Amendment to the Finance Bill, 2021

The Lok Sabha on 23 March 2021 passed the Finance Bill, 2021 with certain amendments including changes that would concern transfers between a firm and its partners.

The Finance Bill, 2021 (Bill) was passed by the Lok Sabha on 23 March 2021 with amendments to the original Bill that was tabled before the Lok Sabha on 1 February 2021 (Original Bill). Subsequently, the Bill was affirmed by the Rajya Sabha on 24 March 2021, without any further amendments.

Provisions for taxing firms with respect to receipt of cash or specified assets by partners in connection with dissolution or reconstitution, as proposed by the Bill, are now revamped and streamlined. The extant provisions of the tax laws in India provide for capital gains taxation in the hands of the firm or association or person (AOP) or body of individuals (BOI) commonly and collectively referred to as specified entity on distribution of capital asset to partners on dissolution or otherwise.

Income on receipt of capital asset or stock in trade by a partner from a firm

New Section 9B states that if a partner receives any capital asset or stock-in-trade (SIT) or both during the tax year from a specified entity in connection with the dissolution or reconstitution of such specified entity

• Specified entity shall be deemed to have transferred such capital asset or SIT or both to the partner during such tax year;
• Any profits and gains arising from such deemed transfer, shall be deemed to be income of such specified entity, chargeable to income-tax as capital gains or business income; and for this purpose, Fair Market Value  of capital asset or SIT or both on the date of such receipt by the partner will be deemed to be full value of consideration received or accruing as a result of such deemed transfer.

If a partner in a firm receives any capital asset or stock-in-trade or both during the previous year from a firm in connection with the dissolution or reconstitution of such firm, then the firm will be deemed to have transferred these capital assets or stock-in-trade or both, to the partner in the year in which it was received by that partner.

Any profits and gains arising from such deemed transfer of capital asset or stock in trade or both, by the firm will be deemed to be the income of the firm of the previous year, in which stock or capital asset were received by the partner and chargeable to income-tax under the head business or professional  or capital gains .

Furthermore, the fair market value of the capital asset or stock on the date of its receipt by the partner shall be deemed to be the full value of consideration while computing profit and gains arising from deemed transfer of such stock or capital asset by the firm.

Reconstitution of Specified Entity

• One or more of its partners or members ceases to be partners or members;
• One or more new partners or members are admitted. However, at least one existing partner or member should continue to be partner or member of the specified entity after admission of the new partner(s) or member(s); or
• All the partners or members continue with change in their respective share or in share of some of them.

Further, the Central Board of Direct Taxation (CBDT) is empowered to issue guidelines, with prior approval of the Central Government, for removing difficulties arising in giving effect to the provisions of this section. Every such guideline shall be laid before each house of parliament and shall be binding on the Income-tax authorities and assesses.

The newly added Section 9B deals with the following

Distribution of stock or capital asset by a firm to its partner is deemed as transfer

This provision creates a deeming fiction that the distribution of stock or capital asset by a firm to its partner is a transfer. This is done to overrule various judicial rulings, which held that the distribution, division or allotment of assets by a partnership firm upon dissolution or reconstitution is nothing but a mutual adjustment of rights between the partners.

The Supreme Court, in the case of Malabar Fisheries Co. v. CIT, had held that a partnership firm, under the Indian Partnership Act, 1932, is not a distinct legal entity, apart from the partners constituting it. The firm, as such, has no separate rights of its own in the partnership assets and when one talks of the  firm’s property or firm’s  assets, all that is meant is property or assets in which all partners have a joint or common interest. If that be the position, it is difficult to accord the contention that upon dissolution the firm’s  rights in the partnership assets are extinguished. The firm, as such, has no separate rights of its own in the partnership assets but it is the partners who own jointly, in common its assets. Therefore, the consequence of the distribution, division or allotment of assets to the partnership, which flows upon dissolution after discharge of liabilities, is nothing but a mutual adjustment of rights between the partners and there is no question of any extinguishment of the firm’s  rights in the partnership assets amounting to a transfer of assets within the meaning of Section 2(47).

How to compute the gains arising from deemed transfer of stock-in-trade?

Sub-section (2) of Section 9B provides that any profit and gains arising from deemed transfer of stock-in-trade shall be deemed to be income of the partner of the year in which such stock is received by the partner and, accordingly, it shall be charged to tax under the head Profit and gains from business or profession.

For such computation, it provides that the fair market value of the stock on the date of its receipt by the partner shall be deemed to be the full value of consideration while computing profit and gains arising from deemed transfer of such stock by the firm. The income arising from the transfer of stock shall be taxable as business income under Section 28. In simple words, the fair market value of stock transferred to the partner shall be recorded as sale by the firm as the same shall form part of the business of the firm.

Substitution of existing Section 45(4)

If a partner receives, during the tax year, any money or capital asset or both from a specified entity in connection with the reconstitution of such specified entity, capital gains taxation in the hands of the specified entity, shall be determined in accordance with following formula:

A = B + C +  D,

where A = capital gains chargeable as income of specified entity, B = value of any money on the date of such receipt, C = FMV of capital asset on the date of such receipt, and D = partner’s  capital account balance (represented in any manner) in the books of accounts of the specified entity at the time of its reconstitution (without taking into account the increase due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset)

It is clear that when a capital asset is received by a partner from a specified entity in connection with the reconstitution of specified entity, Section 45(4) would operate in addition to Section 9B and taxation under Section 9B shall be worked out independently. If any difficulty arises in giving effect to these provisions, the CBDT, may with the approval of the Central Government, issue guidelines for the purposes of removing the difficulty. Every such guideline, as soon as may be after it is issued, shall be laid before each house of Parliament and shall be binding on the tax authority and on the taxpayers.

Interplay between section 9B and section 45(4)

Section 9B effectively deals with income arising from receipt of capital asset or stock in trade by partners or members upon transfer or extinguishment of their right in the firm or AOP or BOI, whereas Section 45(4) deals with income arising in the hands of the firm or AOP or BOI upon transfer of its property to the partner or member.

The provision of Section 9B of the Act comes into play in case of dissolution and reconstitution of the entity whereas the provision of Section 45(4) applies only to reconstitution of the firm and thus, where the firm or AOP or BOI has been dissolved, one needs to look only at the provision of Section 9B of the ITA.