Judicial Analysis Court Copy Headnote Facts Arguments Court observation

2012 Supreme(Kar) 911

IN THE HIGH COURT OF KARNATAKA AT BANGALORE
N. Kumar and Ravi Malimath, JJ.
Commissioner of Income Tax —Appellant
Vs.
P.N. Panjawani —Respondent
Income Tax Appeal Nos. 1316 to 1318 of 2006 (Arising out of order of ITAT in Income Tax Appeal No. 1227/Bang. of 2003, dated 31-3-2006.)
Decided on : 12-03-2012

Advocates:
Advocate Appeared:
Mr. G. Kamaladhar, for the Appellant
Mr. A. Shankar, M. Lava, for the Respondent

The reconstitution of the firm and reduction in the share of the partners did not amount to transfer of capital assets, and therefore, the capital gain tax was not applicable to the individual partners.

Headnote:
Capital Gain - Partnership Firm - Income Tax Act, 1961 - Sections 45(1), 45(3), 45(4) - The court held that the reconstitution of the firm and reduction in the share of the partners did not amount to transfer of capital assets and therefore, the capital gain tax was not applicable to the individual partners. The judgment highlighted the distinction between the income of the firm and the income of the partners, and emphasized that the firm is a separate taxable entity liable to pay tax on income arising or accruing to it because of its own distinct set of income earning activities and factors.
Fact of the Case:

The firm M/s. Kamal Industries reconstituted by admitting four new partners and the three erstwhile partners reduced their share in the partnership firm. The Assessing Authority held that there was a relinquishment of right and interest in the assets of the firm, resulting in capital gain tax liability for the individual partners.
Finding of the Court:

The court found that the reconstitution of the firm and reduction in the share of the partners did not amount to transfer of capital assets, and therefore, the capital gain tax was not applicable to the individual partners.
Issues: The main issue was whether the admission of new partners and reduction of share in the firm amounted to transfer in the hands of the individual partners under the Income Tax Act, 1961.
Ratio Decidendi: The court emphasized the distinction between the income of the firm and the income of the partners, and highlighted that the firm is a separate taxable entity liable to pay tax on income arising or accruing to it because of its own distinct set of income earning activities and factors.
Final Decision: The substantial question of law was answered in favor of the assessees and against the revenue, and the appeals were dismissed with parties to bear their own costs.

JUDGMENT

N. Kumar , J.—As a common question of law is involved in all these three appeals, they are taken up for consideration together and disposed off by this common order. The firm M/s. Kamal Industries was dealing in manufacturing and marketing of audio and video cassettes. The partnership was constituted on 05.04.1961. The firm owned property in the form of land situated at 6/2 and 6/3, Doddanakundi Industrial Road, Tubbarahalli village, Marathahaili measuring 1,67,765 sq.ft. The firm filed its return of income for the assessment year 1992-93. Afterwards, no returns were filed on the ground that the firm had stopped its activities and there was no income. In the books of account, the value of the land shown is at Rs. 25,747/-, the value at which it was purchased in the year 1967. The value of the borewell, dining room and factory building along with the value of the land were shown at Rs. 1,93,510/-. The firm revalued the assets as on 01.04.1995 and the opening value was at Rs. 7/- crores. As on 31.03.1995, the firm consisted three partners each having equal share. The said partnership was reconstituted by a partnership deed dated 12.10.1995 admitting four more new partners. The four new partners contributed Rs. 3.50 crores towards their share of capital. As a result of reconstitution of the firm, the assets hitherto owned by the firm of three partners were made over to the reconstituted firm, of seven partners. The result was that the interest of the three partners of the erstwhile firm which in the immovable property was reduced from 1/3rd to 1/6th or 16.67%. Therefore, the Assessing Authority held that there was a relinquishment of right and interest insofar as 50% of the interest of each of the partners in the erstwhile firm by means of assets made over to the reconstituted firm which amounted to transfer within the terms of Section 2(47) of the Income Tax Act, 1961 (for short hereinafter referred to as 'the Act'). The erstwhile three partners after reconstitution of the firm have withdrawn a sum of Rs. 1,16,66,666/- each on 14.10.1995. According to the Assessing Authority, this amount represented the capital gain for relinquishment of their 50% of the right in the erstwhile partnership firm and its assets. Therefore, he framed an assessment order and accordingly held that Rs. 3,46,84,942/- is the capital gain and accordingly, apportioned the same from each of the partners at Rs. 1,16,66,666/- and called upon them to pay income tax on long term capital gain of Rs. 23,04,329/- with interest under Section 234(A) and 234(B), in all in a sum of Rs. 59,56,689/-. Aggrieved by the said order, the assessee preferred an appeal to the Commissioner of Income Tax (Appeals). The Appellate Authority after referring to Sections 45(1), 45(3) and 45(4) of the Act held that the facts of the case clearly suggest that the property in the form of the land or the landed property was certainly not held by the assessee partners in their own personal capacity. This landed property was actually an asset of the firm in its capacity as legal owner. This landed property belonged to the firm and stood in its name in the relevant legal documents of ownership and was reflected as such in its books of account also. Therefore, if at all there was a transfer of these assets or landed property from the firm to the incoming partners in which event it is the firm, which is to be taxed, and not the individual partners. It also held that reduction in the share of profit and loss of the firm on account of induction of new partners qualifies to be categorized as "capital gains" in the hands of the old and continuing partners, is not correct. None of the provisions of the Income Tax Act specifically envisages a situation where capital gains would be chargeable on account of reduction in the share of a partner in the firm following the reconstitution of the firm by way of induction of new partners. Therefore, a reduction in the share in a partnership firm on acc

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2012 Supreme(Kar) 911

The reconstitution of the firm and reduction in the share of the partners did not amount to transfer of capital assets, and therefore, the capital gain tax was not applicable to the individual partners.

Cases Referred (1)