Tax on Transfer of Money or Property by FIRM/AOP/BOI to Partners or Members – Finance Act 2021 Amendment
Executive Abstract & Legislative Background
“The Finance Act 2021 (FA 2021) introduced over 100 changes to the original Finance Bill presented in Lok Sabha on 1st February 2021. A vital issue addressed by the FA 2021 was the amendment in existing as well as introduction of new sections providing taxation mechanism on income arising out of receipt of money/assets/stock-in-trade by a specified person (partner or member) from a specified entity (firm/AOP/BOI) during the dissolution or reconstitution of such entity. This has been a grey area and a subject of intense litigation in the past. Read on…”
1. Overview of the Interconnected Statutory Architecture
Multiple provisions have been inserted and they function both independently and in conjunction to each other which makes the understanding of these provisions somewhat complex to the reader. These amendments will be effective from assessment year (AY) 2021-22 onwards. We have tried to explain these provisions with the comparative matrix below and detailed analytical discussion.
Scenario A: When Both Section 9B and Section 45(4) are Triggered
- Applicability: On dissolution or reconstitution of specified entity.
- Transfer of: Capital asset or stock in trade or both.
- Taxability:
- Capital asset: Chargeable under Section 9B and Section 45(4).
- Stock in trade: Chargeable under Section 28 (Profits and Gains of Business or Profession).
- Relief against Double Taxation: Capital gain under Section 45(4) is reduced while calculating Capital Gain under Section 9B read with Section 48(iii).
Scenario B: When Only Section 45(4) is Triggered
- Applicability: Exclusively on reconstitution of specified entity (not applicable on dissolution).
- Transfer of: Capital asset or money or both.
- Taxability: Capital asset and money received in excess of net capital balance are taxable under Section 45(4) in the hands of the specified entity as Capital Gains.
2. Detailed Discussion of Substantive Provisions
2.1 Newly Introduced Section 9B – Income on Receipt of Capital Asset or Stock in Trade by a Partner from Firm
Section 9B provides that 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 dissolution or reconstitution of such entity, then the entity shall be deemed to have transferred such capital asset or stock in trade or both, to the partner/member in the year in which such capital asset or stock in trade or both are received by the partner/member.
Further, the section provides that, profits arising out of the aforesaid deemed transfer shall be chargeable to tax in the hands of the entity under the head ‘business or profession’ or ‘capital gain’ in accordance with the provisions of the Act. For computation purposes, the fair market value of the capital asset or stock in trade as on date of its receipt by the partner/member shall be deemed to be full value of consideration.
Statutory Definition of ‘Reconstitution of Specified Entity’ [Section 9B]
An important point to note here is that this section has introduced the statutory meaning of the term ‘reconstitution’ of the firm as explained below:
- (a) One or more of its partners or members ceases to be partner or members;
- (b) One or more new partners or members are admitted. However, at least one existing partner or member should continue to be partner or members of the specified entity after admission of the new partner or member; or
- (c) All the partners or members continue with change in their respective share or in share of some of them.
2.2 Tax on Receipt of Money or Capital Asset by Partner/Member in Connection with Reconstitution of Entity [Section 45(4)]
The FA 2021 has substituted the earlier sub-section (4) of section 45. The new section 45(4) provides that where a partner/member receives during the previous year any capital asset or money or both from a specified entity in connection with reconstitution of such entity, then any profit and gains arising from such receipt of asset/money by partner/member shall be deemed to be the income of the entity under the head ‘Capital Gains’ of the previous year in which such capital asset or money or both were received by the partner/member.
Computation Formula under Substituted Section 45(4)
A = Income chargeable under the head ‘Capital Gains’ in the hands of the entity;
B = Value of money received by partner/member on the date of such receipt;
C = Fair market value of the capital asset received by the partner/member on the date of such receipt; and
D = Balance in capital account of the partner/member in the books of account of the entity without considering the increase in capital account due to revaluation of any asset or due to self-generated goodwill or self-generated any other asset at the time of reconstitution.
(Note: If the calculated value of A is negative, it shall be deemed to be nil).
“When a capital asset is received by the partner/member of the entity in connection with reconstitution, the provision of the said section shall operate in addition to the provision of section 9B. Thus, the taxation under both the provisions shall be worked out independently.”
2.3 Mode of Computation of Capital Gain u/s 48 Modified to Avoid Double Taxation [Section 48(iii)]
A new clause (iii) is inserted u/s 48 to provide that capital gains chargeable to tax under section 45(4) which is attributable to capital asset being transferred by the entity shall be reduced while computing capital gain in the hands of the entity. The capital gain attributable to such a capital asset shall be computed in a prescribed manner. Till date no such manner has been prescribed.
The computation of capital gain u/s 9B read with section 48(iii) shall be as follows:
| Particulars | Amount |
|---|---|
| Full value of consideration received or accrued (FMV of capital asset) | XXXX |
| Less: | |
| (a) Expenditure incurred in connection with transfer | (xxx) |
| (b) Cost of Acquisition / indexed cost of acquisition | (xxx) |
| (c) Cost of improvement / indexed cost of improvement; or | (xxx) |
| (d) The amount chargeable to tax as income of the firm under section 45(4) which is attributable to capital asset being transferred by the firm | (xxx) |
| (e) Exemption under section 54 to 54GB to the extent of net result of above calculation | (xxx) |
| Income under the head Capital Gains | xxx |
3. Practical Illustrations & Numerical Applications
Case Study 1: Practical Example in Case of Reconstitution of the Firm
R, S and P are three partners of a firm RSP & Co. On February 28, 2021, P retired from the firm. The following assets were distributed to partners:
| Particulars | Commercial Property (₹) | Money (₹) |
|---|---|---|
| Fair market value on February 28, 2021 | 45,00,000 | 10,00,000 |
| Cost of Acquisition | 20,00,000 | – |
| Written down value as per section 50 of the Act | 8,00,000 | Not Applicable |
| Balance in capital account of P | 25,00,000 (it includes ₹ 5,00,000 on account of revaluation of asset) | |
Solution – Step 1: Computation of Capital Gain in the Hands of Firm for PY 2020-21 u/s 45(4)
| Fair market value of asset on February 28, 2021 (C) | 45,00,000 |
| Money received by partner on February 28, 2021 (B) | 10,00,000 |
| Less: Capital balance in account of P (without taking into account revaluation credited to partner’s account) [₹ 25,00,000 − ₹ 5,00,000] (D) | (20,00,000) |
| Amount chargeable as Capital Gain in the hands of firm [A = B + C − D] | 35,00,000 |
Solution – Step 2: Computation of Capital Gain in the Hands of Firm for PY 2020-21 as per Section 9B r.w.s. 48
| Fair market value of asset on February 28, 2021 | 45,00,000 |
| Less: Cost of Acquisition of asset as per section 50 | (8,00,000) |
| Less: The amount chargeable to tax as income of the firm under section 45(4) which is attributable to capital asset being transferred by the firm* | (XXXX)* |
| Amount chargeable as Capital Gain in the hands of firm | XXXXX |
Case Study 2: Practical Example in Case of Dissolution of the Firm
R and S are two partners of a firm RS & Co. On 28th February 2021, the firm was dissolved. The following assets were distributed to partners:
| Particulars | Commercial Property (taken over by R) (₹) | Stock in Trade (taken over by S) (₹) |
|---|---|---|
| Fair market value on 28th February 2021 | 45,00,000 | 11,00,000 |
| Cost of Acquisition | 20,00,000 | 9,00,000 |
| Written down value as per section 50 of the Act | 8,00,000 | Not Applicable |
Solution – Part A: Computation of Capital Gain for PY 2020-21 in Hands of Firm as per Section 9B r.w.s. 48 (Commercial Property)
| Full value of consideration (FMV of commercial property) | 45,00,000 |
| Less: Expense on transfer | – |
| Net Consideration | 45,00,000 |
| Less: Cost of Acquisition as per section 50 | (8,00,000) |
| Short Term Capital Gain | 37,00,000 |
Solution – Part B: Computation of Business Profit for PY 2020-21 in Hands of Firm as per Section 9B (Stock in Trade)
| Sale Consideration (FMV of stock in trade) | 11,00,000 |
| Less: Cost of acquisition of stock | (9,00,000) |
| Business Gain (Chargeable under Section 28) | 2,00,000 |
Crucial Statutory Note: Section 45(4) is not applicable in case of dissolution of the firm; it applies strictly in cases of reconstitution.
4. Judicial Precedents Reversed / Nullified by Finance Act, 2021
By introducing these provisions, some of the contentious issues where taxpayers enjoyed favorable judgements in the past have now been statutorily reversed/nullified by the Government. Some of these are highlighted as under:
| Earlier Issue | Judicial Precedent (Prior Law) | Position Now After FA, 2021 |
|---|---|---|
| Transfer of assets on reconstitution of the firm – taxable? |
CIT v. G.K. Enterprises [2003] 131 Taxman 181 (Mag.): Section 45(4) is not applicable where some partners retire and the firm continues to carry on the business with remaining partners and with new partners or without new partners. |
Statutorily Overruled: New section 9B defines reconstitution which includes scenario when one or more of its partners ceases to be partner, admission of new partner, etc. |
| Sum of money received by partner in excess of balance in capital account – taxable to firm or partner? |
Bangalore Bench of ITAT Ruling: Held that the retiring partner is liable to capital gains tax being the excess payment received over and above the sum to the credit of her capital account at the time of retirement. |
Taxable in Hands of Firm: As per new provision of section 45(4), sum of money in excess of balance in capital account is taxable in the hands of the Partnership firm. |
| Consideration received by partner on change in profit sharing ratio – Taxability? |
CIT v. P.N. Panjawani [2012] 208 Taxman 22 (Kar): Section 45(4) is not applicable if on inclusion of new partners, shares of existing partners are reduced. In such a case, there is no provision in the Act for levying capital gain tax on consideration received by a partner for reduction of his share in partnership firm. |
Reconstitution Broadened: As per new section 9B, reconstitution of firm explicitly includes reduction in profit sharing ratio or change in respective shares. |