Tax Implications on Reconstitution/Dissolution of a firm and Transfer of Assets to partners

Reconstitution/Dissolution of firm? Transfer of Assets to partner? Wait!! Here are the tax implications

Finance Act 2021 has made amendments to the provisions of the Income Tax Act, pertaining to the tax liability arising on distribution of assets by the *firm to its *partners on its reconstitution or dissolution. (Note: The words 'Firm' and 'Partners' are used to simplify the explanation. The provisions of the act also apply to Association of Persons (AOP) and Body of Individuals (BOI) distributing assets to its members.

Before we begin, please understand that writing the bare act here will unnecessarily confuse the reader. 

OK! Let us begin by understanding which provisions we will have to understand to cover the concept.

1. Section 9B - Income on receipt of capital asset or stock in trade by specified person from specified entity.(This section has been inserted by finance act 2021)
2. Section 45(4)
3. Section 48(iii)
4. Rule 8AB of Income Tax Rules.
5. Guidelines under Sec 9B and Sec 45(4) issued by CBDT on 2^nd July 2021.

(Note that owing to such enormous provisions, the author shall try to cover the concept through more than 1 article)

Section 9B states that whenever a partner of firm or member of AOP/BOI, receives a capital asset or stock in trade (SIT) on the *reconstitution or dissolution of Firm/AOP/BOI, then it shall be DEEMED that the firm has transferred such capital asset or stock in trade to such partner/member and any profits and gains arising from such transfer shall be deemed to be the income of such firm/AOP/BOI in the year in which such capital asset/stock in trade is received by the partner. Note that the head under which the profits and losses shall be taxable shall be determined on case to case basis.

A question arises as to what will be the full value of consideration. In this context Section 9B(3) states that the Fair Market Value of the Asset Shall be deemed to be the full value of consideration.

*"Reconstitution" means,

(a) One or more of its partners or members, ceases to be partners or members; or

(b) Admission of new partners or members, or

(c) Change in profit sharing ratio among the existing partners or members.

SECTION 45 is the charging section for Capital Gains. Consequently sub section 4 of this section provides the amount which shall be regarded as capital gain on distribution of assets by firm/AOP/BOI to its partners/members. As per this provision the profits and gains which shall be regarded as capital gains shall be computed using the formula: A=B+C-D

A = income chargeable to income-tax under this subsection as income of the specified entity under the head "Capital gains";

B = value of any money received by the specified person from the specified entity on the date of such receipt;

C = the amount of fair market value of the capital asset received by the specified person from the specified entity on the date of such receipt; and

D = the amount of balance in the capital account (represented in any manner) of the specified person in the books of account of the specified entity at the time of its reconstitution:

Let us understand this with an example.

There are three partners "A", 'B " and "C" in a firm "FR", having one third share each. Each partner has a capital balance of Rs10 lakh in the firm. There are three pieces of lands "S", "T" and "u" in that firm and there is no other capital asset in that firm. Book value of each of the land is Rs10 lakh. All these three lands were acquired by the firm more than two years ago. Partner "A" wishes to exit. The firm revalues its lands based on valuation report from a registered valuer, as defined in rule 11U of the Rules, and as per that valuation report fair market value of lands "s" and "T" is Rs 70 lakh each, while fair market value of land "u" is Rs50 lakh. On the exit of partner "A", the firm decides to give him Rs11lakh of money and land "u" to settle his capital balance.

Now as per section 9B, following shall be chargeable to tax in the hands of firm:

Sales consideration - 50 lakh
Less: Indexed cost of acqⁿ of land U - 15lakh (assumed)

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Long term capital gains for firm Rs 35lakh

(THIS SHALL BE TAXABLE IN THE HANDS OF FIRM U/S 9B)

Tax Amount (35*20%) Rs 7 lakh
Net Book Profit (50-10-7) Rs 33 lakh

Now this 33lakh is to be apportioned among the partners in equal proportion which comes to 11 lakh each. New capital balance of partners will be Rs 10 lakh + Rs 11 lakh = Rs 21 Lakh.

As against capital balance of 21, lakh, partner "A" has received 61 lakh 11lakh of money plus land “U" of fair market value of 50 lakh. Thus 40 lakh is required to be charged to tax under sub section (4) of section 45 of the Act. This shall be in addition to an amount of35 lakh charged to tax under section 9B of the Act.

6. We shall restrict our explanation in this article till here. In the coming article we shall discuss and understand the provisions of section 45(iii), Rule 8AB and Guidelines under Sec 9B and Sec 45(4) issued by CBDT on 2^nd July 2021.

Disclaimer: The views expressed are strictly of the author. The contents of this article are solely for informational purpose. It does not constitute professional advice or recommendation of firm. Neither the author nor firm and its affiliates accepts any liabilities for any loss or damage of any kind arising out of any information in this article nor for any actions taken in reliance thereon.