By TIOL News Service

NEW DELHI, OCT 19, 2016: THE issue is - Whether when the partnership firm was dissolved as per the deed but was sold as a going concern, the capital gains arising out of the bid price is to be treated as capital gains. YES is the verdict.

Facts of the case

Whether when the assets of the firm were sold as capital assets within the meaning of Sec 2(14), the gains from such sale are necessarily capital gains as per Sec 45 - YES: SC

Assessees were partners of a partnership firm - 'M/s. Mangalore Ganesh Beedi Works', which was sold to three other partners, as a going concern, but after the dissolution of the partnership firm. Certain considerations received were treated as capital gains on which income tax was charged by the Assessing Officer. The case of the assessees was that it was a capital receipt in their hands, not exigible to income tax. Assessees' appeals did not succeed up to the level of High Court.

On appeal, the Apex Court held that,

++ since the firm stood dissolved with effect from December 06, 1987, it is the firm which had filed the income tax returns in respect of the income which it had earned, for payment of income tax thereupon. However, though the firm was dissolved, but the business continued because of the orders passed by the High Court keeping in view the provisions contained in the Partnership Deed. The income that was earned from the date of dissolution till the date of winding up and when the firm was sold to AOP-3 was assessed at the hands of dominant partners controlling the business activities (seven in number) as “Association of Persons” (AOP), meaning thereby, the income from the business of the said firm December 06, 1987 till winding up was assessed as an AOP. At the same time, these assessees were also filing their individual returns as well;

++ the assessees filed the return for the Assessment Year 1995-1996. It is in this Assessment Year the assets of the firm were sold as ongoing concern to AOP-3 on September 21, 1994. The Assessing Officer, while making the assessments, bifurcated this Assessment Year into two periods. One period from April 01, 1994 to November 20, 1994 (as AOP of the partners who had continued the business in that capacity in previous years). Second period from November 20, 1994 till March 31, 1995 (as the business was handed over to AOP-3 and the assessment was treated as that of AOP-3). While doing so, the Assessing Officer observed that the entire capital gains on the sale as a going concern of the business of the firm as well as the proportionate profits for the period April 01, 1994 to November 20, 1994, when the controlling AOP was carrying on business as computed in accordance with the order of the High Court in Company Petition No. 1 of 1988, on a notional basis a sum of Rs 9,57,57,007 should be taxed in the hands of the firm. However, according to the Assessing Officer, to protect interests of the Revenue, the same amounts were included in the assessment of the AOP for the first period. The income and tax computations were made separately for the two periods in the order of assessment. The Assessing Officer apportioned the consideration among the various assets comprised within the business with further splitting between short term and long term capital gains;

++ while the treatment was given to the assessment of the income of the firm, insofar as the assessees as individuals are concerned, on the same date the Assessing Officer made assessment in their cases also by including therein the proportionate share from out of Rs 92 crores as capital gain at their hands and bifurcated the same into long term and short term gain. The manner in which it is done can be discerned from one such Assessment Order where the capital gain is computed in a particular manner;

++ the total proceeds of Rs 92 crores are first apportioned among the assessees in the ratio in which they had received the said amount. Thereafter, this amount is divided into long term capital gains and short term capital gains. Two components of long term capital gains are taken into consideration, namely goodwill and sale of land. Likewise, short term capital gain is arrived at in respect of transfer of movables which were depreciable assets. For the purposes of calculation, figures were taken from Table II incorporated in the Assessment Order itself mentioning the market value of these assets;

++ it becomes apparent that the approach adopted by the Assessing Officer was to take into consideration market value of the assets of the firm, viz. land, building and plant & machinery, which had already been evaluated by the Registered Valuers as reflected in the Table above. The market value of these three assets was Rs 21,52,90,000. Since total sale consideration at which the firm was sold was Rs 92 crores, balance amount of Rs 70,47,10,000 was treated as representing goodwill of the firm which was taxed as long term gain. This mode of arriving at short term and long term capital gain and taxing it accordingly by the Assessing Officer has received the stamp of approval by the Commissioner of Income Tax (Appeals) and the Income Tax Appellate Tribunal, as well as the High Court;

++ we find that the Revenue has been able to substantiate its submission. We have already noticed that the firm was dissolved on December 06, 1987 by afflux of time. This event happened as per the terms stipulated in the partnership deed itself. The necessity for filing the petition under the Companies Act arose because of differences between the erstwhile partners that had erupted, pertaining to the affairs of the firm. No doubt, in the said petition interim order dated November 05, 1988 was passed by the High Court permitting the group of persons (seven in number), having controlling interest in the firm, to continue the business. However, this was done as an interim arrangement till the completion of winding up proceedings. Pertinently, insofar as the firm is concerned, it did not carry on business thereafter as an existing firm. On the contrary, few ex-partners with controlling interest were allowed to continue the business activity in the interregnum as a stopgap arrangement. Another important fact which needs a mention is that, insofar as the firm is concerned, it did not file income tax returns after the date of dissolution. Obviously so, as it stood dissolved and was no more in existence. Precisely for this reason, the income that was generated from the business, after the dissolution, was assessed by the income tax authorities in the hands of such erstwhile partners as an AOP. It is this AOP which was filing the returns and getting the same assessed in that capacity and paying the income tax thereupon. Further, in the orders passed by the High Court from time to time in the said petition, insofar as the firm is concerned, it has always been described as 'the dissolved partnership firm'. Thus, the assets which were sold ultimately on November 20, 1994 were of a dissolved partnership firm, though as a going concern;

++ once we straighten the factual position, the whole legal edifice of the assessees case crumbles down. At this stage, we would like to clarify one more factual aspect. During the pendency of the winding up petition before the High Court, the High Court had passed various orders which included an order for valuation of the assets of the firm. This valuation was done to enable the Court to fix the reserve price for the purpose of inter se bidding between the erstwhile partners and/or association of erstwhile partners. The Chartered Accountants had done the valuation and submitted reports on the basis of which base price was fixed at Rs 30 crores taking into account the value of various assets. These assets valued at Rs 30 crores are sold for Rs 92 crores. Thereafter, AOP-3, the successful bidder, deposited the amount of bid in respect of the share of nine other partners and a settlement was also prepared recording the value of the assets of the firm after deducting the liability of the said nine partners. The net value of the assets so arrived at and distributed among the nine partners;

++ what follows is that the firm stood dissolved with effect from December 06, 1987; the company petition had to be filed by two partners in view of eruption of disputes among the partners; the business was carried on by the partners with controlling interest as an interim arrangement; the income was assessed in their hands as AOP and not in the hands of the firm which had already been dissolved; assets of the company were put to sale in accordance with Clause 16 of the Partnership Deed of a dissolved firm, though as a going concern; and outgoing partners (assessees herein) received their net share of the value of the assets of the firm out of the amount received by way of sale of the assets of the firm as per Clause 16 of the Partnership Deed;

++ it becomes clear that asset of the firm that was sold was the capital asset within the meaning of Section 2(14) of the Act. It is not even disputed. Once it is held to be the “capital asset”, gain therefrom is to be treated as capital gain within the meaning of Section 45 of the Act;

++ the assessees, however, are attempting the wriggle out from payment of capital gain tax on the ground that it was a “slump sale” within the meaning of Section 2(42C) of the Act and there was no mechanism at that time as to how the capital gain is to be computed in such circumstances, which was provided for the first time by Section 50B of the Act with effect from April 01, 2000. However, this argument fails in view of the fact that the assets were put to sale after their valuation. There was a specific and separate valuation for land as well as building and also machinery. Such valuation has to be treated as that of a partnership firm which had already stood dissolved;

++ sale in question could be treated as slump sale only if there was no value assigned to the individual assets and liabilities in such sale. This has obviously not happened. It is stated at the cost of repetition that not only value was assigned to individual assets, even the liabilities were taken care of when the amount of sale was apportioned among the outgoing partners, i.e. the assessees herein. Once we hold that the sale in question was not slump sale, obviously Section 50B also does not get attracted as this section contains special provision for computation of capital gains in case of slump sale. As a fortiorari, the judgment in the case of PNB Finance Limited also would not apply;

++ in this scenario, when the Official Liquidator has distributed the amount among the nine partners, including the assessees herein, after deducting the liability of each of the partners, the High Court has rightly held that the amount received by them is the value of net asset of the firm which would attract capital gain. Scope of Section 45 of the Act was explained in Commissioner of Income Tax, Faridabad v. Ghanshyam (HUF);

++ in para 45 of the judgment, the Court also stated that capital gains under Section 45 of the Act are not income accruing from day to day. It is deemed income which arises at a fixed point of time, viz. on the date of transfer;

++ when we apply the said legal principle to the facts of the instant case, we find that the partnership firm had dissolved and thereafter winding up proceedings were taken up in the High Court. The result of those proceedings was to sell the assets of the firm and distribute the share thereof to the erstwhile partners. Thus, the 'transfer' of the assets triggered the provisions of Section 45 of the Act and making the capital gain subject to the payment of tax under the Act;

++ insofar as argument of the assessees that tax, if at all, should have been demanded from the partnership firm is concerned, we may only state that on the facts of this case that may not be the situation where the firm had dissolved much before the transfer of the assets of the firm and this transfer took place few years after the dissolution, that too under the orders of the High Court with clear stipulation that proceeds thereof shall be distributed among the partners. Insofar as the firm is concerned, after the dissolution on December 06, 1987, it had not filed any return as the same had ceased to exist. Even in the interregnum, it is the AOP which had been filing the return of income earned during the said period. The High Court has touched upon this aspect in greater detail in para 30 of its judgment;

++ in view of the discussion, the arguments that valuation of goodwill was wrongly done may also not survive. In any case, we find that no such plea was taken by the assessees in the High Court or before the Tribunal or lower authorities.

(See 2016-TIOL-177-SC-IT)