SC’s Recent Judgment on Revaluation of Capital Assets

Shreya Patel

30 May, 2024

The Supreme Court’s decision, with Justices M.R. Shah and M.M. Sundresh sitting on the divisional bench, ruled that Section 45(4) of the Income Tax Act applies in instances when current partners of a partnership transfer assets to a partner who is retiring as well as cases of dissolution The Court noted that the distribution of capital assets was formerly exempt from the concept of “transfer” due to the absence of Clause (1) from Sections 2(47) and 47(i). The assessee could avoid paying capital gains tax by revaluing the assets and then transferring and distributing them at the dissolution procedure.

The Bombay High Court’s decision, which upheld the Income Tax Appellate Tribunal (ITAT) judgments and deleted the Assessing Officer’s (A.O.) inclusion of short-term capital gains, dissatisfied the Commissioner of Income Tax, who filed this appeal. The appeals mentioned above concerned a partnership-owned company called M/s. Mansukh Dyeing and Printing Mills. The High Court upheld the rulings of the “ITAT” that had eliminated the Assessing Officer’s inclusion of short-term capital gains by dismissing the appeals.

Facts of the case

• In this instance, a partnership company of four brothers participated in manufacturing, processing, and trading clothing: Shri M.H. Doshi, one of the partners.
• Initially held a 25% profit share; a family settlement eventually reduced this to 12%.
• The partnership was reconstituted due to the admission of three new partners and the retirement of several existing members.
• The company was once more reconstituted on November 1, 1992, with three additional partners as a private limited company.
• On January 1, 1993, the firm’s assets underwent a revaluation, increasing their worth.
• The revised amount was credited to the capital accounts of the partners in accordance with their profit-sharing ratios.
• The Income Tax Department first accepted the company’s tax return for the pertinent assessment year.
• After the assessment was later reopened, the assessing officer added money to the short-term capital gains account in accordance with Section 45(4) of the Income Tax Act, asserting that the reassessment and crediting of the sum to the partner’s accounts had been a transfer that was subject to capital gains tax.
• The Commissioner of Income Tax (Appeals) confirmed the addition of short-term capital gains, noting that by allocating the firm’s assets in accordance with each partner’s profit-sharing percentage, the prerequisites of Section 45(4) were satisfied.
• The Income Tax Appellate Tribunal (ITAT) upheld the taxpayer’s appeal and invalidated short-term capital gains.
• Based on the ruling of CIT West Bengal vs Hind Construction Lid, the ITAT noted that the revaluation and crediting the money to partners’ accounts did not include a transfer.
• The Revenue’s appeals were subsequently denied by the High Court, which based its judgment on the Hind Construction Lid case. The Revenue has now filed the current appeals.

Issue of the case

What is the Income Tax Act’s Section 45(4) scope?

Arguments of the case

The petitioner’s attorney criticized the High Court and the Income Tax Appellate Tribunal (ITAT) for incorrectly omitting the Assessing Officer’s (A.O.) comments about short-term capital gains. The petitioner claimed that in enacting Section 45(4), which was intended to address avoidance of taxes, the High Court did not sufficiently explain its justification. Section 2(47)(ii) was excluded from the definition of “transfer,” which allowed taxpayers to avoid paying capital gains tax by revaluing and distributing capital assets during the dissolution process.

 The petitioner asked the Court to resolve this matter by eliminating Section 2(47)(i) and inserting Section 45(4). Despite the ITAT’s disagreement, the petitioner maintains that the A.O. had good reason to include short-term capital gains under Section 45(4). The petitioner claimed that the distribution of capital assets to partners’ accounts constituted a transfer liable to capital gains tax after implementing Section 45(4). In contrast to Hind Construction Ltd., which relied upon rules that predate Section 45(4), the petitioner advised considering AN. Naik Associates and Ors, which dealt exclusively with Section 45(4).

The excess amount was credited to the partners’ capital accounts following revaluation in the case, which concerned the reconstruction of a partnership business. The defence put out by the attorney was that this surplus sum shouldn’t be regarded as a transfer in accordance with Section 45(4) of the I.T. Act. Two requirements must be met for Section 45(4) to be applicable: the transfer must involve the distribution of capital and result from the dissolution of the partnership company or another event.

The attorney argued that there had been no asset distribution, dissolution, or other event that would have required the use of Section 45(4): a single notional entry reflecting no extra physical asset or income, the surplus credited upon revaluation. As no actual income or gain accruing to the company existed, profits and gains could not be distributed. As a result, they should not be contributed as capital gains to the partnership firm’s Revenue.

The attorney emphasized that the case mentioned by the Revenue was not relevant in this situation and relied on the ruling of the High Court of Bombay to support their argument. According to the decision of the Bombay High Court, the transfer of assets took place when the partnership assets were given to a departing partner using a retirement deed. According to the definition of capital gains and business profits in Section 45(4) of the Income Tax Act, the Court determined that such asset transfers to retiring partners would be subject to taxation.

Judgment

The Supreme Court ruled that revaluing assets and crediting the amount to the accounts of new partners should be deemed a distribution of assets throughout the year, triggering the application of Section 45(4). The admittance of new partners with big credits in their accounts shortly after joining bolstered this view even further. The Court overruled the High Court and ITAT’s decisions, siding with the Revenue.

Conclusion

The key question was about the applicability of Section 45(4) of the Income Tax Act, a provision dealing with capital gains taxation on asset transfers. The petitioner contended that the High Court misapplied Section 45(4) and that it should be applied to the division of assets in the matter at hand. According to the response, there was no dissolution, merely revaluation, and the extra funds were credited to partners’ capital accounts rather than transferred. The Supreme Court found in favour of the petitioner, determining that the revalued sum credited to partners’ capital accounts did not constitute a “transfer” and hence came under Section 45(4)’s “otherwise category. The Court emphasized the need to close tax loopholes in order to avoid tax evasion.

Read Our Article: How to File an Income Tax Appeal with ITAT?