Supreme Court clarifies Capital Gains Tax on Asset Revaluation in Partnership Firms: Commissioner of Income Tax vs. Mansukh Dyeing and Printing Mills (24 November 2022)

Date of the Judgment: 24 November 2022
Citation: 2022 INSC 1121
Judges: M.R. Shah, J. and M.M. Sundresh, J.
Can a partnership firm be taxed for capital gains when its assets are revalued and the increased value is credited to the partners’ accounts, even if the firm isn’t dissolved? The Supreme Court of India addressed this question in a recent case involving M/s. Mansukh Dyeing and Printing Mills. The court examined whether such revaluation and credit constitutes a “transfer” under Section 45(4) of the Income Tax Act, 1961, and if so, whether it attracts capital gains tax. The bench comprised Justices M.R. Shah and M.M. Sundresh, with the judgment authored by Justice M.R. Shah.

Case Background

The case revolves around M/s. Mansukh Dyeing and Printing Mills, a partnership firm initially consisting of four brothers. On 02 May 1991, a family settlement led to a reduction in one partner’s share and the admission of three new partners. Later, some partners retired, and the firm was reconstituted. On 01 November 1992, four more partners were admitted, including two individuals and a private limited company, with new capital contributions. On 01 January 1993, the firm revalued its assets, increasing their value by ₹17.34 crores. This revalued amount was then credited to the partners’ capital accounts in their profit-sharing ratio. The Income Tax Department argued that this revaluation and credit constituted a transfer of assets, attracting capital gains tax under Section 45(4) of the Income Tax Act, 1961.

Timeline:

Course of Proceedings

The Assessing Officer (AO) added ₹17.34 crores to the firm’s income as short-term capital gains, arguing that the revaluation and credit to partners’ accounts constituted a transfer under Section 45(4) of the Income Tax Act, 1961. The Commissioner of Income Tax (Appeals) [CIT(A)] upheld the AO’s decision. However, the Income Tax Appellate Tribunal (ITAT) reversed this decision, relying on the Supreme Court’s judgment in Commissioner of Income Tax, West Bengal Vs. Hind Construction Ltd., (1972) 4 SCC 460, which stated that revaluation of assets does not involve a transfer. The High Court of Bombay upheld the ITAT’s decision, leading the Revenue to appeal to the Supreme Court.

Legal Framework

The core legal issue revolves around Section 45(4) of the Income Tax Act, 1961, which states:

“(4) 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.”

This provision, introduced by the Finance Act, 1987, with effect from 01 April 1988, aims to tax capital gains arising from the distribution of assets by firms. The key phrase in this section is “or otherwise,” which the court had to interpret. Before the introduction of Section 45(4), clause (ii) of Section 2(47) and Section 47(ii) exempted the transfer by way of distribution of capital assets from the ambit of the definition of ‘transfer’. This allowed firms to avoid capital gains tax by revaluing assets and then distributing them upon dissolution. This loophole was closed by inserting Section 45(4) and omitting Section 2(47)(ii).

Arguments

Revenue’s Arguments:

• The Revenue argued that the revaluation of assets and the subsequent credit to the partners’ capital accounts constituted a “transfer” under Section 45(4) of the Income Tax Act, 1961.
• The Revenue contended that the phrase “or otherwise” in Section 45(4) should not be limited to cases of dissolution but should also include situations where assets are distributed to partners of a continuing firm.
• The Revenue emphasized that the introduction of Section 45(4) was intended to prevent tax avoidance through asset revaluation and distribution.
• The Revenue relied on the Bombay High Court’s decision in Commissioner of Income Tax Vs. A.N. Naik Associates and Ors., (2004) 265 ITR 346 (Bom.), which interpreted “otherwise” to include transfers to retiring partners.
• The Revenue argued that the decision of the Supreme Court in Commissioner of Income Tax, West Bengal Vs. Hind Construction Ltd., (1972) 4 SCC 460, was not applicable because it predates the insertion of Section 45(4).

Assessee’s Arguments:

• The assessee argued that Section 45(4) applies only when there is a dissolution of the partnership firm and a distribution of assets.
• The assessee contended that the revaluation of assets and the credit to partners’ accounts were merely notional entries and did not constitute a transfer.
• The assessee submitted that there was no actual distribution of assets, only a notional increase in the value of the partners’ capital accounts.
• The assessee relied on the Supreme Court’s decision in Commissioner of Income Tax, West Bengal Vs. Hind Construction Ltd., (1972) 4 SCC 460, and the Bombay High Court’s decision in Commissioner of Income-Tax Mumbai Vs. Texspin Engg. and Mfg. Works, Mumbai, (2003) 263 ITR 345 (Bom.), to support their claim that revaluation does not amount to a transfer.
• The assessee argued that the Bombay High Court’s decision in Commissioner of Income Tax Vs. A.N. Naik Associates and Ors., (2004) 265 ITR 346 (Bom.), was not applicable as it involved the transfer of assets to a retiring partner, not a simple revaluation.

Submissions Table

Issues Framed by the Supreme Court

The Supreme Court framed the following issue for consideration:

1. Whether Section 45(4) of the Income Tax Act, 1961, is applicable to the facts of the present case.

Treatment of the Issue by the Court

The following table demonstrates as to how the Court decided the issues

Authorities

Cases Relied Upon by the Court:

• Commissioner of Income Tax, West Bengal Vs. Hind Construction Ltd., (1972) 4 SCC 460 – Supreme Court of India. This case was cited by the assessee to argue that revaluation of assets does not constitute a transfer. However, the Supreme Court distinguished this case because it was decided before the insertion of Section 45(4) of the Income Tax Act, 1961.
• Commissioner of Income Tax Vs. A.N. Naik Associates and Ors., (2004) 265 ITR 346 (Bom.) – High Court of Judicature at Bombay. The court relied on this case to interpret the word “otherwise” in Section 45(4) to include cases of subsisting partners transferring assets to a retiring partner.
• Commissioner of Income-Tax Mumbai Vs. Texspin Engg. and Mfg. Works, Mumbai, (2003) 263 ITR 345 (Bom.) – High Court of Judicature at Bombay. This case was relied upon by the assessee to argue that revaluation of assets does not constitute a transfer. However, the Supreme Court distinguished this case as it was decided before the insertion of Section 45(4) of the Income Tax Act, 1961.

Legal Provisions Considered by the Court:

• Section 45(4) of the Income Tax Act, 1961 – This section deals with the taxation of capital gains arising from the transfer of assets by way of distribution on the dissolution of a firm or otherwise. The court interpreted the phrase “or otherwise” to include transfers to partners of a continuing firm.
• Section 2(47) of the Income Tax Act, 1961 – This section defines the term “transfer” and clause (ii) of this section was omitted by the Finance Act, 1987 w.e.f. 01.04.1988.
• Section 47(ii) of the Income Tax Act, 1961 – This section exempted the transfer by way of distribution of capital assets from the ambit of the definition of ‘transfer’ and was omitted by the Finance Act, 1987 w.e.f. 01.04.1988.

Authorities Table

Judgment

How each submission made by the Parties was treated by the Court?

How each authority was viewed by the Court?

• The Supreme Court distinguished the case of Commissioner of Income Tax, West Bengal Vs. Hind Construction Ltd., (1972) 4 SCC 460, stating that it was decided before the insertion of Section 45(4) of the Income Tax Act, 1961.
• The Supreme Court followed the High Court of Judicature at Bombay’s decision in Commissioner of Income Tax Vs. A.N. Naik Associates and Ors., (2004) 265 ITR 346 (Bom.), agreeing with its interpretation of the word “otherwise” in Section 45(4).
• The Supreme Court distinguished the case of Commissioner of Income-Tax Mumbai Vs. Texspin Engg. and Mfg. Works, Mumbai, (2003) 263 ITR 345 (Bom.), stating that it was decided before the insertion of Section 45(4) of the Income Tax Act, 1961.

What weighed in the mind of the Court?

The Supreme Court’s decision was primarily influenced by the legislative intent behind the introduction of Section 45(4) of the Income Tax Act, 1961. The court emphasized that the amendment was brought to prevent tax avoidance through the revaluation and distribution of assets by partnership firms. The court highlighted the significance of the phrase “or otherwise,” stating that it should not be interpreted narrowly to only include cases of dissolution. The court’s reasoning focused on the following points:

• The objective of introducing Section 45(4) was to plug the loophole that allowed firms to avoid capital gains tax by revaluing assets and distributing them upon dissolution.
• The word “otherwise” in Section 45(4) should be interpreted broadly to include all forms of asset distribution, not just those occurring upon dissolution.
• The revaluation of assets and their subsequent credit to the partners’ capital accounts effectively amounted to a distribution of assets, thereby triggering the provisions of Section 45(4).

Sentiment Analysis of Reasons

The following table shows the ranking of sentiment analysis of reasons given by the Supreme Court as to what weighed in the mind of the court to come to the conclusion with the various points emphasized in the reasoning portion.

Fact:Law Ratio

The following table shows the sentiment analysis of the Supreme Court to show the ratio of fact:law percentage that influenced the court to decide.

The court rejected the assessee’s argument that the revaluation was merely a notional entry, stating that the credit to the partners’ accounts effectively constituted a distribution of assets. The court also clarified that the phrase “or otherwise” in Section 45(4) should not be limited to cases of dissolution but should include all forms of asset distribution. The Supreme Court quoted the Bombay High Court’s observation:

“The expression “otherwise” in our opinion, has not to be read ejusdem generis with the expression, dissolution of a firm or body or assets of persons. The expression “otherwise” has to be read with the words ‘transfer of capital assets” by way of distribution of capital asset’s. If so read, it becomes clear that even when a firm is in existence and there is a transfer of capital assets it comes within the expression “otherwise” as the object of the amending Act was to remove the loophole which existed whereby capital gain tax was not chargeable.”

The court also noted:

“In the present case, the assets of the partnership firm were revalued to increase the value by an amount of Rs. 17.34 crores on 01.01.1993 (relevant to A.Y. 1993-1994) and the revalued amount was credited to the accounts of the partners in their profit-sharing ratio and the credit of the assets’ revaluation amount to the capital accounts of the partners can be said to be in effect distribution of the assets valued at Rs. 17.34 crores to the partners…”

The court further stated:

“Therefore, the assets so revalued and the credit into the capital accounts of the respective partners can be said to be “transfer” and which fall in the category of “OTHERWISE” and therefore, the provision of Section 45(4) inserted by Finance Act, 1987 w.e.f. 01.04.1988 shall be applicable.”

There were no dissenting opinions in this case. The court’s decision clarified that Section 45(4) of the Income Tax Act, 1961, applies not only to the distribution of assets upon dissolution of a firm but also to the distribution of assets to partners of a continuing firm, especially when such distribution is a result of asset revaluation.

Key Takeaways

• Revaluation of assets in a partnership firm, followed by crediting the increased value to partners’ capital accounts, is considered a “transfer” under Section 45(4) of the Income Tax Act, 1961.
• The phrase “or otherwise” in Section 45(4) is interpreted broadly to include any distribution of assets, not just those occurring upon dissolution of the firm.
• Partnership firms may be liable for capital gains tax on the revaluation of assets even if the firm is not dissolved.

Directions

The Supreme Court quashed the judgments of the High Court and the ITAT and restored the order passed by the Assessing Officer.

Development of Law

The ratio decidendi of this case is that the revaluation of assets and the subsequent credit to the partners’ capital accounts constitutes a “transfer” under Section 45(4) of the Income Tax Act, 1961, and is therefore subject to capital gains tax. This decision clarifies the scope of Section 45(4) and broadens its application to include situations beyond the dissolution of a partnership firm. This is a change in the previous position of law which had exempted revaluation of assets from the ambit of capital gains tax.

Conclusion

The Supreme Court’s judgment in Commissioner of Income Tax vs. M/s. Mansukh Dyeing and Printing Mills clarifies that partnership firms cannot avoid capital gains tax by revaluing assets and crediting the increased value to partners’ accounts. The court’s interpretation of Section 45(4) of the Income Tax Act, 1961, emphasizes that the phrase “or otherwise” includes all forms of asset distribution, not just those occurring upon dissolution. This decision has significant implications for partnership firms and their tax liabilities.

Category

Parent Category: Income Tax Act, 1961
Child Categories:

• Section 45(4), Income Tax Act, 1961
• Capital Gains Tax
• Partnership Firms
• Asset Revaluation

FAQ

Q: What is Section 45(4) of the Income Tax Act, 1961?
A: Section 45(4) of the Income Tax Act, 1961, deals with the taxation of capital gains arising from the transfer of assets by way of distribution on the dissolution of a firm or otherwise.

Q: What does the term “or otherwise” mean in Section 45(4)?
A: The term “or otherwise” in Section 45(4) has been interpreted broadly by the Supreme Court to include any distribution of assets, not just those occurring upon dissolution of the firm. This includes situations where assets are distributed to partners of a continuing firm, especially when such distribution is a result of asset revaluation.

Q: If a partnership firm revalues its assets and credits the increased value to the partners’ capital accounts, will it attract capital gains tax?
A: Yes, as per the Supreme Court’s judgment, the revaluation of assets and the subsequent credit to the partners’ capital accounts is considered a “transfer” under Section 45(4) of the Income Tax Act, 1961, and will attract capital gains tax.

Q: Does Section 45(4) apply only when a partnership firm is dissolved?
A: No, Section 45(4) applies not only to the distribution of assets upon dissolution of a firm but also to the distribution of assets to partners of a continuing firm, especially when such distribution is a result of asset revaluation.

Q: What should partnership firms do to comply with this ruling?
A: Partnership firms should be aware that revaluing assets and crediting the increased value to partners’ accounts can attract capital gains tax. They should seek professional advice to understand the implications of this ruling and ensure compliance with the Income Tax Act, 1961.