Valuation of closing stock on dissolution or taking over of the firm or conversion into a Co. - Income Tax - 5155/1993

INSTRUCTION NO. 5155/1993 Dated: March 17, 1993 Section(s) Referred: 145 ,170 Statute: Income - Tax Act, 1961 The office of the C AG is raising a number of objection on the valuation of closing stock on dissolution of firm or taking over of the firm or conversion into a company generally in following type of cases:- i) a proprietary business is taken over by a partnership firm; ii) a firm is taken over by or converted into a limited company. The Supreme Court has given its decision in the case of ALA Firm Vs. Commissioner of Income-tax(189 ITR 285) holding that in the event of the dissolution of a firm the market value of the closing stock has to be adopted to determine the profits. 2. Ministry of Law who has also been consulted in the matter is of the opinion that in the case of the succession of the firm falling u/s.170 of the I.T. Act, market value has to be adopted though it will be a mixed question of law and facts to be decided by the assessing authorities whether the case is one of the transfer/succession or the same persons continuing their same business in another form. 3. The opinion of the Ministry of Law which is self-explanatory is enclosed for information. DEPARTMENT OF LEGAL AFFAIRS ADVICE SECTION The question for consideration is as to whether the value of the stock is to be taken at cost price or market price when: 1) a proprietary business of an individual is taken over by a partnership firm (partnership deed dated 1-4-1983) and 2) when a partnership firm is converted, or taken over by a Private Limited Company. Both these questions have arisen as a result of objections from the audit. Full facts have been given in UO. No. 236/103/87-A PAC-II dated 24-1-1990 bearing our Dy. No. 2037/90. 2. It has also been indicated that earlier acquisition had arisen relating to the valuation of closing stock of a partnership firm in the event of dissolution. The said question also arose as a result of Audit objections. This Ministry had then opined "The safer course for the Department would, therefore, be to value the closing stock at the market rate till such time there is a clear judicial pronouncement to the contrary." 3) The matter was discussed in a meeting which was attended by S/Shri K/Krishnan(Dir) K. Malhotra from Audit side and Shri Prem Verma (Dir), CBDT, Shri M.C. Singhal and Shri. A. Chandra from CBDT. 4) It may be pointed out that it was admitted that during the relevant years, there was no specific provision in the I.T. Act on this point. 5) Section 170 of the I.T. Act, 1961 contains the heading, "Succession to business otherwise than on death". Its sub-section(1) in so far as relevant provides as under: 1) Where a person carrying on any business or profession (such person hereinafter.. referred to as the predecessor) has been succeeded therein by any other person(...successor) who continues to carry on that business or profession- The predecessor shall be assessed in respect of the income of the previous year in which the succession took place upto the date of succession; b) the successor shall be assessed in respect of the income of the previous year after the date of succession. 6. The Audit side had relied on the case of ALA firm vs. CIT(102)ITD(600) as well. The department has out in the note that the CIT(A) held that the decision of the Madras High Court in ALA firm applied to cases where a firm which was running a business was dissolved, whereas in the case under reference, the firm was succeeded by a company within the meaning of Section 170 of the Act. 7. The facts of the case of ALA vs. CIT 102 ITR 622 (1976) in nut shell were that the assessee was a partnership firm. The firm closed its accounts on 13-3-61 as it were dissolved on that date. The question was as to how the stock was valued. The court referred to the earlier decisions of G.R. Ramachari Co., vs. CIT(1966)2 STR 60 decided by the Supreme Court wherein the Supreme Court has held that there was no sale when a company in liquidation distributed its assets. The case of CIT vs. M.K. Chettiar (1935) 3 ITR 206(PC) was also referred and the conclusion arrived at was that the stock in trade had to be valued at their market value. It seems that the High Court considered various cases decided till then. 8) The above case of ALA was followed by Kerala High Court in the case of Popular Workshops vs. CIT (1987) 166 ITR 348. It was observed inter alia at p.350-351 as under:- "So long as the firm continues, it makes no difference to the partners that notional value is taken as the value of the assets. The assets at the book value continue to belong to the firm and the benefit or the loss as arising from fluctuations in their value would accrue to the firm. But the position is entirely different upon dissolution of the firm or upon retirement of a partner. The accounts in such an event must be settled not on a notional basis, that is, the book value, but on the real basis, that is, by conversion of every asset into money and the account of each partner settled on that basis. For this purpose, the assets have to be valued on the basis of the market value as on the date of the dissolution (see Muhammed Ussain Sahib V. Abdul Safoor Sahib, AIT 1950 Mad 758; Lindley on the law of Partnership, 14th edn. p. 878). Upon dissolution of a firm, the share of each partner is his proportion of the assets of the firm after they are realised and converted into money and after the debts and liabilities of the firm have been paid and discharged (see Addanki Narayanappa V. Bhaskara Krishnappa, AIR 1966 SC 1300)." 9. Reference may now be made to some other cases which are not directly on the point. In the case of CIT V.R.H. Chamber(1965) ITR vol. 55 p.674, transfer was made by a father of a son. Substantial asset of business were retained by father for discharging old debts. Observations were made indicating that succession involves change of ownership, i.e., the transferer goes out and the transferee comes in. It connotes that the whole business is transferred etc. 10. In the case of CIT vs. Janab N. Hyath Batcha Sahib (1969) 72 ITR 529 it was indicated that in the normal position in law is that a firm is not a legal entity. Therefore, when a person hands over his property to a firm or partners consisting of himself and others, there is no transfer of property so as to constitute a sale of goods as defined in the Sale of Goods Act. In the case of CIT vs. H. Rajan and H. Kannan (1984) 149 ITR 545, the individual converted the proprietary business into a partnership firm along with others. It was held in substance that there was no sale, exchange or relinquishment of asset or establishment of any right in any asset and there was no liability to tax. It was held that there was no transfer of asset in that case within the meaning of sec. 2(47) read with sec. 45 of the Income tax Act, 1961. 11. In the case of CIT vs. Hind Construction Ltd.(1972) 83 ITR 211, the Supreme Court agreed with the findings of the Tribunal. The findings were that the machinery that fell to the share of the assessee was never sold. Therefore there was no question of assessee making any profit out of them. If a person revalues his goods and shows a higher value for them in his books, he cannot be considered as having sold these goods and made profit there from. 12. In so far as the cases falling u/s.170 of the I.T. Act are concerned, the position of law is clear that the predecessor is to be assessed in respect of income of the previous year in which the succession took place upto the date of success. Therefore, when the case falls u/s.170 of the said Act, the market value of the assets may have to be determined. 13. However, whether there is a case of succession or not will have to be determined on the facts and circumstances of each case. The guidelines or the ingredients as laid down by the Hon'ble Supreme Court in the case of K.H. Chambers referred to above, will have to be considered. In that case, the Supreme Court had observed at p.682 that the cases they had considered and similar others had laid down some tests though not exhaustive to ascertain whether there is succession in a given case or not. The test of change of ownership integrity, identity and continuity of a business have to be satisfied before it can be said that a person 'succeeded' to the business of another. It further observed that the tests crystallised by decision had given a legal context to the expression 'succession' within the meaning of Sec. 25(4) of the Act and whether the facts proved satisfied these facts is a mixed question of law and fact. 14. In view of the above, though we agree with the views of the Audit that when a case falls u/s.170, the market value of the assets needs to be seen, yet it will remain a question for determination in each case whether on the facts and circumstances of the case, the said section is applicable or not. 15. In the case of Sunit Siddarthbhai vs. CIT 156(1935) ITR 509(S.C.) it was held that where a partner of a firm makes over capital assets which are sold by him to a firm as his contribution towards capital, there is a transfer of a capital asset within the terms of sec. 45 of the I.T. Act, 1961 because an exclusive interest of the partner in personal assets is reduced on their entry into the firm, into a share certificate. It was observed at p.517 of this judgment inter alia:- "Therefore, when a partner brings in his personal asset into the capital of the partnership firm as his contribution to its capital, he reduces his exclusive rights in the asset to shared rights in it with the other partners of the firm......". 16. The questions which arose for consideration in those appeals were answered as under:- "1. There was a transfer of the shares when the assessee made them over to the partnership firm as his capital contribution. 2. When the assessee transferred his shares to the partnership firm, he received no consideration within the meaning of Sec. 48 of the I.T. Act, 1961, nor did any profit or gain accrue to him for the purpose of Sec. 45 of the I.T. Act, 1961. These answers are given by us subject to the reservations made by us in the preceding paragraph." The observations in the preceding paragraph in that case were inter alia as under:- "We have decided these appeals on the assumption that the partnership firm in question is a genuine firm and not the result of a sham or unreal transaction and that the transfer by the partner of his personal asset to partnership firm represents a genuine intention to contribute to the share capital of the firm for the purpose of carrying on the partnership business. If the transfer of the personal asset by the assessee to a partnership in which he is or becomes a partner is merely a device or ruse for converting the asset into money which would substantially remain available for his benefit without liability to income tax on capital gain, it will be open to the income tax authorities to go behind the transaction and examine whether the transaction of creating the partnership is a genuine, or a sham transaction and, even where the partnership is genuine the transaction of transferring the personal asset to the partnership firm represents a real attempt to contribute to the share capital of the partnership firm for the purpose of carrying on the partnership business or is nothing but a device or ruse to convert the personal asset into money substantially for the benefit of the assessee while evading tax on a capital gain. The income-tax officer will be entitled to consider all the relevant indicia in this regard, whether the partnership is formed between the assessee and his wife and children or substantially limited to them whether the personal asset is sold by the partnership firm soon after it is transferred by the assessee to it, whether the partnership firm has no substantial or real business or the record shows that there was no real need for the partnership firm for such capital contribution from the assessee. All these and other pertinent considerations may be taken into regard when the ITO enters upon a scrutiny of the transaction, for, in the task of determining whether a transaction is a sham or illusory transaction or a device or ruse, he is entitled to penetrate the evil converting it and ascertain the truth." 17. In the case of CIT vs. Morning Star Bus Service (49) 1963 ITR 927, an association consisting of five persons who were carrying on transport business formed themselves into a private limited company and the assets of the association including 7 buses were transferred to the company. The written down value of the buses in the books of association was Rs. 24,302 and their value was shown in the books of the company as Rs. 70,000. The income-tax authorities assessed the difference as profits of the association of the year in which transfer took place. The court cited the following observation from the case of Rogers Co. Vs. CIT 34 ITR 336, also at page 930:- " But in all transactions which come up for consideration in a taxing statute we have to look at the real nature of the transaction, we have not to look at the form - the legal form- which a transaction has, and when we look at the real nature of the transaction before us, although legally it is a sale, substantially and really it is only a readjustment made by certain persons so as to carry on business in one form rather than in another. Eleven persons are carrying on business as a firm. They are carrying on a particular activity and making profits. These eleven persons make up their mind to readjust their business, the identical activity, by means of a limited company. The assets of the firm now belong to the company. No change has taken place except the legal change of a company taking the place of a firm. Under these circumstances, can it be said that there is a sale by the firm to the company which attracts the application of the second proviso to sec. 10(2)(vii) ?" and observed as under "And answered the question in the negative. Calcutta High Court in CIT vs. Mugneeram Bangur Co." 18. In view of the above, we fully endorse the opinion of Ministry of Law given earlier on the facts/reference then made. 19. In view of the observations in the cases referred to above, we are of the opinion that no general opinion can be given/applicable to all the transactions referred to in the questions posed. In each case, it will be a mixed decision of law and fact to be decided by the assessing authorities whether the case is one of transfer / succession or the same persons continuing their same business in another form. In case the intention may be to provide uniformity in this regard the concerned departments may consider making appropriate amendments in the law. F.No. 228/2/93-ITA.II