PCIT vs. Electroplast Engineers (Bombay High Court)

IN THE HIGH COURT OF JUDICATURE AT BOMBAY
ORDINARY ORIGINAL CIVIL JURISDICTION
INCOME TAX APPEAL NO. 137 OF 2017

Principal Commissioner of Income Tax30,
Room No. 402, 4th Floor, Pratyaksh Kar …..Appellant
Bhavan BKC, Bandra Mumbai 400 051
V/s.

Electroplast Engineers,
143, Garuda House, Upper …..Respondent
Govind Nagar, Malad (E),
Mumbai 400097

Mr. Arvind Pinto a/w Mr. N. C. Ranganayakulu
Mr. R. Murlidhar i/b Mr. Vaibhav Pandya for Respondent

CORAM : AKIL KURESHI &
SARANG V. KOTWAL, JJ.
DATE : 26th MARCH, 2019.

ORAL JUDGMENT: (PER AKIL KURESHI, J.)

This appeal is filed by the Revenue to challenge the Judgment
of Income Tax Appellate Tribunal (“ITAT” for short). Following
question was presented for our consideration:
“Whether in law and on the facts of the instant
case, was the Tribunal correct in holding that
there was no transfer of capital asset by way of
distribution at the time of making payment to
the retiring partners”.

2 Brief facts are as under.
(I) Respondent assessee a partnership firm, had filed return of
income for the assessment year 20102011.

The assessee was
engaged in manufacturing of tubelight fittings and other lighting
accessories for over 13 years. The firm was constituted under
Partnership Deed dated 16/11/1996, originally consisting of two
partners. On 15/01/2010, constitution of the firm underwent a
change under a Deed of Reconstitution of partnership. Three new
partners were admitted. On 16/01/2010, another Deed of
Retirement cum Reconstitution of the partnership was executed by
which the original two partners retired from the firm and the
remaining three partners redistributed
their share in a partnership
firm. The partnership created a goodwill account and a sum of Rs.
3.75 Crores (rounded of) was credited in the books of the firm in the
said account. The retiring parters were paid sums of Rs. 2.97 Crores
(rounded of) and 77.27 Lakhs (rounded of) respectively in proportion
of their shares in the partnership business.

(II) The Assessing Officer was of the opinion that in terms of
section 45(4) of the Income Tax Act, 1961, (“the Act” for short) the
firm had to pay short term capital gain tax on such amounts. The
Assessing Officer was of the opinion that the goodwill credited by the
firm of Rs. 3.75 Crores was nothing but the capital gain arising on
distribution of the capital asset by way of “dissolution of the firm or
otherwise”.

(III) The assessee carried the matter in appeal in which heavy
reliance was placed on Full Bench Judgment of Karnataka High
Court in the case of Commissioner of IncomeTax
and Another v.
Dynamic Enterprises1. The Commissioner agreed with the
contention of the assessee that there was neither dissolution of the
firm nor the firm was discontinued. He, however, held that the rights
and interests in assets of the firm were transferred to the new
members and in this manner there was transfer of capital asset. He
was further of the opinion that Section 45(4) of the Act would apply
1 [2013] 359 ITR 83 (Karn) [FB]

in the present case which would cover even a case of transfer of
capital asset otherwise than by dissolution of the firm.

(IV) The assessee carried the matter in further appeal before the
Tribunal. The Tribunal by the impugned Judgment allowed the
assessee’s appeal. The Tribunal was of the opinion that the
conditions required for applying section 45(4) of the Act were not
satisfied in the present case. The Tribunal placed reliance on the
decision of the Karnataka High Court in the case of Dynamic
Enterprises (Supra). The Revenue has filed this appeal against the
said Judgment of the Tribunal.

3 The counsel for the appellant submitted that decision of this
Court in the case of Commissioner of IncomeTax
v. A. N. Naik
Associates and Another2 would be applicable in the present case.
The Tribunal has committed an error in proceeding on the basis that
Section 45(4) of the Act would apply only in a case where there has
been dissolution of the firm.
2 [2004] 265 ITR 346 (Bom)

4 On the other hand, the learned counsel for the assessee
opposed the appeal contending that decision of this Court in the
case of A. N. Naik Associates (Supra) concerned a question whether
Section 45(4) of the Act would apply only in a case of dissolution of
the firm and not in case of retirement of a partner. The Court was
not concerned with the question of applicability of Section 45(4) of
the Act without there being any transfer of capital asset. The
Karnataka High Court in the case of Dynamic Enterprises (Supra)
has noticed the decision of this Court in the case of A. N. Naik
Associates (Supra) and held that when there is no transfer of capital
asset, Section 45(4) will not apply.

5 Having thus heard the learned counsel for the parties, we may
summarise the undisputed facts:
(I) Assessee firm was registered partnership firm, initially
comprising of two partners. After carrying on the business for about
13 years, partnership was reconstituted to bring in three new
partners. Almost immediately thereafter, a new Deed was executed

under which the original two partners retired. Newly inducted three
partners of the firm continued the business of the firm and the
assets were redistributed. While doing so, the partnership evaluated
its goodwill. The retiring partners were paid their share in the
goodwill in proportion of their existing shares in the partnership
business.
(II) Section 45 of the Act pertains to computation of the capital
gains. Sub Section 4 of Section 45 reads as under:
“45 (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 cooperative
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”.

6 As per this provision, profits or gains arising from transfer of
capital asset by way of distribution of capital asset on dissolution of
firm or otherwise shall be chargeable to tax as income of the firm.
For application of this provision, thus, transfer of capital asset is
necessary. Provisions of Section 45(4) of the Act came up for
consideration before this Court in the case of A. N. Naik Associates
(Supra). It was a case in which there was reorganization
of the
partnership in quick succession. The Court held that such reorganization
would not amount to dissolution of the firm. The
question in such background was whether Section 45(4) of the Act
would apply in case there has been transfer of capital asset. The
Court referred to legislative changes and observed that when the
asset is transferred to the partner, that falls within the expression
“otherwise” and the rights of the other partners in that asset of the
partnership are extinguished. It was held that transfer of assets of
the partnerhsip of the retiring partners would amount to transfer of
capital assets.

7 This decision of the Court in the case of A. N. Naik Associates
(Supra) was considered by the Karnataka High Court in the Full
Bench Judgment in the case of Dynamic Enterprises (Supra). The
question considered by the court was when retiring partner takes
only money towards value of his share, whether the firm should be
made liable to pay capital gains even when there is no distribution of
capital asset among the partners under section 45(4) of the Act. In
the said case of Dynamic Enterprises (Supra), the partnership firm
was engaged in the business of buying land and properties and
construction of buildings thereon. The firm underwent
reconstitution. Before such reconstitution the assets of the firm were
revalued as per the report of the registered valuer. Three erstwhile
partners retired. Retiring partners received enhanced value of the
property upon retirement. In this context, the Court considered the
above noted question. The Court held that after retirement of
partners, the partnership continued and the business was also
carried on by the remaining partners. There was thus no dissolution
of the firm and there was no distribution of capital asset. What is
given to the retiring partners was money representing the value of
their share in the partnership. No capital asset was transferred on
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the date of retirement. In absence of distribution of capital asset and
in absence of transfer of capital asset in favour of retiring partners,
no profit of gain arose in the hands of partnership firm. Following
observations of the court may be noted:

“25. In the instant case, the partnership firm had purchased
the property under a registered sale deed in the name of the
firm. The property did not stand in the name of any
individual partners. No individual partners brought that
capital asset as capital contribution into the firm. Five
partners brought in cash by way of capital when the firm
was reconstituted on April 28,1993. Nearly a year thereafter
on April 1,1994, by way of retirement, the erstwhile three
partners took their share in the partnership asset and went
out of the partnership. After the retirement of three partners,
the partnership continued to exist and the business was
carried on by the remaining five partners. There was no
dissolution of the firm or at any rate there was no
distribution of capital asset on April 1,1994, when the three
partners retired from the partnership firm. What was given
to the retiring partners is cash representing the value of their
share in the partnership. No capital asset was transferred
on the date of retirement under the deed of retirement deed
dated April 1,1994. In the absence of distribution of capital
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asset and in the absence of transfer of capital asset in
favour of the retiring partners, no profit or gain arose in the
hands of the partnership firm. Therefore, the question of the
firm being assessed under Section 45(4) and charging them
tax for the profits or gains which did not accrue to them
would not arise.

26. It was contended on behalf of the revenue that the five
incoming partners brought money into the firm. Three
erstwhile partners who retired from the partners on April 1,
1994, took money and left the property to the incoming
partners. It is a device adopted by these partners in order to
evade payment of profits or gains. As rightly held by this
Court in Gurunath’s case (supra) it is taxable. This argument
proceeds on the premise that the immovable property
belongs to the erstwhile partners and that after the
retirement the erstwhile partners have taken cash and given
the property to the incoming partners. The property belongs
to the partnership firm. It did not belong to the partners. The
partners only had a share in the partnership asset. When
the five partners came into the partnership and brought cash
by way of capital contribution to the extent of their
contribution, they were entitled to the proportionate share in
the interest in the partnership firm. When the retiring
partners took cash and retired, they were not relinquishing
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their interest in the immovable property. What they
relinquished is their share in the partnership. Therefore,
there is no transfer of a capital asset, as such, no capital
gains or profit arises in the facts of this case. In that view of
the matter, Section 45(4) has no application to the facts of
this case.
29. In the instant case, the partnership firm did not transfer
any right in the capital asset in favour of the retiring partner.
The partnership firm did not cease to hold the property and
consequently, its right to the property is not extinguished.
Conversely, the retiring partner did not acquire any right in
the property as no property was transferred in their favour.
The Division Bench in Gurunath’s case (supra) did not
appreciate this distinguishing factor and by wrong
application of the law laid down by the Bombay High Court
held the assessee in that case is also liable to pay capital
gains tax under Section 45(4). Therefore, the said judgment
does not lay down the correctlaw”.
8 The issue is thus similar to one considered by the Full Bench
of Karnataka High Court and with which we are in respectful
agreement. The decision of this Court in the case of A. N. Naik
Associates (Supra) was rendered in slightly different background.
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Central question was, would Section 45(4) apply even if there was no
dissolution of the firm. Issue of transfer of capital asset was not the
focal point. In the present case, admittedly there was no transfer of
capital asset upon reconstitution of the firm. All that happened was
the firm’s assets were evaluated and the retiring partners were paid
their share of the partnership asset. There was clearly no transfer of
capital asset. Revenue has not argued that the reconstitution of the
firm was a colourable device to avail tax liability.
9 In the result, we do not find any error in the view of Tribunal.
10 Income Tax Appeal is dismissed.
[SARANG V. KOTWAL, J.] [AKIL KURESHI, J.]
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