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INCOME TAX QUESTIONS & ANSWERS SERIES PART-IX

Tax implications on self generated goodwill on conversion of proprietorship firm into partnership

Dear Friends,

In today's article we are going to discuss the tax implications on self generated Goodwill when a proprietorship firm converts itself into a partnership firm.

PROBLEM

Mr. A (Chartered Accountant) is running a proprietorship firm and his firm is converted into a partnership by inducting his son as new partner on 31.03.2021 with 50% share. All assets and liabilities of the erstwhile proprietary firm were transferred into newly constituted partnership firm.

Mr. A was credited and paid a amount of Rs. 5.00 Lakhs from the firm. Your advise is required on below mentioned points; Changeability of amount of Rs. 5.00 lakhs paid to Mr. A when it stands paid for ;

  1. Transfer of business into partnership;
  2. Goodwill by the incoming partner.
Tax implication on self generated goodwill when conversion of proprietor into partnership

LET'S FIRST CONSIDER APPLICABLE PROVISIONS OF THE INCOME TAX ACT, 1961

SECTION 2(47) DEFINE WHAT IS CONSIDERED TO BE TRANSFER UNDER

Transfer, in relation to capital asset, includes:

  1. the sale, exchange or relinquishment of the asset; or
  2. the extinguishment of any rights therein; or
  3. the compulsory acquisition thereof under any law; or
  4. in a case where the asset is converted by the owner thereof into, or is treated by him, as stockin-trade of a business carried on by him, such conversion or treatment; or
  5. the maturity or redemption of zero coupon bonds; or
  6. any transaction involving the allowing of the possession of any immovable property to be taken or retained in part performance of a contract of the nature referred to in section 53A of the Transfer of Property Act, 1882; or
  7. any transaction (whether by way of becoming a member of, or acquiring shares in a cooperative society, company or other association of persons or by way of any agreement or any arrangement or in any other manner whatsoever) which has the effect of transferring, or enabling the enjoyment of any immovable property.

SECTION 45(3) PROVIDES THAT

The profits or gains arising from the transfer of a capital asset by a person to a firm or other association of persons or body of individuals (not being a company or a co- operative society) in which he is or becomes a partner or member, by way of capital contribution or otherwise, shall be chargeable to tax as his income of the previous year in which such transfer takes place and, for the purposes of section 48, the amount recorded in the books of account of the firm, association or body as the value of the capital asset shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of the capital asset.

 

COST OF ACQUISITION: SECTION 55 OF INCOME TAX ACT 1961

  • Goodwill of business
  • Trademark or brand name associated with business
  • Tenancy rights
  • Loom hours
  • Right to carry on any business or profession
  • Stage carriage permits
  • Right to produce or purchase any article or thing

In case of acquisition from previous owner: Cost of acquisition is purchase price.

In case of self generated: Cost of acquisition is Nil.

ANSWER

  • Where proprietor business is converted into a partnership, the exclusive interest of the proprietor is reduced and the business assets become sets of the firm in which he becomes a partner. Consequently this transaction will be considered as transfer under Section 45(3) of the Income Tax Act, 1961.
  • In above case Mr. A has received Rs. 5.00 Lakhs from the firm , will be considered as consideration of transfer of his interest in proprietorship firm into a partnership firm ad same will be taxable as capital gain in his hands in the year of transfer of business to a partnership firm. According to the provisions of Section 45(3) the Rs. 5.00 Lakhs will be considered as book value recorded into books of accounts of the firm.
  • If the amount is paid by incoming partner as Goodwill;

Let's consider judgement of Supreme Court in case of CIT Vs. B.C. Srinivasa Shetty (1981)128 ITR 294

The apex court observed that the income chargeable to capital gain tax is to be computed by deducting from the full value of consideration," the cost of acquisition of capital asset" and if it is not possible to a certain the cost of acquisition ,then transfer of such asset is not chargeable to tax.

PLEASE NOTE THAT

The case was applicable to all self generated assets but later amendment was made under section 55 to supersede the decision of Supreme Court. Accordingly in case of self generated asset cost of acquisition is Nil in following asset.

  • Goodwill of business
  • Trademark or brand name associated with business
  • Tenancy rights
  • goodwill of profession, therefore the Supreme Court Loom hours
  • Right to carry on any business or profession
  • Stage carriage permits
  • Right to produce or purchase any article or thing.

The above list do not cover Judgement CIT v. B.C.Srinivasa Shetty (1981) 128 ITR 294 (SC) is still applicable on goodwill of profession.

SECTION 55 PROVIDES THAT

Cost of acquisition of self generated asset , including goodwill of a business is NIL. The decision of Supreme Court is not applicable to those self generating assets as mentioned in Section 55.

Since provisions of Section 55 does not cover Goodwill from Professional and hence the judgement of Supreme Court as mentioned above will be applicable and the Cost of Acquisition of Good from professional of Mr. A will not be a certain able and hence same will not be taxable under provisions of Section 48 of the Income Tax Act, 1961.

 

CONCLUSION

  1. In first position the payment to Mr. A of Rs. 5.00 Lakhs will be taxable in his hands;
  2. In second case since cost of acquisition of goodwill from professional is not ascertainable then the judgement of Supreme Court as mentioned above is applicable and no tax will be charged.

DISCLAIMER: The above write up is an attempt to share information and knowledge with our readers. The view expressed here are the personal views of the author and same should not be considered as a professional advice. It is advisable to consult with your tax consultant before acting on any part of this article.

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Category Income Tax, Other Articles by - FCS Deepak Pratap Singh 



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