Analysis of three important judgements (June to October 2011)

Slump Sale – Whether breaking up of price permissible:-

1.1 The decision of the Calcutta High Court in the case of Kwality Ice Creams {I} Ltd [2011] 336 ITR 100 {Cal} may provide fodder for interesting appraisal by the readers. In this case, the assessee, an ice cream manufacturer, transferred its marketing undertaking for a price of Rs. 3 crores. There is nothing in the decision to suggest that the price of Rs. 3 crores was a composite price for transfer of individual assets of the marketing undertaking sold. On the contrary, from the facts of the case, it appears that the price was paid for a slump sale of the marketing undertaking as a whole. The decision related to Assessment Year 1996-97 i.e. before the slump sale provisions of section 50B were brought on the statute book.

The issues for consideration of the High Court was whether the price of Rs. 3 crores could be severed and allocated individually to the various assets of the marketing undertaking transferred – so that the capital gains relating to depreciable assets could be taxed separately u\s 50. The High Court here has held in affirmative. In coming to this conclusion, it was drawn support from the decision of the Supreme Court in the case of CIT vs. Artex Manufacturing Co [1997] 227 ITR 260 {SC}. According to the High Court, the Supreme Court has specifically held that if item wise allocation of the price is possible towards the assets of the business transferred, then capital gains should be determined vis-à-vis the individual assets.

1.2 According to me, the Supreme Court has not held in this manner in the Artex decision. In the Artex case, though it was stated in the transfer agreement that the business was transferred for a lump sum price, the Assessing Officer had found that the assessee had obtained a valuation report of the individual assets for the purpose of fixing the sale price of the business. This meant that the lump sum price in the agreement was, in reality, not a slump sale price for the business as a whole, but an aggregated price of the individual assets of the business sold. It was a composite price for the sale of a bunch of assets and not a single price for the business as a whole. The findings of the Apex Court are understandable because the real underlying agreement between the parties was to transfer itemized assets at a bunched price and this was not a case of slump sale simpliciter as made out in the written agreement.

In fact, in another decision of the same date of the Supreme Court in the case of CIT vs. Elecon Control Gear Mfg. Co. [1997] 227 ITR 278 {SC}, the Apex Court distinguishing its earlier decision in the Artex case, has held that the agreement of the assessee was for a slump sale of the business as a whole as there was nothing in the transfer agreement to suggest that there was itemized sale of the assets.

1.3 Whether a transfer agreement is of a slump sale of a business undertaking or a sale of a bunch of assets of the business undertaking for a composite price, should be discerned from the terms and conditions of the agreement. If the transfer agreement shows that the real intention of the parties was to effect a transfer of the business as a whole for a slump price, then it would not be permissible for the Court to read the agreement otherwise. The sale must then be assessed to tax as on slump sale basis only. The decision of the Supreme Court in Elecon Control Gear is a clear authority for this proposition.

On the other hand, if the real intention of the parties, as apparent from their conduct, was sell individual assets only, the fact that transfer agreement cites a slump sale should hardly matter. Here, it should definitely be permissible for the Court to come to the conclusion that the price mentioned in the agreement was merely a composite price for itemized sale of various assets and the Court should sever the sale consideration over the transferred assets as done by the Supreme Court in the Artex Case. After all, if the substance of an agreement is manifestly at variance from the form in which it is projected, nothing should preclude the Court from ignoring the form and assessing the transaction on the basis of this substance.

In short, the decision of the Supreme Court in the Artex case never carried an authority that if the sale is factually a slump sale, it is permissible for the tax authority to break down the price – even on any scientific basis – `and allocate the price over the assets. The finding of the Calcutta High Court that the Apex Court in Artex case permitted such breaking up of the slump price does not appear manifest from a reading of the Artex decision.

There is tangible difference between slump sale of a business for a unit price and composite sale of assets of the business at an aggregated price. Whereas in the former, it is not permissible for the tax authority to split the price over the assets transferred even on scientific basis, in the latter case it is permissible. This distinction, according to me, has been well maintained in a balanced manner by the Supreme Court in its Artex and Elecon Control decisions. Readers are invited to form their opinions on this issue.

Capital Gains on retirement of partner on assignment of his share.

2.1 The decision of the Mumbai Tribunal in the case of Sudhakar M. Shetty decision – [2011] 130 ITD 197 {Mum} makes a distinction between the tax incidents visiting a partner who merely realises his share due to him on retirement and a retiring partner who assigns his share to a continuing partner for lump sum consideration. Whereas the former mode has been held not to invite capital gains tax, the latter was held to be not so fortunate.

The Tribunal has observed that a partner’ share’ in the partnership is a ‘property’ and its assignment would constitute a transfer of a capital asset giving rise to capital gains. The difference between consideration received on assignment and his capital account balance was held taxable as capital gains

According to the Tribunal, the assessee, Sudhakar Shetty’s retirement was under the second mode – i.e. by assignment of share and hence, his retirement gave rise to taxable capital gains

2.2. It is pertinent that the issue in the decision concerns the normal capital gains’ provisions of section 45 [1] i.e. between partners inter se in their individual capacities and has nothing to do with the provisions of section 45 [4], where the transfer contemplated is between the firm and a partner.

2.3 For analysing this decision, let us first understands as to what constitutes a partner’s ‘share’ in partnership?

As per the classical English partnership law cited by Lindsay and adopted by Indian Courts in Narayanappa vs. Bhaskara Krishnappa {AIR 1966 SC 1300}and Dewas Cine Corporation – 68 ITR 240 {SC}, a partner’s monetary rights are two folds . Firstly, during his tenure as partner, whereas he has no specific right in any individual asset of the partnership, his right is only to receive his share of profit Secondly, on dissolution or retirement, he has a right to a share in the net estate of the firm {i.e. assets minus liabilities and winding up expenses- valued on the basis of a notional sale} as on date of the retirement or dissolution. This bundle of rights constitutes the ‘share ‘of the partner.

So, when a partner retires, the accounts of the firm are made up –valuing the assets on basis of a notional sale, the liabilities and notional winding up expenses are deducted – and the amount due to the retiring partner towards his share, as worked out by this arithmetic, is determined as payable to him.

It is pertinent that a partner’s right to this share is not created on retirement. This right existed the moment he joined the partnership. It was a right in presenti , whose value was merely determinable at time of retirement and this right, the partner carried with him all along as ‘his property’ from the time of his joining till he retires.

On retirement, the retiring partner takes away his own money due to him and the shares of the continuing partners remain intact without an enlargement. So, there is no ‘transfer” of any property from such retiring partner to the continuing partners. This logic can be found in the decision of the Gujarat High Court decision in the case of Mohanbhai Pamabhai as reported 91 ITR 393 {Guj} as approved by the Supreme Court in 165 ITR 166 {SC}

Even if the continuing partners bring in further capital to settle the retiring partner, the enlargement of the continuing partner’s shares is due to their own ‘self –acts” of bringing in more funds and not due to anything done by the retiring partner. Hence, there is no act of ‘transfer’ from the retiring partner to continuing partner.

The Gujarat High Court decision in the case of Mohanbhai Pamabhai – 91 ITR 393 {Guj} referred above was distinguished by the Bombay High Court in Tribhuvandas Patel case – 115 ITR 95 {Bom} . The Bombay High Court distinguished between two modes of retirement as under ;-

[a] Where a partner merely retires by taking away the money due on his share as per accounts – no transfer and capital gains – agreeing with Mohanbhai Pamabhai – 91 ITR 393 {Guj}.

[b] But, where the partner assign his share to a continuing partner for a lump sum consideration, the ‘share’ is property in hands of the retirement partner and hence a capital asset. Its assignment is a transfer. On such assignment, there is a transfer of capital asset from retiring partner to continuing partner and hence, capital gains result.

In the case before the Bombay HC, there was dispute between the partners and under a court settlement agreement, it was cited that the retiring partner was ‘assigning’ his share to the continuing partner for an amount of say – Rs. 4.71 lacs. It was held that there was transfer on such assignment resulting in capital gains. This Bombay High Court decision has also been followed by the same High Court in other decisions.

The Bombay High Court decision in Tribhuvandas Patel [115 ITR 95] came up for consideration before the Supreme Court in 236 ITR 515 {SC}. Here, it appears that a short question was put to the Supreme Court as to whether the amount of Rs. 4.71 lacs received on retirement attracted capital gains. The Supreme Court, probably appraising the issue as a case involving a retiring partner merely realising the money due towards his share on retirement, held that this amount was not taxable as capital gains following its earlier decision in Mohanbhai Pamabhai 165 ITR 166 {SC}.

The Mumbai Tribunal in Sudhakar Shetty’s case has apparently taken the view that the issue about capital gains implications on assignment of share by partner had not been addressed as a question before the Apex Court in Tribhuvandas Patel case in 236 ITR 515 {SC} and therefore, the decision of the Bombay HC in Tribhuvandas Patel’s case in 115 ITR 95 {Bom} remains not overruled and binding on it as a decision of jurisdictional High Court.

It is in this scenario that readers are invited to appraise the decision of the Mumbai Tribunal in Sudhakar Shetty‘s case.

In order to do, let us firstly understand what is the general partnership law relating to assignment of share by partner?

Section 29 of the Indian Partnership Act cites the rights of an assignee of share by partner as under:-

Firstly, when a partner assigns his ‘share’, the assignor continues to be the partner and the assignee can neither take part in the conduct of the partnership business nor has right to ask or inspect the accounts. He has only a right to receive the share of profit due to the assignor-partner, which accounts he must accept without demur. In short, it is not open to the assignee to challenge the correctness of the accounts and has to accept it as correct.

Secondly, when the assignor-partner ceases to be a partner, the assignee gets the right to demand the assignor-partner’s share in the assets of the firm as due to him on such cessation and also a right to the accounts from the date of cessation onwards till he is fully settled.

So, on the issue of assignment of a partner’s share, the following points emerge-

[a] It is not specified in the section 29 as to who can be an assignee. So, the assignee can be a rank outsider to the partnership or even a continuing partner.

[b] An assignee does not automatically become a partner in place of the assignor-partner. He remains only an assignee. This is even so if the other partners have consented to the assignment. This is because the consent operates only in respect of the ‘assignment’. They cannot be presumed to have agreed to his introduction as partner.

[c] The assignee cannot take part in the business of the partnership.

[d] The assignor-partner continues to remain the partner and is not relieved from his mutual obligations to the other partners under the partnership deed.

[e] The assignment does not take place under the auspices of the partnership deed, but is private deal between the assignor-partner and the assignee. This is in marked contrast to retirement, which takes places under the terms and conditions of the partnership deed.

Therefore, a possible view is that even if the assignment of the partner’s share is done to a continuing partner, the continuing partner remains an ‘assignee’ qua the share assigned and not a ‘partner’. No doubt, in his capacity as an existing partner, he can take part in the business of the partnership and access the accounts directly. But, it may be noted that this right is due to his natural right as an existing partner and has nothing to do with his acquiring the subsequent partnership share on assignment

The disability of the assignee-partner, in operating as a fully fledged partner qua the share assigned can be best understood by this example. Assume A, B & C are partners. As per the partnership deed, A is designated as Managing Partner and B is supposed to remain as dormant partner. An assignment by A of his share to B cannot make B the Managing Partner. This is because as per section 29 [1] of Partnership Act, a partner cannot assign his right to take part in the business to an assignee. So, the disability of the assignee remains.

In contrast to a retirement by a partner, an assignment by a partner of his ‘share’ to a continuing partner results in enlargement of his property holdings. The assignee partner now has two properties – [a] his original share as partner and [b] his new share as assignee. The assignment also results in diluting of the assignor-partner’s rights in the sense that he can no longer take home his share in profits or his share in the net asset on retirement or dissolution, since these rights he has given to the assignee.

If seen from the above angle, a transfer of property rights from the assignor partner to the assignee partner would be evident and the assignment transaction gets exposed to capital gains’ tax. In contrast, a ‘transfer’ is not existent when a partner merely realises his share on retirement as he is merely getting the money due to him from the firm.

2.12. More ever, when a partner retires, it become necessary to prepare the accounts in order to determine the share payable to the retiring partner. But, in an assignment, the question of preparing the accounts of the firm for the purpose of settling the assignee partner does not arise. The price is fixed between the assignor and assignor without reference to the accounts and that is why, I think, it was referred as ‘lump sum bases by the Bombay High Court decision in Tribhuvandas Patel’s case.

It may be noted that the expression ‘lump sum’ – does mean that amount due to a retiring partner cannot be determined at an agreed ‘rounded – up’ figure by the continuing partners. After all, the rounded up figure is also agreed after a fair assessment of the accounts.

It is in this legal background that the decision of the Mumbai Tribunal in Sudhakar Shetty’s case may be appraised by the readers now.

In Sudhakar Shetty’s case, both the assessee and his wife were partners with a few others. His wife retired in the prior financial year and for settling her account, a revaluation [assumedly at market value on basis of a notional sale] was done of the assets and the surplus on revaluation was credited to all partners.

In the next financial year, within few months of his wife’s retirement, the assessee also retired. No fresh revaluation was apparently done as a revaluation was done only a few months ago. On retirement, he received the amount due on his capital, which includes his share on revaluation surplus. A possible view is that this was a case of a normal retirement by a partner and did not involve any assignment. The assessee had apparently taken only the money due to him on retirement.

A citation in the retirement deed that the assessee would not have any right in the assets of the firm after retirement should not constitute an assignment. The cessation of the rights in the net assets of the partnership was a natural incidence of his retirement.

It may be noted that there is a significant difference between [a] an assignment of share by partner followed by retirement and [b] only retirement simpliciter. In the former case, the transfer event takes place because of a prior assignment and the subsequent retirement is only a consequential incident. On the other hand, when a partner retires, the nature of his right in his hands undergoes a transformation. His original contractual rights qua the other partners are not the same as he had when he was a partner. For example, he ceases to have the right to profits, right to take part in the business thereafter etc. What remains in his hands is only to seek the money worth of the net assets due to his share. In short, on retirement, he ceases to have the original rights of a partner and there can be obviously no assignment of rights which he longer has. Readers may thus note that whereas there can be an assignment before retirement. there cannot be an assignment of a partner’s share after retirement . A citation in the retirement deed that the retiring partner would no longer have any right in the assets of the partnership cannot therefore amount to an assignment of a partnership share by the retiring partner to the continuing partner.

It is therefore a possible view that there was no assignment of share by the retiring partner to the continuing partner in the Sudhakar Shetty’s case. Readers may therefore examine this decision carefully.

Income – Diversion vs. Application

3.1 The decision of the Mumbai Tribunal in the case of RSM and Co vs. Addl. CIT [2011] 10 ITR {Trib} 614 {Mumbai} is a thought provoking decision. In this case, partnership deed of the assessee chartered accountant firm, provided in its terms and conditions for payment to a retiring partner, who had completed fifty years of age, an amount [calculated at 25 % of the average earnings of the partner from the firm of three completed years prior to his retirement] payable in four quarterly instalments for a period of five years. The issue, before the Tribunal, was whether the payments made by the assessee to the retiring partners was a case of diversion of income at source by an overriding title or application of income after it accrued to the assessee.

3.2 The Tribunal firstly considered the decision of The Supreme Court in the case of CIT vs. Sitladas Tirathdas [1961] 41 ITR 367 {SC}. Here, the Apex Court had laid down the ground rules as to when a payment made under an obligation would constitute a diversion of income by overriding title and per contra, when such payment would otherwise be a mere application of income after it accrued to the assessee. The Apex Court had observed as under:-

“Obligations, no doubt, there are in every case, but it is the nature of the obligation which is the decisive fact. There is a difference between an amount which a person is obliged to apply out of his income and an amount which by the nature of the obligation cannot be said to be a part of the income of the assessee. Where by the obligation income is diverted before it reaches the assessee, it is deductible ; but where the income is required to be applied to discharge an obligation after such income reaches the assessee, the same consequence, in law does not follow. It is the first kind of payment which can truly be excused and not the second. The second payment is merely an obligation to pay another a portion of one’s own income, which has been received and is since applied. The first is a case in which the income never reaches the assessee, who even if he were to collect it, does so, not as part of his income, but for and on behalf of the person to whom it is payable”

3.3 The Tribunal then dealt with various decision of the Bombay High Court where the issue of diversion of income by overriding charge was involved. These decisions were rendered after considering the decision of the Supreme Court in the case of Sitaldas Tirathdas cited above.

The decisions are:-

CIT vs. Patuck {C.N.}[1969] 71 ITR 713 {Bom}

CIT vs. Crawford Bayley and Co [1977] 106 ITR 884 {Bom}

CIT vs. Nariman B. Bharucha & Sons [1981] 130 ITR 863 {Bom}

The sum and substance of these decisions is that whenever an obligation to pay any income is created by way of a charge on the income, a superior title is created over the income in favour of the charge holder to the extent of the charge. Qua this income, the charge holder has a paramount or superior title over that of the assessee. The income, to the extent of the charge, is diverted in favour of the assessee before it reaches the assessee. Even if the income charged lands in the hands of the assessee, he is only its collector of the sum on behalf of the charge holder. The position of the assessee, as such collector, is that of a ‘cestui que’ trustee, who holds the income in trust for the charge holder. The income belongs to the charge holder only and cannot be assessed in the hands of the assessee.

It is pertinent that the decisions in the cases of CIT vs. Crawford Bayley and Co [1977] 106 ITR 884 {Bom}and CIT vs. Nariman B. Bharucha & Sons [1981] 130 ITR 863 {Bom}directly involved cases where the payments, made by partnership firms to erstwhile partners or their heirs under obligations agreed in the partnership deeds, were held to be diversions of incomes not taxable in hands of the firms.

3.4. After considering the above precedents laid down by the Supreme Court and the Bombay High Court, the Mumbai Tribunal in the case of RSM and Co held that covenant in the partnership deed to make payment to the retired partner created an overriding charge on the income of the assessee in favour of the retired partner. By virtue of this charge, the income to the extent of the charge was diverted to the retiring partner before it reached the hands of the assessee. The Tribunal thus held that this income cannot be assessed in the hands of the assessee.

3.5. According to me, whereas the decision of the Mumbai Tribunal has been correctly laid, it is also possible support the decision from another angle. Some Courts have made a fine distinction between an obligation which attaches to the source of income and an obligation which attaches to the income itself According to these decisions, the diversion of income is only in the former case and in the later cases, it application of income. Without dwelling at length on these decisions, I would invite the attention of the readers to the decision of the Supreme Court in the case of CIT vs. Travancore Sugars and Chemicals Ltd [1973] 88 ITR 1 {SC}, which comes to my mind. Here, it appears that the Apex Court has made an observation to the effect that where the obligation is attached to the profit earning apparatus, the income can be said to be diverted at the source. On the other hand, if the obligation is attached to the profit earning process, the payment may have to be considered as to whether the same is allowable as expenditure from business profits.

From the facts of the case cited in the Mumbai Tribunal decision in the case of RSM & Co, it can be seen that there was a covenant in the partnership deed obliging the partnership firm to pay an assured amount to a retiring partner. When the partners sign such a deed, the covenant binds both the continuing partners and the retiring partners at the time of future retirement. The effect of this covenant is that the continuing partner would be entitled to continue the business of the partnership only under a pre-condition that the retiring partner would be paid this assured amount. In short, the profit earning apparatus of the partnership firm is released by retiring partner in to the hands of the continuing partners subject only to their commitment to this obligation. This is veritably a case, where the obligation to pay an income is attached to the very source of income i.e. the profit earning apparatus.

Therefore, even viewing from this angle, it is possible to also support the decision of that the Mumbai Tribunal in RSM & Co’s case.