Section 45(3) has been introduced in the Income-tax Act, 1961 (Act) by the Finance Act, 1987 w.e.f 01.04.1988. Section 45(3) states that “the profits or gains arising from the transfer of a capital asset by a person to a firm or other association of persons or body of individuals (not being a company or a co-operative society) in which he is or becomes a partner or member, by way of capital contribution or otherwise, shall be chargeable to tax as his income of the previous year in which such transfer takes place and, for the purposes of section 48, the amount recorded in the books of account of the firm, association or body as the value of the capital asset shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of the capital asset”.  

The reason for insertion of sub-section(3) in section 45 has been explained, inter alia, by CBDT in circular no. 495 dated 22.09.1987.  A perusal of para 24.1 and 24.2 of the said circular would show that section 45(3) has been introduced in the statute apparently to legislatively overrule the decision rendered by the Hon’ble SC by way of a common judgment in Sunil Siddharthbhai v. CIT and Kartikeya V. Sarabhai v. CIT [TS-4-SC-1985-O] [hereinafter referred to as Siddharthbhai’s case for the sake of brevity].  

The Hon’ble SC in Siddharthbhai’s case addressed following three questions:

1. On introduction of shares into the partnership firm as contribution towards capital, was there a transfer of a capital asset?

2. Whether any consideration can be said to have been received as understood in the scheme of capital gains?

3. Whether any profit or gain can be said to arise to a partner on such transfer?

The SC answered the first question in favour of the revenue and second and third in favour of the assessee.  It held that on partner's bringing in his capital asset into partnership as capital contribution, no consideration is received by partner within meaning of section 48, nor does any profit or gain accrue to him in commercial sense, and, therefore, no capital gain chargeable under section 45 arises

Perusal of section 45(3) would show that it creates a fiction only to fix the year of transfer and consideration on transfer of capital asset by the partner to the firm by way of capital. It doesn't provide any mechanism to compute profits or gains on introduction of personal asset by partner into the firm as capital.  In fact, the section is worded ‘as though’ profits arose on transfer of capital asset by the partner to the firm by way of capital, in natural course.  This is evident from the opening portion of section 45(3) which states “The profits or gains arising from the transfer of a capital asset by a person to a firm………, shall be chargeable to tax”. This makes it clear that section 45(3) has not addressed one of the main issues addressed by the Hon’ble SC.  The Hon’ble SC clearly held that “Having regard to the nature and quality of the consideration which the partner may be said to acquire on introducing his personal asset into the partnership firm as his contribution to its capital, it cannot be said that any income or gain arises or accrues to the assessee in the true commercial sense which a businessman would understand as real income or gain”. This shows that no real profits or gains arise or accrue to an assessee when he introduces his personal asset as capital of the firm.  The Hon’ble SC in Miss Dhun Dadabhoy Kapadia v. CIT [TS-2-SC-1966-O] held that “In working out capital gain or loss, the principles that have to be applied are those which are a part of the commercial practice or which an ordinary man of business will resort to when making computation for his business purposes”.   This principle has been reiterated in several decisions.     

Section 45(3) creates fiction only to fix the year of transfer and consideration on transfer. There is no fiction regarding accrual of profits or gains on transfer of capital asset. Fiction is created only for timing of transfer and consideration for transfer. This would not automatically lead to fiction regarding accrual of profits or gains on transfer. The Hon’ble SC has categorically stated that no profits or gains, in commercial sense, accrue to partner when he introduces his personal asset as capital. So if one had to get over the SC's decision in totality, a fiction should have been created that the moment a personal asset is introduced as capital, profits or gains accrue to the partner and a further fiction should have been created that the difference in amount recorded in books of the firm and the cost of acquisition in the hands of the partner is the profit or gain arising on such transfer.

There is a fine distinction between providing a mechanism for computing income chargeable under the head capital gains and providing mechanism for computing profits or gains on transfer. The former is a necessary pre-condition for charge to fructify. Section 45(3) fails to provide for the former and it only provides for the latter. The chargeability under the head capital gains gets triggered, if two conditions are satisfied:

1. There is a transfer of capital asset

2. Profits or gains [loss] arise on transfer of such capital asset

The second condition i.e., profits or gains arise on transfer of capital asset means commercially whether any profit or loss is earned or incurred on transfer.  If answer is yes, then one should apply the provisions of Chapter IV-E.  If the nature of transfer is such that no profits or gains in real sense arise but legislature intends to tax even such transfer, a fiction should be created to the effect that there is deemed accrual of profits.  If no profit or gains arise commercially, Chapter IV-E cannot be applied unless a fiction is created that profits or gains do arise.  In the absence of a fiction in the statute to that effect, despite introduction of section 45(3), transfer of capital asset by a partner into the firm is not liable to tax as charge fails.  

The observations of the Hon’ble SC in Siddharthbhai’s case would give an impression that the Hon’ble SC while holding that no profits in commercial sense accrue to the partner on his introduction of his capital asset as capital of the firm had relied on the factor of the non-ascertainability of consideration accruing on account of such transfer. An incidental question that arises is that whether as section 45(3) has created a fiction regarding the consideration that accrues when a partner introduces his capital asset as capital in the firm, profit automatically accrues? The answer is no. One should read the observations of the Hon’ble SC in the context and based on its various other observations. The Hon’ble SC held that it is impossible to conceive of evaluating the consideration acquired by the partner when he brings his personal asset into the partnership firm.  To get over this problem, a fiction is brought in the statute in the form of section 45(3).  Just because a fiction regarding consideration is created, accrual of profits does not automatically follow. One cannot contend that assumption of accrual profits is only logical extension of the fiction created. It is true that when a deeming fiction is created, it should be carried to its logical end, in accordance with the purpose of its enactment and no further. Assumption regarding accrual of profits on transfer cannot be said to be logical extension of fiction created by the statute regarding consideration. Courts have held that in order to survive the charge on transfer of capital asset, real profits or gains as understood in commercial sense should arise. Arisal of profits is an important pillar that holds on the charge in respect of capital gains.  Therefore, argument in favour of automatic accrual of profits when no real profits arise on the purported logical extension of the fiction created in respect of consideration, is not tenable.  Real profits cannot arise from difference between ‘deemed’ consideration and cost of acquisition.  Only notional profits arise from the difference between ‘deemed’ consideration and cost of acquisition.  As no fiction is created regarding accrual of profits, section 45(3) fails to create charge on transfer of capital asset by the partner to the firm by way of capital contribution.  

One may compare the language used in section 45(3) with that used in section 45(6). Section 45(6) creates a fiction on arisal of capital gains on repurchase of units.  This fiction is conspicuously missing in section 45(3).   

The Hon’ble SC in M/s Govind Saran Ganga Saran v. CST & Ors. [TS-5014-SC-1985-O] on analyzing Article 265 noted the following four essential ingredients for a tax levy to withstand its validity:

1. character of the imposition

2. person on whom the levy is imposed

3. rate at which tax is imposed and

4. value to which the rate is applied for computing tax liability

If any of the aforementioned components is/are not clearly and definitely ascertainable, it would be fatal to the very validity of the levy.  In the case transfer of personal asset by partner to firm by way of capital, the first component is not clearly ascertainable.  What section 45(3) provides is only the measure of tax and not levy. Both are distinct components. One should not get confused with measure of tax for levy.  

Section 45 is a charging section.  It is well-settled that a charging section should be construed strictly and that if the words of the taxing statute fail, then so must the tax. The courts cannot, except rarely and in clear cases, help the draftsmen by a favourable construction. Reliance is placed on the following decisions:

1. T.O. v T. S. Devinatha Nadar [TS-5063-SC-1967-O]

2. CIT v. Provident Investment Co. Ltd [TS-5004-SC-1957-O]

3. V. Fernandez v. State of Kerala [1957] 8 STC 561 (SC)

4. CIT v. Elphinstone Spinning and Weaving Mills Co. Ltd. [TS-5020-SC-1960-O]

5. CIT v. Jalgaon Electric Supply Co. Ltd. [TS-5022-SC-1960-O] 

6. Banarsi Debi v. ITO, Calcutta [TS-5012-SC-1964-O] 

7. Gursahai Saigal v. CIT [TS-5032-SC-1962-O] 

8. CIT v. Ajax Products Ltd [TS-5-SC-1964-O]

Subject is not to be taxed unless the charging provision clearly imposes the obligation. Equally important is the rule of construction that if the words of a statute are precise and unambiguous, they must be accepted as declaring the express intentions of the legislature. There is no room for intendment while interpreting the charging provisions. Therefore, charging section is to be strictly construed. Section 45(3) should hence be strictly construed.  Moreover, section 45(3) is also a deeming provision. The principle of strict interpretation will have to be applied even on this count. The Hon’ble SC in Gopal and Sons (HUF) v. CIT [TS-5002-SC-2017-O] reiterated this principle.  The Hon’ble SC in CIT v. Mother India Refrigeration Industries (P.) Ltd. [TS-7-SC-1985-O] following the decision of the Hon’ble SC in Bengal Immunity Co. Ltd. v. State of Bihar [1955] 2 SCR 603 held that while construing the scope of legal fictions are created only for some definite purpose and these must be limited to that purpose and should not be extended beyond that legitimate field.  In the case of section 45(3), the very purpose for which the fiction is created is not achieved because of inadequate language used.  The principle of plain interpretation applies even for a provision creating a fiction. Therefore, the question of interpreting the provision in a manner which effectuates the purpose for which the fiction is sought to be created doesn’t arise if the plain reading of the provision doesn’t so warrant.

Section 2(24)(vi) is not sufficient to fill the vacuum.  On the other hand, section 2(24)(vi) treats only those capital gains which are chargeable as capital gains under section 45 as income.  The Hon’ble Bombay High Court in Cadell Weaving Mill Co. vs. CIT [TS-4-HC-2001(BOM)-O] [upheld in CIT vs. D.P. Sandu Bros. Chember (P) Ltd. [TS-5-SC-2005-O]] held that a capital receipt is not income under section 2(24) unless it is chargeable to tax as capital gains under Section 45. It is for this reason that under section 2(24)(vi) that the Legislature has expressly stated, inter alia, that income shall include any capital gains chargeable under section 45. 

As no fiction is created regarding accrual of profits, section 45(3) falls short to create charge on transfer of capital asset by the partner to the firm by way of capital contribution.  The lacuna which is present in sub-section(3) of section 45 is also present in sub-sections (1A), (2), (3), (4) , wherein legislature has sought to create charge in respect of those instances wherein there is no accrual of real profit or gain in commercial sense.  But the provisions are not adequate to create charge in respect of transactions dealt with by them.  Therefore, even in these cases one may argue that applying the above analysis, the charge fails.