[Vishal Rajvansh and Saumya Sinha are students at National University of Study and Research in Law Ranchi]
With evolving times, the Indian tax regime has undergone several developments. One such recent development related to taxing partnership firms in cases of reconstitution or dissolution of firms. Noticeably, reconstitution or dissolution tax have been a matter of discussion and contemplation for the Indian courts and tax authorities for a long period of time. The courts earlier expressed a view that distribution or allotment of assets to the partner(s) during reconstitution or dissolution is a mutual adjustment of rights, therefore, cannot be termed as transfer of assets to the concerned partner(s).
However, the anew enacted Finance Act 2021 (“Finance Act”) differs from this established view of the courts. The Finance Act amended section 45 of the Income Tax Act 1961 (amended 2021) (“the Act”) to substitute section 45(4) and inserted a newly drafted section 9B to the Act. By virtue of section 9B of the Act, the distribution or allotment of capital assets or stocks in trade or both to any partner shall be deemed as transfer of that asset to the partner. Further, any profit or gain arising pursuant to such transfer will be deemed as income of the firm and hence be taxable under the head “Profits and gains of business or profession” or “Capital gains.”
The introduction of the new provisions raised several questions as they seemingly lacked clarity and mandated taxation of self-generated assets as well and goodwill, which is generally kept outside the purview of tax. Remarkably, the legislators prospectively anticipated interrogations and objections on the provisions while drafting them, as reflected from Clause 4 of section 9B.
This clause states that “if any difficulty arises in giving effect to the provisions of section 9B and sub-section (4) of section 45, the Central Board of Direct Taxes (“CBDT”) may, with the approval of the Central Government, issue guidelines for the purposes of removing the difficulty.” Certain questions and objections arose pursuant to the introduction of these provisions regarding the computation of taxes and justification of taxing self-generated assets and goodwill.
Consequently, by effect of section 9B(4), the CBDT on 2 July 2021 issued guidelines regarding the application of section 9B and section 45(4) of the Act, explicating that the guidelines will be applied in determining tax liability during the reconstitution or dissolution of partnership firms. The guidelines state that if the taxed asset is distributed amongst the partners, it shall not be taxed again in the future in case of further reconstitution or dissolution of the firm, hence, double taxation shall be avoided.
In this context, the guidelines state that “the amount taxed under sub-section (4) of section 45 of the Act is required to be attributed to the remaining capital assets of the specified entity, so that when such capital assets get transferred in the future, the amount attributed to such capital assets gets reduced from the full value of the consideration and to that extent the specified entity does not pay tax again on the same amount.” The guidelines further enunciate a few examples to clarify the emerging doubt in the application of both the provisions.
Furthermore, the CBDT, on the same day, issued a notification to insert sub-rule (5) to Rule 8AA and a new Rule-8AB prescribing the manner of calculating the income chargeable to tax under section 45(4) of the Act as “capital gains” and also the method by which such income shall be attributed to remaining assets with the specified entity (partnership firm) under clause (iii) of section 48 of the Act.
On a related context, the CBDT on 7 July 2021 brought the Income Tax Amendment (19th Amendment) Rules, 2021 wherein computation of short-term capital gains and depreciation on goodwill for taxation determinations have been relooked upon. The 19th Amendment rules inserted Rule 8AC to the Income Tax Rules. Rule 8AC (3) states that “the actual cost of any asset falling within the block of assets “intangible”, other than goodwill, acquired during the previous year relevant to the assessment year commencing on the 1st day of April, 2021, such excess shall be deemed to be the capital gains arising from the transfer of short-term capital assets.”
Thus, the amendment rule exempts goodwill from falling under the ambit of capital gains arising from the transfer of short-term capital gains. However, as per Rule 8AB prescribed by the 18th Amendment Rules, goodwill purports to construe transfer of short-term capital assets thus, be amenable to taxation. Prior to these amendments, the ambit of section 45(4) often emerged as a cause of concern before various judicial forums thereby emanating the need for a legislative clarification.
2. Pre-amendment judicial controversy
The application of the erstwhile provision contained in section 45(4) of the Act has often been a matter of dispute before various judicial forums that upheld contrary positions. This was primarily owing to the ambiguity caused by the word ‘otherwise’ used in the provision which has been interpreted differently in various instances. While some courts read the provision to not apply to instances other than the dissolution of a partnership; others held the same applicable in circumstances such as reconstitution or retirement of partners, thereby making the capital gains arising from the distribution of assets taxable under the statute.
In the landmark case of Commissioner of Income Tax (2003),the Bombay High Court interpreted the scope of section 45(4) of the Act and enunciated that “the expression ‘otherwise’ has to be read with the words ‘transfer of capital assets’ by way of distribution.” The Court thus ruled that the term ‘otherwise’ sweeps within its ambit even those cases where the firm is in existence and a transfer of capital assets occurs, thereby making them chargeable. This interpretation was followed in numerous subsequent cases, including New Kamlesh Jewellers (2011),where the tribunal reaffirmed that “the intention of the Parliament was to bring under the purview of tax, net transactions whereby assets were brought into or taken out of the firm.”
Contrastingly, the Madras High Court in the recent case of National Company (2019),wherein the partnership firm had been reconstituted, held that the transfer of assets taking place pursuant to such reconstitution was not amenable to the provision of section 45(4) of the Act. The court based its decision on the rationale that “when a partner retires from a partnership, he receives his share in the partnership and this does not represent consideration received by him in lieu of relinquishment of his interest in the partnership asset.” The Court referred to various precedents, including the case of Commission of Income-Tax (2001), where the Apex court had iterated that the retirement of a partner and the reconstitution thereof does not fall within the purview of section 45 and as such is not chargeable.
A similar view was earlier taken by the Andhra Pradesh High Court in the case of Commissioner of Income Tax (1988), wherein the Court held that no liability to capital gains arose in context of reconstitution of the firm. Furthermore, the Supreme Court affirmed the view of Gujarat High Court in Commissioner of Income Tax (1971)that “there is no transfer of interest in the partnership assets involved when a partner retires from the partnership and he merely receives his share in the partnership and not any consideration for transfer of his interest in the partnership to the continuing partners”, thus providing a narrow interpretation to the scope of section 45(4).
Pertinently, the Finance Act seeks to amend section 45(4) of the Income Tax Act and explicitly includes “reconstitution” within its confines and makes any capital gains arising out of the receipt of capital assets on reconstitution or dissolution taxable. Consequently, this amendment clarifies the disputed scope of section 45(4) with reference to reconstitution of the firm and overrules all aforementioned contrary judicial precedents.
3. Distribution/allotment of assets among/to partners – Actual transfers?
Imperatively, an underlying quandary arising subsequent to these provisions and the said guidelines is “if it would be justified to sell a property to a partner when the property is allotted to the same partner”. If the allotted asset to the partner would deem to accrue income, it does not remain an allotment and exhibits the characteristics of a sale. Although the new provisions render an allotment of assets to a partner as transfer of the concerned asset thereby making it taxable but the legislative intent behind the introduction of the new provisions seems bleak. In this context, it becomes domineering to consider the judicial standpoint on the issue which differ from the present standing.
Notably, in the case of Commissioner of Income Tax (1968), the court ruled that the allotment of assets to a partner in order to balance his stake in the firm is a mere adjustment of the rights of the partners in a dissolving firm thus, is not a transfer, thereby eliminating the probability of taxation.
Further in this context, the court in the case of Malabar Fisheries (1980)held that the distribution, division or allotment of assets at the time of dissolution is nothing more than mutual adjustment and does not meet the criteria mentioned in section 2(47) of the Act wherein the factors to constitute a transfer has been laid down. The allotment or distribution of assets would not constitute a transfer majorly because there is no extinguishment of the firm’s rights in relation to the assets.
The Supreme Court brought finality in this issue through its judgment in the case of Kartikeya Sarabhai (1985) wherein it was held that allotment of assets to a partner shall not attract capital gain taxation as the consideration for a transfer in such a case is indeterminate. Particularly, by virtue of the latest amendments in the Act and rules, and the issued guidelines, although the mode of computation has been inserted under section 48 but the consideration in the deemed transfers is still indeterminate, posing certain difficulties and impediments to the applicability of the new provisions.
4. Cross jurisdictional comparative analysis of taxation of partnerships
The provisions contained in sections 9B and 45(4) of the Act purport to make the capital gains chargeable as the income of the specified entity. The rule for taxing profits or gains arising out of the receipt of assets by the partners on reconstitution or dissolution of the firm especially in the hands of the firm itself is in contrast with the partnership taxation regime of a number of countries.
The United Kingdom follows the principle of ‘tax transparency’ in the context of taxation of partnerships. In accordance with this principle, the partnership itself is not taxed, instead the partners are taxed directly for their share of profits and gains, as and when they arise. In the case of disposal of assets by a partnership to an outside party, the partners are treated as disposing of their fractional shares of the assets. Furthermore, at the time of distribution of assets to one or more partners, any resultant gain attributable to the partners (other than the one receiving the asset) shall be chargeable.
A similar taxation regime as that of the UK is followed in Germany, and commercial partnerships are treated as being ‘tax transparent’ for the purpose of income tax. The partners are taxed at their level with personal income tax (if the partner is an individual) or corporation income tax (in cases of corporations being partners) after due allocation of taxable income to respective partners. An analogous practice is followed in Singapore for the taxation of partnerships.
Further, the French tax law also manifests the ‘look-through’ approach in the context of partnerships thereby implying that the partnership firm is neither liable for personal income tax or corporate income tax itself, rather the partners include their respective profits in their taxable income. Any profits or gains arising out of the transfer of assets between the partnerships and an individual partner is attributable to the relevant partner for purposes of income tax, such gain is computed on the basis of fair market value, as in India.
The taxation regime in the United States is governed largely by the Internal Revenue Code, 1986. It categorically lays down, “A partnership as such shall not be subject to the income tax. Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities.” Thus, each partner is taxed separately, for which his distributive share in the partnership is taken into account encompassing the gains and losses arising out of the sale or exchange of assets. The distributive share is determined either by the partnership agreement or in accordance with the partner’s interest in the partnership.
Evidently, the aforementioned tax practices in various jurisdictions in the context of partnerships present a drastic variation from those followed in India. Even though the transfer of capital assets on reconstitution or dissolution of the firm or otherwise is generally taxable in most jurisdictions, there exist significant variations when compared to the Indian taxation system.
As discussed above, most of the jurisdictions follow the ‘look-through’ or ‘tax-transparency’ principle, wherein the partnership firm itself is not liable to tax, and the partners are taxed directly. Distinctively, under the newly amended provisions of Income Tax Act in India, any capital gains arising out of the distribution or allotment of assets on reconstitution or dissolution of partnership is chargeable as the income of the partnership firm itself and the firm is treated as a separate entity under the Act. This is a seemingly less favourable regime for firms, primarily because there exists a possibility of taxation of self-generated assets of the partners in the hands of the firm thereby adding to the tax liability of the firm.
5. Prudential assessment of the new provisions
Interestingly, the new provision under section 9B lays down a rule for taxing profits or gains arising only from capital assets or stocks in trade in connection with reconstitution or dissolution of the firm. However, section 45(4), mandates taxation of profits or gains arising from money or capital assets or both received by any partner while his exit thereby rendering reconstitution of the firm. There stands a difference between the factors governing the transfer that generate income in the two provisions. Therefore, profits or gains arising from money or other assets than capital gains or stocks in trade received under section 9B cannot be taxed and similarly, profits or gains arising from stocks in trade or other assets than money or capital assets cannot be taxed under this section.
This limitation reflects the short-sightedness of the legislators as it leaves scope for the firms to evade the concerning tax. Absence of proper reasoning behind only including two transferrable factors in each provision to construe income of the specified entity i.e., the firm births several difficulties and questions the essence of making such exceptions. The partial treatment not only excessively scrutinises the firm’s capital assets but also introduces selectivity in the system of taxation of short or long-term capital gains which, more than often, can prove to be counter-productive.
For instance, in a fictional scenario, if a firm sells the property in the name of developing/expanding itself or other related reasons, the amount received by the firm through such sale would not be amenable to tax under section 9B of the Act. Further, if the firm, instead of investing the money on the firm, utilises the money to settle the balance of a partner who wishes to exit the firm, such payment would not accrue as its income. Thus, payments of such nature would not attract taxation under section 9B of the Act.
In addition, another indispensable anomaly existing in the new system is the taxability of self-generated assets and goodwill. As goodwill denotes the benefit arising from the connection or reputation wherefore, taxation of income accruing from it, seems unfounded and unwarranted. Relatively, the Bombay High Court in the Commissioner of Income-tax (1977), has taken the view that the receipt on the transfer of goodwill generated in a business is not subject to income tax as a capital gain as the cost of acquisition cannot be computed in such transfers. However, this standing was nullified with the introduction of section 55(2) of the Act wherein self-generated asset, which includes goodwill, was made privy to taxation with the cost of acquisition being nil.
With the introduction of Rule 8AA of the Income Tax Amendment (“18th Amendment”), Rules, 2021, transfer of self-generated assets and goodwill to a partner shall constitute a transfer of short-term capital assets thus, it still remains taxable under the Act. However, the recent amendment also fails to provide justifications to rationalise taxation of self-generated assets and goodwill, whose cost of acquisition still cannot be computed. Further, pursuant to the 19th Amendment Rules, goodwill is not deemed to be capital gains arising from the transfer of short-term capital assets which itself contradicts the 18th Amendment Rules to an extent. The existing ambiguities in the two rules possess the potential to cause several disputes in related matters.
Consequently, there still exists an uncertainty regarding the applicability of the discussed provisions to circumstances where assets are revalued or self-generated assets are recorded in the books of accounts and the partner receives payment from such assets that is in excess of his capital contribution. The latest amendments reflect more impasses than resolutions, one commendable decision of the legislators is the rule to avoid double taxation. The CBDT noticed that the amount taxed under section 45(4) of the Act is required to be attributed to the remaining capital assets of the specified entity. Thus, in case of reconstitution or dissolution of the firm in the future, the taxed amount on any capital assets would be reduced, essentially preventing double taxation on a specified capital asset.
However, the existing predicaments outweigh the laudable changes incorporated in the amendments. Although the CBDT issued guidelines to clarify the intricacies involved in the computation of taxes in the short and long-term capital assets but it did not clarify the legislative intent behind the changes. Additionally, it did not advance enough explanations to assure that the changes brought through the latest amendments is in the larger interest and not just another means to increase taxed income for the government.
The amendments introduced by the Finance Act, the Rules and the guidelines issued consequently by the CBDT mark significant developments in the sphere of taxation for partnership firms. Remarkably, the amendments have successfully put an end to the existing judicial divergence regarding the taxability of transfer of assets on reconstitution and dissolution of partnerships by bringing it under the ambit of sections 9B and 45(4). Imperatively, these amendments contradict most of the judicial decisions in the given context. The guidelines issued by the CBDT further seek to clarify the method of computation of such capital gains to be charged on the income of the firm.
However, these amendments are still faced with anomalies with respect to their application in certain situations, such as in the context of self-generated assets and goodwill or re-evaluation of assets. The amendment makes the transfer of goodwill chargeable as short-term capital assets without a justifiable rationale for the same. The amendments to the provisions of the Act i.e., sections 9B and 45(4) further present plausible means for tax evasion by the firms as they do not comprehensively cover all transferrable factors in their ambit. This is a potential cause for ambiguity and barrier in the applicability of the rules.
Although the guidelines issued by CBDT reaffirm the avoidance of double taxation which is a laudable effort by the authorities, the enactment of these amendments without clarification of the legislative intent behind the same present merely a means of yielding a larger taxable income to the authorities. The taxation of partnership firm itself is also a practice that is not usually followed in other jurisdictions, thereby adding to the questionability of the rationale and prudence behind the same.
Although CBDT’s endeavour to remove the difficulty arising in the implementation of the new rules is commendable yet the guidelines issued for the resolution of such difficulties does not seem entirely efficient. Thus, forming a requirement to bring a wholesome mechanism to balance the capital and shares of partners while reconstitution or dissolution of firms. Such provisions should lucidly lay out a manner regarding taxation of profits or gains arising from capital assets, stocks in trade, money or other assets without causing further bewilderments. Additionally, in order to answer the quandaries arising in taxation of deemed transfers, the legislator or the tax authorities need to issue clarifications and explanations that also lays down the legislative intent behind the taxation of the deemed transfers and self-generated assets and goodwill. The taxpayers prospectively await action from the Indian legislators as well as the tax authorities.
 IN: Income Tax Act of 1961, sec. 28 (amended 2021), National Legislation IBFD.  Sec. 45(4) ITA 1961 (amended 2021).  Sec. 9B(4) ITA 1961 (amended 2021).  Guidelines under section 9B and sub-section (4) of section 45 of the Income Tax Act 1961, Central Board of Direct Taxes, Government of India, 2 July 2021.  Income Tax Amendment (18th Amendment) Rules 2021.  Commissioner of Income Tax v. A. N. Naik Associates and anr., 2003 SCC OnLine Bom 688.  Id.  New Kamlesh Jewellers v. ITO 25(1)(4), 2011 SCC OnLine ITAT 218.  National Company v. Assistant Commissioner of Income Tax, 2019 SCC OnLine Mad 8343.  Commissioner of Income Tax v. R. Lingmallu Raghukumar, (2001) 247 ITR 801.  Commissioner of Income Tax v. P.H. Patel, (1988) 171 ITR 128.  Commissioner of Income Tax v. Mohanbhai Pamabhai, 1971 SCC OnLine Guj 101.  CIT v. Dewas Cine Corporation, (1968) 68 ITR 240 (SC).  Malabar Fisheries Co. v. CIT, 1980 SCR (1) 696.  Kartikeya v. Sarabhai v. CIT, (1985) 156 ITR 509.  Sec. 48 ITA 1961 (amended 2021).  Partnerships and Tax- Overview, Lexis Psl, https://www.lexisnexis.com/uk/lexispsl/tax/document/393773/577S-MJK1-F18C-V4N3-00000-00/Partnerships_and_tax_overview.  Statement of Practice D12: Partnerships, HM Revenue & Customs, https://www.gov.uk/government/publications/statement-of-practice-d12/statement-of-practice-d12.  Id.  Introduction to income taxation of German corporations and partnerships, Deloitte, 2020.  Id.  Basic Guide for Partnerships, Inland Revenue Authority of Singapore, https://www.iras.gov.sg/irashome/Businesses/Self-Employed/Learning-the-basics/Basic-Guide-for-Partnerships/.  Philippe Derouin, Regulation of Partnerships in France, https://www.lexology.com/library/detail.aspx?g=a56c3f11-48a5-4e09-b6bd-ef0da92479cb.  US: Internal Revenue Code of 1986, sec. 701, National Legislation IBFD.  Sec. 702, IRC 1986.  Sec. 704, IRC 1986.  Sec. 9B, 45(4), ITA 1961 (amended 2021).  Commissioner of Income-tax v. Home Industries & Co., (1977) 107 ITR 609 Bom.