INCOME TAX: Taxation on Retirement of a Partner from a partnership firm

When one or more partners leave the firm and the remaining partners continue to do the business of the firm, it is known as retirement of a partner. A partner who cut his connection with the firm is called a retiring partner or outgoing partner. Retirement of a partner leads to reconstitution of a partnership firm as the original agreement between the partners comes to an end. The business may continue with a new agreement with the remaining partners. A partner may retire from the partnership with the consent of all other partners. He may also retire in accordance with an express agreement by the partners or by giving notice to other partners of his intention to retire. The retired partner is however liable to all the acts of the firm dealing with third parties before his retirement.

Every partner of a partnership firm has the right to withdraw from the business with the consent of all the other partners. In the case of a partnership formed at will, this may be done by giving a notice to that effect to all the other partners.

A partner retires when he ceases to be a member of the firm without ending the subsisting relations between the other members of the firm or between the firm and other parties. If a partner withdraws from a firm by dissolving it, then it is a dissolution and not retirement of a partner. The retirement of a partner from a firm does not dissolve it.

Meaning of Retirement of a Partner

Withdrawal of a partner from the partnership with the consent of other partners or as per the provisions of the partnership deed or by giving notice of retirement is termed as retirement of a partner. A partner who cut his connection with the firm is called a retiring partner or outgoing partner. Retirement of a partner leads to reconstitution of a partnership firm as the original agreement between the partners comes to an end. The business may continue with a new agreement with the remaining partners. When a partner retires, his share in the firm is to be correctly ascertained and settled.

Retirement of an Existing Partner

A partner may decide to retire or withdraw from the firm due to reasons such as his age, his bad health, change in firm’s nature of a business, etc. In case of Partnership at Will, a partner may retire at any time. Retirement amounts to a reconstitution of a firm where the number of partners, their capital contribution ratio and also the profit sharing ratio changes. The retiring partner is paid his share of capital, goodwill and revaluation profit or loss.

For example, X, Y, and Z are partners in the firm sharing profits in the ratio of 3:2:1. X chooses to retire and Y and Z decide to share the future profits equally. This is a reconstitution of the firm where the number of partners and their profit sharing ratio both have changed.

Q : A, B and C are partners sharing profits in the ratio of 2:2:1. They are having a capital of 2,00,000, 2,00,000 and 1,00,000 respectively. It is decided that C should bring additional capital of 100000. And then the profit sharing ratio should be calculated on the basis of their capitals. Is this a case of reconstitution of a firm and how?

Answer: Now, the new capitals are Rs. 2,00,000 each and thus the new profit sharing ratio is 1:1:1. As there is a change in the profit sharing ratio, this is definitely a case of reconstitution of a partnership.

Sections 32 to 38 of the Indian Partnership Act, 1932 deal with different ways in which a partner may cease to be a partner and his rights and liabilities thereafter. These provisions pertain to situations when the outgoing partner ceases to be a partner, but the firm is not dissolved and it continues with the remaining partners. A partner may cease to be a partner in the following ways:

(a) By retirement;

(b) By expulsion;

(d) By death.

Section 32 of the Indian Partnership Act, 1932 deals with the retirement of a partner as under:

Text of Section 32 of the Indian Partnership Act, 1932

RETIREMENT OF A PARTNER

(1) A partner may retire-

(a) with the consent of all the other partners,

(b) in accordance with an express agreement by the partners, or

(c) where the partnership is at will, by giving notice in writing to all the other partners of his

intention to retire.

(2) A retiring partner may be discharged from any liability to any third party for acts of the firm done before his retirement by an agreement made by him with such third party and the partners of the reconstituted firm, and such agreement may be implied by a course of dealing between such third party and the reconstituted firm after he had knowledge of the retirement.

(3) Notwithstanding the retirement of a partner from a firm, he and the partners continue to be liable as partners to third parties for any act done by any of them which would have been an act of the firm if done before the retirement, until public notice is given of the retirement:

PROVIDED that a retired partner is not liable to any third party who deals with the firm without knowing that he was a partner.

(4) Notices under sub-section (3) may be given by the retired partner or by any partner of the reconstituted firm.

The word ‘retire’ in the said section is confined to cases where a partner withdraws from the firm and the remaining partners continue to carry on the business without dissolution as between them. It does not cover a case where a partner withdraws from the firm by dissolution and not by retirement.

Sub-section (2) of the said section states that a partner may be discharged from any liability to any third party for acts of the firm, before his retirement, by an agreement made by him with such third party and partners of reconstituted firm, and such agreement may be implied by course of dealing between such third party and reconstituted firm after he had knowledge of retirement.

Further, sub-section (3) lays down that notwithstanding retirement of a partner, he and the other partners continue to be liable to third parties for any acts done by any of them which would have been act of the firm if done before retirement until public notice of the retirement is given. However, the retired partner shall not be liable to third party who deals with the firm without knowledge that he was a partner.

Liabilities of an Outgoing Partner

As per section 32(2) of the Indian Partnership Act, 1932, Every partner is liable for all acts of the firm done while he is a partner14.If liability has arisen during the period while a person was a partner, such liability does not come to an end by his retirement, he shall be liable for the debts contracted before his retirement

A retiring partner may be discharged from any liability to any third party for acts of the firm done before his retirement by an agreement made by him with such third party and the partners of the reconstituted firm, and such agreement may be implied by a course of dealing between such third party and the reconstituted firm after he had knowledge of the retirement.

A retired partner continues to be liable to the third party for acts of the firm till such time that he or other members of the firm give a public notice of his retirement. However, if the third party deals with the firm without knowing that he was a partner in the firm, then he will not be liable to the third party.

The retired partner, however, continues to be liable for acts of the firm done before such retirement of a partner. This liability holds good unless there is an agreement between him, the concerned third party, and partners of the reconstituted firm. Such an agreement can also be implied by the course of dealings between the third party and the reconstituted firm post announcement of the retirement of a partner.

If the partnership is at will, then it can relieve a partner without giving a public notice. To do so, the partnership needs to give a written notice to all the partners of his intention to retire.

If the public notice is not issued, the partners continue to be liable

According to Section 32(3) of the Indian Partnership Act, 1932; until any public notification is made in the promulgation of such retirement, the retired partner along with the other partners of the firm continue to be liable towards the third parties for any act done by them which would have been considered an act of the done if had been done prior to the retirement.

According to Section 32(4) of the Indian Partnership Act, 1932, the aforementioned public notification can be made by the retired partner or any partner of the reconstituted firm.

ILLUSTRATION

Mr ‘X’ is a partner at a firm. He resigns from his partnership one day. Thereby, he is discharged from any third party liability or any act of the firm which was incurred in the course of his partnership. However, such liability shall exist until the time of the promulgation of his retirement, through a public notification, made either by him or the continuing partners in the firm.

If the public notice is not issued, the partners continue to be liable

According to Section 32(4) of the Indian Partnership Act, 1932, the aforementioned public notification can be made by the retired partner or any partner of the reconstituted firm.

ILLUSTRATION

Terms and conditions of retirement of a partner

The terms and conditions of retirement of a partner are normally provided in the partnership deed. If not, they are agreed upon by the partners at the time of retirement. The old partnership comes to an end and a new partnership is formed among the remaining partners

ILLUSTRATION

‘X’, ‘Y’ and ‘Z’ are partners in a firm. Due to some family problems, ‘X’ wants to leave the firm. The other partners decide to allow him to withdraw from the partnership. Thus, due to some reasons like old age, poor health, strained relations etc., an existing partner may decide to retire from the partnership. Due to retirement, the existing partnership comes to an end and the remaining partners form a new agreement and the partnership firm is reconstituted with new terms and conditions. At the time of retirement the retiring partner’s claim is settled.

Ascertaining the Amount Due to Retiring/ Deceased Partner

The sum due to the retiring partner (in case of retirement) and to the legal representatives/ executors (in case of death) includes:

(i) credit balance of his capital account;

(ii) credit balance of his current account (if any);

(iii) his share of goodwill;

(iv) his share of accumulated profits (reserves);

(v) his share in the gain of revaluation of assets and liabilities;

(vi) his share of profits up to the date of retirement/death;

(vii) interest on his capital, if involved, up to the date of retirement/death; and

(viii) salary/commission, if any, due to him up to the date of retirement/death.

The following deductions, if any, may have to be made from his share:

(i) debit balance of his current account (if any);

(ii) his share of goodwill to be written off, if necessary;

(iii) his share of accumulated losses;

(iv) his share of loss on revaluation of assets and liabilities;

(v) his share of loss up to the date of retirement/death;

(vi) his drawings up to the date of retirement/death;

(vii) interest on drawings, if involved, up to the date of retirement/death.

Rights of a Retiring

Retiring partner is entitled to get his share of capital, interest on capital, revaluation profit, share of profit etc. up to the date of his retirement. Similarly he is liable for his share in all the losses like accumulated loss, revaluation loss, Drawings, interest on drawings, share of current year’s loss up to the date of retirement, drawings, interest on drawings etc. till the date of his retirement. He is not liable for any loss incurred by the firm after his retirement.

Right of outgoing partner [Section 36 of the Indian Partnership Act, 1932]

Text of Section 36 of the Indian Partnership Act, 1932

36. Right of outgoing partner to carry on competing business. —

(1) An outgoing partner may carry on a business competing with that of the firm and he may advertise such business, but subject, to contract to the contrary, he may not
(a) use the firm-name,
(b) represent himself as carrying on the business of the firm, or
(c) solicit the custom of persons who were dealing with the firm before he ceased to be a partner.

(2) AGREEMENT IN RESTRAINT OF TRADE.
A partner may make an agreement with his partners that on ceasing to be a partner he will not carry on any business similar to that of the firm within a specified period or within specified local limits; and, notwithstanding anything contained in section 27 of the Indian Contract Act, 1872, such agreement shall be valid if the restrictions imposed are reasonable.

Text of Section 37 of the Indian Partnership Act, 1932

37. RIGHT OF OUTGOING PARTNER IN CERTAIN CASES TO SHARE SUBSEQUENT PROFITS.

Where any member of a firm has died or otherwise ceased to be a partner, and the surviving or continuing partners carry on the business of the firm with the property of the firm without any final settlement of accounts as between them and the outgoing partner or his estate, then, in the absence of a contract to the contrary, the outgoing partner or his estate is entitled at the option of himself or his representatives to such share of the profits made since he ceased to be a partner as may be attributable to the use of his share of the property of the firm or to interest at the rate of six per cent. per annum on the amount of his share in the property of the firm :

PROVIDED that where by contract between the partners an option is given to surviving or continuing partners to purchase the interest of a deceased or outgoing partner, and that option is duly exercised, the estate of the deceased partner, or the outgoing partner of his estate, as the case may be, is not entitled to any further or other share of profits, but if any partner assuming to act in exercise of the option does not in all material respects comply with the terms thereof, he is liable to account under the foregoing provisions of this section.

Adjustments/Accounting treatment required at the time of retirement of a partner

1. Calculation of new profit sharing ratio and gaining ratio

2. Treatment of goodwill

3. Treatment of accumulated profit and losses

4. Revaluation of assets and liabilities

5.Ascertainment of profit and loss upto the date of retirement

6. Calculation of total amount due to the retiring partner

7. Settlement of total amount due to the retiring partner

8. Adjustment of capitals of the continuing partners

Accounting treatment required at the time of retirement of a partner

I. Calculation of New profit sharing ratio and gaining ratio

At the time of retirement of a partner, the business continues with the remaining partners.

New Ratio

The ratio, in which the continuing partners decide to share the future profits and losses, is known as new profit sharing ratio.

Gaining Ratio

The ratio in which the continuing partners have acquired the share from the retiring/deceased partner is called the gaining ratio.

The ratio in which the continuing partners have acquire the retiring/deceased/ outgoing partner’s share is called gaining ratio. It is called gaining ratio because the continuing partners stand to gain by acquiring the retiring partner’s share in profits.

Normally, the continuing partners acquire the share of retiring/deceased partner in their old profit sharing ratio, In that case, the gaining ratio of the remaining partners will be the same as their old profit sharing ratio among them and there is no need to compute the gaining ratio, Alternatively, proportion in which they acquire the share of the retiring/deceased partner may be duly spacified. In that case, again, there is no need to calculate the gaining ratio as it will be the ratio in which they have acquired the share of profit from the retiring deceased partner.

The problem of calculating gaining ratio arises primarily when the new profit sharing ratio of the continuing partners is specified. In such a situation, the gaining ratio should be calculated by, deducting the old share of each continuing partners from his new share i.e., new profit share minus old profit share, i.e., new profit share minus old profit share.

For example, Amit, Dinesh and Gagan are partners sharing profits in the ratio of 5:3:2.

Dinesh retires. Amit and Gagan decide to share the profits of the new firm in the ratio of 3:2. The gaining ratio will be calculated as follows :

Amit’s Gaining Share = 3 5 = 6 - 5 = 1

5 10 10 10

Amit’s Gaining Share = 2 2 = 4 - 2 = 2

5 10 10 10

Thus, Gaining Ratio of Amit and Gagan = 1 : 2

This implies Amit gains 1 and Gagan gains 2 of Dinesh’s share of profit.

3 3

Gaining share of Continuing Partner = New share – Old share

ILLUSTRATION - 1

Madhu, Neha and Tina are partners sharing profits in the ratio of 5:3:2. Calculate new profit sharing ratio and gaining ratio if : (1) Madhu retires. (2). Neha retires (3). Tina retires.

Solution :

Given old ratio among Madhu : Neha : Tina as 5 : 3 : 2

(1). If Madhu retires, new profit sharing Ratio between Neha and Tina will be

Neha : Tina = 3:2 and

Gaining Ratio of Neha and Tina =3:2

(2). If Neha retires new profit sharing Ratio between Madhu and Tina will be

Madhu : Tina = 5:2

Gaining Ratio of Madhu and Tina = 5:2

(3). If Tina retires, new profit sharing ratio between Madhu and Neha will be:

Madhu : Neha = 5:3

Gaining ratio of Madhu and Neha = 5:3

ILLUSTRATION - 2

Alka, Harpreet and Shreya are partners sharing profits in the ratio of 3:2:1. Alka retires and her share is taken up by Harpreet and Shreya in the ratio of 3:2. Calculate the new profit sharing ratio.

Solution

Gaining Given, Ratio of Harpreet and Shreya = 3:2 = 3 : 2

5 5

Old Profit Sharing Ratio of between Alka, Harpreet and Shreya 3:2:1 = 3 : 2 : 1

6 6 6

Share acquired by Harpreet = 3 of 3 = 9

5 6 30

Share acquired by Shreya = 2 of 3 = 6

5 6 30

New Share = Old Share + Acquired Share

Harpreet’s New Share = 2 + 9 = 19

6 30 30

Shreya’s New Share = 1 + 6 = 11

6 30 30

New Profit Sharing Ratio of Harpreet and Shreya = 19:11

ILLUSTRATION 3

Murli, Naveen and Omprakash are partners sharing profits in the ratio of 3 1 1,.

8 , 2 and 8

Murli retires and surrenders 2/3rd of his share in favour of Naveen and the remaining share in favour of Omprakash. Calculate new profit sharing and the gaining ratio of the remaining partners.

Solution

Naveen Omprakash

(i) Old Share 1 1

2 8

(ii) Share Acquired by Naveen

and Omprakash from Murli = 2 of 3 = 2 1 of 3 = 1

3 8 8 3 8 8

(iii) New Share = (i) + (ii) = 1 + 2 1 + 1

2 8 8 8

= 6 or 3 = 2 or 1

8 4 8 4

Thus, the New profit sharing Ratio = 3 : 1 or 3:1, and the

4 4

Gaining Ratio = 2 : 1 or 2 : 1 [as calculated in (ii)]

8 8

ILLUSTRATION - 4

Kumar, Lakshya, Manoj and Naresh are partners sharing profits in the ratio of 3 : 2 : 1 : 4. Kumar retires and his share is acquired by Lakshya and Manoj in the ratio of 3:2. Calculate new profit sharing ratio and gaining ratio of the remaining partners.

Solution

Lakshya Manoj Naresh

(i) Old Share 2 1 4

10 10 10

(ii) Acquired Share from Kumar = 3 of 3 2 of 3 NIL

5 10 5 10

= 9 6 NIL

50 50

(iii) New share = (i) = (ii) = 2 + 9 1 + 6 4 + NIL

10 50 10 50 10

= 19 11 20

50 50 50

The New Profit Sharing Ratio is 19 : 11 : 20

Gaining ratio is 3 : 2 : 0

Notes :

1. Since Lakshya and Manoj are acquiring Kumar’s share of profit in the ratio of 3:2, hence, the

gaining ratio will be 3:2 between Lakshya and Manoj.

2. Naresh has neither sacrificed nor gained.

ILLUSTRATION - 5

Ranjana, Sadhna and Kamana are partners sharing profits in the ratio 4:3:2. Ranjana retires; Sadhna and Kamana decided to share profits in future in the ratio of 5:3. Calculate the Gaining Ratio

Gaining Share = New Share – Old Share

Sadhna’s Gaining Share = 5 - 3 = 45 - 24 = 21

8 9 72 72

Kamana’s Gaining Share = 3 - 2 = 26 - 16 = 11

8 9 72 72

Gaining Ratio between Sadhna and Kamana = 21:11.

Difference between sacrificing and Gaining Ratio

Bases of Difference	Sacrificing Ratio	Gaining Ratio
Meaning	The ratio in which the old partners sacrifice their share of profit in favour of the new partner	The ratio in which the continuing partners acquire the outgoing partner’s share is called gaining ratio.
When to calculate	It is calculated at the time of admission of a partner and change in profit sharing ratio	It is calculated at the time of retirement/death of a partner and change in profit sharing ratio
Purpose	It is calculated to know how much each partner needs to sacrifice for the new partner	It is calculated to know how much more each partner will gain when a partner retires or die
Objective	It is used to share the goodwill brought in cash by new partner between old partners	Gaining ratio is used to determine the compensation payable to the retiring by the continuing partners
Calculation	Old Share– New Share	New Share-Old Share
Effect on Capital	Old Partners Capital Accounts are credited in the sacrificing ratio	Remaining partners capital accounts are debited in gaining ratio

Case - 1 Relative Ratio between remaining partners unchanged

If the continuing partners maintain their relative ratio, the gaining ratio and the new ratio will be the same. In this case there is no need to calculate gaining ratio, new ratio and gaining ratio will be the same

Example :

Q.X,Y and Z are partners sharing profits in the ratio of 1/2, 3/10, 1/5 or (5/10:3/10:2/10).Calculate the new ratio and sacrificing ratio if X retires.

Old ratio of X, Y and Z = 5:3:2 New ratio of Y and Z = 3:2

Gaining Ratio = New share – Old share

Y’s Gain = 3/5 – 3/10 or 6/10 – 3/10 =3/10

Z’s Gain = 2/5 – 2/10 or 4/10 – 2/10 = 2/10

Gaining ratio of Y and Z = 3:2

In this type problem (Case-1) Gaining Ratio = New Ratio So in this type problem there is no need to calculate gaining ratio

Case - 2 When the profit sharing ratio between continuing partners is changed/The new ratio between remaining partners is given

If the continuing partners decide to share future profits in some other ratio, the gaining ratio will also change.

In this case it is necessary to calculate gaining ratio.

Gaining Ratio = New Share – Old Share

In this case old share and new share of continuing partners is given

Q. A,B and C were sharing profits in the ratio of 3:2:1.C retires from the firm. A and B decided to share future profits in the ratio of 7:5.Calculate gaining ratio.

Old ratio of A,B and C = 3:2:1 New ratio of A and B = 7:5

Gaining Ratio = New Share – Old Share

A’s Gain = 7/12 – 3/6 or 7/12 -6/12 =1/12

B’s Gain = 5/12 – 2/6 or 5/12 – 4/12 =1/12

Gaining ratio = 1:1

PROVISIONS ILLUSTRATED – 1

A, B and C were partners sharing profits in the ratio of 12, 25 and 110. Find the new ratio of the remaining partners if C retires.

Answer : New profit ratio of A : B will be 5 : 4

PROVISIONS ILLUSTRATED – 2

From the following particulars, calculate the new profit sharing ratio of the partners:

X, Y and Z were partners in a firm sharing profits in the ratio of 5: 5: 4. Y retired and his share was divided equally between X and Z .

Answer : X and Z new profit ratio = 15 : 13

PROVISIONS ILLUSTRATED – 3

P, Q and R were partners sharing profits in the ratio of 5: 4: 1. P retires from the firm.

Answer : New Profit Ratio Q : R = 4:1

Distinction between ‘retirement of a partner’ and ‘dissolution of a partnership firm’

There is a clear distinction between ‘retirement of a partner’ and ‘dissolution of a partnership firm’. On retirement of the partner, the reconstituted firm continues, and the retiring partner is to be paid his dues in terms of Section 37 of the Partnership Act. In case of dissolution, accounts have to be settled and distributed as per the mode prescribed in Section 48 of the Partnership Act.

Capital gain on transfer of capital assets by a firm/AOP/BOI to partner/member on its reconstitution [Section 45(4)]

Section 45(4) substituted by the Finance Act, 2021 with effect from 01.04.2021, contains a non-obstante provision for deemed capital gains in the hands of the specified entity where a specified person receives money or capital asset or both from a specified entity in connection with its reconstitution in the year in which such money or capital asset or both are received by the specified person and also provides a special formula for computation of capital gains.

As per substituted Section 45(4) with effect from Assessment year 2021-22, if any partner receives any money or capital asset upon reconstitution of the firm then profits and gains arising from such receipt of money or asset by the partner shall be deemed to be the capital gain in the hands of the firm in the year of receipt of asset or money by the partner.

Section 45(4) applies to a Specified Entity (SE) when there is a reconstitution of the SE as a result of which a Specified Person (SP) ceases to be a partner/member or one or more new partners are admitted in the SE or existing partners/members continue with change in their respective shares or in shares of some of them.

“Specified entity” means a firm or other association of persons or body of individuals (not being a company or a co-operative society)

“Specified person” means a person, who is a partner of a firm or member of other association of persons or body of individuals (not being a company or a co-operative society) in any previous year.

Since the definition of firm in the section 2(23) of the Act covers a LLP so the said section equally applies to a LLP.

Section 45(4) is notwithstanding section 45(1) and provides that where a specified person receives during the previous year any money or capital asset or both from a specified entity in connection with the reconstitution of such specified entity, then any profits or gains arising from receipt of such money 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 capital asset or both were received by the specified person.

Text of Section 45(4)

^[1][(4) Notwithstanding anything contained in sub-section (1), where a specified person receives during the previous year any money or capital asset or both from a specified entity in connection with the reconstitution of such specified entity, then any profits or gains arising from such receipt 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 capital asset or both were received by the specified person, and notwithstanding anything to the contrary contained in this Act, such profits or gains shall be determined in accordance with the following formula, namely: -

A = B + C D

Where,

A = income chargeable to income-tax under this subsection as income of the specified entity under the head “Capital gains”;

B = value of any money received by the specified person from the specified entity on the date of such receipt;

C = the amount of fair market value of the capital asset received by the specified person from the specified entity on the date of such receipt; and

D = the amount of balance in the capital account (represented in any manner) of the specified person in the books of account of the specified entity at the time of its reconstitution:

Provided that if the value of “A” in the above formula is negative, its value shall be deemed to be zero :

Provided further that the balance in the capital account of the specified person in the books of account of the specified entity is to be calculated without taking into account the increase in the capital account of the specified person due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset.

Explanation 1. - For the purposes of this sub-section, -

(i) the expressions “reconstitution of the specified entity”, “specified entity” and “specified person” shall have the meanings respectively assigned to them in section 9B;

(ii) “self-generated goodwill” and “self-generated asset” mean goodwill or asset, as the case may be, which has been acquired without incurring any cost for purchase or which has been generated during the course of the business or profession.

Explanation 2. - For the removal of doubts, it is clarified that when a capital asset is received by a specified person from a specified entity in connection with the reconstitution of such specified entity, the provisions of this sub-section shall operate in addition to the provisions of section 9B and the taxation under the said provisions thereof shall be worked out independently.]

KEY NOTE

1. Substituted by the Finance Act, 2021, with effect from 01.04.2021. Earlier inserted by the Finance Act, 1987, with effect from 01.04.1988 which read as under :

“(4) 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.”

Section 45(4) : Erstwhile scheme of taxation up to Assessment year 2020-21

[i] Section 45(4) provides for capital gains taxation in hands of firm, on transfer of capital asset to

partners, by way of distribution, on dissolution or otherwise

· Capital gains = FMV* of capital asset on the date of distribution minus cost/WDV

* FMV defined in section 2(22) as open market price (where such price is not ascertainable,

reference is to be drawn to rules)

[ii] Besides taxation on dissolution, Firm also exposed taxation on distribution of CA on retirement of

partner

[iii] However, settlement of Retired partner’s account in cash (even beyond his capital balance) is not hit by section 45(4) in the hands of the firm

[iv] No tax incidence in the hands of retired partner on receipt of cash or capital asset

· What partner receives is his share in the firm and not any consideration for ‘transfer’ of his partnership interest

[v] Cash pay out on retirement : Cash payment to settle account of retiring partner does not result in

transfer of capital asset by firm

[vi] No taxation also in the hands of retiring partner as what he receives is always belonging to him

Section 45(4) : Rationale for new scheme of taxation from Assessment year 2020-21

FM’s speech: “Taxability of surplus amount received by partners: In order to provide certainty, it is proposed to rationalise the provisions relating to taxation of the assets or amount received by partners from the partnership firm in excess of their capital contribution”

Before proceeding to understand more about the new Section 45(4), it is important to also understand what new section is trying to achieve. On a reading of the new section, it is evident that the specified entity is made to pay tax on the amounts which are in excess of the capital account balances of the specified person. The profits/gains arising from allotting of capital asset or stock in trade would be deemed to be income of the specified entity and the entity is required to pay tax on the same in terms of Section 9B. The role of Section 45(4) is not to tax the same transaction but to tax the excess amount over the capital account balances.

Determination of the excess amount over the capital account balances

Section 45(4) states that tax is payable B + C – D. The ‘B’ is defined to mean that value of money received by the specified person from the specified entity on the date of receipt. The ‘C’ is defined to mean the amount of fair market value of capital asset received by the specified person on the date of its receipt. The ‘D’ is defined to mean the balance in capital account (represented in any manner) of the specified person in books of account of specified entity at the time of its reconstitution. As stated earlier, the proviso to the said sub-section states that balance in the capital account is to be calculated without taking into account the increase in the capital account due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset.

From the above, it is evident that the specified entity in the year in which the specified person receives money or capital asset as a result of reconstitution of the specified entity, has to pay tax on difference of the fair market value of capital asset and money and amount lying in the capital account of the specified person at the time of reconstitution. The capital account should be free from all the increases from revaluation of asset or self-generated good will or other self-generated asset. The difference, if positive, the same is taxable under the head ‘capital gains’ and if negative, ignored for the purposes of taxation. In other words, the law does not recognize any loss and taxes only the profit.

It is important to note that up to assessment year 2020-21, Section 45(4) was dealing only with dissolution and the question, whether reconstitution is covered under the said sub-section or not, was not clear. It was only in the case of CIT v. AN Naik & Associates (2004) 265 ITR 346 : 187 CTR 162 (Bom.), the Panaji Bench of the Bombay High Court has held that retirement is also covered under the sub-section (4) under the ambit of ‘otherwise’. To this extent, the new Section 9B has made it clear that the reconstitution is also covered. Hence, receipt of any capital asset or stock in trade by retiring partner would be taxable under the appropriate head in the hands of firm. In other words, if the retired partner is allotted a capital asset, when he is retiring from the firm, the firm is required to pay tax under the head ‘capital gain’. In case, if stock in trade is allotted, then the same will be taxable under the head ‘profits and gains from business or profession’ in the hands of the firm. The firm is required to pay tax in the year in which the specified partner (the retiring partner) receives the capital asset or stock in trade as the case may be.

With effect from Assessment year 2021-22, section 45(4) provides that where a specified person receives any money or capital asset or both from a specified entity, during the previous year, in connection with the reconstitution of such specified entity, then any profits or gains arising from receipt of such receipt by the specified person shall be chargeable to income-tax as income of the specified entity under the head “Capital gains”.

It has been further deemed that this income shall be the income of the specified entity of the previous year in which such money or capital asset or both were received by the specified person.

It has been further clarified that when a capital asset is received by a specified person from a specified entity in connection with the reconstitution of such specified entity, the provisions of sub-section (4) of section 45 of the Act shall operate in addition to the provisions of section 9B of the Act and the taxation under the said provisions thereof shall be worked out independently.

Section 48(iii) inserted to mitigate the effect of double taxation by virtue of Section 45(4)

New Section 45(4) is taxing the specified entity on revaluation of assets/recognition of self-generated assets/goodwill. If the amount is doubly taxed in the hands of ABC, once as a transfer of asset under Section 9B and second time under Section 45(4) being excess over capital account balance received by the partner. Hence, in order to mitigate effect of the double taxation, Section 48(iii) has been inserted so as to provided that income which is considered under Section 45(4) on account of revaluation of assets or recognition of assets shall be attributable to remaining assets of the specified entity and such amount has to be reduced while computing the capital gains of remaining assets when such assets have been transferred in future by the specified entity.

Clause (iii) of section 48 has been inserted by Finance Act 2021, with effect from 01.04.2021, which provide that if any money or capital asset is received by a specified person from a specified entity, then the amount chargeable to income-tax as income of such specified entity under section 45(4), which is attributable to the capital asset being transferred by the specified entity, shall be calculated in the prescribed manner and shall be allowed as a deduction in computing capital gains.

The amount which is chargeable to tax under section 45(4) shall be reduced for calculating capital gain under section 9B to avoid double taxation, that’ is why 48(iii) has been introduced in Finance Act, 2021

Understanding of provisions of section 45(4)

On plain reading of section 45(4) given above, the following are the important features of the provisions of section 45(4):

v It is applicable on reconstitution of firm/AOP/BOI. It is not applicable on dissolution of firm/AOP/BOI.

v When a partner of a firm or a member of BOI /AOP receives any money or capital asset or both from the firm, section 45(4) will come into play. Also, it is applicable only when the receipt of such capital asset or money is related to reconstitution of the firm/ AOP/BOI. It does not apply when a partner receives capital asset by continuing to remain in the firm without any change in profit sharing ratio. Same is the case for AOP /BOI.

v The value of money received plus fair market value of the capital asset less the balance in the capital account of the partner is the amount chargeable to tax as capital gain.

v Though a partner or member is the person who receives capital asset and money which in aggregate is more than the amount standing to his credit in the capital account of the firm / AOP /BOI, the tax liability however is on the partnership firm / AOP/BOI and not on the recipient partner / member.

v Explanation 2 to section 45(4) clarifies that the computation under section 45(4) is independent and in addition to the computation envisaged in section 9B.

Pre-conditions for applicability

Section 45(4) applies if the following conditions are satisfied:

(a) There is a specified person as defined

(b) There is a specified entity as defined

(i) any capital asset, or

(ii) money, or

(iii) both

(d) The receipt referred to in (c) is during the previous year

(e) The receipt referred to in (c) is from a specified entity

(f) The receipt is in connection with the reconstitution of a specified entity.

Implications

If all the aforesaid conditions are satisfied, the following implications arise under section 45(4):

(a) Any profits or gains arising from such receipts by the specified person shall be chargeable to income-tax as income of such specified entity under the head “Capital gains”.

(b) The profits and gains shall be deemed to be the income of such specified entity of the previous year in which such money or capital asset were received by the specified person.

A = B+C-D

Where,

A = income of the specified entity chargeable under the head “Capital gains”;

However, if the value of ‘A’ in the above formula is negative, ‘A’ shall be deemed to be zero:

B = value of any money received by the specified person from the specified entity on the date of such receipt;

C = the amount of fair market value of the capital asset received by the specified person from the specified entity on the date of such receipt; and

D = the, amount of balance in the capital account (represented in any manner) of the specified person in the books of accounts of the specified entity at the time of its reconstitution:

For the purpose of D, the balance in the capital account of the specified person is to be calculated without taking into account the increase in the said account due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset [proviso to section 45(4)].

Computation of Capital Gains under Section 45(4):

Proceed to compute the capital gains under Section 45(4). As stated earlier, for the purpose of computation of capital gains, the formula prescribed section 45(4) needs to be applied, A = B + C – D

Item	Description	Scenario 1	Scenario 1
B	Value of any money received by the specified person	140	140
C	Amount of fair market value of the capital asset received by the specified person [Partner]	-	-
D	Amount of balance in capital account without considering revaluation profit	100	110
A=B+C-D	Income Chargeable under Capital Gains in hands of Specified Entity [Firm]	40	30

As evident from the table above, in Scenario 1, the capital balance appears as Rs 100 and in Scenario 2, Rs 110. The common thing in both the scenarios is removal of revaluation profit from the capital account balance. Since the capital account balance is Rs 140 and the profits arising from revaluation is Rs 40, the balance would be Rs 100. However, in Scenario 2, there is an extra balance of Rs 10 as against in Scenario 1.

KEY NOTE

(1) Levies capital gains tax on realization by partner in excess of his capital account balance, in connection with reconstitution

· Gains are computed from partner’s perspective but are taxable in hands of firm

(2) If a partner receives any money or capital asset or both from a firm in connection with reconstitution of firm, firm shall be liable to pay capital gains tax as per following formula:

A = B + C - D, where

► A = Capital gains chargeable as income of firm

► B = Value of any money on the date of such receipt

► C = FMV of capital asset on the date of such receipt

► D = Partner’s capital account balance (represented in any manner) in books of firm at time of its reconstitution (without taking into account increase (a) due to revaluation of any asset or (b) due to self-generated goodwill/asset)

§ Capital gains (A) will be nil if result of formula is negative

(3) Self-generated goodwill or asset means that:

► which has been acquired without incurring any cost for purchase or

► which has been generated during the course of the business or profession

(4) Section 45(4) deals with taxation in the hands of specified entity (Firm) when the specified person (partner) receives money or capital asset in the event of reconstitution of specified entity.

(5) Section 45(4) deals with taxation only in case of ‘reconstitution of specified entity’. Hence, for the instances of dissolution, the provisions of this sub-section shall not be applicable.

Section 45(4) overrides section 45(1)

Section 45(4) starts with the expression “notwithstanding anything contained in sub-section (1)”. Thus, it overrides section 45(1). In other words, if there is any conflict or inconsistency between section 45(1) and section 45(4), the latter provision will prevail.

When Specified entity (Firm) allots any capital asset or stock in trade to a specified person (partner) in connection with dissolution or reconstitution of the specified entity. The specified entity is required to pay tax in the year in which the specified person receives the capital asset or stock in trade. [Section 9B]

Section 9B aims to cover two events, namely the dissolution or reconstitution. Section 9B states that where any specified person receives any capital asset or stock in trade at the time of reconstitution (or dissolution) of any specified entity, such receipt of capital asset or stock in trade would be considered as transfer of capital asset or stock in trade by a specified entity in the normal course of a business. At the time reconstitution of a specified entity, both Section 9B as well as Section 45(4) would be applicable.

It is important to note that Section 9B covers only, in case where the specified person, receives the capital asset or stock in trade. In case, if the specified partner receives money, then the said section is not applicable.

Taxation under section 9B is permitted

It is clarified that the provisions of section 45(4) shall operate in addition to the provisions of section 9B and when a capital asset is received by a specified person from a specified entity in connection with the reconstitution of such specified entity, the provisions of both the sections may operate independently (Explanation 2).

Definitions

For the above purposes, the following expressions shall have the meanings assigned to them in section 9B:

(a) reconstitution of the specified entity

(b) “specified entity”

“self-generated goodwill” means goodwill that has been acquired without incurring any cost for purchase or which has been generated during the course of the business or profession [Explanation 1(ii)].

“self-generated asset” means an asset that has been acquired without incurring any cost for purchase or which has been generated during the course of the business or profession [Explanation 1(ii)].

Taxability of the income arising to the firm on transfer of capital asset or stock in trade to a partner in connection with dissolution or reconstitution [Section 9B]

Section 9B deals with a situation where a Specified Person (SP) receives during the previous year any capital asset or stock in trade or both from a Specified Entity (SE) in connection with the dissolution or reconstitution of such SE, then the SE shall be deemed to have transferred such capital asset or stock in trade or both, as the case may be, to the SP in the year in which such capital asset or stock in trade or both are received by the specified person. The section further provides that any profits and gains arising from such deemed transfer of capital asset or stock in trade or both, as the case may be, by the specified entity shall be -

(i) Deemed to be the income of such specified entity of the previous year in which such capital asset or stock-in-trade or both were received by the specified person; and

(ii) Chargeable to income tax as income of such SE under the head ‘profits and gains of business or profession’ or under the head ‘capital gains’ in accordance with the provisions of this Act.

Text of Section 9B

INCOME ON RECEIPT OF CAPITAL ASSET OR STOCK IN TRADE BY SPECIFIED PERSON FROM SPECIFIED ENTITY.

9B. (1) Where a specified person receives during the previous year any capital asset or stock in trade or both from a specified entity in connection with the dissolution or reconstitution of such specified entity, then the specified entity shall be deemed to have transferred such capital asset or stock in trade or both, as the case may be, to the specified person in the year in which such capital asset or stock in trade or both are received by the specified person.

(2) Any profits and gains arising from such deemed transfer of capital asset or stock in trade or both, as the case may be, by the specified entity shall be—

(i) deemed to be the income of such specified entity of the previous year in which such capital asset or stock in trade or both were received by the specified person; and

(ii) chargeable to income-tax as income of such specified entity under the head “Profits and gains of business or profession” or under the head “Capital gains”, in accordance with the provisions of this Act.

(3) For the purposes of this section, fair market value of the capital asset or stock in trade or both on the date of its receipt by the specified person shall be deemed to be the full value of the consideration received or accruing as a result of such deemed transfer of the capital asset or stock in trade or both by the specified entity.

(4) If any difficulty arises in giving effect to the provisions of this section and sub-section (4) of section 45, the Board may, with the approval of the Central Government, issue guidelines for the purposes of removing the difficulty.

(5) Every guideline issued by the Board under sub-section (4) shall, as soon as may be after it is issued, be laid before each House of Parliament, and shall be binding on the income-tax authorities and on the assessee.

Explanation. - For the purposes of this section, -

(i) “reconstitution of the specified entity” means, where -

(a) one or more of its partners or members, as the case may be, of such specified entity ceases to be partners or members; or

(b) one or more new partners or members, as the case may be, are admitted in such specified entity in such circumstances that one or more of the persons who were partners or members, as the case may be, of the specified entity, before the change, continue as partner or partners or member or members after the change; or

(c) all the partners or members, as the case may be, of such specified entity continue with a change in their respective share or in the shares of some of them;

(ii) “specified entity” means a firm or other association of persons or body of individuals (not being a company or a co-operative society);

(iii) “specified person” means a person, who is a partner of a firm or member of other association of persons or body of individuals (not being a company or a co-operative society) in any previous year.]

Understanding of provisions of section 9B

The following are the features of provisions of section 9B:

(i) It is applicable in the case of partnership firms, AOP or BOI who are referred to as ‘specified entity’.

(ii) Section 9B is applicable both on the occasion of dissolution or reconstitution of a partnership firm/AOP/ BOI.

(iii) It is applicable for the purpose of computing the appreciation in value of capital asset of the firm which is distributed / transferred to a partner on dissolution or reconstitution of the firm / AOP/BOI. This does not affect the recipient partner / member as the case may be.

(iv) Reconstitution of partnership firm or AOP or BOI would mean admission of a partner or partners or retirement of one or more partners or change in respective shares of one or more partners.

(v) When a partner referred to as specified person receives capital asset or stock in trade from the firm upon reconstitution of firm or dissolution of the firm, the consequences enumerated in section 9B would follow.

(vi) When capital asset is given by the firm (AOP / BOI) to a partner (or member) the fair market value will have to be ascertained and it shall be deemed to be the full value of consideration accruing to the firm. The difference between the cost of acquisition or indexed cost of acquisition as the case may be, with reference to the firm and fair market value is chargeable to tax in the hands of the firm, as capital gain. It can be either short-term or long-term.

(vii) Where stock in trade is given by the firm (AOP/BOI) to a partner (or member) on reconstitution or dissolution of the firm, the fair market value of the stock in trade shall be deemed to be the full value of consideration. The difference between the cost of acquisition or manufacture or purchase and the fair market value is chargeable to tax in the hands of the firm as profits and gains of business or profession.

(viii) If the capital asset is given without there being any reconstitution or dissolution of the firm the provisions of section 9B would not be attracted. However, section 56(2)(x) will apply with regard to recipient partner and not the firm. Therefore, the partnership firm would be outside the scope of section 9B on transfer of capital asset to a partner without any change in constitution of the firm.

Pre-conditions for applicability of section 9B

Section 9B applies if all of the following conditions are satisfied:

(a) There is a specified person as defined

(b) There is a specified entity as defined

(i) any capital asset, or

(ii) stock in trade, or

(iii) both

(d) The receipt referred to in (c) is during previous year

(e) The receipt referred to in (c) is from a specified entity

(f) The receipt is in connection with the dissolution or reconstitution of specified entity (as defined [section 9B(1)]

Implications

If all of the aforesaid conditions are satisfied, the following implications arise:

(a) It shall be deemed that

(i) the specified entity has transferred such capital asset or stock in trade or both;

(ii) the transfer is to the specified person;

(iii) the transfer is in the year in which the capital asset or stock in trade are received by the specified person. [section 9B(1)]

(“deemed transfer”)

(b)

(i) Profits and gains arising on deemed transfer shall be deemed to be the income of such specified entity [section 9B(2)(i)];

(ii) Such income shall be deemed to be of the previous year in which capital asset or stock-in-trade are received by the specified person [section 9B(2)(i)];

(iii) The income shall be chargeable to tax as income of the specified entity under the head “profits and gains of business or profession” or under “capital gains” in accordance with the provisions of the Act [section 9B(2)(ii)];

(iv) FMV of the capital asset or stock in trade on the date of receipt by specified person shall be deemed to be full value of consideration for the specified entity [section 9B(3)]

Resolution of difficulty

If any difficulty arises in giving effect to the provisions of this section and section 45(4), the CBDT may, with the approval of the Central Government, issue guidelines for the purposes of removing the difficulty. Every such guideline issued by the CBDT shall, as soon as may be after it is issued, be laid before each House of Parliament, and shall, be binding on the income-tax authorities and on the assessee [Section 9B(4)/(5)].

Aspects common to section 9B and 45(4)

(1) ‘Specified entity’ means firm/LLP/AOP/BOI - not being a company or a cooperative society

(2) ‘Specified person’ means a person, who is a partner of firm or member of AOP/BOI in any previous year

(3) When a capital asset is received by a partner from a firm in connection with reconstitution of firm, section 45(4) shall operate in addition to section 9B and taxation under section 9B shall be worked out independently

(4) “Reconstitution” of the firm means, where:

(i) One or more partners cease to be partners; or

(ii) One or more new partners are admitted in such circumstances that one or more persons who were partners before the change, continue as such after the change; or

(iii) All the partners continue with a change in their respective shares or in the shares of some of them

(5) Difficulty in giving effect to the above provisions can be removed by issuance of guidelines by CBDT – to be placed before both Houses of Parliament and binding on both taxpayer and tax authority

§ CBDT issued guidelines via Circular No. 14/2021 dated 02.07.2021

Comparative analysis

S.N.	Parameters	Section 45(4) [Applicable up to Assessment year 2020-21]	Section 9B [Applicable from Assessment year 2021-22]	Section 45(4) [Applicable from Assessment year 2021-22]
(1)	Taxable entity	Firm*	Firm*	Firm*
(1)	* While the above table is based on partnership firm and partner, it will apply equally to AOP/BOI and their members
(2)	Event of trigger of taxability	Transfer of capital asset by way of distribution, on dissolution or otherwise of firm	Receipt of capital asset or stock in trade or both by partner in connection with dissolution or reconstitution of firm	Receipt of money or capital asset or both by partner in connection with reconstitution of firm
(3)	Year of taxability	Transfer of capital asset	Receipt by partner	Receipt by partner
(4)	Head of income	Capital gains	(i) Capital asset – Capital gains (ii) Stock in trade – Business income	Capital gains - as per formula A = B + C – D
(5)	Quantum of consideration	FMV of capital asset on date of transfer	FMV of capital asset or stock in trade or both on date of receipt by partner	Value of money (B) + FMV of capital asset (C) on date of receipt by partner
(6)	Cost of acquisition	As per section 48/49 in respect of capital asset transferred	As per section 48/49 in respect of capital asset transferred	Partner’s capital account balance (represented in any manner)** at the time of reconstitution
(6)	** Without taking into account increase (a) due to revaluation of any asset or (b) due to self-generated goodwill/asset)
(7)	Treatment of loss	Loss admissible	Loss admissible	Not admissible
(8)	Interplay between different provisions	Not applicable	Not specified	Section 45(4) shall operate in addition to section 9B and both shall be worked out independently
(9)	Reduction from sale consideration due to capital gains taxation in hands of firm	Not applicable as capital asset is no longer with firm	Not applicable	Section 48 (iii) contemplates reduction from sale consideration on transfer of remaining capital assets, as per prescribed rules (refer later case studies)
(10)	Cost of capital asset in hands of recipient partner	FMV based on general principles	FMV based on general principles	FMV based on general principles, also supported by CBDT guidelines
(11)	Definition of ‘reconstitution’, ‘specified entity’ and ‘specified person’	Not applicable – Refer back to judicial conflict on whether ‘retirement’ falls within scope of section 45(4)	Includes retirement, admission or change in profit sharing ratio	Borrowed from section 9B
(12)	CBDT’s power to issue guidelines to remove difficulties	Not applicable	Exists – Binding on both tax authority and taxpayers on placing before both Houses of Parliament	Exists – Provided in section 9B

Method of determination of period of holding of capital assets in certain cases

CBDT vide Notification No. 76/2021- Income Tax - dated 02.07.2021 amended rule 8AA which relates to Method of determination of period of holding of capital assets in certain cases and added rules related to amount which is chargeable to income-tax as income of specified entity under subsection (4) of section 45 under the head Capital gains.

Notification further inserted new Income Tax Rule 8AB related to Attribution of income taxable under sub-section (4) of section 45 to the capital assets remaining with the specified entity, under section 48 alongwith form namely ‘Details of amount attributed to capital asset remaining with the specified entity

Text of Rule 8AA(5)

^[1][(5). In case of the amount which is chargeable to income-tax as income of specified entity under sub-section (4) of section 45 under the head – “Capital gains”,-

(i)

the amount or a part of it shall be deemed to be from transfer of short term capital asset, if it is attributed to,-

(a)		capital asset which is short term capital asset at the time of taxation of amount under sub-section (4) of section 45; or
(b)		capital asset forming part of block of asset; or
(c)		capital asset being self-generated asset and self-generated goodwill as defined in clause (ii) of Explanation 1 to sub-section (4) of section 45; and

(ii)

the amount or a part of it shall be deemed to be from transfer of long-term capital asset or assets, if it is attributed to capital asset which is not covered by clause (i) and is long term capital asset at the time of taxation of amount under sub-section (4) of section 45.]

KEY NOTE

1. Inserted by the Income tax Amendment (Eighteenth Amendment), Rules, 2021 vide CBDT Notification No. 76/2021, dated 02.07.2021.

Text of Rule 8AB

^[1][8AB. ATTRIBUTION OF INCOME TAXABLE UNDER SUB-SECTION (4) OF SECTION 45 TO THE CAPITAL ASSETS REMAINING WITH THE SPECIFIED ENTITY, UNDER SECTION 48.-

(1) For the purposes of clause (iii) of section 48, where the amount is chargeable to income-tax as income of specified entity under sub-section (4) of section 45, the specified entity shall attribute such amount to capital asset remaining with the specified entity in a manner provided in this rule.

(2) Where the aggregate of the value of money and the fair market value of the capital asset received by the specified person from the specified entity, in excess of the balance in his capital account, chargeable to tax under sub-section (4) of section 45,relates to revaluation of any capital asset or valuation of self -generated asset or self-generated goodwill, of the specified entity, the amount attributable to the capital asset remaining with the specified entity for purpose of clause (iii) of section 48 shall be the amount which bears to the amount charged under sub-section (4) of section 45 the same proportion as the increase in, or recognition of, value of that asset because of revaluation or valuation bears to the aggregate of increase in, or recognition of, value of al I assets because of the revaluation or valuation.

(3) Where the aggregate of the value of money and the fair market value of the capital asset received by the specified person from the specified entity, in excess of the balance in his capital account, charged to tax under sub-section (4) of section 45 does not relate to revaluation of any capita asset or valuation of self -generated asset or self-generated goodwill, of the specified entity, the amount charged to tax under sub-section (4) of section 45 shall not be attributed to any capita asset for the purposes of clause (iii) of section 48.

(4) Notwithstanding anything contained in sub-rules (2) or (3), where the aggregate of the value of money and the far market value of the capital asset received by the specified person from the specified entity, in excess of the balance in his capital account, charged to tax under sub-section (4) of section 45 relate only to the capital asset received by the specified person from the specified entity, the amount charged to tax under sub-section (4) of section 45 shall not be attributed to any capita asset for the purposes of clause (iii) of section 48.

(5) The specified entity shall furnish the details of amount attributed to capital asset remaining with the specified entity in Form No. 5C.

(6) Form No. 5C shall be furnished electronically either under digital signature or through electronic verification code and shall be verified by the person who is authorised to verify the return of income of the specified entity under section 140.

(7) Form No. 5C shall be furnished on or before the due date referred to in the Explanation 2 below subsection (1) of section 139 for the assessment year in which the amount is chargeable to tax under subsection (4) of section 45.

(8) The Principal Director General of Income-tax (Systems) or the Director General of Income-tax (Systems), as the case may be, shall –

(i) specify the procedure for filing of Form No. 5C;

(ii) specify the procedure, format, data structure, standards and manner of generation of electronic verification code, referred to in sub-rule (6), for verification of the person furnishing the said Form; and

(iii) be responsible for formulating and implementing appropriate security, archival and retrieval policies in relation to the Form No 5C so furnished.

Explanation 1: For the purposes of this rule, the amount chargeable to tax under sub-section (4) of section 45 shall relate to revaluation of any capita asset or valuation of self-generated asset or self-generated goodwill, of the specified entity, if the revaluation is based on a valuation report obtained from a registered valuer as defined in clause (g) of rule 11U.

Explanation 2: For the removal of doubt it is clarified that revaluation of an asset or valuation of self-generated asset or self-generated goodwill does not entitle the specified entity for the depredation on the increase in value of that asset on account of its revaluation or recognition of the value of self-generated asset or self -generated goodwill due to its valuation.

Explanation 3: For the purposes of this rule, the expressions “self-generated asset” and “self-generated goodwill” shall have the same meaning as assigned to them in clause (ii) of Explanation 1 to sub-section (4) of section 45.”.

4. In the principal rules, in Appendix II, after Form No. 5B, the following Form shall be inserted, namely: —

(See rule 8AB)

Details of amount attributed to capital asset remaining with the specified entity

1. Name of the specified entity

2. Permanent Account number

3. Assessment Year

4. Amount taxable under sub-section (4) of section 45

5. Attribution of amount taxable under sub-section (4) of section 45 to capital assets remaining

Sr. No.	Capital Asset		Book Value	Revalued amount/valued amount for self-generated asset	Amount attributed	Short term/ long term
	Name	Whether self generated yes/no	Book Value	Revalued amount/valued amount for self-generated asset	Amount attributed	Short term/ long term



	Total

6. Name and registration number of the valuer based on whose valuation report information at serial no 5 is provided.

VERIFICATION

___________________________________________________ son/daughter of ________________solemnly declare that to the best of my knowledge and belief, the information given in the form is correct and complete and is in accordance with the provisions of the Income-tax Act, 1961. I further declare that I am furnishing the form in my capacity as ________________ (drop down to be provided in e-filing utility) and I am also competent to furnish this form and verify it. I am holding permanent account number________________

Place:

Date :

Signature………………….]

KEY NOTE

1. Inserted by the Income tax Amendment (Eighteenth Amendment), Rules, 2021 vide CBDT Notification No. 76/2021, dated 02.07.2021.

For the above purposes, the various terms have been defined as follows:

“Specified entity” means

(a) a firm; or

(b) other AOP; or

but excludes a company or a cooperative society.

“Firm” includes a limited liability partnership as defined in a Limited Liability Partnership Act, 2008 [section 2(23)(i)] Hence, a partner in an LLP is also a specified person.

Specified person

“Specified person” means any one of the following

(a) a person who is a partner of a firm

(b) a member of any AOP

The term “partner” includes a minor who has been admitted to the benefits of partnership (section 2(23)(ii)].

“Reconstitution of the specified entity” means, a case where

(a) one or more partners or members of such specified entity cease to be its partner or member; or

(b) one or more new partners or members are admitted in such specified entity in such circumstances that one or more of the partners or members of the specified entity, before the change, continue as partner(s) or member(s) after the change; or

(c) all the partners or members of such specified entity continue with a change in their respective share or in the shares of some of them.

Receives

The provision applies when a specified person ‘receives’ a capital asset or stock in trade. Any change in share of a partner results in reconstitution of the specified entity. However, mere reconstitution will not trigger tax under section 9B unless it is accompanied by a specified person “receiving” any capital asset or stock in trade.

To illustrate, A and B are partners in a firm sharing profits and losses equally. Suppose, they decide to change the profit sharing ratio to 60:40 and pursuant to the change in share, A brings in additional Rs.50 lakhs as capital as a result of which the total capital of the partnership firm is Rs. 250 lakhs. In such circumstances, although there is a reconstitution of the specified entity, no capital asset or stock in trade is received by a specified person and hence, tax under section 9B is not triggered.

Capital asset or stock-in-trade

The section applies only if the specified person receives any capital asset or stock in trade. The character as capital asset or stock in trade should be as in the hands of the specified entity and not the specified person.

The term “capital asset” is defined in section 2(14). The definition applies unless the context otherwise requires. However, it appears that an asset which is not capital asset within the meaning of section 2(14) is not a capital asset for the purposes of section 9B.

To illustrate, agricultural land which is not a capital asset under section 2(14) cannot be regarded as a capital asset for the purposes of section 9B and the transfer of such an asset will not result in any tax implication under section 9B. On the other hand, all capital assets (whether movable or immovable or actionable or claim, etc.) are covered by the expression capital asset.

Year of transfer

The capital asset or stock in trade is deemed to be transferred in the year in which the capital asset or stock in trade is received by the specified person.

Year of taxation of income

The profits and gains arising from the deemed transfer shall be deemed to be the income of such specified entity of the previous year in which the capital asset or stock in trade is received by the specified person. The use of the term ‘receives’ suggests that the method of accounting followed by specified entity or specified person is not relevant.

If the reconstitution and receipt by specified person are in different previous years with the receipt following the reconstitution, on a literal reading, the tax will be in the year of receipt on the firm, as reconstituted.

Manner of computation of income

The profits and gains arising from deemed transfer of stock in trade shall be chargeable to income tax under the head “profits and gains of business or profession”.

The profits and gains arising from deemed transfer of capital asset shall be chargeable to income tax under the head “capital gains”.

In both cases, the profits and gains are chargeable to income-tax under the head business income or capital gains “in accordance with the provisions of the Act”.

Computation on account of section 48(iii)

Section 48 provides for mode of computation of capital gains. Broadly, the section provides that capital gains shall be computed as follows:

Full value of consideration received or accruing as a result of a transfer of the capital asset

Less: Expenditure incurred wholly and exclusively in connection with such transfer [clause (i)]

Less: The cost of acquisition of the asset and any cost of improvement thereto [clause (ii)]

Further, clause (iii) has been inserted by the Finance Act, 2021 in section 48 to provide that if any money or capital asset is received by a specified person from a specified entity, then the amount chargeable to income-tax as income of such specified entity under section 45(4), which is attributable to the capital asset being transferred by the specified entity, shall be calculated in the prescribed manner and shall be allowed as a deduction in computing capital gains.

To illustrate, suppose the capital gains calculated under section 9B on a standalone basis is Rs.2 crores; suppose the amount of capital gains taxable under section 45(4) and calculated in the prescribed manner under section 48(iii) is Rs.1.8 crores. In this case, the final capital gains chargeable under section 9B read with section 48 shall be Rs.20 lakhs (Rs.2 crores less Rs.1.8 crores).

Computation of capital gain under section 9B read with section 48(iii) shall be as follows:

S. No.	Particular
(i)	Full value of consideration received or accrued (FMV of capital asset)
(ii)	Less:
	(a) Expenditure incurred wholly and exclusively in connection with transfer;
	(b) Cost of acquisition/indexed cost of acquisition;
	(c) Cost of improvement/indexed cost of improvement; and
	(a) The amount chargeable to tax as income of specified entity under section 45(4)
	(b) which is attributable to capital asset being transferred by the said entity [section 48(iii)].
(iii)	Exemption under Sections 54 to 54GB to the be extent of net result of above calculation
(iv)	Income taxable under the head capital gains

Understanding the provisions with example:

Let us understand the applicability of the provisions by taking an example as given below:

1	Name of the firm	X & Co
2	Partners	Mr.A, Mr.B, Mr.C and Mr.D
3	Capital	All partners Rs.1 crore each
4	Profit sharing ratio	25% each
5	Date of reconstitution	30.04.2021
6	Nature of reconstitution	Mr. C retires from the firm and others continue with 1/3 share each
7	Compensation to retiring partner	Vacant land acquired by the firm on 01.07.2012 for Rs. 22 lakhs. FMV = Rs. 2 crores
		Stock in trade (cost Rs.90 lakhs) FMV = Rs.100 lakhs
		Cash = Rs. 50 lakhs
	Computation under section 9B chargeable to tax in the hands of the firm X & Co
	Deemed sale consideration	Land	200.00
		Less: Indexed cost acquisition (Rs. 22 lakhs X 310 (assumed) / 220	31.00
		Long-term capital gain	169.00
		Stock in trade – FMV	100.00
		Less: Cost	90.00
		Business income	10.00
KEY NOTE : The capital gain and business income computed under section 9B is chargeable to tax in the hands of the firm.

Computation under section 45(4) chargeable to tax in the hands of firm X & Co
	Applying the formula A = B+C – D
	Income chargeable under the head capital gains = value of money received + value of capital asset received minus the amount of balance in the capital account.
	Income chargeable under the head capital gains	Money received Rs. 50 lakhs + value of capital asset Rs.200 lakhs – capital account balance Rs.100 lakhs.
	Income chargeable under the head capital gains in the hands of the firm	Rs. 150 lakhs

Computation of Capital Gains Tax under Section 45(4)

PROVISIONS ILLUSTRATED

X and Y are two partners of a hardware trading firm. It is dissolved on 15.02.2021. At the time of dissolution, a plot of land owned by the firm is given to Mr. ‘X’ (amount recorded in books of the firm is Rs. 50,00,000, however, fair market value is Rs. 70,00,000). This plot was purchased by the firm for Rs. 37,00,000 on 10.03.2014. Find out the amount of capital gain.

SOLUTION :

Capital gain will be taxable in the hands of Firm for the assessment year 2021-22 :

S. No.	Particulars	Amount (in Rs.)
(i)	Full value of consideration (i.e., fair market value on the date of distribution)	70,00,000
(ii)	Less: Indexed cost of acquisition (Rs. 37,00,000 × 301 ÷ 220)	50,62,273
(iii)	Long-term capital gain taxable in the hands of Firm	19,37.727

Rate of tax

The rate at which such capital gain shall be charged to tax will depend on the nature of capital asset transferred and period for which such asset is held by the specified entity. Hence, the capital gains may be liable to concessional tax rate as provided in section 111A or section 112 or section 112A, as the case may be, subject to fulfilment of conditions specified therein.

CBDT Guidelines under section 9B and 45(4)

CBDT issues Circular No. 14 / 2021 prescribing guidelines under section 9B and 45(4) aimed at removing difficulties in the implementation of these provisions inserted by Finance Act, 2021 with effect from 01.04.2021; As per the Guidelines, the attribution of amount taxed under section 45(4) is to be made to capital assets forming part of block of assets, clarifies that Rule 8AB (Notification no. 76 dated 02.07.2021) applies to capital assets forming part of the block; Reference to capital assets in Rule 8AB will include reference to capital assets forming part of the block and a reference to section 48 will include reference to section 43(6)(c) and section 50; Further clarifies that in case the capital asset remaining with the specified entity is forming part of block of assets, amount attributed to such capital assets u/r 8AB shall be reduced from the sale consideration received or accruing as a result of subsequent transfer of such asset by the specified entity, also, the net value of consideration shall be reduced from the WDV of such block under section 43(6)(c) or for purpose of computation of capital gains under section 50; Circular arithmetically illustrates the applicability of sections 9B and 45(4); Highlights that there is no actual cost element to the Assessee in case of revaluation and thus, depreciation will not be admissible on revaluation component, also state that depreciation will not be admissible in case of self-generated assets, since actual cost in these cases is Nil.

Retirement of one partner from a partnership firm will lead to its dissolution if the firm contains only two partners

Most recently, the Supreme Court in Guru Nanak Industries, Faridabad Amar Singh, also explained the distinction between ‘retirement of partner’ and ‘dissolution of partnership firm’, observing as under:

“13. There is a clear distinction between ‘retirement of a partner’ and ‘dissolution of a partnership firm’. On retirement of the partner, the reconstituted firm continues and the retiring partner is to be paid his dues in terms of Section 37 of the Partnership Act. In case of dissolution, accounts have to be settled and distributed as per the mode prescribed in Section 48 of the Partnership Act. When the partners agree to dissolve a partnership, it is a case of dissolution and not retirement…. In the present case, there being only two partners, the partnership firm could not have continued to carry on business as the firm. A partnership firm must have at least two partners. When there are only two partners and one has agreed to retire, then the retirement amounts to dissolution of the firm.” – [Guru Nanak Industries, Faridabad v. Amar Singh (Dead ) Through Lrs. 2020 SCC OnLine SC 469 : AIR 2020 SC 2484 (SC)]

Retirement of a partner from a firm does not dissolve the firm, but merely severs the partnership between retiring partners and continuing partners, leaving the partnership among continuing partners unaffected

The Supreme Court in CIT, West Bengal v. A.W. Figgies & Co. has explained the provisions of retirement of a partner as:

“9. It is true that under the law of partnership a firm has no legal existence apart from its partners and it is merely a compendious name to describe its partners but it is also equally true that under that law there is no dissolution of the firm by the mere incoming or outgoing of partners. A partner can retire with the consent of the other partners and a person can be introduced in the partnership by the consent of the other partners. The reconstituted firm can carry on its business in the same firm’s name till dissolution. The law with respect to retiring partners as enacted in the Partnership Act is to a certain extent a compromise between the strict doctrine of English common law which refuses to see anything in the firm but a collective name for individuals carrying on business in partnership and the mercantile usage which recognises the firm as a distinct person or quasi corporation.” - [CIT, West Bengal v. A.W. Figgies & Co. (1953) 24 ITR 405 : 1954 SCR 171 (SC)]

INCOME TAX

Saturday, 11 December 2021

Taxation on Retirement of a Partner from a partnership firm

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