Reduction In A Partner's Share On Reconstitution Not A Capital Asset Transfer

BACKGROUND

• The Assessee¹ , is one of the partners in M/s. CRCL LLP ('CRCL or Firm') with a 12% profit-sharing ratio.
• During AY 2017-18, M/s Elior India Catering LLP ('Elior') was admitted as a partner in the Firm with 51% profit share by contributing INR 31.75 crores into CRCL out of which INR 19.88 crores was credited to the existing partners' current account in their respective sacrificing ratio.
• Pursuant to admission, Assessee's profit-sharing ratio also got reduced from the existing 12% to 5.88% and INR 2.39 crores was credited to the Assessee's current account held in CRCL for sacrificing his proportionate profit share.
• The Assessing Officer ('AO') argued that on admission of a new partner, profit sharing ratio changed, the goodwill was calculated and distributed amongst the existing partners including the Assessee.
• AO further contended that the Assessee has released his partnership interest in CRCL in favour of Elior acquiring the partnership interest in CRCL. Against this reduction of his right to receive profit and goodwill, the Assessee received payments from Elior which have been subsequently withdrawn from the current account by the Assessee.
• Basis the above, the AO concluded that the right to receive profit in a partnership firm is a capital asset u/s 2(14) of the Income-tax Act, 1961 ('the Act') and relinquishment of such right to receive profit is a transfer within the definition of 2(47) of the Act. Accordingly, AO treated the amount of INR 2.39 crores received by the Assessee from Elior as income from Short-term Capital Gains.
• On appeal, CIT(A) confirmed the additions made by AO.
• Aggrieved by order of CIT(A), the Assessee filed an appeal before the Tribunal.

CONTENTIONS OF ASSESSEE'S REPRESENTATIVE ('AR')

• The assets belonging to CRCL are not transferred from the Assessee on account of admission of a new partner as the assets continue to be held by the CRCL and no partner has got any independent or specific interest in respect of the assets of the firm.
• Assessee's share in assets of CRCL, inter-alia, goodwill would be crystallized only on dissolution of firm or retirement of any partner(s).
• Reconstitution agreement indicates that none of the existing partners retired or there was any distribution of assets, thereby, the amount credited to respective partners' current account represents goodwill, is not correct.
• No goodwill existed at the time of Elior's investment in CRCL, making it impossible for the Assessee to receive a share of non-existent goodwill.
• Even if amount of INR 2.39 crores is considered as goodwill, the same cannot be treated as income in Assessee's hands as a partner does not have any right over the assets of the firm when the firm is still in existence and it could best be envisaged under section 45(4) of the Act to tax in firms' hands and not in hands of partners.
• AR relied upon various judicial precedents² to support his claims.

ARGUEMENTS OF DEPARTMENTAL REPRESENTATIVE ('DR')

• Relied upon Apex's court ruling³ wherein it was upheld that extinguishment/transfer of interest in a partnership firm's assets for a consideration that results in transfer of capital asset is liable to tax.
• Case on hand is not a distribution of assets/value of assets by the firm for section 45(4) of the Act to be made applicable, but a transfer of partnership interest by the old partner to the new partner for a consideration.
• The current situation is similar to a corporate set up, wherein, a shareholder sell his/her stake in the company to a third party, it is subject to capital gain taxes even though the shareholder does not own the assets of the company, he is only entitled to dividend and share of assets on winding up of the Company.
• LLP is a new form of organization, therefore, what is transferred in this case is the economic rights of the Assessee partner and the same is an asset under 2(47) and therefore, the transfer is liable to capital gains under section 45(1) of the Act.
• DR relied on various case laws⁴ in support of the above arguments.
• Also relied upon Supreme Court's judgement⁵ to propose that pursuant to reconstitution of partnership's firm, assets are revalued and revalued amount is credited to partner's account in their profit-sharing ratio, the assets so revalued and credited into capital accounts can be said to be transfer and hence the said amount would be chargeable to capital gains.

TRIBUNAL'S OBSERVATIONS

• It is an admitted fact that the erstwhile partners of CRCL have not retired, and they continued to be partners along with new partner, Elior.
• Referred to the decision of Hon'ble Karnataka High Court in case of CIT v. P.N. Panjawani, which is squarely applicable to the facts of the present case. This judgement was upheld by the Apex Court as well.
• Noted the key findings of the Hon'ble High Court as under-
  1. An exclusive interest of a partner in his personal asset, upon its introduction into the partnership firm as his share, transforms into a shared interest with other partners.
  2. During the subsistence of the partnership, the value of each partner's interest qua that asset cannot be isolated from value of partner's interest in totality of partnership assets.
  3. The evaluation of a partner's interest takes place only when there is a dissolution of the firm or upon his retirement from it. What the partner gets upon dissolution or upon his retirement is the realization of a pre-existing interest or right.
  4. The Act recognizes the firm as a distinct legally assessable entity apart from its partners. Prior to reconstitution, the firm's property was owned and belong to the firm and not the erstwhile partners. Therefore, upon reconstitution, it cannot be said that partners transferred/relinquished their interest in partnership's assets in favour of new partners.
  5. There is no provision under the scheme of the Act for levying capital gains on consideration received for reduction of the share in partnership firm.
• As the partners have no defined share in the assets of the partnership firm during its subsistence, thus on realignment of profit-sharing ratio due to the admission of a new partner, there is no relinquishment of any non-existent share in the firm's assets as the assets remained with the firm.
• The revaluation of CRCL's assets and credit of revalued amount to partners' capital accounts in their respective share ratio would not entail any transfer under section 2(47) of the Act.
• Rejected the judicial precedents relied upon by DR being distinguished by facts and therefore, has no application to the present case.
• Provisions of amended 45(4) as well as the provisions of section 9B came into force w.e.f. 01.04.2021, are not applicable, being prospective⁶ in nature.
• Held that compensation received by the Assessee partner from Elior for reduction in his profit-sharing ratio would not be tantamount to capital gains, thereby allowed the appeal of the Assessee.

AURTUS COMMENTS

• Under this ruling, the Chennai Bench of the Tribunal followed the decision of Hon'ble Karnataka High Court in case of CIT v. P.N. Panjawani and distinguished the judgements relied upon by DR wherein upon reconstitution of the partnership firm, either one or more partner(s) were retired or the firm was winded up.
• This judgement further strengthens the taxability position of reduction in a partner's share upon reconstitution of a partnership firm in the pre-amended 45(4) and newly introduced section 9B era.

Footnotes

1. Gokulakrishna [TS-798-ITAT-2025(CHNY)]

2. CIT v. P.N. Panjwani 356 ITR 676 (Kar.) CIT v. Kunnamkulam Mill Board 257 ITR 544 (Kerala) ITO v. Smt. Paru D. Dave [2008] 110 ITD 410 (Mum.) ITO v. Fine Developers [2013] 55 SOT 122 Radhu Palace v. Addl. CIT 148 ITD 424 (Delhi)

3. JCIT v. Vatsala Sheny [2016] 74 taxamann.com 143 (SC)

4. Sudhakar M Shetty v. ACIT [2011] 130 ITD 197 (Mumbai) Samir Suryakant Seth v. ACIT [ITA Nos. 2919 & 3092/Ahd./2002] B. Raghurama Prabhu Estate v. JCIT [2012] 20 taxmann.com 390 (Karnataka)

5. CIT v. Mansukh Dyeing and Printing Mills 449 ITR 439 (SC)

6. In order to bring the profit or gains from receipt of money or capital asset or both by the specified person from a specified entity on reconstitution of the specified entity shall be chargeable to income-tax as income of such specified entity under the head 'Capital Gains', the legislation amended the provisions of Section 45(4) and Section 9B vide Finance Act, 2021, which came into force on the April 1, 2021, thus the same have no application in the present case as it is not applicable to the relevant AY 2017-18.

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