2020 (3) TMI 953 - AT - Income Tax

Capital gain u/s 45 - compensation received by a partner from another partner for relinquishing rights in the partnership firm - whether no transfer of asset within the meaning of Sec.45(4) ? - assessee reiterated that the rights of the existing partner was reduced in the firm and the right was created in favor of the existing partner of the firm but the ownership of the property did not change even with the change in the constitution of the firm - whether or not the compensation received by an existing partner from other partners for reduction in profit sharing ratio would be chargeable to tax as Capital Gain u/s 45(1)? - HELD THAT - It cannot be said that, upon dissolution, the firm's rights in the partnership assets are extinguished. It is the partners who own jointly or in common the assets of the partnership and, therefore, the consequence of the distribution, division or allotment of assets to the partners which flows upon dissolution after discharge of liabilities is nothing but a mutual adjustment of rights between partners and there is no question of any extinguishment of the firm's rights in the partnership assets amounting to a transfer of assets within the meaning of sec.2(47). There is no transfer of assets involved even in the sense of any extinguishment of the firm's rights in the partnership assets when distribution takes place upon dissolution. In order to attract S.34(3)(b) it is necessary that the sale or transfer of asset must be by the assessee to a person. Dissolution of a firm must, in point of time, be anterior to the actual distribution, division or allotment of the assets that takes place after making accounts and discharging the debts and liabilities due by the Firm. Upon dissolution the firm ceases to exist; then follows the making up of accounts, then the discharge of debts and liabilities and thereupon distribution, division or allotment of assets takes place inter se between the erstwhile partners by way of mutual adjustment of rights between them. The distribution, division, or allotment of assets of the erstwhile partners, it not done by the dissolved firm. During the subsistence of a partnership, a partner does not possess an interest in specie in any particular asset of the partnership. During the subsistence of a partnership, a partner has a right to obtain a share in profits. On a dissolution of a partnership or upon retirement, a partner is entitled to a valuation of his share in the net assets of the partnership which remain after meeting the debts and liabilities. An amount paid to a partner upon retirement, after taking accounts and upon deduction of liabilities, does not involve an element of transfer within the meaning of Section 2( 47 ). See M/S RIYAZ A SHEIKH 2013 (12) TMI 248 - BOMBAY HIGH COURT We hold that the compensation received by the assessee from existing partners for reduction in profit sharing ratio would not tantamount to Capital Gains chargeable to tax u/s 45(1). Therefore, by deleting the impugned addition, we allow the appeal.

Summary

Issues Involved:
1. Chargeability of Capital Gains on reduction of share in a partnership firm.
2. Applicability of Section 45(1) and Section 45(4) of the Income Tax Act.
3. Interpretation of "transfer" under Section 2(47) of the Income Tax Act.
4. Taxability of compensation received for reduction in profit-sharing ratio.

Detailed Analysis:

1. Chargeability of Capital Gains on Reduction of Share in a Partnership Firm:
The primary issue was whether the compensation received by the assessee for reducing its share in a partnership firm constituted chargeable capital gains. The assessee argued that the compensation received was a capital receipt and not taxable. The Assessing Officer (AO) and Commissioner of Income Tax (Appeals) [CIT(A)] held that the compensation was taxable as capital gains under Section 45(1) of the Income Tax Act.

2. Applicability of Section 45(1) and Section 45(4) of the Income Tax Act:
The tribunal examined whether Section 45(4) applied, which deals with the distribution of capital assets on the dissolution of a firm. It was determined that Section 45(4) did not apply as the case involved a reduction in the share of one partner, not the dissolution of the firm. The firm continued its business with the existing partners, including the assessee.

3. Interpretation of "Transfer" under Section 2(47) of the Income Tax Act:
The tribunal considered whether the reduction in the profit-sharing ratio and the compensation received constituted a "transfer" under Section 2(47). The AO argued that the relinquishment of the share in the firm amounted to a transfer and was taxable. The tribunal referred to various judicial precedents, including the decision of the Karnataka High Court in CIT V/s P.N. Panjawani, which held that such a reduction does not amount to a transfer under Section 2(47).

4. Taxability of Compensation Received for Reduction in Profit-Sharing Ratio:
The tribunal noted that the compensation received by the assessee was credited to its current account with the firm and was an adjustment of profit-sharing ratios among the existing partners. The tribunal relied on the Karnataka High Court's decision in CIT V/s P.N. Panjawani, which stated that compensation for the reduction in profit-sharing ratio does not constitute capital gains chargeable to tax under Section 45(1).

Conclusion:
The tribunal concluded that the compensation received by the assessee from existing partners for the reduction in profit-sharing ratio did not amount to capital gains chargeable to tax under Section 45(1). The appeals for both assessment years were allowed, and the additions made by the AO were deleted.