Gain on revaluation, transferred to partner’s current account and subsequently partner’s current account converted into loan account, cannot be taxed in the hands of partners/firm.

Facts of the Case:

  • M/S. Salapuria Soft Zone (firm or Assessee) was a partnership firm. Two partners of the firm bought land jointly and introduced it as a part of their capital contribution in the firm. The land so brought in as capital contribution was shown as stock in trade till 30.03.2008.
  • On 31.03.2008, the said land was revalued and converted to fixed asset from “inventory” and subsequently the revaluation gain was transferred into partner’s current account. From 29.09.2008, the partnership firm got converted into a company and partners current account’s balance got converted into loan and shown as a liability in the books of the company and no tax was paid on transfer of assets & liabilities in accordance with the provision of Section 47(xiii) of the Income Tax Act, 1961 (the Act).
  • For AY 2008-09 and AY 2009-10, scrutiny assessment u/s 143(3) of the Act was done however no examination was done by the assessing officer with respect to the taxability of revaluation gain during the course of proceedings.
  • Later on, re-assessment proceedings were initiated u/s 148 of the Act as department was of the view that tax had to be charged on the revaluation gain as it stands credited to partner’s current account and subsequently the balance of partner’s current account got converted into loan account in books of the company which contravene the provision of Section 47(xiii) or Section 45(4) of the Act. The contention of the Assessee that revaluation gain was a notional profit was rejected and department held that gains were chargeable to tax under capital gains head and accordingly order was passed u/s 147 r.w.s. 143(3) of the Act.
  • Aggrieved by the order, the Assessee filed an appeal before CIT(A) and it was partly allowed by CIT(A) in favour of the Assessee. Therefore, Assessee preferred an appeal before ITAT wherein the appeal was allowed the appeal of the Assessee by holding that opening of re-assessment was case of change of opinion. And subsequently, department preferred the appeal before the Hon’ble High Court against the order of ITAT.
  • Question of law before the Hon’ble High Court was that whether ITAT had rightly held that there was no violation of provision of Section 47(xiii) of the Act since, as per the provisions the partners of the assessee firm were not entitled to receive any consideration or benefit directly or indirectly in any form or manner other than by way of allotment of shares for the company however, the erstwhile partners of the firm were made loan creditors of the company formed upon conversion entitling them to withdraw the amount of revaluation profit from the company at their own will.

Observation And Conclusion:

Hon’ble High Court held that:

  • ITAT had rightly held that no real profit or income was accrued or arisen to the Assessee on which tax can be levied. While delivering this decision the Hon’ble High Court relied on the decision of the Hon’ble Supreme Court in Sanjeev Woolen Mills v. Commissioner of Income Tax wherein it was held that the valuation of asset at market value, which was higher than its cost of acquisition, resulted in the imaginary or notional potential profit out itself and not any real profit or income which can be taxed. Further, the applicability of Section 45(4) of the Act was when there is a distribution of assets to the partners. Furthermore, the conditions provided u/s 47(xiii) of the Act were also complied with. And therefore, as neither of the above provisions got triggered, the gain on revaluation is not liable to be taxed. Reliance was also placed on the decision in the case of Ram Krishnan Kulwant Rai Holdings Private Limited having identical facts as of the case in hand wherein it was held that there was no distribution of assets but only taking over of the firm by company and as such there was no transfer of capital assets as contemplated in Section 45(1) or Section 45(4) of the Act. And accordingly, the appeal of the department was dismissed.
SW Point of View:Provisions of law was already settled in the case of Sanjeev Woolen Mills v. Commissioner of Income Tax and Ram Krishnan Kulwant Rai Holdings Private Limited by holding that the revaluation gains will be charged to tax u/s 45(4) of the Act only at the time of disbursement of assets by the firm and not where it notional profits.  Actual profits and its disbursement are a pre-condition to stand satisfy of provisions of Section 47(xiii).

Principal Commissioner of Income Tax-1, Kolkata
M/S. Salapuria Soft Zone

Lakshay Prakash Jonwal, Direct Tax Associate, SW India