When a partnership firm consisting of only two partners stands dissolved on the death of one of its partners, and the capital asset of the firm is sold to a third party, long after the partner’s demise - i.e. when the death of the partner and the sale of the capital asset occur at different Assessment Years, the tax liability of such transaction becomes a subject matter of legal interpretation.

In this insightful column, Mr. K. Ravi and Mr. Varun Ranganathan (Advocates) examine the legal issue arising in the above situation, from various perspectives in light of the provisions of the I-T Act and Indian-Partnership Act, while also addressing the incidental and ancillary issues that are essential to resolving the primary question. Discussing on the issue as to “whether the legal fiction under section 189(1) of the Act, can be extended beyond the year of dissolution”, the Authors remark, “…it is a trite law that machinery provisions should be liberally construed so as to effectuate the liability imposed by the charging section and to make the machinery workable.”, and opine that the gains must unequivocally be taxed in the hands of the erstwhile firm.

“Death, Dissolution & Taxation: The Capital Gains Conundrum”

Introduction

When a partnership firm consisting of only two partners stands dissolved 6n the death of one of its partners, and the capital asset of the firm is sold to a third party, long after the partner’s demise - i.e when the death of the partner and the sale of the capital asset occur at different Assessment Years, the tax liability of such transaction becomes a subject matter of legal interpretation, raising a complex question:

“Whether the gains arising from such a transaction should be assessed in the hands of the erstwhile firm or in the hands of the surviving partner and the legal heirs of the deceased partner?”

This article seeks to examine the issue from various perspectives in light of the provisions of the Income-Tax Act, 1961, and the Indian-Partnership Act, 1932, and endeavours to unravel the dilemma by addressing the incidental and ancillary issues that are essential to resolving the primary question.

I. Aspects for Consideration

Before probing into the primary question, it is essential to enumerate the key factors which play a pivotal role in determining the appropriate hands for taxation: -

1. The status of the firm after the death of one of the partners, for the purpose of tax assessment.

2. The implications of the sale of the capital asset in subsequent year (or even later), after the year of dissolution.

3. The creation of charge upon the transfer of the capital asset

4. The Entitlement of partners/legal representatives over the capital asset after the dissolution of the firm

5. The precise point of taxation

All these factors are intricately intertwined, and an attempt is made to meticulously dissect each of them separately to address the primary question at hand.

II. Scope of framing an assessment on a dissolved firm

The issue stems-out from an undisputed position of law that when one of the partners in a firm consisting of two partners, passes away, the firm stands dissolved. Following such dissolution, there cannot be a partnership between the surviving partner and the legal heirs of the deceased partner. [1] 

In this premise, it is imperative to note that the partnership firm is not a juristic person, separate and distinct from its partners as per the Indian-Partnership Act, 1932, but, it is treated as an assessable entity under the Income-Tax Act, 1961. Thus, upon dissolution, the firm is ceases to have its legal existence. [2]Further, in Jullundur Vegetables Syndicate’s case[3], the Supreme Court has clarified that the provisions of partnership act cannot be called in aid to resurrect a dissolved firm for the purpose of assessment under a different statute. Therefore, since any proceeding initiated against a non-est entity would be null and void[4], a possible view is that the capital gains must be charged in the hands of the surviving partner and the legal heirs of the deceased partner.

Contrarily, it is equally possible to suggest that the firm, despite its dissolution, continues for the purposes of winding up by drawing support from on Section 47 of the Indian-Partnership Act, 1932, r.w. Section 189(1) of Income-Tax Act, 1961. This is because, even after dissolution of a firm, the partnership subsists for the purpose of winding up, and Section 47 of the Indian-Partnership Act, 1932, permits any act necessary for such winding- up, which includes sale of the asset of the dissolved firm.[5] This  act of sale, which attracts “capital gains”, could thereafter be taxed by virtue of Section 189 (1) of the Income-Tax Act, 1961, which provides a machinery for assessment of a dissolved firm by creating a legal fiction as if no such dissolution had taken place.

This view appears to be acceptable, despite there being a contrary stand taken in Jullundur Vegetables Syndicate’s case[6], because, that case pertains to East Punjab General Sales Tax Act,1948, and unlike Section 189 (1) of Income-Tax Act, 1961, there was no provision in that act so as create a legal fiction for assessing a firm after its dissolution.

Though the latter view appears to be persuasive as the statute itself provides for a mechanism to assess a dissolved firm as an assessee, there is still a catch as to whether such legal fiction can be extended beyond the Assessment Year relevant to the previous year in which the firm stood dissolved?

III. Possibility of extension of the legal fiction u/s. 189 (1)

This issue as to whether the legal fiction could be extended beyond the year of dissolution is based on the language of sub-section (1) of Section 189 of the Income-Tax Act, 1961, which reads as under: -

189. (1) Where any business or profession carried on by a firm has been discontinued or where a firm is dissolved, the Assessing Officer shall make an assessment of the total income of the firm as if no such discontinuance or dissolution had taken place, and all the provisions of this Act, including the provisions relating to the levy of a penalty or any other sum chargeable under any provision of this Act, shall apply, so far as may be, to such assessment

The phraseology employed in the statute, particularly the terms “Where a firm is dissolved” and “to such assessment,” suggests that the legal fiction may be confined solely to the year of dissolution. However, there are plethora of conflicting decisions of various High Courts which have contrasting perspectives on this proposition.

The High Courts of Rajasthan & Delhi, in few cases [7] [8] [9] have held that the deeming fiction under Section 189(1) of Income-Tax Act, 1961, is not applicable to income arising long after dissolution of the firm. A similar view has also been adopted by the Gujarat High Court[10]. The conclusions were based on three-fold reasons: -

1. The Purpose of assessment is to assess the income of the firm, while it existed and not for future transactions.

2. Section 189 of the Income-Tax Act, 1961, is a machinery provision which cannot create a substantive levy by charging an entity which no longer exists.

3. Section 47 of Indian-Partnership Act, 1932, and Section 189 of the Income-Tax Act, 1961, cannot be extended beyond the purpose for which they have been enacted.

The High Court of Kerala has taken a diametrically opposite view in Paulson Constructions vs CIT [TS-5722-HC-1989(Kerala)-O] by holding that the firm will to continue to exist despite the dissolution even for a succeeding assessment year to the assessment year relevant to the previous year, the firm got dissolved. This stand finds support from a couple of decisions of the Bombay High Court, where the court ruled that the assessment could be made on a dissolved firm for a subsequent assessment year[11] and for an assessment year long after its dissolution.[12]

Since there are divergent judicial interpretations, in the absence of a definite ruling by the Supreme Court, and as one of the reasons given by the Gujarat High Court (Supra) is that Section 189 of the Indian-Partnership Act, 1932, is merely a machinery provision, this issue necessities an exploration of the other factors such as the creation of charge by virtue of i.e Section 45 of the Income-Tax Act, 1961, the partner’s entitlement over the surplus after the dissolution of the firm under the Indian-Partnership Act, 1932, and the precise point of taxation, all of which are indispensable to ascertain the correct position of law.

IV. The Charge, The Partner’s entitlement over the surplus and The Point of Taxation

A.  The Charge – on the ‘transferor’

Section 45 of the Income-Tax Act, 1961, creates a charge on the gains arising from the “transfer” of a capital asset. Although the provision does not expressly stipulate that the tax is charged on the transferor of the capital asset, it is reasonable to presume so, given that the gains are   received by the transferor. Since, the charge is created on the transferor, the essential condition to be satisfied before an assessee is subjected to capital gains is that the capital asset should belong to the assessee, and such “gains” should arise or accrue to the assessee a result of such “transfer”.[13]  A negative inference can be drawn from the decision of the High Court of Karnataka in C Kamala v. CIT[14], wherein it was held that the question of capital gains cannot arise, if the capital asset never belonged to the assessee. Thus, when the transfer of title of a capital asset to the transferee is executed by the firm, such the gains are taxable in erstwhile firm’s hands[15]. At, this juncture, the fundamental question that arises is: Is the firm’s property not collectively owned by its partners, as a firm is not a separate legal entity?

B. The Partner’s entitlement over the surplus

Although it remains indisputable that the firm's property is collectively owned by its partners, as per Section 14 of the Indian-Partnership Act, 1932, the property would include all property and rights originally bought into the stock of the firm. Section 46 of the Indian-Partnership Act, 1932, on the other hand entitles the partners or their legal representatives to utilize the firm’s property to settle the debts and liabilities of the firm and to distribute the surplus according their rights. The Supreme Cout in Ravi Prakash Goel’s Case[16] has recognised that Section 46 of the Indian-Partnership Act, 1932, provides the right to realise the assets; and distribute the surplus after payment of liability. The Court further observed, “When a partner dies and the partnership comes to an end it is not only right but also the duty of the surviving partner to realise the assets for the purpose of winding up of the partnership affairs including the payment of the partnership debts.” Moreover, upon the dissolution of the firm, the partners do not automatically acquire the ownership over the firm’s property until the accounts of assets and labilities are settled in accordance with Section 48-55 of the Indian-Partnership Act, 1932.[17] So, when a property is bought into the firm, it retains its character as the firm’ property until the assets are realised and the surplus is apportioned the among the partners / legal representatives. It is only subsequent to such distribution the partners/legal representatives are entitled to the property of the firm. Consequently, it would be unjustified to tax the partners/ legal representatives prior to their rightful entitlement to the gains.

C.  The Point of Taxation – prior to distribution of surplus

Another intriguing line of argument, that comes to aid this proposition is with respect to the point of taxation. A cursory reading of Section 46 of the Indian-Partnership Act, 1932, suggests that, upon the realisation of the firm’s property, the partners are entitled to the surplus only after the settlement of debts and liabilities. However, the crucial point of taxation occurs immediately upon realisation of the asset through sale, prior to the distribution of the surplus. In between these events, comes the discharge of debts and liabilities.  As the language used in Section 46 of the Indian-Partnership Act, 1932, is “debts & liabilities” and not merely “debt”, the liability to pay the gains arises even before the partners/ legal representatives are entitled to claim the property of the firm. This Argument is well-demonstrated by the following chart which tabulates the chronology of events and their corresponding effects:

As illustrated above, the liability to pay to capital gains crystalises in the hands of the erstwhile firm, even before the partners/legal representatives are entitled to their share over the firm’s property, which reinforces that the capital gains have to be assessed in the hands of the erstwhile firm.

Conclusion

These interpretations advocated from Paragraphs A – C while substantiating the argument to tax the gains in the hands of the erstwhile firm, also seamlessly harmonize with the three aforementioned reasons, laid down by various High Courts (Supra), for not extending the legal fiction u/s. 189(1) of Income-Tax Act, 1961, namely:

1. The assessment does not pertain to the future transaction, as the realisation of the firm’s assets is an indispensable step in the process of winding up;

2. The machinery provision of Section 189(1) of the Income-Tax Act, 1961, does not create a substantive levy, while Section 45 of the Income-Tax Act, 1961, clearly does;

3. Sections 47 and 189(1) of the Income-Tax Act, 1961, are not extended beyond their purpose as the liability of the capital gains arises prior to the firm’s winding up.

Finally, the question that was left open (supra), namely, whether the legal fiction under section 189(1) of the Income-Tax Act, 1961, can be extended beyond the year of dissolution, is also answered, as it is a trite law that machinery provisions should be liberally construed so as to effectuate the liability imposed by the charging section and to make the machinery workable[18]. Hence, for this 'taxing' proposition, the authors are of the 'firm' view that the gains must unequivocally be taxed in the hands of the erstwhile firm.