Revaluation of Capital Asset Made Liable to Capital Gains Tax

In the case of The Commissioner of Income Tax v. M/s Manuskh Dyeing and and Printing Mills (Partnership Firm) [Civil Appeal No. 8258 & 8259 of 2022], the Supreme Court panel comprising of Justice M.R. Shah and M.M. Sundresh ruled that Section 45(4) of the Income Tax Act applied where there was an increase in partners’ capital account on account of revaluation of asset (land & building).

The bench stated that the partners had access to the money in order to withdraw it. The assets so revalued and the credit made to the capital accounts of the individual partners were therefore a “transfer” and came under the category of “OTHERWISE.” As a result, Section 45(4)’s provision was applicable.

Background

The assessee a partnership firm constituted with four related individuals were engaged in the business of Dyeing and Printing, Processing, Manufacturing and Trading under the following profit-sharing structure.
Share of Profit
For ease of reference, herewith Partners are referred as A, B, C, D:

Phase 1

Execution of Family Settlement Deed dated 02/05/1991; the share of one of the existing partners (Mr. D) was reduced and distributed among new incoming partners (Let’s say E, F & G):
Partners and Share of Profit (Post Settlement)
 

Phase 2

Reconstitution of Partnership Firm; Partner B, C & D retired from the Firm:
Partnership structure (Post Retirement)
   

Phase 3

The Firm was again reconstituted on 01/11/1992; 4 new partners were added.
Partnership structure and contribution by new partners (Post Reconstruction)
In the reconstituted partnership deed two partners, namely, A and E decided to withdraw part of their capital.

Phase 4

The assessee revalued the asset (Land & Building) for an amount of Rs.17.34 crores against which the capital account of H, I, J & K was revised:  
Particulars H I J K
Initial Capital Contribution 4.5 Lac 2.5 Lac 2.25 Lac 2.25 Lac
Revised Capital Account 3.12 Cr 1.73 Cr 1.56 Cr 1.56 Cr

Facts of the Case

  1. The Return of Income was filed for Assessment Year “AY”1993-1994 declaring total income of Rs. 3,18,760/-. The same was accepted under Section 143(1) of the Income Tax Act, 1961(hereinafter referred to as the Act).
  2. However, thereafter, the assessment was reopened under Section 147 of the Act by issuance of the notice under Section 148 of the Act. The assessment was reassessed under Section 143(3) read with Section 147 of the Act determining the total income of Rs.2,55,19,490/
  3. Addition of Rs.17.34 Cr. was made towards short term capital gain under Section 45(4) of the Act. Similar addition was made for A.Y. 1994-1995.
  4. As per the Assessing Officer., the assessee revalued the land and building and enhanced the valuation from Rs.21,13,225/- to Rs. 17,56,00,000/- for AY 1993-1994 thereby increasing the value of the assets by Rs.17,34,86,772/- and therefore the revaluing of the assets, and subsequently crediting it to the respective partners’ capital accounts constitutes transfer, which was liable to capital gains tax under Section 45(4) of the Act.
  5. As land and building was involved, the assessee had claimed the depreciation on building, and the Assessing Officer assessed the amount of short-term capital gain under Section 50 of the Act.
  6. The CIT(A) confirmed the addition made by the Assessing Officer. However, ITAT allowed the appeal and has set aside the addition made by the A.O. towards Short Term Capital Gains by observing that revaluation of the assets and crediting to partners’ account did not involve any transfer.
  7. The High court dismissed the appeal preferred by the Revenue. Thus, the revenue approached the supreme court.

Question Before the Apex Court

Whether increase in partners’ capital account on account of revaluation of asset (land & building) would fall under section 45(4) of the Act as introduced by the Finance Act, 1987?

Ruling

  1. At the outset, the Apex Court stated that, the object and purpose of introduction of Section 45(4) of the Act was to pluck the loophole by insertion of Section 45(4) and omission of Section 2(47)(ii) of the Act. Earlier, omission of Clause (ii) of Section 2(47) and Section 47(ii) exempted the transform by way of distribution of capital assets from the ambit of the definition of “transfer”. The same helped the assessee in avoiding the levy of capital gains tax by revaluing the assets and then transferring and distributing the same at the time of dissolution. The said loophole came to be plucked by insertion of Section 45(4) and omission of Section 2(47)(ii). At this stage, it is required to be noted that the word used “OR OTHERWISE” in Section 45(4) is very important.
  2. In the present case, the assessee relied upon the decision of Bombay High Court in case of Commissioner of Income Tax, West Bengal Vs. Hind Construction Ltd., (1972) 4 SCC 460 wherein it was stated that “unless there is a dissolution of partnership firm and thereby the transfer of the amount on revaluation to the capital accounts of the respective partners, Section 45(4) of the Income Tax shall not be applicable.” However, the Apex Court stated that, in view of the amended Section 45(4) of the Income Tax Act inserted vide Finance Act, 1987, by which, “OR OTHERWISE” is specifically added, the aforesaid case has no substance.
  3. The CIT(A) relied on the decision of Bombay High Court in case of Commissioner of Income Tax Vs. A.N. Naik Associates and Ors., (2004) 265 ITR 346 (Bom.) wherein the Court had “an occasion to elaborately consider the word “OTHERWISE” used in Section 45(4). After detailed analysis of Section 45(4), it is observed and held that the word “OTHERWISE” used in Section 45(4) takes into its sweep not only the cases of dissolution but also cases of subsisting partners of a partnership, transferring the assets in favour of a retiring partner.”
  4. Under the circumstances, for the purpose of interpretation of newly inserted Section 45(4) to the Act, the decision of this Court in the case of Hind Construction Ltd. (supra) shall not be applicable and/or the same shall not be of any assistance to the assessee. As such, we are in complete agreement with the view taken by the Bombay High Court in the case of A.N. Naik Associates and Ors., (supra). We affirm the view taken by the Bombay High Court in the above decision.
  5. In the present case, the Apex Court held that the assets of the partnership firm were revalued to increase the value by an amount of Rs. 17.34 crores on 01.01.1993 (relevant to A.Y. 1993-1994) and the revalued amount was credited to the accounts of the partners in their profit-sharing ratio and the credit of the assets’ revaluation amount to the capital accounts of the partners can be said to be in effect distribution of the assets valued at Rs. 17.34 crores to the partners and that during the years, some new partners came to be inducted by introduction of small amounts of capital ranging between Rs. 2.5 to 4.5 lakhs and the said newly inducted partners had huge credits to their capital accounts immediately after joining the partnership, which amount was available to the partners for withdrawal and in fact some of the partners withdrew the amount credited in their capital accounts.
Therefore, the assets so revalued and the credit into the capital accounts of the respective partners can be said to be “transfer” and which fall in the category of “OTHERWISE” and therefore, the provision of Section 45(4) inserted by Finance Act, 1987 w.e.f. 01.04.1988 shall be applicable.  

Held

In view of the above and for the reasons stated above, the impugned judgment and order passed by the High Court and that of the ITAT were held unsustainable and were quashed and set aside with the original order being restored. Present appeals were accordingly allowed with no cost.

FM Comments

The Supreme Court decision clarifies the interpretation of the provisions of section 45(4) of the Act and holds that the revaluation of capital asset and consequent credit into the capital accounts of the respective partners would be chargeable to tax as capital gains. The Judgement will impact the Real Estate Industry and others who had taken the benefit of these provisions as a tax planning strategy.

The bench stated that the partners had access to the money in order to withdraw it. The assets so revalued and the credit made to the capital accounts of the individual partners were therefore a “transfer” and came under the category of “OTHERWISE.” As a result, Section 45(4)’s provision was applicable.

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