Gain on revaluation of assets in partnership firm is taxable as capital gains under Section 45(4)- Supreme Court

Facts of the Case:

• The Assessee is a Partnership Firm (the firm) and on 01.11.1992, 4 partners were admitted to the firm, where all 4 new partners brought few lakhs of rupees as their opening capital contribution. Later, on 01.01.1993 assets of the firm were revalued at ₹17.34 crores and the same was credited to the partner’s capital account in their profit-sharing ratio (PSR). At the same time two of the existing partners withdrew part of their capital which was roughly around ₹20-25 lakhs.
• Return of income was filed for AY 1993-94 and same was assessed under Section 143(1) of the Income Tax Act,1961 (the Act) however reassessment proceeding was initiated under Section 147 and an addition was made by the Assessing officer for ₹17.34 crores towards income from short term capital gains. Similar additions were also made in AY 1994-95.
• Further, CIT (A) confirmed the additions made by the Assessing Officer by holding it as transfer by relinquishment of interest in the asset of the firm in favor of each partner in PSR. Thereafter, the matter went before ITAT, wherein such the additions made by AO were deleted. The order of the ITAT was upheld by the Hon’ble High Court of Mumbai. Hence, the revenue went in an appeal before the Hon’ble Supreme Court.
• The question put before the Hon’ble Supreme Court was limited to the interpretation of provisions of Section 45(4) of the Act i.e. where the afore mentioned provisions shall apply in case where assets were revalued and gains on such revaluation were credited to the partner’s capital account.

Observation And Conclusion:

• The provisions of Section 45(4) of the Act were inserted vide Finance Act, 1987. It was inserted to tax certain transactions and the term ‘otherwise’ used there was the matter of contention here in this case.
• In this case, the Hon’ble Supreme Court held that the revaluation gain credited to the partners’ capital accounts and was available to the partners for withdrawal shall be taxable as capital gains. The term ‘otherwise’ has been inserted to tax such transactions and hence the assets so revalued and the credit into the capital accounts of the respective partners can said to be “transfer” for the purposes of tax.
• While deciding this case, the Hon’ble Supreme Court relied on the decision of A.N. Naik Associates and Ors., (supra) – where in the it was held that “otherwise” must be read ‘edjusdem generis’ with the expression ‘transfer of capital assets’ and not with the expression ‘dissolution of firm’ therefore the words “otherwise” used in Section 45(4) of the Act takes into sweep cases of subsisting partners of a partnership and transferring assets in favour of a retiring partner.
• Further, the reliance of the Assessee on the decision of Hind Construction Ltd. (supra) did not come to its rescue for the fact that the afore mentioned decision was pre-insertion of Section 45(4) of the Act inserted by Finance Act, 1987 hence the expression “otherwise” was not considered in the said judgement and hence same shall not be applicable.

SW Point of View:

Hon’ble Supreme Court extends the scope of the expression “otherwise” as mentioned under the section 45(4) of the Act to tax the capital gains in the hands of the partnership firm arising on the distribution of revaluation gain while treating it as deemed transfer even though there is no generation of real income to the partnership firm which was contrary to the principal of ‘real income’ laid down by this court in various judgements while determining the taxability of the income otherwise. 

Lakshay Prakash Jonwal, Article Assistant, Direct Tax, SW

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