Tax Insights
from India Tax & Regulatory Services
www.pwc.in
Supreme Court upheld tax on
capital gains on transfer of interest in partnership asset, in hands of
partner
November 2, 2016
In brief
In a recent decision, the Supreme Court (SC) ruled that the taxpayer1 would be liable to pay tax on capital gains on consideration received towards transfer of their interest in the net assets of the partnership business. The SC also held that as consideration was fixed on the basis of valuation of assets, the sale was not a slump sale but an itemised sale.
In detail
Facts
The taxpayer1 was a partner in a partnership firm (firm).
The firm was last
reconstituted between 13 persons for a fixed duration of five years that could be extended by six months, vide partnership deed dated 30 June, 1982 (the deed).
The firm was dissolved on 06 December, 1987 by afflux of time; however, the affairs of the firm could not be wound up due to difference of opinion among erstwhile partners of the firm.
Two partners filed a winding up petition with the Karnataka High Court (HC) under Part X of the Companies Act 1956 allowing winding up of
1 Civil Appeal No. 1234 of 2012
unregistered companies, including partnership firms.
Clause 16 of the deed provided that in case of dissolution of the firm, the firm’s business, as a going concern, would vest in the partner or group of partners offering the highest bid at a sale held amongst the partners.
In view of the above, the HC passed an interim order on 05 November, 1988 and permitted a group of seven partners to continue the business till the completion of winding up proceedings.
The final order was passed on 14 June, 1991 for
winding up the firm’s affairs by selling its assets as going concern to such partner/(s) who made an offer of the highest price. Reserve price of INR 0.3 billion was fixed.
The successful bidder was also required to pay interest
@ 15% p.a. from 06
December, 1987 till the date of deposit of consideration.
The valuers had valued the firm’s land, building and machinery at INR 39 million and goodwill at INR 261 million. This was the basis for fixing the reserve price of INR 0.3 billion.
On 17 September, 1994, the HC passed an order accepting a bid of INR 0.92 billion made by three partners as association of person (AOP-3). AOP-3 deposited the bid amount and were handed over the business on 7 January 1995.
Some time in 1993, one of the partners had assigned his interest in the firm to 7 other partners. After this
assignment, the firm
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consisted of 12 partners.
Considering that 3 partners were acquiring the business, the remaining 9 partners were referred to as outgoing
partners. The taxpayer was one of the outgoing partners.
AOP-3 deposited the bid amount in respect of outgoing partners after adjusting the amount standing to the accounts of such partners.
AOP-3 did not deposit the bid amount in relation to its 3 members, who were erstwhile partners of the firm.
AOP-3 succeeded the firm’s business and constituted a new firm in the same name.
The return of income of the taxpayer for the assessment year 1995-96 did not include any amount as capital gain in relation to the sale of the firm’s business.
The Tax Officer (TO)
computed capital gains on sale of the firm’s business, and held that gain proportionate to the taxpayer’s share in the firm was taxable in the taxpayer’s hands as capital gain on transfer of interest in the firm’s assets.
The Commissioner of Income- tax (Appeals), Bangalore, the Income-tax Appellate
Tribunal (Tribunal) and the Karnataka HC sustained the TO’s order.
Issue before the Supreme Court
1. Was the sale of the firm’s business a “slump sale”?
2. Was the capital gains arising on sale of the firm’s assets assessable in the outgoing partners’ hands? Was the transfer of business to AOP-3 a mere relinquishment of interest in the firm held by the outgoing partners?
Taxpayer’s contentions
The firm’s business was transferred on a “going concern” basis. It was a case of
“slump sale,” and the consideration was a capital receipt not liable to tax as capital gain. Capital gain on
“slump sale” was not liable to tax till 01 April, 2000, when section 50B providing
mechanism for computation of capital gain on “slump sale” was introduced in the Income-tax Act, 1961 (Act).
Consideration received on transfer of goodwill was capital receipt not liable to tax prior to amendment to section 55(2) with effect from 1 April 2002.
If at all taxable, the firm was liable to tax on the sale of the firm’s business, and not the taxpayer.
The Tribunal’s decision in the case of one of the erstwhile partners, holding that there was extinguishment of interest resulting in transfer, but as it was in course of retirement, it did not result in any capital gain, should have been applied even in the taxpayer’s case.
The assets were in the firm’s name, and the outgoing partners could not have sold them.
Under section 36 of the Partnership Act, 1934, the partner only had the right of general lien, and since there was no cost of acquisition in respect of such right, there could have been no capital gain.
Revenue’s contentions
This was not a case of “slump sale” but one of itemised sale.
The consideration of INR 0.92 billion consisted of sale of land amounting to INR 174.8 million, depreciable assets amounting to INR 40.5 million
and a balance of INR 704.7 million of goodwill.
Accordingly, gain on depreciable asset was short- term capital gain, and gain on other assets was long-term capital gain.
The outgoing partners were paid consideration for surrendering their interest in the firm, which resulted in extinguishment of their interest, and that involved transfer. The outgoing partners had given an undertaking to AOP-3 that they would not interfere with AOP-3 carrying on the firm’s business. Thus, the partners were liable to tax on capital gain arising on such transfer.
One erstwhile partner had assigned his interest to 7 partners, and was taxed on such transfer. The case at hand was the same as that assignment.
Supreme Court Ruling Issue -1:
The assets of the firm that were sold, were a capital asset within the meaning of section 2(14) of the Act. Once held to be a capital asset, gain therefrom had to be treated as capital gain within the meaning of section 45 of the Act.
Separate valuation for land, building, machinery and goodwill were obtained to enable the HC to fix the reserve price. Such valuation had to be treated as that of the firm.
Even if the assets were sold as a going concern, the reserve price of INR 0.3 billion was derived after considering the value of each asset of the firm.
Section 2(42C) of the Act, defined “slump sale” as the transfer of one or more undertakings as a result of the sale for a lump-sum
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consideration, without values being assigned to the
individual assets and liabilities in such sales.
The sale in question could be treated as slump sale only if no value had been assigned to the individual assets and liabilities in such sale. In this case, value assigned to individual assets, and even the liabilities, had been taken care of when the sale proceeds were apportioned amongst outgoing partners.
Therefore, this was not a case of “slump sale.”
Issue – 2:
On the firm’s dissolution, partners became entitled to a proportionate share in the firm’s assets, and the partners together could be compared to tenants-in-common.
The TO’s order holding that the
erstwhile partners were liable to pay tax on capital gains on the amount received towards value of their share in the firm’s net assets was justified.
Accordingly, the HC decision that the amount received by the taxpayer towards the value of net assets of the firm would attract capital gain, was upheld.
The takeaways
The SC has reiterated that a sale of assets can be treated as slump sale only if no value had been assigned to individual assets and liabilities. If values are assigned to individual assets and liabilities, the same cannot be characterised as a slump sale.
The SC also upheld the principle that extinguishment/ transfer of interest in partnership assets for a consideration results in transfer of capital asset liable to tax.
However, the court has not dealt with the issue of cost of
acquisition of such right. The taxpayer had raised this issue before the Tribunal, and claimed that in absence of such cost, it should not be liable to tax. The Tribunal had held that a partner acquired right in the firm’s assets the moment he/ she becomes a partner therein. Further, the Tribunal had held that difficulty in ascertaining cost should be distinguished from impossibility of envisaging cost of an asset, and had held that in this case, the argument that there was no cost of acquisition fails. As the SC has not yet dealt with this issue, the same may still be subject matter of further debate.
Let’s talk
For a deeper discussion of how this issue might affect your business, please contact your local PwC advisor.
Tax Insights
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This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PwCPL, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. Without prior permission of PwCPL, this publication may not be quoted in whole or in part or otherwise referred to in any documents.
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