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Introduction

A partner who receives certain assets upon retirement from a firm would be keen to ensure that such assets do not attract capital gains tax. Read this article to understand the latest position on the question as to whether the assets which a retiring partner receives from a partnership firm is subject to capital gains tax or not There is no direct provision in the Income Tax Act, 1961 which answers the question as to whether a retiring partner would be liable to pay tax on the assets received by her from the firm. Certain decisions from the courts and tax tribunals have provided the answer.

Legal Regime: Erstwhile Section 47(ii) of the Income Tax Act, 1961

Before being deleted by the Finance Act, [1987], Section 47(ii) of the Income Tax Act (now deleted), governed distribution of assets of a partnership. It stated that the distribution of assets of a partnership firm upon dissolution of the same, shall not be considered as transfer of assets and hence will not be subject to capital gains tax. However, payment to one partner upon retirement (and not on the dissolution of the firm) was not expressly covered by that Section. The Supreme Court in the decision of Sunil Sidarthbhai v. CIT (See cases that cite this case), endorsed the view taken in an earlier SC decision viz., Malabar Fisheries Co vs CIT, Kerala that capital gains tax cannot be levied on the assets which are received by a retiring partner. The Supreme Court followed a simple principle viz., upon retirement partners only realize the value of their partnership interest which was created when they became a partner for the first time.

Judicial Position

Madras High Court and Bangalore ITAT recently delivered two decisions, which have extensively discussed the issue of taxability of proceeds in the hands of retiring partners.

  1. In the decision of National Company v. ACIT, decided by Madras High Court, certain retiring partners were given a share in immovable properties. The issue arose that whether capital gains tax can be imposed on the transfer of such immovable properties. The Madras High Court relying on the decision of Prashant S Joshi v. ITO held that the consideration received by the partners is nothing but their interest in the firm and the same cannot be classified as capital gains and hence be made subject to capital gains tax.
  2. The second decision, which discussed at length this issue was rendered by the Bangalore ITAT. This was the decision of Savitri Kadur v. DCIT. In this case, certain amounts over and above those lying in the capital account of the retiring partner was paid to her. The issue which arose was whether the excess amounts paid over and above the amount lying in the partner’s capital account was subject to capital gains tax or not. The Bangalore ITAT considered three situations, and provided a quick guide to the question whether the amounts in each case should be subject to capital gains tax:
    • When the partner was given only the amount lying in the capital account: Following the ratio given in ACIT vs. Mohanbhai Pamabhai, this amount will not be subject to capital gains tax, as it only represents the existing interest of the partner prior to retirement.
    • When the partner is given excess amounts over and above what is lying in the capital account: This amount may be paid to the partner to enable him to release his interest in the firm and transfer his rights, hence, this will be subject to capital gains tax.
    • If a lump sum amount is paid to the partner irrespective of the amounts lying in his capital account, then the same cannot be termed as an amount which the partner was entitled to and hence capital gains will be payable on this amount as well.

Conclusion

The Income Tax Act is silent on the issue of taxation of proceeds in the hands of retiring partners. This has given rise to a number of case laws that have come up with their own interpretations on this issue. The aforementioned decisions augment such list. What is to be seen is whether a concrete position on this issue is taken, either by the legislature or the judiciary at any point of time.

Written by Soumya Shekhar, legal writer @ Riverus

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