This article is written by Sanjay Sawlani, pursuing Certificate course in Advanced Corporate Taxation from LawSikho.com.
A partner who gets certain assets when he retires from the firm would be keen to ensure that such assets do not attract capital gains tax. Every partner has a question that the asset received from the partnership at the time of their retirement is subject to capital gain tax or not. There are various judgments of courts, both in favor and against as regards this excess consideration received from the partnership to its retiring partners. As per the Income Tax Act 1961, the law is silent about the treatment of the excess consideration received in the hands of the partners shall be taxable or not. Therefore, there is ambiguity in the Income Tax Act w.r.t these provisions that govern the taxation of any goodwill paid to the retiring partners i.e.
- The first question arises is whether the excess amount should be taxed in the hands of the retired partner under Section 45 (1);
- The second question arises that whether such excess amount should be taxed in the hands of the partnership firm under Section 45 (4).
Section 45 (1) – Taxable as per IT Act
Section 45(1) of the Income Tax Act defines the taxability of profits or gains arising from the transfer of a capital asset in the previous financial year of transfer under the head “Captial Gains”. The question to be answered concerning taxation of the excess amount i.e. the amount over the credit balance of the partner’s capital account was a transfer of a capital asset by the retired partner in favor of the firm and its continuing partners.
Section 45 (4) – Taxable as per IT Act
Section 45(4) of the IT Act defines that capital gains arising from the transfer of a capital asset in the way of distribution at the time of the dissolution of the firm or in the hands of the firm in the previous year in which transfer takes place. For computing the capital gains, the Fair Market Value (FMV) of the asset on that date when the transfer shall be deemed to be the amount.
Before the introduction of Section 45(4) of the Income Tax Act, there was a clause (ii) of section 47 which defines that the distribution of capital assets at the time of dissolution of a firm, the body of individuals, or other associate persons from the scope of Transfer under Section 2(47) of the IT Act.
The apex courts decide in the case of Malabar Fisheries v. CIT as per Section 45(4) of the IT Act that a partnership firm under the Indian Partnership Act 1932 is not a separate legal entity from its partners and equally in the eyes of law the firm has no separate rights of its own in the partnership assets, therefore, the result of the distribution, division or allotment of assets to the partners of the partnership firm is nothing but a mutual adjustment of rights between the partners and there was no question of any annulment of the firm’s rights in the partnership assets amounting to a transfer of assets which was the similar meaning under the section 2(47) of the Income Tax Act.
What do the courts say?
The major two courts Madras High Court and Bangalore ITAT who have given the decision in the issue of taxability of proceeds in the hands of retiring partners.
- In the case of National Company v. ACIT, Madras High Court decided that certain retiring partners of the Partnership firm were given a share in the immovable properties of the firm. The issue that arises here is whether a capital gains tax can be imposed on the transfer of such immovable properties or not.
- In another case of Savitri Kadur v. DCIT, Bangalore ITAT decided that the certain amounts over and above those which were reflecting in the capital account of the retiring partner were paid to the respective person. The issue arises is whether the excess amount paid on top of the amount reflecting in the partner’s capital account was subject to capital gains tax or not.
The court considered the three situations and guide accordingly:
- When the partner had given only a lying amount in the capital account, as per the partnership agreement, the following ratio shows that in ACIT v. Mohanbhai Pamabhai, that this amount will not be subject to the capital gains tax and it represents only the existing interest of the partner before retirement.
- When the partner gives the excess amount which was reflecting in their respective capital account, that amount may be paid to the respective retiring partners to enable them to release their contribution in the partnership firm and transfer their rights which will be subject to the capital gains tax.
- If the lump sum amount was paid to the partner irrespective of the amount which was lying in their capital account, then the same amount cannot be said as an amount which the partner was entitled to, and this will impact capital gains which will be payable on this amount as well. Based on the Supreme Court’s decision in the case of CIT v. Mohanbhai Pamabhai, the ITAT concluded that there would be no tax incidence in current circumstances. However, in other situations, the over amount would be taxable if the terms and conditions of the partnership deed of retirement employed by the retiring partner constitute a release of any assets of the firm in the favor of the continuing partners.
In the financials of the firm, there was goodwill which was credited to the retiring partner’s capital account which was not taxable as capital gain and only the excess amount is the amount paid more than the credit in the capital account which was taxable under Section 45(1) of the Income Tax Act, provided that the retiring partner had transferred the rights in the firm in the favour of the continuing partners.
From the above court judgments, the common understanding emerging is that only over and above the amount received for transfer of an interest in the partnership firm which would result in a capital gain. However, in the above mentioned cases where the consideration is paid as per the situation, the retiring partner’s interest in the firm is renounced and indirectly transferred to the continuing partners in the partnership firm. The contribution and share of the remaining partners in the net partnership assets might remain as it is, but their share of profit shall be changed and to that extent, there is an indirect transfer of the interest in the firm.
From this example, it is clear that their share in the net assets remains constant, the interest of each continued partner increases from 33.33% to 50% which was indicating an indirect transfer to 33.33% in the partnership held by Pranshu equally to the remaining partners.
In the USA
The most common business transaction is that the withdrawal of a partner from a partnership or the partner leaves from the firm or the resignation may occur after many disagreements and, perhaps, litigation. It has been observed that in case of a partner’s withdrawal from the partnership, neither the continuing partners nor the partnership had assiduously considered the income tax consequence of the withdrawal. In the matter of state law, the withdrawal or “retirement” of a partner from the partnership firms occurs when the partnership redeems the retiring partner’s interest. The tax question arises, however, is more involved, and the “retirement agreement” which seeks to address as many tax issues.
As per the Internal Revenue Service, the application for revocation of a Section 754 election must set forth the rules for the request. The sufficient grounds for revocation which include:
- Any changes in the partnership business;
- Any changes in the assets of the partnership;
- Any changes in the character of partnership assets;
- High frequency of retirement of partnership interest;
No application shall be approved if avoid any stepping down the business of partnership assets upon a transfer or distribution.
Example: At the time of death of his father, partner Sanjay acquires by ½ interest in BlackStone Group LLC. Other partners Pranshu and Maneet, each of whom have ¼ interest in the firm. Blackstone’s assets of $20,000 cash and land worth of $20,000 with a basis of $2,000 in the partnership. The partnership had made an election under Section 754 at the time of transfer, Sanjay has a special basis adjustment of $9,000 as per Section 743(b) which defines his interest ½ in the real estate. The basis of Sanjay’s interest is $20,0000, if Sanjay retires from the partnership and receives $20,000 in cash in exchange for his interest at that time Sanjay would receive no benefits at the basis of Special Basis Adjustment in the real estate. The result will be the partnership’s basis in the real estate would be increased by the amount of the Unused basis adjustment, that is by $9,000 (to 11,000).
As per IRS, Section 736 specifies the special rules under which payments could be ordinary income or capital gain to the retiring partner.
Section 736(a) – In this section, except to the extent provided in Section 736(b), the consideration made for the liquidation of the interest of a retiring partner or a deceased partner which was treated as (1) a distributive share to the recipient of partnership income if the amount is determined the income of the partnership or a guaranteed payment which was mentioned under Section 707(c) if the amount is determined without regard to the income of the partnership.
Section 736(b) – In this section, consideration for assets denotes the allocation of partnership income to a retiring partner, the partnership firm needs to understand what payments were made which represent to him. Before characterizing the liquidating payments made to a retiring partner, the payments should be allocated between the amount of the partner’s interest in the partnership assets and any other payments. The value of the partner’s share in the partnership firm should be determined first which includes tangible and intangible assets of the partnership. The valuation should be calculated as per the Arms-length agreement.
The IRS provided the Carryover Rule which defines that if the total amount received in any one year which is less than the amount as a distribution under Section 736(b) for that year, the over and above amount which shall be added to the portion of the payments in the upcoming years which was treated as a distribution.
Example: The retired partner Sanjay has to make an annual payment as per Section 736(b) of $12,000 for 10 years in partnership property. In the year 2010, Sanjay received $7,000 and in the year 2011, he received the amount of $20,000. On the payment of $17,000 in the year 2012 ($12,000 for 2012 plus $5,000 carryover) which was treated as a distribution under Section 736(b) and the balance amount of $3,000 which was treated as a distribution under Section 736(a).
Under Section 45(4), no dispute on the taxation of capital gain whereas the capital asset was distributed by the firm to the retired partner. None of the witnesses having the ambiguity in the principles from the judgments of the court, the clarification explains Section (45) of the IT Act, whereas the retirement of the partner from the partnership firm should be treated as dissolution under Section 45(4) of the Income Tax Act. Also, this section does not apply when the amount is paid to the retiring partner and is not a capital asset. It would be supreme to mark a parallel line between the current issue at hand and the government’s inclusion of non-compete fees receivable as “Profits and gains of business or profession under Section 28 of the Income Tax Act.
The government can be provided a similar treatment by way of insertion, of a sub-section to Section 28 of the IT Act wherein it will state the law on the receipt of the excess amount representing the actual goodwill be treated as profits/gains from business or profession in the hands of the retiring partners. As far now, the income tax was silent on the issue of taxation of proceeds in the hands of retiring partners.
The foregoing tax issues should be addressed in the partnership agreement before the retirement of any partner. They can cover the liquidation agreement between the retired partner and the partnership. If the partner and partnership firm fail to calculate the tax issues, the courts may do for them which causes a huge tax amount and other consequences for the parties (partner and partnership firm).
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