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Amount received by erstwhile partners on Admission of a new partner to the partnership firm – Taxability under the Income Tax Act, 1961.

Reduction of share in partnership firm by an existing partner in favour of a new partner does not attract Capital Gains Tax. The Karnataka High Court in the case of P.N Panjawani, held that any reduction in share of a partner in the partnership firm on admission of new partners does not amount to transfer of share in the landed property of the firm and accordingly, the same cannot be taxed in the hands of the existing partners. Therefore no capital gains tax arises in the hands of the erstwhile partners. The 2012 judgement of the Karnataka High Court seems to have decided the question of law in favour of the Assessees that when new partners are admitted into the partnership and there is a reduction of their share in the firm, then any amount received by the erstwhile partners cannot be taxed in their hands, if what they receive represents only their share in the partnership.

Amount received by erstwhile partner on Retirement from the partnership firm –Taxability in hands of the Retiring Partner as well as the Partnership Firm.

The Karnataka High Court in the case of Dynamic Enterprises held that the firm shall not be liable to capital gains tax under Section 45(4) of the Income-tax Act, 1961 on account of payment of money to the retiring partner, not involving distribution of any asset. In order to attract capital gains tax under Section 45(4) of the Act, there should be an absolute cessation of right in property of the firm, as a result of which the retiring partners should hold an absolute title to property so relinquished by the firm. If this condition is absent, there could be no application of Section 45(4) of the Act.

In the present case, the retiring partners were given the value of their share in the partnership and no capital asset was transferred. In the absence of distribution of the capital asset, no profit or gain arose in the hands of the partnership firm. When the existing partners took cash and retired, they were not relinquishing their interest in the immovable property of the firm, but they relinquished their share in the partnership.

The question whether the retiring partner was liable to capital gains tax for the amount received on retirement, is left unanswered. However, this matter was decided by the Supreme Court in the case of Mohanbhai Pamabhai wherein it was held that when the partner retired from the firm, there was no transfer of interest of any of the taxpayers in the asset of the firm and no part of the amount received by any of the taxpayers was assessable to capital gains tax under Section 45 of the Act. Therefore, it seems that the amount paid to the retiring partner should neither be taxable in the hands of the firm nor in hands of the partner.

Compiled by CA Prateek Jain
Email: prateekjain135@gmail.com

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