The Supreme Court's division bench comprising Justices M.R. Shah and M.M. Sundresh recently ruled that Section 45(4) of the Income Tax Act applied not only to cases of dissolution, but also to cases of existing partners of a partnership transferring assets in favour of a retiring partner.

The court noted that previously, the omission of Clause (ii) of Section 2(47) and Section 47(ii) exempted the transformation by way of capital asset distribution from the definition of "transfer." The assessee avoided paying capital gains tax by revaluing the assets and then transferring and distributing them at the time of dissolution. The insertion of Section 45(4) and the omission of Section 2(47) created the aforementioned loophole (ii).

Section 45(4) provides that –

The profits or gains arising from the transfer of a capital asset by way of distribution of capital assets on the dissolution of a firm or other association of persons or body of individuals (not being a company or a co-operative society) or otherwise, shall be chargeable to tax as the income of the firm, association or body, of the previous year in which the said transfer takes place and for the purposes of section 48, the fair market value of the asset on the date of such transfer shall be deemed to be the full value of the consideration received or accruing as a result of the transfer.

It added–

"However, in view of the amended Section 45(4) of the Income Tax Act inserted vide Finance Act, 1987, by which, "OR OTHERWISE" is specifically added, the aforesaid submission on behalf of the assessee has no substance. After detailed analysis of Section 45(4), it is observed and held that the word "OTHERWISE" used in Section 45(4) takes into its sweep not only the cases of dissolution but also cases of subsisting partners of a partnership, transferring the assets in favour of a retiring partner."

The respondent-assessee, a partnership firm, was founded by four brothers who were involved in the dyeing and printing, processing, manufacturing, and trading of clothing businesses. One of the brother's shares was reduced as part of the family settlement, and three new partners were admitted. Following that, three of the brothers retired and formed a new firm with three other partners. Two of the partners in the new partnership decided to withdraw their capital. In this case, the partnership firm (assessee) filed its Return of Income for the relevant assessment years. The assessment was then reopened under Section 147 of the Income Tax Act by issuing a notice under Section 148. According to the Assessing Officer (A.O.), the assessee revalued the land and building and increased the valuation, thereby increasing the asset value. As a result, revaluing the assets and crediting it to the respective partners' capital accounts constituted a transfer subject to capital gains tax under Section 45(4) of the Income Tax Act.

Case Title: The Commissioner of Income Tax v. M/s. Mansukh Dyeing and Printing Mills

Citation: CIVIL APPEAL NO. 8258 OF 2022

Link: https://main.sci.gov.in/supremecourt/2014/994/994_2014_5_1501_39976_Judgement_24-Nov-2022.pdf