or when he leaves with some assets. The Revenue saw this as a loophole in the law. The Finance Act, 1987 brought in comprehensive amendments to Section 45 of the I-T Act and inserted sub-section (3) to take care of induction of partners into the firm and sub-section (4) to govern transfer of capital assets by a firm to a partner on dissolution or `otherwise'.
The definition of the term `transfer' contained in Section 2 (47) was left untouched, and this led to confusion about the true import of Section 45(4). Various Benches of the Tribunal have been taking contrary views on the subject.
Recently, the Madhya Pradesh High Court had to handle a case on this subject. Moped and Machines was a partnership firm that consisted of two partners. One of them expired on April 19, 1990. In the assessment year 1991-92, the assessing officer (AO) took the view that there was dissolution of the firm on the death of one of the partners and this should attract capital gains tax under Section 45(4).
The Jabalpur Bench of the Income-Tax Appellate Tribunal (ITAT) decided the matter against Revenue and the case came up before the Madhya Pradesh High Court in
CIT vs Moped and Machines (150 Taxman 98 MP 2006). The Revenue submitted that Section 45(4) would take in cases of dissolution also and even relied on the Supreme Court ruling in
CIT vs Grace Collis (2001 3 SCC 430 Para 6).
On behalf of the firm, the argument rested on the interpretation of the term `transfer' given by the Supreme Court in the
Malabar Fisheries vs CIT (1979 120 ITR 49)case. It was held in that case that there was no transfer of asset within the meaning of Section 2 (47) on dissolution of the firm. Section 45(4) was inserted subsequently in the statue book with effect from April 1, 1988, but there was no consequential amendment to Section 2(47).
Therefore, the decision rendered in the
Malabar Fisheries(supra) case would continue to hold the field. If the business continues and there was no distribution of assets, the concept of capital gains under Section 45(4) would not be attracted. In the case of a two-partner firm, if one dies, there would only be a single surviving partner and, therefore, there would be no distribution. The firm had ceased to exist on the death of the partner and, therefore, there can be no capital gains tax in respect of an entity which is non-existent.
Agreeing with the submissions of the counsel for the firm, the MP High Court held that in the case of dissolution of a partnership firm on the death of another partner, it is difficult to conceive that there could be a transfer as contemplated under Section 2 (47) of the Act. The case was decided against the Revenue.
The Supreme Court's ruling in the
Grace Callis(supra) case was distinguished on the ground that it was a case of extinguishment on amalgamation of companies, a transaction to which both Section 2(47) and Section 47(vii) applied. Surprisingly, the Revenue did not bring to the notice of the MP High Court the decision of the Bombay High Court in its own favour in
CIT vs A. N. Naik Associates (265 ITR 346). The Bombay High Court had pointed out that under Section 45(4), gains arising from the transfer of capital assets by a firm to a partner on dissolution or `otherwise' would be chargeable as the firm's income in the previous year in which the transfer took place. It laid emphasis on the use of the expression `otherwise'; it meant that both cases of dissolution of a firm and cases of subsisting partners of a partnership transferring assets to a retiring partner would be covered by Section 45(4).
It considered the Madras High Court ruling in
CIT vs Vijayalakshmi Metal Industries (256 ITR 540),which held that until such time the capital assets are transferred by way of distribution of the assets on the dissolution of the firm, no occasion arose for levying tax on capital gains on a transfer which had not taken place. Similarly, it also considered the Supreme Court ruling in
Sakti Trading Company vs CIT (2001 250 ITR 871 SC),where the issue was whether on dissolution or death of one partner and reconstitution with the remaining partners without discontinuance of business how the valuation of the closing stock should be done.
These two judgments were interpreted by the MP High Court to mean that Section 45(4) will not apply. On the other hand, the Bombay High Court thought that the two judgments had no application to the issues it considered with regard to the interpretation of Section 45(4).
Rather than await the Supreme Court ruling, it would be better if the ensuing Finance Bill, 2006 clarified the matter through a suitable amendment to Section 2(47) of the I-T Act.
(The author is a former Chief Commissioner of Income-Tax.)