Capital Gain on transfer of Capital Assets to partner on dissolution or reconstitution of firm: - Amendment by Finance Bill, 2021
Section-45(1) of the Income Tax Act provides that any profits or gains arising from the transfer of a capital asset shall be chargeable to income-tax under the head capital gains and shall be deemed to be the income of the previous year in which such transfer takes place.
Further, section-45(4) of the Income Tax Act 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 AOP or BOI (not being a company or a co-operative society) or otherwise, shall be chargeable to tax as the income of the firm, AOP or BOI, of the previous year in which the said transfer takes place”. For this purpose, the fair market value of the asset on the date of such transfer shall be deemed to be the full value of the consideration.
The expression ‘Otherwise’ in section 45(4) has caused a lot of litigations in the past around the question that “whether it is applicable on retirement of a partner”. Section 45(4) is definitely applicable on distribution of capital assets on dissolution of a firm but can it be equally and squarely applied in case of retirement of a partner is a matter of dispute. To settle this dispute, the Government has come out with the proposed amendment in section 45(4) and also introduced a new sub section 45(4A).
Newly substituted section 45(4) reads as follows: -
“Notwithstanding anything contained in sub-section (1), where a specified person receives during the previous year any capital asset at the time of dissolution or reconstitution of the specified entity, which represents the balance in his capital account in the books of accounts of such specified entity at the time of its dissolution or reconstitution, then any profits or gains arising from the receipt of such capital asset by the specified person shall be chargeable to income-tax as income of such specified entity of the previous year in which such capital asset was received by the specified person”.
Deletion of the words ‘Otherwise’ and bringing the words ‘reconstitution’ in its place clearly indicates the intention of the lawmakers. The word ‘reconstitution’ will include any change in the ownership structure of the firm whether it is retirement or admission or death of a partner or even a change in profit sharing pattern of the firm resulting in any distribution of capital asset.
Newly substituted section 45(4) has been analysed as below: -
- Section 45(4) is applicable where a specified person receives during the previous year any capital asset at the time of dissolution or reconstitution of the specified entity.
- “Specified Person” has been defined as a person who is a partner of a firm or member of AOP/BOI in any previous year.
- “Specified Entity” is defined as a firm or other association of persons (AOP) or body of individuals (BOI) (not being a company or a co-operative society).
- It has been proposed by the newly substituted sub-section that where a partner/ member receives any money or other asset at the time of dissolution or reconstitution of the firm/AOP/BOI, which represents the balance in his capital account in the books of such firm/AOP/BOI, the profits or gains arising from such receipt shall be chargeable under the head ‘Capital Gains’ as income of such firm/AOP/BOI of the previous year in which such money or asset is received by such partner/ member.
- It has been further provided that the balance appearing in the capital account is to be calculated without taking into account increase in the capital account of the partner/ member due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset.
- For the purpose of determining the amount of capital gain, the fair market value of the capital asset on the date of receipt of asset shall be deemed to be the full value of consideration received or accruing as a result of transfer of the capital asset.
- Cost of acquisition of the capital asset shall be determined in accordance with the provisions of this Chapter.
- ‘Self-generated goodwill’ and ‘Self-generated asset’ means goodwill or asset, which has been acquired without incurring any cost for purchase or which has been generated during the course of the business or profession.
Further, a new sub-section 4A has been inserted in section 45 which reads as below: -
“Notwithstanding anything contained in sub-section (1), where a specified person receives during the previous year any money or other asset at the time of dissolution or reconstitution of the specified entity, which is in excess of the balance in his capital account in the books of such specified entity at the time of its dissolution or reconstitution, then any profits or gains arising from receipt of such money or other asset by the specified person shall be chargeable to income-tax as income of such specified entity under the head “Capital Gains” and shall be deemed to be the income of such specified entity of the previous year in which such money or other asset was received by the specified person”.
Newly proposed section 45(4A) is analysed as below: -
- This sub-section is applicable where a partner/ member of firm or AOP/BOI receives any money or asset at the time of dissolution/ reconstitution of the firm/AOI/BOI and such money or asset is in excess of the capital balance of such partner/ member in the books of firm/AOP/BOI.
- In this situation, the profits or gains arising from receipt of such money or other asset by the partner/ member shall be chargeable to tax as capital gains in the hands of the firm/AOP/BOI.
Further, a consequential amendment is proposed in section 48 of the Income Tax Act as below: -
“(iii) in case of a specified entity referred to in sub-section (4A) of section 45, the amount included in the total income of such specified entity u/s 45(4A) which is attributable to the capital asset being transferred, calculated in the prescribed manner.”
The manner of calculation shall be prescribed by the CBDT through rules. The above amendments shall be effective from 1st April, 2021 and thus applicable for A.Y. 2021-22 and subsequent assessment years.
