2019 (6) TMI 1376 - HC - Income Tax

Capital gain computation - conversion of firm into company - before conversion land was revalued and enhanced value of the capital asset credited to the current account of the partners of the firm - after conversion current account of the partners was treated as loan from the partner - violation of clause (c) of the proviso to Section 47(xiii) - whether the transaction amounts to transfer of a capital asset within the purview of Section 45 of the Act? - HELD THAT - we are of the considered view that by crediting the enhanced value of the land, which belonged to the firm, to the current account of the partners of the firm and by treating it as loan from the partners in the accounts of the company, there was violation of the provisions contained in clauses (a) and (c) of the proviso to Section 47(xiii). Therefore, the aforesaid transaction amounts to transfer of a capital asset within the purview of Section 45 and the profits or gains obtained by the transfer of the asset by the firm to the company has to be treated as capital gains. The first and the second substantial questions of law raised are answered in favour of the revenue and against the assessee. As department contend that, applicability of Section 47A(3) would arise only at a stage subsequent to the assessment of tax, when it is later discovered that there was violation of the provisions contained in the proviso to Section 47(xiii) we are not impressed with this contention. It is true that exemption already granted can be withdrawn by virtue of the provision contained in Section 47A(3) of the Act on discovery of violations of the conditions provided in the proviso to Section 47(xiii). But, if the assessing authority finds at the time of assessment, that there is violation of the provisions contained in the proviso to Section 47 (xiii), then transfer of capital assets made in that manner, comes within the ambit of Section 45 and assessment has to be done accordingly. In making such assessment, the authority concerned is obliged to take note of the provisions contained in Section 47A(3) and then the liability to pay tax has to be imposed not on the erstwhile firm but on the successor company. We find that the assessee firm is not liable to be assessed for the capital gains brought within the ambit of Section 45 as a result of violation of the conditions provided in clause (xiii) of Section 47 but the tax liability in that regard had fallen on the successor company. The third substantial question of law raised is answered in favour of the assessee and against the revenue. Appellant firm is not liable to be assessed to tax on capital gains.

Summary

Issues Involved:
1. Violation of clause (c) of the proviso to Section 47(xiii) of the Income Tax Act, 1961.
2. Violation of clause (a) of the proviso to Section 47(xiii) of the Income Tax Act, 1961.
3. Tax liability for the enhanced value of the capital asset credited to the current account of the partners.

Detailed Analysis:

1. Violation of clause (c) of the proviso to Section 47(xiii) of the Income Tax Act, 1961:

The court examined whether the revaluation of a capital asset before the conversion of a partnership firm into a private limited company and the subsequent crediting of the enhanced value to the partners' current account, treated as a loan in the company's accounts, violated clause (c) of the proviso to Section 47(xiii) of the Income Tax Act. The court found that this act amounted to the partners receiving a benefit indirectly, other than by way of allotment of shares, thus violating clause (c). The partners could withdraw the credited amount anytime, which constituted a receipt of benefit indirectly. Therefore, the transaction was deemed a transfer of a capital asset under Section 45 of the Act.

2. Violation of clause (a) of the proviso to Section 47(xiii) of the Income Tax Act, 1961:

The court also considered if the revaluation and crediting of the enhanced value to the partners' current account, creating a liability transferred to the company, violated clause (a) of the proviso to Section 47(xiii). The court concluded that this act was a device for tax evasion, as the liability was artificially created just before the conversion. This new liability did not exist immediately before the conversion, thereby violating clause (a). The court emphasized that tax avoidance schemes should not be judicially approved, citing McDowell & Company Limited v. Commercial Tax Officer.

3. Tax liability for the enhanced value of the capital asset credited to the current account of the partners:

The court addressed whether the enhanced value, if treated as capital gains, should be taxed on the erstwhile firm or the successor company. Referring to Section 47(A)(3) of the Act, the court noted that the tax liability falls on the successor company when the conditions of the proviso to Section 47(xiii) are violated. The court rejected the department's contention that Section 47A(3) applies only post-assessment. The court ruled that if the assessing authority finds a violation during assessment, the tax liability should be imposed on the successor company, not the erstwhile firm.

Conclusion:

The court concluded that the appellant firm violated the provisions of clauses (a) and (c) of the proviso to Section 47(xiii) of the Act, bringing the transaction within the ambit of Section 45. However, the tax liability for the capital gains falls on the successor company, not the erstwhile firm. Consequently, the appeal was partly allowed, and the assessment order was set aside. No costs were imposed in the appeal.