2025 (6) TMI 1400 - AT - Income Tax

Nature of receipt - right to receive profit in a partnership firm and relinquishment of the right to receive profit - asset of the partnership firm was revalued by the partners and the difference on account of revaluation of asset was credited to the partners account - whether the admission of new partners and the consequent reduction in the share of existing partners constituted a taxable event u/s 2(47)? - HELD THAT - The revaluation of partnership firm s asset was anterior to the introduction of new partners. Thus in view of our above discussions as well as judicial precedents we are of the considered opinion that the revaluation of assets by CRCL does not attract capital gains. The revaluation of assets of CRCL and the credit of revalued amount to the capital account of partners in their respective share ratio does not entail any transfer as defined under section 2(47) of the Act. When any new partner is introduced into an existing partnership firm the profit sharing ratios undergo a change which does not amount to transfer as defined u/s 2(47) of the Act as there is no change in the ownership of assets by the partnership firm. As during the subsistence of the partnership firm the partners have no defined share in the assets of the partnership firm and thus on realignment of profit-sharing ratio on introduction of new partners there is no relinquishment of any non-existent share in the partnership firm s assets as the asset remained with the firm. Such an arrangement is not covered by the provisions of section 45(4) of the Act which covers the case of dissolution of partnership firm. Accordingly no capital gains arise on such relinquishment of share ratio in the partnership firm. However we find that in order to bring the profit or gains from receipt of money or capital asset or both by the specified person from a specified entity on reconstitution of the specified entity shall be chargeable to income-tax as income of such specified entity under the head Capital Gains the legislation amended the provisions of section 45(4) vide Finance Act 2021 shall come into force on the 1st day of April 2021 which is prospective in nature. Similarly the provisions of section 9B of the Income Tax Act has been inserted w.e.f. A.Y. 2021-22 vide Finance Act 2021 to bring under the tax net the income on receipt of a capital asset or stock in trade by a specified person from the specified entity in connection with the dissolution or reconstitution of such specified entity shall come into force on the 1st day of April 2021 which is prospective in nature. In fact transfer of capital asset is common in both section 9B and section 45(4) of the Act. In the present case the assessment year under consideration is 2017-18 and accordingly the amendments vide Finance Act 2021 have no application in the present case. Under the above facts and circumstances of the case as well as judicial precedents the addition made by the AO towards levy of short term capital gains tax and confirmed by the CIT(A) stands deleted. Thus the grounds raised by the assessee are allowed.

Summary

The primary legal question considered in this appeal is whether the amount credited to the assessee's current account as consideration for the reduction in profit-sharing ratio on admission of a new partner in an LLP constitutes income chargeable to tax as short-term capital gains under the Income Tax Act, 1961. Specifically, the Tribunal examined whether such a receipt amounts to a transfer of a capital asset under section 2(47) and thereby attracts capital gains tax under section 45 of the Act.

The issue arises from the Assessing Officer's addition of Rs. 2,38,63,452/- to the assessee's income as short-term capital gains, on the ground that the amount represented compensation for relinquishment of the assessee's partnership interest, including goodwill, consequent to the induction of a new partner holding 51% stake in the LLP. The Commissioner of Income Tax (Appeals) upheld this addition, leading to the present appeal.

At the core, the legal questions considered include:

• Whether the amount received by the assessee on admission of a new partner constitutes income taxable as short-term capital gains under the Income Tax Act.
• Whether the right to receive profits in a partnership firm qualifies as a capital asset under section 2(14) of the Act.
• Whether the reduction in the assessee's profit-sharing ratio on admission of a new partner amounts to a transfer of capital asset under section 2(47) of the Act.
• Whether the admission of a new partner and consequent realignment of profit-sharing ratio involves a transfer of partnership assets or rights attracting capital gains tax under section 45(1) or section 45(4) of the Act.
• The applicability and interpretation of relevant judicial precedents on the taxation of partnership reconstitution and admission of new partners.
• The effect of amendments introduced by the Finance Act, 2021, on the taxability of such transactions for the assessment year in question.

Issue-wise detailed analysis:

1. Nature of Amount Received on Admission of New Partner and Taxability as Capital Gains

The Assessing Officer held that the amount credited to the assessee's current account represented consideration for relinquishment of his partnership interest, including goodwill, due to reduction in profit-sharing ratio from 12% to 5.88% upon induction of Elior India Catering LLP as a new partner with 51% stake. The AO treated this as a transfer of a capital asset under section 2(47), attracting capital gains tax under section 45(1).

The assessee contended that no goodwill existed at the time of admission of the new partner, and the amount credited was not consideration for transfer of any capital asset but merely represented realignment of profit-sharing ratio. The assessee argued that assets continued to be owned by the LLP, and partners have no independent interest in specific assets during the subsistence of the LLP. The amount received was not income but a capital receipt not liable to tax under capital gains provisions.

The Tribunal examined the Investment Agreement and Amended and Restated LLP Agreement, noting that the agreements did not specify the credited amount as consideration for goodwill. It was observed that the LLP was nascent, and no revaluation or distribution of assets had taken place on admission of the new partner. The Tribunal emphasized that the relationship between partners is governed by section 23 of the LLP Act, 2008, which permits mutual agreements on rights and duties without necessitating valuation or transfer of goodwill on reconstitution.

Relevant precedents cited by the assessee include CIT v. Kunnamkulam Mill Board, CIT v. P.N. Panjawani, ITO v. Smt. Paru D. Dave, and ITO v. Fine Developers, which support the proposition that mere realignment of profit-sharing ratio on admission of new partners does not amount to transfer of capital asset attracting capital gains tax.

The Tribunal found the assessee's argument persuasive, holding that the credited amount did not represent goodwill or a transfer of capital asset but was a realignment of profit-sharing ratio without transfer of ownership in partnership assets.

2. Whether Right to Receive Profit in Partnership Firm is a Capital Asset under Section 2(14)

The Assessing Officer relied on the definition of capital asset under section 2(14) to assert that the right to receive profits in a partnership firm constitutes a capital asset. Consequently, relinquishment of such right qualifies as a transfer under section 2(47).

The Tribunal analyzed the nature of partnership property and rights under the Indian Partnership Act, 1932, and LLP Act, 2008. It was noted that the firm is not a separate legal entity under the Partnership Act, and partnership property is jointly owned by partners. The right to profits does not confer ownership of specific assets during the firm's subsistence but is a right to share in profits and in the net assets upon dissolution or retirement.

Judicial precedents including Addanki Narayanappa v. Bhaskara Krishnappa, Malabar Fisheries Co., and Sunil Siddharthbhai v. CIT were examined. These judgments clarify that a partner's interest in the firm's assets is a shared interest and that evaluation of such interest occurs only on dissolution or retirement. The right to receive profits is not an independent capital asset transferable during the subsistence of the firm.

The Tribunal concluded that the right to receive profits is not a capital asset in the hands of the partner during the firm's existence and thus, its realignment on admission of a new partner does not amount to transfer of capital asset under section 2(47).

3. Applicability of Section 45(1), Section 45(3), and Section 45(4) of the Income Tax Act

The Assessing Officer applied section 45(1) to tax the amount as capital gains arising from transfer of capital asset. The assessee argued that section 45(3) and 45(4) distinguish between transfer of capital assets by a person to a firm and distribution of assets on dissolution of a firm, respectively, and neither applies to the facts.

The Tribunal examined the provisions, noting that section 45(3) taxes transfer of capital assets by a person to a firm on becoming a partner, while section 45(4) taxes distribution of capital assets on dissolution of a firm. In the present case, no dissolution or retirement occurred; the existing partners continued with reduced shares.

The Tribunal relied on the decision of the Hon'ble Karnataka High Court in CIT v. P.N. Panjawani, which held that admission of new partners and consequent reduction in share does not amount to transfer under section 2(47) and is not taxable under section 45. The Tribunal distinguished judgments relied on by the revenue where dissolution or retirement had occurred, triggering capital gains tax.

Further, the Tribunal observed that amendments introduced by the Finance Act, 2021, to section 45(4) and insertion of section 9B to tax income on reconstitution or dissolution of specified entities are prospective and not applicable to the assessment year 2017-18.

4. Treatment of Competing Arguments and Judicial Precedents

The revenue relied on judgments including JCIT v. Vatsala Sheny, Sudhakar M Shetty v. ACIT, Samir Suryakant Seth v. ACIT, and B. Raghurama Prabhu Estate v. JCIT, which support taxation of transfer of partnership interest or assets on reconstitution or dissolution.

The Tribunal distinguished these cases on facts, noting that in those instances, either the firm was dissolved, or partners retired, effecting actual transfer of capital assets. In contrast, in the present case, the firm continued with existing partners retaining their partnership status, only profit-sharing ratios changed.

The Tribunal further relied on the principle that tax planning within the framework of law is legitimate and that the absence of transfer of capital assets precludes capital gains tax. The Tribunal also noted that the amount credited to partners' accounts represented withdrawal of capital contribution by incoming partners and did not constitute income or capital gains for existing partners.

5. Conclusions

The Tribunal concluded that:

• The amount credited to the assessee's current account on admission of the new partner does not represent consideration for transfer of capital asset or goodwill.
• The right to receive profits in the partnership firm is not a capital asset during the subsistence of the firm and its realignment on admission of new partner does not amount to transfer under section 2(47).
• The reduction in profit-sharing ratio on admission of new partner is a realignment of rights and does not attract capital gains tax under section 45(1), 45(3), or 45(4).
• The amendments introduced by Finance Act, 2021, are prospective and not applicable to the assessment year under consideration.
• The addition of Rs. 2,38,63,452/- as short-term capital gains is therefore unsustainable and is deleted.

Significant holdings:

"The right to receive profit in a partnership firm is not a capital asset under section 2(14) of the Income Tax Act during the subsistence of the firm. The admission of a new partner and consequent realignment of profit-sharing ratio does not amount to transfer of capital asset under section 2(47) and hence does not attract capital gains tax under section 45."

"The assets of the partnership firm continue to be owned by the firm and not by individual partners. The reduction in share of existing partners on admission of new partners is a realignment of profit-sharing ratio and does not amount to transfer of capital asset."

"The provisions of section 45(3) and 45(4) of the Income Tax Act distinguish between transfer of capital assets by a person to a firm and distribution of assets on dissolution of a firm. Where the firm continues and partners do not retire, these provisions do not apply."

"Amendments introduced by the Finance Act, 2021, to tax income arising on reconstitution or dissolution of specified entities are prospective and have no application to assessment years prior to their effective date."

Accordingly, the Tribunal allowed the appeal, deleted the addition made by the Assessing Officer, and dismissed the stay application as infructuous.