2011 (1) TMI 266 - AT - Income Tax

Short term capital gain - Retirement of partner from the partnership firm - Value of net assets taken over by the retiring partners is more than their credit balance in capital account - As per there was a transfer of capital asset viz. good will by the firm to the retiring partners. He also held that goodwill has no cost of acquisition and therefore brought to tax a sum of Rs. 68, 79, 284 being the value of goodwill shown as assets taken over by the retiring partner - AO taxes the same as capital gains of the firm on retirement of two partners - Held that - The capital asset transferred on retirement of a partner from the firm is the right as a partner. The firm settles such right by giving away assets of the firm which includes its stock-in-trade. The stock-in-trade in that event looses its character as stock in trade and becomes a capital asset which is used as a mode of settlement of the claim of the retiring partner by giving it at a value to the retiring partner. - Decided against assessee. Dis allowance of labour charges - The assessee had claimed as deduction a sum of Rs. 51, 73, 783 on account of labour charges for making ornaments - CIT(A) restricted the addition made by the AO from 10% to 2% - Order of CIT(A) sustained Software expenditure - amount paid to SMB Inc. for their efforts in trying to develop tailor-made software for the Assessee s business. Finally the software could not be developed and the amount was paid to SMB Inc. for the time they spent in developing the software and that no software in fact was purchased or owned by the Assessee. - Held as revenue expenditure and allowed in favor of assessee.

Summary

Issues Involved:
1. Sustaining short-term capital gain on assets transferred to retiring partners under Section 45(4).
2. Disallowance of 2% of the labor charges claimed by the appellant.
3. Disallowance of software development expenses.

Issue-wise Detailed Analysis:

1. Sustaining Short-term Capital Gain on Assets Transferred to Retiring Partners under Section 45(4):
The assessee, a partnership firm, challenged the CIT(A)'s decision to sustain a short-term capital gain of Rs. 34,39,643 on assets transferred to two retiring partners, citing Section 45(4) of the Income-tax Act, 1961. The assessee argued that the CIT(A) erred by relying on the decision in CIT v. A.N. Naik Associates, which interpreted "otherwise" in Section 45(4) to include retirement of partners, even without dissolution. The assessee contended that if the legislature intended to tax firms in all asset distribution cases, it would not have included "on dissolution or otherwise" in Section 45(4). The firm also argued that the stock-in-trade allotted to retiring partners should not be considered a "capital asset" under Section 2(14), and excluding it would result in a negative figure, negating any short-term capital gain.

The firm was initially formed by a deed dated 1-4-2001, with five partners and continued its business until 31-8-2002, when two partners retired. The AO taxed the value of goodwill transferred to the retiring partners as capital gain, which was contested by the assessee before CIT(A). The assessee argued that Section 45(4) does not apply to retirement cases, supported by ITAT Jabalpur's decision in ACIT v. Tehmoflies India. The assessee also contended that mere revaluation of assets does not result in capital gains and relied on ITAT Mumbai's decision in ITO v. Smt. Paru D. Dave.

The CIT(A) upheld the AO's decision, citing the Bombay High Court's ruling in CIT v. A.N. Naik Associates, which held that retirement of partners involves transfer of assets, attracting capital gains tax under Section 45(4). The CIT(A) computed the short-term capital gain at Rs. 34,39,642, but did not address the exclusion of stock-in-trade from capital assets. The Tribunal confirmed the CIT(A)'s order, rejecting the argument that stock-in-trade should be excluded, as the transfer involved the partner's share in the partnership and its assets, not individual items.

2. Disallowance of 2% of the Labor Charges Claimed by the Appellant:
The assessee claimed Rs. 51,73,783 as labor charges for making ornaments, which the AO partly disallowed by 10%, citing defects in vouchers and potential inflation of charges. The CIT(A) reduced the disallowance to 2%, acknowledging the defects but also recognizing the necessity of labor charges in the jewelry business. The CIT(A) noted that the labor charges were lower than the previous year and justified a 2% disallowance due to unverifiable vouchers. The Tribunal upheld the CIT(A)'s decision, finding the 2% disallowance reasonable given the circumstances.

3. Disallowance of Software Development Expenses:
The assessee claimed Rs. 20,500 for software development expenses, which the AO treated as capital expenditure, allowing only 30% depreciation and adding Rs. 14,350 to the total income. The assessee clarified that the amount was paid for unsuccessful software development efforts and no software was acquired. The Tribunal allowed the deduction, recognizing the expenditure as incidental to business and not resulting in the acquisition of software.

Conclusion:
The appeal was partly allowed. The Tribunal upheld the CIT(A)'s decision on capital gains and labor charges but allowed the deduction for software development expenses.