No Capital Gain Tax on amount received by Partner on reduction in Profit Sharing Ratio : ITAT

Bhupendra Shah for the Appellant. Manoj Kumar for the Respondent.

ORDER

Manoj Kumar Aggarwal, Accountant Member – Aforesaid appeals by assessee for Assessment Years [in short referred to as ‘AY’] 2010-11 and 2012-13 contest separate orders of Ld. first appellate authority on certain grounds of appeal. Since identical issues are involved in both the appeals, the appeals are being disposed-off by way of this common order for the sake of convenience & brevity.

ITA No.7189/Mum/2014, AY 2010-11

2.1 The appeal for AY 2010-11 contest the order of Ld. Commissioner of Income-Tax (Appeals)-38, Mumbai, [in short referred to as ‘CIT(A)’], Appeal No. CIT(A)-38/IT-239/2013-14 order dated 29/09/2014 on following grounds of appeal: –

As evident, the assessee is contesting the chargeability of Capital Gains of Rs.400 Lacs received by it on account of reduction in share in a partnership firm namely M/s Mahakosh Property Developers.

2.2 We have carefully heard the rival submissions and perused relevant material on record including documents placed in the paper-book. We have also deliberated on various judicial pronouncements as relied upon by both the representatives. The written submissions filed subsequent to the hearing of the case has also been considered. Our adjudication to the subject matter of appeal would be as given in succeeding paragraphs. The Ld.AR submitted that the factual matrix is squarely covered in assessee’s favor by certain binding judicial pronouncements.

2.3 Facts on record would reveal that the assessee being resident corporate assessee stated to be engaged in manufacturing & processing of milk products and also in the business of wind power generation, mining and trading in commodities was assessed for year under consideration u/s 143(3) on 22/03/2013 wherein the income of the assessee was determined at Rs.1419.55 Lacs after certain additions and disallowances as against returned income of Rs.1019.10 Lacs e-filed by the assessee on 13/10/2010. The Capital Gains of Rs.400 Lacs as brought to tax by Ld.AO is the sole subject matter of present appeal before us.

2.4 During assessment proceedings, it transpired that the assessee was a partner of 30% in a partnership firm namely M/s Mahakosh Property Developers (in short ‘firm’). During the year, the assessee received a sum of Rs.400 Lacs on account of surrender of 5% share of profit from 30% to 25% and reduced the said income from its computation of income by submitting that the firm was reconstituted and right was created in favor of existing partners. The change in profit sharing ratio before the constitution of the firm and after the constitution of the firm was as follows: –

It is evident that the assessee’ share was reduced from 30% to 25% which was distributed amongst the other existing partners. One partner namely Ms. Neha Shahra made an exit from the firm. Accordingly, the existing partners whose share was increased, paid compensation of Rs.400 Lacs to the assessee in the following manner: –

The assessee, relied upon the decision of Hon’ble Madras High Court in A.K.Sharfuddin v. CIT (1960 39 ITR 333) for the proposition that compensation received by a partner from another partner for relinquishing rights in the partnership firm would be capital receipt and there would be no transfer of asset within the meaning of Sec.45(4) of the Act. Reliance was placed on other decisions also to submit that the provision of S.28(iv) and S.41(2) shall have no application to such receipts.

2.5 However, Ld. AO opined that a business builds some reputation after it is continued for some time. It is valuable asset and its value depends on personal reputation of the owner / management/ peculiar advantage a firm has. When the partner retires, the accounts of the firm are made up by valuing the assets on notional sale and deducting therefrom liabilities & notional winding up expenses and the share of the partner would be worked out in this manner. This right was created the moment a partner joins a firm and the value of the right would be determined at the time of retirement. At the time of reconstitution of the firm, one of the methods to compensate for the goodwill would be that new incoming partner agrees to make payment directly to the old partners without involving the firm. The said payment was nothing but consideration for intangible asset i.e. the loss of share of partner in the goodwill of the firm. Therefore, this amount was to be charged as capital gains in terms of decision of Ahmedabad Tribunal in Samir Suryakant Sheth v. ACIT (ITA No.2919 & 3092/Ahd/2002) and the decision of Mumbai Tribunal in Shri Sudhakar Shetty (2011 130 ITD 197). Finally, the said amount was brought to tax as capital gains u/s 45(1).

3.1 Before Ld.CIT(A), the assessee reiterated that the rights of the existing partner was reduced in the firm and the right was created in favor of the existing partner of the firm but the ownership of the property did not change even with the change in the constitution of the firm. The assessee relied upon plethora of decision to submit that in terms of Sec. 45(4), profits on distribution of capital asset on the dissolution of the firm would be taxable in the hands of the firm only.

3.2 However, the said submissions could not convince Ld. CIT(A) who confirmed the stand of Ld.AO by observing as under: –

6.1 The facts of the case are that the appellant company is one of the seven partners in a firm M/s Mahakosh Property Developers. During the year, there was a change in the constitution of the firm while the appellant M/s Anik Industries Ltd. reduced the share from 30 to 25% and the other partners increased their share as mentioned in the written submissions of the appellant. The rights of the existing partners M/s Anik Industries i.e. the appellant company were reduced and the rights were created in favour of the other existing partners of the firm. The other partners have paid Rs 4 crore to the appellant for relinquishing its rights in the partnership of its share being reduced from 30% to 25%. The Assessing Officer brought to tax Rs 4 crore as capital gain u/s 45(1) of the Act holding that the sum of Rs 4 crore was received by the appellant company on account of relinquishment of its right in the shares to the extent of 5%.The appellant company during the course of appeal proceedings contended that such receipt is neither revenue receipt nor taxable under the head capital gains. The submissions of the appellant are not acceptable. Section 2(47) of the Act defines the term “transfer”. Relinquishment of the asset and the extinguishment of any rights therein are included as ‘transfer’ under the provisions of section 2(47) of the Act. Therefore, relinquishment or the extinguishment of the appellant’s right over the share of profit in the firm from 30% to 25% and the consideration of a sum of Rs.4 crore received on account of same have to be necessarily treated as consideration received for transfer of capital asset. Accordingly, the addition of Rs 4 crore made by the AO u/s 45(1) of the Act is hereby confirmed.

Aggrieved as aforesaid the assessee is in further appeal before us. Our adjudication to the issue would be as given in succeeding paragraphs.

4. At the outset, upon careful consideration of factual matrix, we find that the provisions of S.45(4) shall have no application since it was not a case of distribution of capital assets on the dissolution of firm rather it was a case of reduction in share of one partner which was taken over by existing partners. The firm has continued its business with existing partners including the assessee.

5. Proceeding further, the perusal of assessee’s as well as firm’s financial statements, as placed on record, would reveal that the assessee has opening balance of Rs.2321.60 Lacs in current account held with partnership firm namely M/s Mahakosh Property Developers. An amount of Rs.400 Lacs has been credited in the assessee’s account on 31/03/2010 towards reduction of profit-sharing ratio and after adjusting the same, the closing balance in the current account is reflected as Rs.1600 Lacs. The perusal of the same would reveal that whatever adjustments have been made on account of reconstitution of firm, the same has been routed through respective partner’s current account held with the firm. The current account of the assessee has been credited with corresponding debit to the other partners’ current accounts whose profit-sharing ratio was improved. It is further noted that the firm was constituted vide deed of partnership dated 14/12/2004. There is reconstitution of the firm vide reconstitution of partnership deed dated 31/03/2010 wherein the assessee has released 5% of his share in the partnership firm which devolve upon in favor of 5 existing partners to the to the extent of 1% each against consideration of Rs.80 Lacs each and accordingly, the assessee’s account has been credited with Rs.400 Lacs. The business of the firm continues with the remaining partners including the assessee as per new profit-sharing ratio. Thus, it is neither a case of dissolution of firm nor payment on retirement of the partner of the firm. Rather it is a case wherein there is an adjustment of profit-sharing ratio inter-se between the existing partners which was routed through partners’ current account held with the firm. The assessee continue to remain partner of the firm and the business of the firm also continues. 6.1 There is no dispute on the factual matrix. The only issue that fall for our consideration is that whether or not the compensation received by an existing partner from other partners for reduction in profit sharing ratio would be chargeable to tax as Capital Gain u/s 45(1)? As per the provisions of S.45(1), any profits or gains arising from the transfer of a capital asset effected in the previous year shall be chargeable to Capital Gains Tax. We find that the answer to aforesaid question lies in the decision of Hon’ble Karnataka High Court in CIT v. P.N.Panjawani (356 ITR 676) wherein this question was elaborately examined by the Hon’ble High Court in the light of various judicial precedents. The relevant discussion was as under: –

5. These appeals were admitted to consider the following substantial question of law

“Whether the appellate authorities were right in holding that the admission of the new partners and assignment of right in the firm to the new partners out of the rights of the assessee for consideration does not amount to transfer in the hands of assessee under Sec. 2(47) of the Act and consequently not liable to tax under Sec.45 of the Act?”

6. The Assessing Authority relying on the judgment of the Apex Court in the case of Malbar Fisheries Co., (supra) has proceeded on the assumption that the partnership firm has no legal existence. The partnership property will vest in all the partners and in that sense, every partner has an interest in the property of the partnership. The partnership firm under the Indian Partnership Act, 1932 is not a distinct legal entity apart from the partners constituting it and equally in law, the firm as such has no separate rights on its own in the partnership assets and when one talks of the firm’s property or firm’s assets all that is meant is properties or assets in which all the partners have a joint or common interest. Therefore, he was of the view that the ownership of the properties vest in all the partners of the firm and no partner of a firm has got any independent interest in respect of the assets of the firm. But at the same time, the firm as such has no will of its own although, it is an assessable entity under the provisions of the Act. Therefore, he was of the view that when the existing three partners having a share of 1/3rd each in the assets of the firm have relinquished their 50% share i.e., from 1/3rd to 16.67% in favour of the four new partners on account of which each of the three partners were able to gain a sum of Rs. 1,16,66,666/- each. By the said relinquishment of their share by 50% it has resulted in a capital gain accrued even though the firm continued after its reconstitution. Further, he held that the capital gains arising in the hands of the partners of the erstwhile firm computed on the basis of reduction in their respective shares consequent to the admission of the new partners has to be brought to tax by holding that the reconstitution of the firm had the effect or relinquishment of the part of the rights of the old partners. He further relied on the judgment in McDowell & Co. Ltd. v. CTO [1985] 22 Taxman 11 (SC) wherein it was held that tax planning may be legitimate, provided it is within the frame work of law. Colourable devices cannot be a part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods. It is the obligation of every citizen to pay taxes honestly, without resorting to subterfuges. Therefore according to him, the assessee being one of the partners of the erstwhile firm having derived a gain in the process of revaluation and reconstitution of the firm is liable to capital gain tax to the extent of relinquishment of his rights in the assets of the erstwhile firm in favour of the four partners of the reconstituted firm. It is the correctness of this finding, which is before us.

7. The assessee are sought to be taxed under Section 45(1) of the Act on the ground that there is a transfer. The word ‘transfer’ has been defined in Section 2(47) of the Act as under- “transfer”, in relation to a capital asset, includes, –

Explanation. – For the purpose of sub-clauses (v) and (vi), “immovable property” shall have the same meaning as in clause (d) of section 269UA;]”

8. Section 14 of the Indian Partnership Act, 1932 deals with the property of the firm, which reads as under: –

“14. The property of the firm – Subject to contract between the partners, the property of the firm includes all property and rights and interests in property originally brought into the stock of the firm, or acquired, by purchase or otherwise, by or for the firm, or for the purposes and in the course of the business of the firm, and includes also the goodwill of the business.

Unless the contrary intention appears, property and rights and interest in property acquired with money belonging to the firm are deemed to have been acquired for the firm.”

9. The Apex Court in the case of Addanki Narayanappa v. Bhaskara Krishnappa AIR 1966 SC 1300 dealing with the concept of partnership held as under:- “The Whole concept of partnership is to embark upon a joint venture and for that purpose to bring in as capital money or even property including immovable property. Once that is done, whatever is brought in would cease to be the exclusive property of the person who brought it in. It would be the trading asset of the partnership in which all the partners would have interest in proportion to their share. The person who brought it in would, therefore, not be able to claim or exercise any exclusive right over any property which he has brought in, much less over any other partnership property. He would not be able to exercise his right even to the extent of his share in the partnership. His right during the subsistence of the partnership is to get his share of profits from time to time as may be agreed upon among the partners and after the dissolution of the partnership or with his retirement from the partnership, of the value of his share in the net partnership assets as on the date of dissolution or retirement after a deduction of liabilities and other prior charges.”

10. The Supreme Court in the case of Malabar Fisheries Co. (supra) explaining the position of a partnership under the Partnership Act as well as Income Tax Act held as under: –

“A Partnership Firm under the Indian Partnership Act, 1932, is not a distinct legal entity apart from the partners constituting it and equally in law the Firm as such has no separate rights of its own in the Partnership Assets and when one talks of firm’s property or the firm’s assets all that is meant is property or assets in which all partners have a joint or common interest. It cannot, therefore, be said that, upon dissolution, the firm’s rights in the partnership assets are extinguished. It is the partners who own jointly or in common the assets of the partnership and, therefore, the consequence of the distribution, division or allotment of assets to the partners which flows upon dissolution after discharge of liabilities is nothing but a mutual adjustment of rights between 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 sec.2(47) of the IT Act, 1961 There is no transfer of assets involved even in the sense of any extinguishment of the firm’s rights in the partnership assets when distribution takes place upon dissolution.

In order to attract S.34(3)(b) it is necessary that the sale or transfer of asset must be by the assessee to a person. Dissolution of a firm must, in point of time, be anterior to the actual distribution, division or allotment of the assets that takes place after making accounts and discharging the debts and liabilities due by the Firm. Upon dissolution the firm ceases to exist; then follows the making up of accounts, then the discharge of debts and liabilities and thereupon distribution, division or allotment of assets takes place inter se between the erstwhile partners by way of mutual adjustment of rights between them. The distribution, division, or allotment of assets of the erstwhile partners, it not done by the dissolved firm.”

11. The Apex Court in the case of Sunil Siddharthbhai v. CIT [1985] 156 ITR 509 /23

Taxman 14W at pages 518, 519, 520 and 522 held as under:-”When a partner brings in his personal asset into a partnership firm as his contribution to its capital, an asset which originally was subject to the entire ownership of the partner becomes now subject to the rights of other partners in it. It is not an interest which can be evaluated immediately. It is an interest which is subject to the operation of future transactions of the partnership, and it may diminish in value depending on accumulating liabilities and losses with a fall in the prosperity of the partnership firm. The evaluation of a partner’s interest takes place only when there is a dissolution of the firm or upon his retirement from it. It has some times been said, and we think erroneously, that the right of a partner to a share in the assets of the partnership firm arises upon dissolution of the firm or upon the partner retiring from the firm. We think it necessary to state that what is envisaged here is merely the right to realise the interest and receive its value. What is realised is the interest, which the partner enjoys in the assets during the subsistence of the partnership firm by virtue of his status as a partner and in accordance with the terms of the partnership agreement.

What the partner gets upon dissolution or upon retirement is the realisation of a pre-existing right or interest. It is nothing strange in the law that a right or interest should exist in praesenti but its realisation or exercise should be postponed. Therefore, what was the exclusive interest of a partner in his personal asset is, upon its introduction into the partnership firm as his share to the partnership capital, transformed into an interest shared with the other partners in that asset. Qua that asset, there is a shared interest. During the subsistence of the partnership, the value of the interest of each partner qua that asset cannot be isolated or carved out from the value of the partner’s interest in the totality of the partnership assets. And in regard to the latter, the value will be represented by his share in the net assets on the dissolution of the firm or upon the partner’s retirement.

What is the profit or gain which can be said to accrue or arise to the assessee when he makes over his personal asset to the partnership firm as his contribution to its capital? The consideration, as we have observed, is the right of a partner during the subsistence of the partnership to get his share of profits from time to time and after the dissolution of the partnership or with his retirement from the partnership to receive the value of the share in the net partnership assets as on the date of dissolution or retirement after a deduction of liabilities and prior charges. When his personal asset merges into the capital of the partnership firm a corresponding credit entry is made in the partner’s capital account in the books of the partnership firm, but that entry is made merely for the purpose of adjusting the rights of the partners inter se when the partnership is dissolved or the partner retires. It evidences no debt due by the firm to the partner. Indeed, the capital represented by the notional entry to the credit of the partner’s account may be completely wiped out by losses which may be subsequently incurred by the firm, even in the very accounting year in which the capital account is credited. 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 business man would understand as real income or gain.”

12. From the aforesaid judgments, it is clear that under the provisions of the Indian Partnership Act, 1932, the firm is not recognised as a legal entity. However, the Income Tax Act recognises the firm as a distinct legally assessable entity apart from its partners. This is clear from Sections 45(1), (3) and (4), of the Income Tax Act which reads as under :

“45. [(1)] Any profits or gains arising from the transfer of a capital asset effected in the previous year shall, save as otherwise provided in sections [***] [54, [54B, [***], [54D, [54E, [54EA, 54EB,] 54F [, 54G and 54H]]]]], be chargeable to income tax under the head “Capital gains”, and shall be deemed to be the income of the previous year in which the transfer took place.

[(1A) Notwithstanding anything contained in sub-section (1), where any person receives at any time during any previous year any money or other assets under an insurance from an insurer on account of damage to, or destruction of, any capital asset, as a result of-

then, any profits or gains arising from receipt of such money or other assets shall be chargeable to income-tax under the head “Capital gains” and shall be deemed to be the income of such person of the previous year in which such money or other asset was received and for the purposes of section 48, value of any money or the fair market value of other assets on the date of such receipt shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of such capital asset.

Explanation,- For the purposes of this sub-section, the expression “insurer” shall have the meaning assigned to it in clause (9) of section 2 of the Insurance Act, 1938 (4 of 1938)]

[(3) 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.

(4) The profits or gains arising from the transfer of a capital asset by way of distribution of capital assets on the dissolution of a firm or other association of persons or body of individuals (not being a company or a co-operative society) or otherwise, shall be chargeable to tax as the income of the firm, association or body, of the previous year in which the said transfer takes place and, for the purposes of section 48, the fair market value of the asset on the date of such transfer shall be deemed to be the full value of the consideration received or accruing as result of the transfer]”

13. Section 2(31) of the Income Tax Act defines ‘person’ as follows:- (31) ” person” includes-

[Explanation – For the purposes of this clause, an association of persons or a body of individuals or a local authority or an artificial juridical person shall be deemed to be a person, whether or not such person or body or authority or juridical person was formed or established or incorporated with the object of deriving income, profits or gains;]”

14. Therefore, from the aforesaid provisions, it is clear that in the context of the Income Tax Act, the identity of the firm as well as that of the partners for taxability of income are separate and distinct. The firm is a separate taxable entity liable to pay tax on income arising or accruing to it because of its own distinct set of income earning activities and factors. Similarly, in the case of individual partners also. If there is a transfer effected by a firm of capital assets i.e., property held by the firm, the capital gain tax arises in the hands of the firm and not in the hands of the partners and vice versa.

15. Section 45(3) of the Act, which was inserted by the Finance Act, 1987, which came into effect from 01.04.1988, deals with a person who transfers a capital assets to a firm as a capital contribution and becomes a partner of a firm. The income so derived is liable to be taxed at the hands of such member or partner. Whereas sub-Section (4) of Section 45 deals with profits or gains arising from the transfer of a capital asset by way of distribution of capital assets on the dissolution of a firm chargeable to tax as the income of the firm. Therefore, a clear distinction has been made between the income of the firm and income of the partner and the person who is transferring the capital assets being liable to pay capital gains.

16. It is in this background if we look at the background of this case, the landed property was not owned by the erstwhile partners. It was owned by the partnership firm. May be the erstwhile partners had l/3rd share each in all the partnership assets including this assets. On reconstitution of the firm, four more partners were inducted, who contributed Rs.2.50 crores as their capital contribution. Thus, the inducted partners also became partners in the firm and the firm continue to assets own, including this, landed property. The erstwhile partners withdrew the money brought in by the incoming partners as drawings, They did not retire from the partnership firm. They continued to be the partners of the firm. However, their share got reduced. In other words, 50% of their share held before reconstitution became the share of the incoming partners. As the property was not owned by this erstwhile partners, it cannot be said they transferred 50% in favour of incoming partners and any amount represents the consideration received for such transfer and as such it is liable for payment of capital gains under Section 45 (1) of the Act. It is because they did not transfer the capital assets. Insofar as arguments with regard to the reconstitution, their share got reduced and the amount which was withdrawn and partnership represents inducted partners along with erstwhile partners. As rightly pointed by the appellate authorities in the scheme of the Income Tax Act, there is no provision for levying capital gains on such consideration received for reduction of the share in the partnership firm. The provisions of Section 45(3) or 45(4) is not applicable to the facts of the case. Insofar as the contention that this is a colourable device adopted by the firm as well as the assessees to avoid payment of tax is concerned, it has no substance because tax planning is legitimate. However, it has to be done within the frame work of law.

17. The partnership firm came into existence in the year 1962. It acquired property in the year 1967. It carried on business up to 1992-93 and returns were filed from time to time. It is only in the year 1995, revaluation was done, four new partners inducted who brought in cash and the firm was not dissolved, the incoming partners did not retire from the firm and it only reduced their share in the partnership firm. The erstwhile partners only reduced their share in the partnership firm and continued to be the partners of the reconstituted firm also. Therefore, it cannot be said that either the firm is a dubious one or the entire transaction is a colourable device and the only object is to avoid payment of tax. Therefore, the law laid down by the Apex Court in the case of McDowell Co. Ltd.’s case (supra) has no application to the facts of this case.

18. The learned Counsel for the revenue relied on the judgment of the Apex Court in the case of Kartikeya V. Sarsbhai v. CIT [1997] 228 ITR 163 / 94 Taxman 164 where it was held as follows:

“Section 2(47) of the Income-tax Act, 1961, defines “transfer” in relation to a capital asset. It is an inclusive definition which, inter alia, provides that relinquishment of an asset or extinguishment of any right therein amounts to a transfer of a capital asset. It is not necessary for a capital gain to arise, that there must be a sale of a capital asset, Sale is only one of the modes of transfer envisaged by Section 2(47) of the Act. Relinquishment of the asset or extinguishment of any right in it, which may not amount to sale, can also be considered as a transfer and any profit or gain which arises from the transfer of a capital asset is liable to be taxed under section 45 of the Act.”

19. In the instant case, as the assessee was not the owner of this capital asset, the question of relinquishing their interest in that asset or extinguishment of their right in their asset would not arise. The assets belong to the firm. The incoming partners paid money to the firm by way of their capital contribution. The firm as such has not relinquished its interest in favour of the incoming partners. On the contrary, by inducting them, they are also entitled to interest in the said assets and therefore, the said judgment has no application to the facts of this case.

20. Further, reliance was placed on the judgment of this Court in the case of CIT v. Gurunath Talkies [2010] 328 ITR 59 / 189 Taxman 171, where it was held as follows: –

“Section 47 of the Income-tax Act, 1961, was introduced to take out certain transactions which otherwise are transfers of capital assets and otherwise taxable under section 45, from being taxed. On the reintroduction of sub-sections (3) and (4) by the Finance Act, 1987 in section 45 clause (ii) of section 47 has been expressly omitted removing the protective umbrella. The legislative intent is quite clear and this takes care of any situation where in effect there is transfer of a capital asset, by any mode and to ensure the gain being taxed.”

21. In the aforesaid case, a reconstitution of the firm took place in July 1994 by addition of two partners to the firm, who brought in about Rs. 17 lakhs towards their capital contribution to the firm. Thereafter, again the firm was reconstituted with the erstwhile four partners retiring from the partnership and newly added partners remaining in the firm and continuing the firm. It is in that context, it was held that the series of transactions such as reconstitution of firm twice; once in July 1994, and again in December 1994 and entire assets retained in the hands of the newly added two partners, resulted in transfer of assets of the firm in the sense that the assets of the firm as had been held by the erstwhile partners were transferred to the newly added two partners though all along the assets of the firm continued in the hands of the firm. Therefore, it was held that there was transfer of capital assets within the meaning of Section 2(47) attracting capital gains tax in terms of Section 45(4) of the Act.

22. In the instant case, the firm is not taxed. It is the individual partners who are taxed. Moreover, in the instant case, the erstwhile partners have not retired, they also continued to be the partners along with the incoming partners. All that has happened is that the shares of the erstwhile partners are reduced. Therefore, the said judgment also has no application to the facts of this case.

23. For the aforesaid reasons, we do not see any merit in these appeals. The substantial question of law is answered in favour of the assessees and against the revenue. Consequently, the appeals are dismissed.

The aforesaid decision considers catena of judicial pronouncements on the given issue. The Hon’ble Apex Court in Malabar Fisheries Co. (supra) explaining the position of a partnership under the Partnership Act as well as Income Tax Act held that a partnership firm under the Indian Partnership Act, 1932, is not a distinct legal entity apart from the partners constituting it and equally in law the firm as such has no separate rights of its own in the Partnership Assets and when one talks of firm’s property or the firm’s assets all that is meant is property or assets in which all partners have a joint or common interest. It cannot, therefore, be said that, upon dissolution, the firm’s rights in the partnership assets are extinguished. It is the partners who own jointly or in common the assets of the partnership and, therefore, the consequence of the distribution, division or allotment of assets to the partners which flows upon dissolution after discharge of liabilities is nothing but a mutual adjustment of rights between 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 sec.2(47) of the IT Act, 1961 There is no transfer of assets involved even in the sense of any extinguishment of the firm’s rights in the partnership assets when distribution takes place upon dissolution. In order to attract S.34(3)(b) it is necessary that the sale or transfer of asset must be by the assessee to a person. Dissolution of a firm must, in point of time, be anterior to the actual distribution, division or allotment of the assets that takes place after making accounts and discharging the debts and liabilities due by the Firm. Upon dissolution the firm ceases to exist; then follows the making up of accounts, then the discharge of debts and liabilities and thereupon distribution, division or allotment of assets takes place inter se between the erstwhile partners by way of mutual adjustment of rights between them. The distribution, division, or allotment of assets of the erstwhile partners, it not done by the dissolved firm.

The decision also takes note of the fact that the firm is not recognised as a legal entity but Income Tax Act recognises the firm as a distinct legally assessable entity apart from its partners. A clear distinction has been made between the income of the firm and the income of the partner. It is further noted that there is no provision for levying capital gains on consideration received by the partner for reduction in the share in the partnership firm. Upon perusal of para-22 of the decision, it is quite discernible that the factual matrix is identical in the present case. The aforesaid decision has been rendered after considering the various case laws on the subject as rendered by Hon’ble Apex Court. We find this decision to be applicable to the given factual matrix.

6.2 The case law of Mumbai Tribunal in Shri Sudhakar Shetty (2011 130 ITD 197) deal with a situation wherein their was retirement of the partner from the firm and the clauses in the retirement deed do convey interest in immovable property and further refers to the fact that the assessee will not have any interest over the assets of the firm. In the said background, it was noted that it was a case of lump sum payment in consideration of the retiring partner assigning or relinquishing his share or right in the partnership and its assets in favor of the continuing partners. The coordinate bench chose to follow the decision of Hon’ble Bombay High Court in CIT v A.N.Naik Associates (2004 265 ITR 346) and distinguished the case law of Prashant B.Joshi v. ITO (324 ITR 154).

However, factual matrix is not the same here since the reconstitution deed do not envisages relinquishment of assessee’s right in the assets of the firm. Therefore, the said case law as well as the case law of CIT v A.N.Naik Associates (supra) is not applicable. 6.3 The Hon’ble Bombay High in Prashant B.Joshi v. ITO (supra) observed as under: –

13. During the subsistence of a partnership, a partner does not possess an interest in specie in any particular asset of the partnership. During the subsistence of a partnership, a partner has a right to obtain a share in profits. On a dissolution of a partnership or upon retirement, a partner is entitled to a valuation of his share in the net assets of the partnership which remain after meeting the debts and liabilities. An amount paid to a partner upon retirement, after taking accounts and upon deduction of liabilities does not involve an element of transfer within the meaning of section 2(47). Chief Justice P.N. Bhagwati (as the learned Judge then was) speaking for a Division Bench of the Gujarat High Court in CIT v. Mohanbhai Pamabhai [1973] 91 ITR 393 dealt with the issue in the following observations:—

“…When, therefore, a partner retires from a partnership and the amount of his share in the net partnership assets after deduction of liabilities and prior charges is determined on taking accounts on the footing of notional sale of the partnership assets and given to him, what he receives is his share in the partnership and not any consideration for transfer of his interest in the partnership to the continuing partners. His share in the partnership is worked out by taking accounts in the manner prescribed by the relevant provisions of the partnership law and it is this and this only, namely, his share in the partnership which he receives in terms of money. There is in this transaction no element of transfer of interest in the partnership assets by the retiring partner to the continuing partners : vide also the recent decision of the Supreme Court in CIT v. Bankey Lal Vaidya. It is true that section 2(47 ) defines “transfer” in relation to a capital asset and this definition gives an artificially extended meaning to the term “transfer” by including within its scope and ambit two kinds of transactions which would not ordinarily constitute “transfer” in the accepted connotation of that word, namely, relinquishment of the capital asset and extinguishment of any rights in it. But even in this artificially extended sense, there is no transfer of interest in the partnership assets involved when a partner retires from the partnership.”

The Gujarat High Court held that there is, in such a situation, no transfer of interest in the assets of the partnership within the meaning of section 2(47). When a partner retires from a partnership, what the partner receives is his share in the partnership which is worked out by taking accounts and this does not amount to a consideration for the transfer of his interest to the continuing partners. The rationale for this is explained as follows in the judgment of the Gujarat High Court :—

“…What the retiring partner is entitled to get is not merely a share in the partnership assets; he has also to bear his share of the debts and liabilities and it is only his share in the net partnership assets after satisfying the debts and liabilities that he is entitled to get on retirement. The debts and liabilities have to be deducted from the value of the partnership assets and it is only in the surplus that the retiring partner is entitled to claim a share. It is, therefore, not possible to predicate that a particular amount is received by the retiring partner in respect of his share in a particular partnership asset or that a particular amount represents consideration received by the retiring partner for extinguishment of his interest in a particular asset.”

14. The appeal against the judgment of the Gujarat High Court was dismissed by a Bench of three learned Judges of the Supreme Court in Addl. CIT v. Mohanbhai Pamabhai [1987] 165 ITR 166. The Supreme Court relied upon its judgment in Sunil Siddharthbhai v. CIT [1985] 156 ITR 509. The Supreme Court reiterated the same principle by relying upon the judgment in Addanki Narayanappa v. Bhaskara Krishnappa AIR 1966 SC 1300. The Supreme Court held that what is envisaged on the retirement of a partner is merely his right to realise his interest and to receive its value. What is realised is the interest which the partner enjoys in the assets during the subsistence of the partnership by virtue of his status as a partner and in terms of the partnership agreement. Consequently, what the partner gets upon dissolution or upon retirement is the realisation of a pre-existing right or interest. The Supreme Court held that there was nothing strange in the law that a right or interest should exist in praesenti but its realisation or exercise should be postponed. The Supreme Court inter alia cited with approval the judgment of the Gujarat High Court in Mohanbhai Pamabhai’s case (supra) and held that there is no transfer upon the retirement of a partner upon the distribution of his share in the net assets of the firm. In CIT v. R. Lingmallu Raghukumar [2001] 247 ITR 801, the Supreme Court held, while affirming the principle laid down in Mohanbhai Pamabhai that when a partner retires from a partnership and the amount of his share in the net partnership assets after deduction of liabilities and prior charges is determined on taking accounts, there is no element of transfer of interest in the partnership assets by the retired partner to the continuing partners.

15. At this stage, it may be noted that in CIT v. Tribhuvandas G. Patel [1978] 115 ITR 95 (Bom.), which was decided by a Division Bench of this Court, under a deed of partnership, the assessee retired from the partnership firm and was inter alia paid an amount of Rs. 4,77,941 as his share in the remaining assets of the firm. The Division Bench of this Court had held that the transaction would have to be regarded as amounting to a transfer within the meaning of section 2(47) inasmuch as the assessee had assigned, released and relinquished his share in the partnership and its assets in favour of the continuing partners. This part of the judgment was reversed in appeal by the Supreme Court in Tribhuvandas G. Patel v. CIT [1999] 236 ITR 515. Following the judgment of the Supreme Court in Sunil Siddharthbhai’s case (supra), the Supreme Court held that even when a partner retires and some amount is paid to him towards his share in the assets, it should be treated as falling under clause (ii) of section 47. Therefore, the question was answered in favour of the assessee and against the revenue. Section 47(ii) which held the field at the material time provided that nothing contained in section 45 was applicable to certain transactions specified therein and one of the transactions specified in clause (ii) was distribution of the capital assets on a dissolution of a firm. Section 47(ii) was subsequently omitted by the Finance Act of 1987 with effect from 1-4-1988. Simultaneously, sub-section (4) of section 45 came to be inserted by the same Finance Act. Sub-section (4) of section 45 provides that profits or gains arising from the transfer of a capital asset by way of distribution of capital assets on the dissolution of a firm or other association of persons or body of individuals (not being a company or a co-operative society) or otherwise, shall be chargeable to tax as the income of the firm, association or body, of the previous year in which the said transfer takes place. The fair market value of the assets on the date of such transfer shall be deemed to be the full value of the consideration received or accruing as a result of the transfer for the purpose of section 48. Ex facie sub-section (4) of section 45 deals with a situation where there is a transfer of a capital asset by way of a distribution of capital assets on the dissolution of a firm or otherwise. Evidently, on the admitted position before the Court, there is no transfer of a capital asset by way of a distribution of the capital assets, on a dissolution of the firm or otherwise in the facts of this case. What is to be noted is that even in a situation where sub-section (4) of section 45 applies, profits or gains arising from the transfer are chargeable to tax as income of the firm.

It was observed that during the subsistence of a partnership, a partner does not possess an interest in specie in any particular asset of the partnership. During the subsistence of a partnership, a partner has a right to obtain a share in profits. On a dissolution of a partnership or upon retirement, a partner is entitled to a valuation of his share in the net assets of the partnership which remain after meeting the debts and liabilities. An amount paid to a partner upon retirement, after taking accounts and upon deduction of liabilities, does not involve an element of transfer within the meaning of Section 2(47). This decision has subsequently been followed by Hon’ble Court in CIT v. Riyaj A.Sheikh (26/02/2013). Similar analogous view has been taken by Hon’ble court in subsequent decisions titled as Pr.CIT v. Electroplast Engineers (26/03/2019) which follows the decision of Hon’ble Karnataka High Court in CIT v. Dynamic Enterprises (359 ITR 83 2013). Similar is the view of Hon’ble court in Pr. CIT v. R.F.Nangrani HUF (2018 ). Similar is the view of Hon’ble Madras court in National Company v. ACIT (2019 . 6.4 On the other hand, the facts in the case law of Ahmedabad Tribunal in Samir Suryakant Sheth v. ACIT (ITA No.2919 & 3092/Ahd/2002) were different since in that case the assessee had transferred his share in favor of a third party against consideration, which is not the case here since there is only a re-adjustment of profit-sharing ratio inter-se between the existing partners. The decision of Hon’ble Madras High Court in CIT v. Bharani Pictures (129 ITR 244 16/02/1979) deal with a situation wherein one partner released and relinquished his interest in favor of other partner qua certain building and agricultural land which is not the case here since there is no such release of asset by one partner in favor of other partners. The decision of Hyderabad Tribunal in Smt. Girija Reddy v. ITO (ITA No.297/Hyd/2012 23/05/2012) 129 ITR 244 16/02/1979) deal with a situation wherein one partner received share of goodwill which is not the case here. The case law of Hon’ble Delhi High Court in J.K.Kashyap v. ACIT (302 ITR 255 2008) is a case of joint owners of certain property. Therefore, the case laws being relied upon by Ld. DR are not applicable to given factual matrix.

7. Finally, on the facts and circumstances, we hold that the compensation received by the assessee from existing partners for reduction in profit sharing ratio would not tantamount to Capital Gains chargeable to tax u/s 45(1). Therefore, by deleting the impugned addition, we allow the appeal.

ITA No. 5234/Mum/2016, AY 2012-13

8. Facts are pari-materia the same in this year. An assessment u/s 143(3) was framed on 30/03/2015 and further compensation of Rs.800 Lacs was received by the assessee on account of reduction of share in the firm from 25% to 21% in favor of an existing partner. The same was brought to tax by Ld. AO in similar manner. The Ld. CIT(A), inter-alia, relying upon the appellate order for earlier year, confirmed the stand of Ld.AO. Aggrieved, the assessee is under further appeal before us with similar grounds of appeal.

9. Facts and circumstances being pari-materia the same, our adjudication for AY 2010-11 shall mutatis-mutandis apply to this year also. Resultantly, the appeal stands allowed.

Conclusion

10. Both the appeals stand allowed in terms of our above order.

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