NEW PARTNER ADDED - OLD SHARE REDUCED -CAPITAL GAIN NOT APPLICABLE

Recently, the Karnataka High Court (High Court) in the case of CIT v. P.N.Panjawani, [ITA Nos 1316 to 1318 of 2006(Kar) dated 12 March 2012, (the taxpayer) held that any reduction in share of a partner in the partnership firm on admission of new partners does not amount to transfer of share in the landed property of the firm and accordingly, the same cannot be taxed in the hands of the existing partners.

Facts of the case

• M/s Kamal Industries (the firm), a partnership firm constituted in 1961, owned certain immovable property in the form of land, building and borewell.
• The firm had three partners entitled to 1/3rd share each as on 31 March 1995.
• The immovable property of the firm was revalued at INR 70 million on 1 April 1995.
• The firm was reconstituted by partnership deed dated 12 October 1995 admitting four new partners. The new partners made a total capital contribution of INR 35 million. As a result of the admission of new partners for 50 percent share, the share of the existing partners was reduced to 1/6th (16.67 percent) from 1/3rd (33.33 percent).
• On 14 October 1995, the existing partners withdrew a sum of INR 11.7 million each.
• The Assessing Officer (AO) treated the amounts withdrawn by the existing partners as capital gains arising on relinquishment of 50 percent right in the erstwhile partnership firm and its assets and levied tax thereon.
• On an appeal by the taxpayer, the Commissioner of Income-tax Appeals [CIT(A)] held that the firm was the owner of land and borewell and therefore, if at all there was a transfer of these assets, it was from the firm to the incoming partners. Therefore, the firm should be taxed and not the individual partners. The CIT(A) held that none of the provisions of the Act specifically envisages a situation where capital gains would be chargeable on account of reduction in the share of a partner in the firm following the reconstitution of the firm by way of induction of new partners. Also such reduction could not be said to have effected transfer of any kind even by an act of extinguishment. Accordingly, the CIT(A) set aside the order of the AO.
• On an appeal by the tax department, the Tribunal upheld the order of the CIT(A) and held that reduction in share of interest of a partner on introduction of new partner is not same as transfer of property in favour of the new partner.

Issue before High Court

Whether the appellate authorities were right in holding that the admission of the new partners and assignment of right in the firm to new partners out of the rights of the taxpayer for consideration does not amount to transfer in the hands of taxpayer under Section 2(47) of the Act, 1961 (the Act) and consequently not liable to tax under Section 45 of the Act?

Taxpayer’s contentions

• The reduction in share does not amount to a ‘transfer’ under Section 2(47) of the Act.
• Assuming it is a transfer, the tax is to be levied in the hands of firm and not partners.
• The partnership continues and the erstwhile partners continue to have an interest in the partnership assets. Merely because, they have withdrawn money from the firm, it does not constitute consideration for proportionate reduction in their share in the firm.

Tax department’s contentions

• The existing partners have withdrawn entire funds introduced by new partners. Further the firm is not carrying on any business. Under the circumstances, the amount withdrawn by the partners represents consideration for the reduction of their share of interest in the firm and, hence, it is liable to capital gains under Section 45(1) of the Act.
• Reliance was placed on the Supreme Court decision in case of Malbar Fisheries2 in support of the view that the partnership firm is not a distinct legal entity apart from its partners and when one talks of firm’s property it means property or asset in which all partners have a joint controls or interest.
• For the contention that reduction of share in partnership by 50 percent amounted to relinquishment, reliance was place on the decision of the Supreme Court in the case of Kartikeya V Sarabhai3 holding that relinquishment can also be considered a transfer within the meaning of the Act.
• Further reliance was placed on the Supreme Court decision in the case of McDowell Co Ltd4 where it was held that colourable devices cannot be a part of tax planning. The taxpayer had derived a gain in the process of revaluation and reconstitution and should be liable to capital gains to the extent of relinquishment of share in the firm in favour of the new partners.

High Court’s ruling

• In context of the Act for taxability of income, the identity of the firm and that of the partners are separate and distinct.
• Considering provisions of Section 45(3) and 45(4) of the Act it was held that a clear distinction can be made between income of the firm and that of partner and person transferring the asset should be liable to pay capital gains tax.
• The landed property was not owned by the erstwhile partners. Therefore, it cannot be held that they transferred 50 percent thereof to the new partners.
• There is no provision in the Act for levying capital gains on consideration received for reduction of share in the firm.
• Contention of the tax department that the transaction is a colourable device has no substance.
• Further, the firm itself has not relinquished any share in property in favour of new partners.
• Based on above, it was held that the admission of new partners and consequent reduction in share of existing partner does not result in any transfer as such. Therefore, the amount withdrawn by the existing partners is not taxable.

CONCLUSION

The decision of Karnataka High Court provides clarity on taxation in hands of the partners, on reconstitution of the firm, during subsistence of the partnership firm.

Download above Post and complete Case law decision CIT v. P.N.Panjawani, [ITA Nos 1316 to 1318 of 2006(Kar) dated 12 March 2012