2009 (6) TMI 645 - AT - Income Tax

Capital gain - Whether CIT(A) erred in holding that on dissolution of partnership firm the difference between the market value of stock and book value of stock lying with the firm at the time of dissolution cannot be brought into tax since it is not a capital asset - In the present case, all the assets and liabilities including capital assets were taken over by M/s D.D. International (P) Ltd. as sole proprietor as a going concern on the dissolution of the firm - As it is the finding of the Tribunal that no transfer had taken place in this year, the occasion for levying tax on any capital gain did not arise. From that the conclusion is that the relevant date for ascertaining the year in which the capital gains are to be charged under s. 45(2) is the year in which the transfer took place - There was no transfer of capital gain under s. 45(4) in the relevant year. - Decided in favor of the assessee Regarding valuation of closing stock or it is treated as capital assets u/s 2(14) - AO valued the closing stock at fair market value by adding 10.16 per cent to the stock declared by the assessee in its books of account - Held that GP rate of the assessee-firm and the AO has taken the same GP rate for computing profit element on taking over stock by M/s D.D. International (P) Ltd. from assessee - Decided in favor of the assessee

Issues Involved:
1. Applicability of Section 45(4) of the IT Act.
2. Treatment of stock-in-trade as a capital asset.
3. Valuation of closing stock at market value.
4. Validity of reopening the assessment under Section 147.

Issue-wise Detailed Analysis:

1. Applicability of Section 45(4) of the IT Act:

The Revenue contended that the CIT(A) erred in holding that Section 45(4) was not applicable. The firm dissolved with the retirement of all partners except one, and the business was taken over by M/s D.D. International (P) Ltd. The CIT(A) observed that for Section 45(4) to apply, two conditions must be fulfilled: (i) dissolution of the firm and (ii) distribution of capital assets on such dissolution. The CIT(A) held that although the firm dissolved, there was no distribution of assets among the partners, as the assets and liabilities were taken over by M/s D.D. International (P) Ltd., and the capital standing to the credit of the retiring partners was adjusted against shares or kept as deposits.

Upon review, it was determined that Section 45(4) gets attracted in cases of transfer of capital assets by way of distribution on the dissolution of a firm. The partners relinquished their rights in the firm's capital assets, and M/s D.D. International (P) Ltd. took over the business as a sole proprietor. The term "otherwise" in Section 45(4) includes not only dissolution but also other forms of transfer. Thus, the transfer of assets to a retiring partner amounts to a transfer of capital assets, invoking Section 45(4).

2. Treatment of Stock-in-Trade as a Capital Asset:

The CIT(A) held that stock-in-trade is not a capital asset under Section 2(14) of the IT Act, and thus, the difference in value between closing stock and fair market value cannot be taxed under Section 45(4). The Revenue argued that the CIT(A) misunderstood the concept and that the AO did not treat the closing stock as a capital asset but valued it at market price based on the Supreme Court's decision in A.L.A. Firm vs. CIT.

The Tribunal agreed with the AO, stating that the closing stock should be valued at market price upon dissolution and discontinuation of business, as per the precedent set in A.L.A. Firm vs. CIT. The business of the assessee ceased to exist upon dissolution, and the transaction with M/s D.D. International (P) Ltd. was separate, justifying the valuation of closing stock at market value.

3. Valuation of Closing Stock at Market Value:

The CIT(A) computed the profit element in the sale of stock from the assessee firm to M/s D.D. International (P) Ltd. based on the net profit rate earned by M/s D.D. International (P) Ltd. The Tribunal found this approach incorrect, emphasizing that the profit should be based on the GP rate of the assessee firm, which was 10.16%. The AO's method of adding 10.16% to the stock declared by the assessee was upheld.

4. Validity of Reopening the Assessment under Section 147:

The assessee argued that the AO could not make additions for undervaluation of closing stock as this was not mentioned in the reasons recorded for reopening the assessment. The Tribunal noted that the validity of reopening was not challenged by the assessee through appeal or cross-objection and thus dismissed the argument.

Conclusion:

The Tribunal allowed the Revenue's appeal, holding that Section 45(4) applied to the transfer of capital assets upon dissolution and that the closing stock should be valued at market price. The cross-objection by the assessee was dismissed, affirming the AO's actions and the principles set out in A.L.A. Firm vs. CIT.

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