Section 45(4) of the Income Tax Act, 1961 is proposed to be substituted and section 45(4A) inserted vide the Finance Bill, 2021, with consequential amendment of section 48.  CA Dindayal Dhandaria & CA Naveen Kumar Dhandaria explore the proposals and point out the anomalies therein. Noting that the receipt of capital asset is in the hands of the ‘specified person’ but the incidence of tax is on the specified entity which does not receive the capital asset but transfers it, the authors point out that “The provisions of section 2(47) have not been amended to take care of such an exceptional situation”. Further, they highlight that section 45(4A) is proposed to apply to “money” also and state that “By no stretch of imagination, money can be a “capital asset”. The definition of “capital asset” given in section 2(14) of the Act does not cover it.”

Budget 2021: Capital gains on firms/AOPs 

HISTORICAL BACKGROUND

One of the methods resorted by the assessees to avoid/evade tax on capital gains was by using the medium of a partnership firm or an Association of Persons (AOP) or a Body of Individuals (BOI), by transferring their individual assets to such entities at cost or at a price lower than the fair market value and later, withdrawing themselves from the said partnership or such entity by taking only the balance in their capital accounts and allowing other partners to continue to hold these capital assets.  When a person introduced his capital asset in such entities at a price higher than cost, the difference was held not liable to tax by the Hon’ble Supreme Court in the case of  Sunil Siddharthbhai v. CIT [TS-4-SC-1985-O]. In this case, though the Supreme Court held it to be a transfer, it held that the consideration therefore was indeterminate.  To nullify the effect of this decision, the provisions of section 45(3) were inserted by Finance Act, 1987 w.e.f. 1-4-1988 providing that the fair market value of the capital asset so transferred shall be deemed to be the amount recorded in the books of accounts of the firm. 

Another method of tax avoidance/evasion was that a capital asset held by a firm was taken over by a retiring partner or distributed among the partners on dissolution of the firm at book value.  With a view to plugging this loophole, the Finance Act, 1987 inserted section 45(4) also w.e.f. 1-4-1988.  But this section applied to cases of distribution of capital assets on the dissolution of a firm, an AOP and a BOI, or otherwise.

Although, the provisions of section 45(3) achieved its objects, difficulties arose in implementation of section 45(4).  The withdrawal of a capital asset by a partner at the time of retirement or reconstitution was not expressly covered in the erstwhile sub-section (4) of section 45.  The attempt to cover such a case within the meaning of the word “otherwise” did not find judicial favour.  Refer to National Company v. CIT [TS-5372-HC-2019(Madras)-O],  CIT v. Kunnamkulam Mill Board, [TS-17-HC-2002(KER)-O] and CIT v. Dynamic Enterprise [TS-556-HC-2013(KAR)-O]. This has led to the substitution of section 45(4) of the Act.

However, the Memorandum explaining the Finance Bill, 2021 states that there is uncertainty regarding applicability of provisions of the aforesaid sub-section to a situation where assets are revalued, or self-generated assets are recorded in the books of accounts and payment is made to partner or member which is in excess of the capital contribution.  This Explanation holds good in case of insertion of section 45(4A).

SCOPE OF THE ARTICLE

This article is confined to substitution of section 45(4) of the Income Tax Act, 1961 (“the Act”) and insertion of section 45(4A) therein by clauses 14 and 16 of the Finance Bill, 2021, respectively and a consequential amendment of section 48.   

AMENDMENTS PROPOSED BY THE SUBSTITUTED SECTION 45(4) AT A GLANCE

As per the proposed provisions:

1. The taxable event will be “the profits and gains arising from receipt of capital asset by specified person from a specified entity on account of its dissolution or reconstitution”.

2. The capital asset will represent the balance in a specified person’s capital account in the books of the specified entity at the time of its dissolution or reconstitution.

3. In determining the capital account balance of the specified person, any increase on account of revaluation of any asset or due to self-generated goodwill or any other self-generated asset will be excluded.

4. These amounts will be chargeable as income of the specified entity under Capital Gains and it will be deemed to be income of the specified entity for the previous year in which such capital asset is received by the specified person.

5. As far as the computation of capital gains is concerned, the fair market value of the capital asset on the date of receipt by the specified person shall be deemed to be the full value of consideration.

6. So far as the cost of acquisition is concerned, it is to be ascertained in the usual manner.

7. The terms "specified entity", "self-generated goodwill" or self-generated asset" and "specified person" are defined by way of Explanation to the proposed section.

"specified entity" means a firm or other association of persons or body of individuals (not being a company or a cooperative society);

"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.

"specified person" means a person who is partner of a firm or member of other association of persons or body of individuals (not being a company or a cooperative society), in any previous year.

AMENDMENTS PROPOSED BY SECTION 45(4A) AT A GLANCE

The provisions of this section are pari materia with those proposed section 45(4) except that it applies to “money and other assets” whereas sub-section (4) applies to capital assets.

COMMENTS ON THE PROPOSED SECTION 45(4)

1. As per the existing provisions, the taxable event was “distribution of capital assets on the dissolution or otherwise”. As per the proposed provisions, the taxable event will be “the profits and gains arising from receipt of capital asset by specified person from a specified entity on account of its dissolution or reconstitution”.  Although the word “reconstitution” has not been defined in the Act, it will take its meaning from the expression “change in constitution” as appearing in Section 187 of the Act.   Thus, there is now an express provision to cover cases of retirement of a partner or a reconstitution of a firm. 

2. The existing provisions do not provide that balance in the capital account of a partner shall represent capital asset. But the proposed amendment provides that the capital asset will represent the balance in a specified person’s capital account in the books of the specified entity at the time of its dissolution or reconstitution.  It is also provided that in determining the capital account balance of the specified person, any increase on account of revaluation of any asset or due to self-generated goodwill or any other self-generated asset will be excluded.

3. It is provided that so far as the cost of acquisition is concerned, it is to be ascertained in the usual manner. There was no such provision in the existing provisions.

4. Other provisions are same as the existing provisions.

COMMENTS ON THE PROPOSED SECTION 45(4A)

1. This provision is intended to bring into its ambit the consideration received for self-generated goodwill by the specified persons.

2. If any revaluation is done by the specified entity prior to its dissolution or reconstitution increasing the value of any asset, such revaluation will be ignored for the purpose of determination of the capital account balances of the specified persons.

3. Similarly, any increase on account of self-generated goodwill or any other self-generated asset will be ignored for the purpose of determination of the capital account balances of the specified persons.

4. The amendment proposes to tax any money received by the specified persons in excess of their capital account balances.

CONSEQUENTIAL AMENDMENT OF SECTION 48

Consequential amendment is also proposed in section 48 of the Act to provide that in case of specified entity, the amount included in the total income of such specified entity under sub-section (4A) of section 45 which is attributable to the capital asset being transferred, shall be reduced from the full value of the consideration to compute income charged under the head “capital gains”. This is to be calculated in the manner to be prescribed later. This is to mitigate the double taxation which may have happened but for this provision in a situation where an asset which was revalued and for which income under the proposed sub-section (4A) of section 45 of the Act was brought to tax is transferred subsequently by the specified entity.

ANOMOLIES

1. Section 45(1) provides that any profits and gains arising from the “transfer of a capital asset” shall be chargeable as “capital gains”. But the proposed provisions of section 45(4) and 45(4A), the taxable event is linked to “receipt of a capital asset”.   For this purpose, both the sub-sections (4) and (4A) of section 45 have been enacted with a ‘non-obstante clause’ to override the provisions of sub-section (1) thereof.  In this connection, it is important to note that the receipt of capital asset is in the hands of the specified person but the incidence of tax is on the specified entity which does not receive the capital asset but transfers it.   The provisions of section 2(47) have not been amended to take care of such an exceptional situation.

2. Further, section 45(4A) is proposed to apply to “money” also. By no stretch of imagination, money can be a “capital asset”. The definition of “capital asset” given in section 2(14) of the Act does not cover it.

CONCLUSION

While proposing to substitute section 45(4) and inserting section 45(4A), the Memorandum explaining the Finance Bill, 2021 describes this as “Rationalisation of provision of transfer of capital asset to partner on dissolution or reconstitution”.  The dictionary meaning of the word “Rationalization” is “the action of attempting to explain or justify behaviour or an attitude with logical reasons, even if these are not appropriate”.  It is evident that the amendment to section 45(4) is being proposed with a view to overcoming the difficulties in taxing the capital gains arising at the time of retirement/reconstitution of a Firm and other specified entities and section 45(4A) is intended to tax self-generated goodwill and other self-generated assets.  So, these proposals are aimed at plugging the loopholes regarding taxation at the time of retirement/ reconstitution and extending the scope of taxation to self-generated goodwill, etc.  However, the legislature thinks it fit to describe these attempts as “rationalisation”.

Lastly, it is imperative to point out that the word “reconstitution”  means “change in constitution” which is defined in section187 of the Act.  Sub-section 2(b) thereof provides that change in constitution takes place when all the partners continue with a change in their respective shares or in the shares of some of them.   During the subsistence of a partnership firm, the share in profits and/or loss of a partner is often changed and if on every such occasion, fair market value of the assets of the firm is required to be determined and capital gains tax is imposed, the firms would face an onerous task.  The manner of calculation is yet to be prescribed.   

These amendments will be effective from the 1st April, 2021 and will accordingly apply to the assessment year 2021-22 and subsequent assessment years.