Taxation of Assets upon Dissolution or Reconstitution of Firms/AOP in the hands of Firm/Specified Entity
Prior to the amendment by Finance Act, section 45(4) of the income tax act states the manner in which profit or gain will be taxable if transfer of capital assets by specified entity to specified person on account of dissolution or otherwise of specified entity takes place.
Specified entity means a firm or AOP or BOI.
Specified person means a person who is a member or partner of the specified entity in any previous year.
There were various loopholes in the section 45(4) prior to the amendment like the section does not cover reconstruction. When the partner takes capital asset on account of reconstruction it was not taxable in the hands of firm creating an opportunity to transfer asset without taxation.
There was a lack of clarity in the prior provision for example:
- a) Whether the provisions covers reconstruction of specified entity?
- b) Whether the specified entity is liable to tax if retiring partner/member takes money towards his share?
- c) Whether the revaluation of assets will be considered?
Amendment in section 45(4) was done along with introduction of a new section 9B.
Amended section 45(4) provides that where a specified person receives any money or capital asset or both from a specified entity, during the previous year, in connection with the reconstitution of such specified entity, then any profits or gains arising from receipt shall be taxable as capital gain in hands of specified entity.
In simple words, 45(4) covers the transfer of capital asset or money or both from Partnership firm, AOP or BOI on account of reconstruction. Any gain from such transfer will be deemed to be the income of firm or AOP or BOI. The scope of transfer has been increased via the amendments. Now, section 45(4) covers the transfer of money also.
Reconstruction covers the following:
a) one or more partners or members of such specified entity cease to be its partner or member; or
(b) one or more new partners or members are admitted in such specified entity in such circumstances that one or more of the partners or members of the specified entity, before the change, continue as partner(s) or member(s) after the change; or
(c) all the partners or members of such specified entity continue with a change in their respective share or in the shares of some of them.
It has been further deemed that this income shall be the income of the specified entity of the previous year in which such money or capital asset or both were received by the specified person.
A formula to calculate such profits and gains has also been provided in this sub-section.
Capital Gain = A +B – C
where ,
A= Value of money received by the specified person.
B= FMV of the capital assets received by the specified person.
C= Balance in the capital account of the partner at the time of reconstruction.
Where there is value of capital gain is negative, then profit and gain shall be deemed to be nil.
Furthermore, for computation of balance in capital account, an increase on account of revaluation on any asset, self generated goodwill or other self generated asset shall not be taken into account.
For example:
- Mr Ram, Mr Krishna and Mr Rohit are 3 partners in a firm “RKR“ having firm “FR”, having one third share each. Each partner has a capital balance of Rs. 2 Lakhs in the firm. Mr Ram retires and the firm has given him Rs 3 Lakhs,
In the given case Section 45(4) will be applicable and capital gain will be RS 1 lakh (3lakhs-2lakhs). Section 9B is not applicable in case of transefer of money.
2. Mr Ram, Mr Krishna and Mr Rohit are 3 partners in a firm “RKR“ having firm “FR”, having one third share each. Each partner has a capital balance of Rs. 2 Lakhs in the firm. There are 3 pieces of land in that firm and there is no other capital asset in that firm. Book value of the land is Rs. 2 lakh. Fair market value is Rs 5 lakhs. Mr Ram retires and firm has given him a piece of land and Rs 3 Lakhs.
In the above case in accordance with the provisions of section 9B of the Act, it would be deemed that the firm “RKR” has transferred one piece of land to the partner “Ram” at its fair market value of Rs.5 lakh. Let us assume that the land is acquired within 1 year. Now on account of the deeming provisions of section 9B of the Act, it is deemed that the firm “RKR” has transferred piece of land to partner Ram. Thus, an amount of Rs.5 lakh less Rs.2 lakh would be charged to tax in the hands of firm “RKR” under the head “Capital gains”. For partner Ram, the cost of acquisition of this land would be Rs.5 lakh. Hence, the amount of Rs. 3 lakh is charged to short term capital gains and let us assume that the tax is Rs. 90,000 lakh(assume no surcharge or cess and taxable @30% just for ease of calculation and illustration purposes).
This, net book profit after tax of Rs. 2.1 lakh (capital gains of Rs. 3 lakh less tax of Rs. 90,000) is to be credited in the capital account of each of the three partners, i.e. Rs. 70,000 each. Thus partner Ram’s capital account would increase to Rs. 2,70,000. This exercise is required to be carried out since section 9B of the Act mandates that it is to be deemed that the firm “RKR” has transferred the land to partner Ram and the short term capital gains of Rs. 3 Lakhs is chargeable to tax in the hands of the firm.
As against capital balance of Rs. 2,70,000 partner “Ram” has received Rs. 8 lakh (Rs. 3 lakh of money plus land of fair market value of Rs. 5 lakh). Thus Rs. 5,30,000 lakh is required to be charged to tax under subsection (4) of section 45 of the Act. This shall be in addition to an amount of Rs. 3 lakh charged to tax under section 9B of the Act.
Section 9B
This section mandates that whenever a specified person receives any capital asset or stock in trade or both from a specified entity, during the previous year, in connection with the dissolution or reconstitution of such specified entity, then it shall be deemed that the specified entity has transferred such capital asset or stock in trade or both, as the case may be, to the specified person and would be in the year in which such capital asset or stock in trade or both are received by the specified person.
Any profits and gains arising from such transfer is deemed to be the income of such specified entity of the previous year in which such capital asset or stock in trade or both were received by the specified person.
Further, it is chargeable to income-tax as income of such specified entity under the heads “Profits and gains of business or profession” or under the head “Capital gains”, in accordance with the provisions of this Act.
It is important to understand that when a partner retires from the firm and obtains money or property from the firm, there are two transactions.
- First one, with the partner and
- Second one, transfer of money or property by the firm.
The first transaction is dealt with in section 45(4) and the second in section 9B. Section 45(4) now provides for taxation if the partner receives the “capital assets” or “money“ at the time of reconstitutions whereas Section 9B covers situation where the partner receives capital assets or stock in trade at the time of reconstitutions or dissolution.
It is important to note that section 9B is applicable because stock in trade or capital asset is transferred and the gain is chargeable as Capital gain or Profit and gain from Business and Profession.
And section 45(4) is applicable because of the gain in transaction between partner and firm.
Section 9B provides for taxation of income of the firm on transfer of capital assets & stock in trade whereas Section 45(4) provides for taxation of income in the hands of the firm which is actually the income in the hands of the partner.
Note
Specified entity shall pay tax under section 45(4) is in addition to tax which is to be paid under section 9(B).
Key differences in section 45(4) before and after amendment :
BEFORE AMENDMEND | AFTER AMENDMEND |
Section 45(4) deals with transfer of asset by specified entity to specified person on account of dissolution. | Section 45(4) deals with transfer of asset by specified entity to specified person on account of reconstruction. For dissolution section 9B in introduced. |
It deals with transfer of capital asset only. | It covers transfer of capital asset or money or both. |
Key differences in section 9B and amended section 45(4):
- a) 9B covers reconstruction as well as dissolution while 45(4) covers only reconstruction
- b) Section 9B covers transfer of stock in trade or capital asset but 45(4) covers transfer of money or capital assets or both.
Examples:
- a) Mr Ram has received money of Rs. 10,000 on account of reconstruction of firm.
In the given case Mr Ram has received the money so it will not be covered in section 9B. Section 9B is attracted only when specified person receives stock in trade or capital assets.
But section 45(4) will be attracted as Mr Ram has received money on account of reconstruction.
- b) Mr Ram received Rs 10000 from partnership firm on account of Dissolution.
In this example neither section 45(4) nor section 9B is trigger as dissolution is not covered in 45(4) and as Mr Ram has received money so it is not covered in the section 9B also.