Tax Insights
from India Tax & Regulatory Services
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Tribunal holds that amount received by a retiring partner above his capital account is chargeable as capital gains
May 20, 2019
In brief
Recently,1 the Bangalore bench of Income-tax Appellate Tribunal (Tribunal) held that the retiring partner is liable to capital gains tax being the excess payment received over and above the sum to the credit of her capital account at the time of retirement. However, the Tribunal modified the computation by treating the goodwill, which was recorded post 31 March 2007, as a part of the partner’s capital account.
In detail
Facts
Pursuant to a Memorandum of Understanding (MOU) signed by the partners of a partnership firm on 8 June 2007, it was agreed that the taxpayer would retire from the firm with effect from 1 April 2007, and shall be paid a sum on retirement.
The taxpayer gave up all her rights as a partner of the firm and in its assets, and further, she was not liable to pay any of firm’s liabilities.
The balance to the credit of taxpayer’s capital account as on 31 March 2007 was INR 27.78m, which included INR 6.25m credited towards
1 ITA No. 1700/Bang/2016 [TS -257-ITAT-2019(Bang)]
2 CIT v. A N Naik Associates and Anr. [2004] 265 ITR 346 (Bom)
revaluation of land and building in past.
On 9 June 2007 the taxpayer was paid INR 3.83m towards goodwill credited in her capital account.
The taxpayer had invested INR 5m in specified bonds and claimed part exemption under section 54EC of the Income-tax Act, 1961 (Act).
The Tax Officer (TO) charged the difference between the actual payment of INR 33.95m and balance in the capital account of INR 27.78m i.e., INR 6.16m as capital gains.
The Commissioner of Income-tax (Appeals) upheld the TO’s order by placing reliance on the Bombay High Court’s (HC)
decision in the case of A. N Naik.2
Issues before the Tribunal
Whether the TO was justified in charging tax under the head capital gain on amount received on retirement?
Whether there was a transfer of capital asset by the retiring partner in favour of the firm and its continuing partners to attract a charge under section 45 of the Act?
Taxpayer’s contentions
Total amount received on retirement consisted of credit balance in capital account and the balance was goodwill.
Relying on the decision of the Supreme Court (SC) in
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the case of Mohanbhai Pamabhai3 and Karnataka HC in the case of Dynamic Enterprises,4 the taxpayer contended that the amount received by a partner on his retirement from the
partnership firm is towards his share in the firm and not towards transfer of his interest in the firm to the other partners.
Thus, there was no transfer of interest in the assets of the partnership firm in terms of the definition of “transfer”
under section 2(47) of the Act. Accordingly, there was no capital gain that could be brought to tax in the hands of the taxpayer.
Revenue’s contentions
The Revenue contended that amount received from the erstwhile firm was goodwill, which attracts the liability of capital gains under section 45 of the Act. The amount paid to the retiring partner towards goodwill would represent the amount paid for the taxpayer giving up her right in the existing goodwill of the firm.
Further, the taxpayer had also extinguished her right to claim any share in the fixed assets of the partnership firm.
The MOU provided for the assignment of the taxpayer’s share in the partnership to the continuing partners.
Thus, there was a “transfer”
by the taxpayer within the meaning of section 2(47) of the Act and the liability to capital gains existed.
3 ACIT v. Mohanbhai Pamabhai [1987]
165 ITR 166 (SC)
Tribunal’s ruling
The Tribunal held that only the credit to the capital account of the partner has to be seen and the fact that there was revaluation of the assets of the firm, and the resultant, enhancement in the capital account of the firm was not relevant.
The question of taxability of an amount received by a partner on retirement from the firm would depend upon the mode in which retirement is affected.
When there is a
reconstitution of the firm, the retiring partner is paid:
a. On the basis of amount in his/ her capital account;
b. On the basis of amount in his/ her capital account and on the basis of amount over and above the sum in his/ her capital account; or
c. A lump-sum consideration with no reference to the amount in his/ her capital account; in consideration for relinquishing all his rights and interest in the partnership firm as partner.
In situation (a), there can be no incidence of tax in view of SC’s decision in the case of Mohanbhai Pamabhai3.
For situation (b) and (c) [which applies in the present case], there is conflict of opinion amongst courts on whether there would be incidence of tax.
4 CIT v. Dynamic Enterprises [2013] 359 ITR 83 (Karnataka)
In Sudhakar M. Shetty5 case it was held that the act of relinquishment of rights as a partner in the firm would amount to transfer of capital asset and the capital gains shall be the sum paid over and above the sum standing to the credit in the capital account. The facts of the aforesaid case are identical to the facts of the present case and therefore, excess amount should be chargeable to capital gains tax.
The book entries for goodwill were only for INR 3.84m, which was recorded in the taxpayer’s capital account, as against INR 6.16m claimed by the taxpayer.
Thus, capital gains was recomputed by reducing capital account balance as on 31 March 2007, and further credit of INR 3.84m for goodwill and tax on balance capital gains of INR 2.32m was upheld.
However, no capital gains were chargeable to tax since the taxpayer had invested a sum of INR 5m in specified bonds.
The takeaways
While the taxability in the hands of the partners upon retirement is an issue prone to litigations, this decision adds up to the conflicting judgements on this issue.
Let’s talk
For a deeper discussion of how this issue might affect your business, please contact your local PwC advisor
5 Sudhakar M. Shetty v. ACIT [2011] 130 ITD 197 (Mumbai)
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