Controversies in taxation of partnership firms and partners are quite common as partnership as a form of organization is pretty old and innumerable controversies have arisen over the years. Rich resource base by way of legal decisions on taxation in various fact situations has lent adequate scope and support for devising novel tax planning ideas and to avoid delicate and debatable tax strategies. The tax officers have to grapple with some of the measures of the taxpayers which may not have a precedent and thus it continues to fascinate the students of law.

The Bombay Bench of ITAT dealt with a case where the company being a partner received huge amounts from other partners for reducing its profit sharing rights. It was held that the amount is not chargeable to tax under the head ‘capital gains’ and thus the taxpayer went tax-free for an aggregate amount of Rs.12 crores received in two assessment years due to apparent gaps or non-coverage of the said eventualities in the legal provisions.

Anik Industries Ltd. v. Dy. CIT [2020] 116 taxmann.com 385 (Mumbai- tribunal):

During the previous year relevant to the assessment year 2010-11, the assessee-company a partner in a firm with 30% share reduced its share to 25% and the said 5% was distributed to other existing partners. The assessee received Rs.400 lakhs from those partners and claimed the same as exempt from income-tax on the plea that it is a capital receipt. For the assessment year 2012-13, the assessee further reduced its share from 25% to 21% and received Rs.800 lakhs from other partners of the firm.

The assessee, relied upon the decision of Madras High Court in A.K. Sharfuddin v. CIT [1960] 39 ITR 333 for the proposition that compensation received by a partner from another partner for relinquishing his rights in a partnership firm is a capital receipt and there would be no transfer of asset within the meaning of section 45(4) of the Act. Reliance was placed on other decisions to submit that the provisions of section 28(iv) and section 41(2) shall have no application to tax such receipt.

Decision of Assessing Officer

The Assessing Officer opined that a business builds some reputation after it is continued for some time. It is valuable asset and its value depends on personal reputation of the owner/management/peculiar advantage a firm has. When the partner retires, the accounts of the firm are made up by valuing the assets on notional sale value and deducting there from of liabilities and notional winding up expenses, the share of the partner would be ascertained.

This right was created the moment a partner joins the firm and the value of the right would be determined at the time of retirement. At the time of reconstitution of the firm, one of the methods to compensate for the goodwill would be that new incoming partner agrees to make payment directly to the old partners without involving the firm. The said payment was nothing but consideration for intangible asset i.e. the loss of share of partner in the goodwill of the firm. Therefore, this amount was to be charged as capital gains in terms of decision of Ahmedabad Tribunal in Samir Suryakant Sheth v. ACIT (ITA No.2919 & 3092/Ahd/2002) and the decision of Mumbai Tribunal in Shri Sudhakar Shetty [2011] 130 ITD 197. Finally, the Assessing Officer held that the said amount was chargeable to tax as capital gains under section 45(1) of the Act.

Proceedings before CIT (Appeals)

Before CIT (Appeals), the assessee contended that such receipt is neither revenue receipt nor taxable under the head capital gains. It was reiterated that the rights of one existing partner was reduced in the firm and the right was created in favour of the other existing partners and one new partner who joined the firm. The ownership of the property did not change even with the change in the constitution of the firm. The assessee relied upon plethora of decisions to submit that in terms of section 45(4), profits on distribution of capital asset on the dissolution of the firm would only be taxable in the hands of the firm and not in the hands of the partners.

There was a change in constitution of the firm with the exit of one partner and the assessee being a continuing partner reduced its share from 30% to 25% and the other partners increased their share by 1% each. The right of the existing partner viz the assessee was reduced and those rights were created in favour of the other existing partners and a new partner who joined the firm. The other partners in consideration have paid Rs 4 crore to the appellant for relinquishing its rights in the partnership being reduced from 30% to 25%. The amount was received by the assessee on account of relinquishment of its right in the share in the firm to the extent of 5%.

The CIT (Appeals) held that section 2(47) of the Act defines the term “transfer” and it includes relinquishment of an asset and the extinguishment of any rights therein also. Therefore, relinquishment or the extinguishment of the appellant’s right over the share of profit in the firm from 30% to 25% and the consideration of a sum of Rs.4 crore received on account of the same have to be necessarily treated as consideration received for transfer of capital asset. Accordingly, the addition of Rs 4 crore made by the AO under section 45(1) of the Act was upheld by him.

Proceedings before Tribunal

It firstly opined that the provisions of section 45(4) has no application to the case as it was not a case of distribution of capital assets on the dissolution of firm or to the retiring partner. The partner who benefitted monetarily continued to be a partner with reduction in share of profits. It is a case where there is reduction in share of one partner which was taken over by other existing partners. The firm continued its business with existing partners including the assessee.

The amount of Rs.400 lacs was credited in the assessee’s account by means of accounting entries viz. the current account of the assessee was credited with corresponding debit to the other partners’ current accounts since their profit-sharing ratio was increased by 1% each to them. The business of the firm remained the same with the remaining partners including the assessee as per new profit-sharing ratio. Thus, it is neither a case of dissolution of firm nor payment on account of retirement of the partner of the firm. Rather it is a case wherein there is an adjustment of profit-sharing ratio inter-se between the existing partners which was routed through partners’ current account held with the firm.

The only issue to be adjudicated was whether the compensation received by an existing partner from other partners for reduction in profit sharing ratio is taxable as capital gain under section 45(1) and if not, whether it is taxable under section 56(2).

Legal Background

Section 14 of the Indian Partnership Act, 1932: It deals with the property of the firm and reads as follows: Subject to contract between the partners, the property of the firm includes all property and rights and interests in property originally brought into the stock of the firm, or acquired, by purchase or otherwise, by or for the firm, or for the purposes and in the course of the business of the firm, and includes also the goodwill of the business.

Unless the contrary intention appears, property and rights and interest in property acquired with money belonging to the firm are deemed to have been acquired for the firm.”

A.K. Sharfuddin v. CIT [1960] 39 ITR 333 (Mad): The assessee engaged in the business of hardware entered into a partnership agreement with another person for importing scrap iron worth about Rs.2 lakhs and sell the same to earn income. After import of goods, the Government of India did not give permission to the firm to sell the goods. Hence, the firm was dissolved and the assessee gave all his rights in the firm in consideration for receiving Rs.31,000 from the other partner. The issue before the court was, whether the amount so received is chargeable to tax as income from business. The court held the partnership deed provided only for one item of business viz. scrap iron and that item of business was given up and the partner was paid compensation. Therefore, it was held that that it is not a trading receipt and the compensation was really for loss of a capital asset. Readers may note that this decision deals with dissolution of firm and compensation received by one partner from another partner who took the risk of selling those stocks subsequently. This decision pertains to the era before section 45(4) was inserted in to the statute book. This decision with respect is factually different from the facts of the case Anik Industries Ltd. (supra) and hence is not applicable.

Samir Suryakant Sheth v. ACIT (ITA No.2919 & 3092/Ahd/2002): In this case, the assessee and his brother were partners in a firm with 55% and 45% profit sharing rights respectively. They admitted a third party as a partner with 51% share and reduced to their shareholding to 27% and 22% respectively. The newly admitted partner paid privately Rs.369 lakhs and Rs.301 lakhs to the sacrificing partners. The amounts were not routed through the firm. The Assessing Officer taxed the amount as capital gain. During the course of assessment proceedings, the assessee argued that on partial retirement of a partner with reduction in profit sharing rights which is at par with retirement of a partner and the amount so received hence is not chargeable to tax as capital gains.

It was further stated that the Gujarat High Court had held in the case of Rajendra B Modi [1993] 200 ITR 98 (Guj) that the amount received on reduction of share in the firm constituted capital receipt. The assessee failed to furnish any basis on which the consideration for relinquishing the right to the extent of 28% was worked out at Rs.369 lakhs. The assessee reiterated his earlier stand that there is no transfer of interest of the assessee in the goodwill of the firm and no amount is assessable under section 45 of the Income- tax Act. The assessee argued that, the amount received for sterilization or annihilation of source of income would not be income at all and the amount received on loss of source of income constitutes capital receipt in the hands of the assessee. The tribunal held that the amount received is chargeable to tax as capital gain. It took note of the decision in the case of CGT v. Chhotalal Mohanlal [1987] 166 ITR 124 (SC) where the Supreme Court held that the reduction in share of profit of father upon admission of a minor son tantamounts to gift by father to minor son of the goodwill of the firm.

CIT v. P.N. Panjawani [2013] 356 ITR 676 (Karn): The issue before the court was upon admission of new partners, whether there is assignment of right in the firm in favour of new partners resulting in ‘transfer’ in order to be chargeable to tax under section 45 of the Act. The firm with 3 equal partners not doing any business for some years had owned a piece of land shown at Rs.25,747 (which acquired during the year 1967). The value of borewell, dining room and factory building along with value of land were shown at Rs.1,93,510 up to 31.03.1995. The firm revalued the assets on 01.04.1995 @ Rs.7 crores. It inducted 4 new partners on 12.10.1995 and they contributed Rs.3.50 crores towards their share of capital. The existing partners withdrew Rs.1.17 crore each on 14.10.1995, which prompted the Revenue to treat the entire scheme of transaction as relinquishment of right in the capital assets by the existing partners by reducing their share from 1/3rd to 1/6th after reconstitution of the firm. The Court held that the landed property was owned by the firm and not by the partners. The erstwhile partners withdrew the money brought by the incoming partners as drawings and they did not retire from the firm. They continued to be partners and their share got reduced from 100% to 50% after reconstitution. The court held that the continuing or existing partners did not transfer any capital asset in favour of the incoming partners and therefore the amount received is not chargeable to tax under section 45(3) or section 45(4) since no capital gain arose there from.

Prashant S. Joshi v. ITO [2010] 324 ITR 154 (Bom): The assessee in this case entered into a partnership with two other persons for the purpose of real estate business. After couple of years, the assessee retired from the firm. He received Rs.50 lakhs more than the amount standing to his credit in capital and current account maintained by the firm. The issue was whether the amount so received excessively over and above the amount of capital is chargeable to tax as income under section 28. The court held section 28(iv) will not apply to the benefits which are paid in cash or money. Similarly, payment made to a partner in realization of his share in the net value of assets upon his retirement from the firm, is also not covered by section 28(v). Thus the amount received excessively upon retirement is not chargeable to tax under the head ‘profits and gains of business or profession’.

Sudhakar M. Shetty v. Asstt. CIT [2011] 130 ITD 197 (Mum): In this case, the assessee entered into a partnership for doing real estate business. Later, the firm underwent a change in constitution with the induction of some new partners. After a period of 1 year the assessee retired from the firm after revaluation of assets of the firm. The capital account of the partner was enhanced by Rs.25.59 crores just one day before retirement. The payment of Rs.25 crores was made immediately upon revaluation and the balance was paid subsequently. The tribunal held that in the retirement deed there were clauses to convey interest in immovable property owned by the firm and the assessee on retirement would not have any interest over the assets of the firm. The tribunal held that it is a case of lump sum payment in consideration of the retiring partner assigning or relinquishing his share or right in the partnership and its assets in favour of the continuing partners. The manner of retirement was such that it could be regarded as assigning or relinquishing of interest or share or right in the partnership assets in favour of the continuing partners. The tribunal applied the rationale of the decision in the case of CIT v. A.N.Naik Associates [2004] 265 ITR 346 (Bom). It distinguished the facts of the case from the facts in the case of Prashant S.Joshi (supra).

Addanki Narayanappa v. Bhaskara Krishnappa AIR 1966 SC 1300: The Apex Court dealing with the concept of partnership held as under: “The whole concept of partnership is to embark upon a joint venture and for that purpose to bring in as capital money or even property including immovable property. Once that is done, whatever is brought in would cease to be the exclusive property of the person who brought it in. It would be the trading asset of the partnership in which all the partners would have interest in proportion to their share. The person who brought it in would, therefore, not be able to claim or exercise any exclusive right over any property which he has brought in, much less over any other partnership property. He would not be able to exercise his right even to the extent of his share in the partnership. His right during the subsistence of the partnership is to get his share of profits from time to time as may be agreed upon among the partners and after the dissolution of the partnership or with his retirement from the partnership, of the value of his share in the net partnership assets as on the date of dissolution or retirement after a deduction of liabilities and other prior charges”.

Malabar Fisheries Co v. CIT [1979] 120 ITR 49 (SC): Explaining the position of a partnership under the Partnership Act as well as Income-tax Act held “A Partnership Firm under the Indian Partnership Act, 1932, is not a distinct legal entity apart from the partners constituting it and equally in law the Firm as such has no separate rights of its own in the Partnership Assets and when one talks of firm’s property or the firm’s assets all that is meant is property or assets in which all partners have a joint or common interest. It cannot, therefore, be said that, upon dissolution, the firm’s rights in the partnership assets are extinguished. It is the partners who own jointly or in common the assets of the partnership and, therefore, the consequence of the distribution, division or allotment of assets to the partners which flows upon dissolution after discharge of liabilities is nothing but a mutual adjustment of rights between partners and there is no question of any extinguishment of the firm’s rights in the partnership assets amounting to a transfer of assets within the meaning of sec.2(47) of the IT Act, 1961 There is no transfer of assets involved even in the sense of any extinguishment of the firm’s rights in the partnership assets when distribution takes place upon dissolution”.

Sunil Siddharthbhai v. CIT [1985] 156 ITR 509 (SC): The Apex Court held as under: ”When a partner brings in his personal asset into a partnership firm as his contribution to its capital, an asset which originally was subject to the entire ownership of the partner becomes now subject to the rights of other partners in it. It is not an interest which can be evaluated immediately. It is an interest which is subject to the operation of future transactions of the partnership, and it may diminish in value depending on accumulating liabilities and losses with a fall in the prosperity of the partnership firm. The evaluation of a partner’s interest takes place only when there is a dissolution of the firm or upon his retirement from it. It has sometimes been said, and we think erroneously, that the right of a partner to a share in the assets of the partnership firm arises upon dissolution of the firm or upon the partner retiring from the firm. We think it necessary to state that what is envisaged here is merely the right to realise the interest and receive its value. What is realised is the interest, which the partner enjoys in the assets during the subsistence of the partnership firm by virtue of his status as a partner and in accordance with the terms of the partnership agreement.

What the partner gets upon dissolution or upon retirement is the realisation of a pre-existing right or interest. It is nothing strange in the law that a right or interest should exist in praesenti but its realisation or exercise should be postponed. Therefore, what was the exclusive interest of a partner in his personal asset is, upon its introduction into the partnership firm as his share to the partnership capital, transformed into an interest shared with the other partners in that asset. Qua that asset, there is a shared interest. During the subsistence of the partnership, the value of the interest of each partner qua that asset cannot be isolated or carved out from the value of the partner’s interest in the totality of the partnership assets. And in regard to the latter, the value will be represented by his share in the net assets on the dissolution of the firm or upon the partner’s retirement.

What is the profit or gain which can be said to accrue or arise to the assessee when he makes over his personal asset to the partnership firm as his contribution to its capital? The consideration, as we have observed, is the right of a partner during the subsistence of the partnership to get his share of profits from time to time and after the dissolution of the partnership or with his retirement from the partnership to receive the value of the share in the net partnership assets as on the date of dissolution or retirement after a deduction of liabilities and prior charges. When his personal asset merges into the capital of the partnership firm a corresponding credit entry is made in the partner’s capital account in the books of the partnership firm, but that entry is made merely for the purpose of adjusting the rights of the partners inter se when the partnership is dissolved or the partner retires. It evidences no debt due by the firm to the partner. Indeed, the capital represented by the notional entry to the credit of the partner’s account may be completely wiped out by losses which may be subsequently incurred by the firm, even in the very accounting year in which the capital account is credited. Having regard to the nature and quality of the consideration which the partner may be said to acquire on introducing his personal asset into the partnership firm as his contribution to its capital it cannot be said that any income or gain arises or accrues to the assessee in the true commercial sense which a business man would understand as real income or gain.”

Decision of the Tribunal

The tribunal took note of the catena of decisions and reasoned as under:

a.		Under the provisions of the Indian Partnership Act, 1932 a partnership firm is not recognized as a legal entity. However, Income-tax Act,1961 recognizes the partnership firm as a distinct legally assessable entity apart from its partners. This is clear from sections 45(1), 45(3) and 45(4).
b.		Since the firm is a separate taxable entity, it is liable to pay tax on its income arising or accruing to it because of its own distinct set of income earning activities. Similarly, individual partners have to pay tax on their personal income. If there is a transfer of capital asset by a firm, the capital gain is taxable in the hands of the firm and not in the hands of the partner(s) and vice versa.
c.		The partners in this case were not owners of the capital asset held by the firm. Therefore, the question of relinquishing its interest in the asset or extinguishment of right due to reconstitution of firm and reduction in profit sharing rights, will not impact any of the partners.
d.		The firm or the existing partners have not relinquished any interest in favour of incoming partners. By joining the firm, the incoming partners and existing partners were entitled to interest in the assets owned by the firm.
e.		During subsistence of partnership, a partner does not possess any interest in specie in any particular asset owned by the partnership firm. The partner has a right to obtain share of profits from the partnership firm. In the assets of the firm, there is no specific share or ownership rights to the partners and the assets are owned by the firm only. The firm is a compendious medium holding assets in its own right.
f.		The compensation received by the assessee from existing partners for reduction of profit sharing ratio does not have any semblance of “transfer” of capital asset and hence the amount received is not chargeable to tax.

Fallout of the decision

The facts of the case in Anik Industries (supra) are somewhat similar to the decision rendered in the case of P.N.Panjawani (supra) where the partner withdrew money from the firm and the tax dispute arose at that point of time. In Anik Industries case (supra) the existing 5 partners were debited and one partner was credited by equivalent amount. There is yet another partner who also retired from the firm and her entire share of profit was allocated fully to one existing partner. This aspect however has no bearing in appreciating the tax consequence of the case in hand.

In Anik Industries case (supra) the amount was credited to the partner with a corresponding debit to other partners who benefitted 1% each out of 5% share sacrificed by the assessee Anik Industries Ltd. There was no revaluation of assets in Anik Industries case. The case law relied upon in P.N.Panjawani’s case is distinguishable to the extent of revaluation of assets which is absent in Anik Industries case.

The assessee relied upon A.K.Sharfuddin’s case (supra) but a factual comparison would show that they are not comparables. In the case of A.K. Sharfuddin (supra) there was dissolution of firm and one partner was compensated to the extent of Rs.31,000 by the other partner and as per the present section 45(4) such amount is chargeable to tax notwithstanding the observation of the High Court made about 6 decades ago.

The tribunal relied on Prashant B. Joshi’s case (supra) of the jurisdictional High Court which dealt with the excess amount received by the retiring partner over and above the amount standing to his credit in the capital account. The coordinate Bench of the Tribunal in Shri Sudhakar Shetty’s case (supra) relied on A.N.Naik Associates (supra) for the reason that the retirement deed explicitly stated that the retiring partner will not have any interest in the immovable properties owned by the firm. Thus the presence of certain features in the retirement deed or absences of such features in the retirement deed have influenced the appellate authorities in arriving at the judgment.

In Anik Industries case there was no retirement of partner receiving any amount in excess to the amount standing to his capital account. Therefore, the jurisdictional High Court decisions such as Prashant B.Joshi and A.N.Naik Associates with respect are not applicable in deciding Anik Industries case.

The rationale of the decision that the capital account of the gaining partners is debited and the sacrificing partners capital account is credited by the identical amount would show that there is an implicit understanding of foregoing of one partner’s interest/right in favour of the other partners.

In Samir Suryakant Sheth’s case (supra), the payment was made by the incoming partner directly to the existing partners and it was not routed through the firm. If such payment is made in the present day context, section 56(2)(x) will directly apply for taxing the said receipt.

Whether provisions of section 56(2)(x) could have been applied to this case is yet another issue. The partner in this case, is a corporate entity. Section 56(2)(x) is applicable from 01.04.2017 and prior to that its applicability was limited to individual and HUF assessees by virtue of section 56(2)(vii). The facts of the case relate to assessment years 2010-11 and 2012-13. At that point of time section 56(2)(vii) did not cover corporate taxpayers. Therefore, the assessee Anik Industries was not hit by section 56(2)(vii). The same facts if emerges today, section 56(2)(x) may apply and the partner who gains by debit to other partners current account could be subjected to tax. However, this argument too could be contested by claiming that the notional journal entries are no way covered by the term “property” contained in the Explanation to section 56(2).

Snapshot of legal precedents

S. No	Case Name	Issue involved and special feature	Yes or No in Anik Industries case
1	A. K. Sharfuddin v. CIT [1960] 39 ITR 333 (Mad)	Dissolution of firm and partner receiving amount from another partner.	No
2	Samir Suryakant Sheth v. ACIT (ITA No.2919 & 3092/Ahd/2002)	Incoming partner paid amount privately to partners who reduced their ratio. It was not routed through the books.	No
3	Rajendra B Modi [1993] 200 ITR 98 (Guj)	When a partner receives an amount at the time of retirement, it is a capital receipt.	No
4	CGT v. Chhotalal Mohanlal [1987] 166 ITR 124 (SC)	Reduction in share of father upon admission of minor sons is gift of goodwill, liable for gift tax.	No
5	CIT v. P.N.Panjawani [2013] 356 ITR 676 (Karn)	Defunct firm, Revalued assets before admission of partners and existing partners withdrew money after capital was brought in by the new partners.	No
6	Prashant S.Joshi v. ITO [2010] 324 ITR 154 (Bom)	Retiring partner received more than the amount standing to his credit in the capital account.	No
7	Sudhakar M.Shetty v. Asstt. CIT [2011] 130 ITD 197 (Mum)	Retirement of partner but the retirement deed contained a clause that the retiring partner shall not make any claim on immovable properties of the firm.	No

Conclusion

The decision of Anik Industries Ltd. (supra) was in favour of the taxpayer because of combination of factors such as (i) absence of revaluation before making book entries; (ii) the benefitting partner continues to remain with the firm and has not retired or severed its connection with the firm; (iii) there is no retirement deed or limitation of his interest in the assets of the firm being explicitly stated by means of any document; (iv) there is a notional journal entry among the partners debiting and crediting inter se for the reasons best known to them; and (v) the transaction is not covered by section 56(2) for the assessment years in question. The legal decision is interesting but could not be applied or adopted in the present day context due to insertion of section 56(2)(x) notwithstanding the debatable aspects contained therein.

Based on the decisions narrated above, it is possible to conclude that a partner by reducing his share of profit can enrich himself by inducting new partners and receive some compensation from them indirectly by routing it through the firm. Even such amount could be received from the other partners who gain in such realignment of profit sharing rights. This approach of obtaining consideration without retirement from the fellow partners or new partners, could be free from tax. However, before such planning is liberally used by the taxpayers, the Government may think of inserting a provision in section 28 to tax such benefits accruing or arising to a continuing partner so that any doubt in application of section 56(2)(x) could be effectively addressed by such a specific legal provision.