Structuring Investments in Partnership Firms
If a partner’s contribution attracts tax, the manner in which the investment is structured could be significantly different as the contributing partner would require funds initially to meet the income tax liability. Devoid of such liability, partners would be free to structure the transaction as per their commercial negotiations.
A partnership firm is one of the oldest structures typically adopted by businesses, including joint ventures.
The Indian Partnership Act, 1932 defines a partnership as “the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all.”
When a partnership firm is set up, the partners raise capital to run the business. The capital does not necessarily have to be cash; the partners can contribute assets such as land/ immovable property where, for instance, the proposed business is development of the said land/ immovable property.
In real estate development transactions, the owners typically contribute land towards the firm’s capital, and the developers bring in cash as their capital contribution, with the agreement to undertake development of the land through the firm. It may seem logical that such a contribution should not amount to a transfer (considering a partnership firm is not a separate legal entity and the contributing partner receives no consideration), but it should be noted that such a contribution is deemed to be a transfer for income tax purposes.
A key aspect that should be borne in mind while structuring such investments is that value attributed to immovable property as capital could be considered as consideration received and may result in capital gains liable to tax in the partner’s hands.
Charging section of capital gains i.e. Section 48 of the Income Tax Act, 1961 (“IT Act”) requires that the income chargeable under the head ‘Capital Gains’ shall be computed by deducting the cost of acquisition of asset and cost of any improvements and all expenditure connected with the transfer from the full value of the consideration received or accruing.
Capital gains are profits or gains arising from the transfer of a capital asset, i.e. an increase in the worth of a capital asset that fetches a price higher than the purchase price. Capital asset is defined under the IT Act to mean, inter-alia, property held by a person whether or not it is connected with the business or profession, but does not, inter-alia, include any stock-in-trade, consumable stores, or raw materials held for the purpose of the business or profession, and personal effects or agricultural land in India. Hence, in a case where the asset contributed qualifies as stock-in-trade, the transfer of such an asset ought not trigger capital gains tax liability.
The Hon’ble Supreme Court of India in 1985 (in the matter of Shri Sunil Siddharthbhai & others vs Commissioner of Income Tax) held that when the assessee contributed certain shares to the partnership firm’s capital, this constituted a transfer of a capital asset as per the provisions of the IT Act. In the said case, the Hon’ble Court also stated that it is impossible to evaluate the consideration acquired by the partner when the partner contributes his personal assets to the firm’s capital and that no profit or gain can be said to arise, since the consideration received by the partner on transfer does not fall within Section 48 of the IT Act.
After the aforesaid judgment of the Supreme Court, Section 45(3) was introduced under the Finance Act, 1987 to tax gains on contribution of capital assets to partnership in the hands of partner. Section 45(3) of the IT Act provides that the amount recorded in the firm’s books as the value of capital asset shall be deemed to be the value of consideration received by the partner for transfer of a capital asset contributed by such partner in the firm.
Subsequently, Section 50C was introduced in the IT Act vide the Finance Act, 2002 which provides that where the consideration received or accruing as a result of the transfer by an assessee of an immovable property being a capital asset is less than the value adopted or assessed or assessable by the stamp duty authority for the purpose of payment of stamp duty in respect of such transfer, the value so adopted or assessed or assessable shall, for the purposes of Section 48, be deemed to be the full value of the consideration received or accruing as a result of such transfer.
Section 50C of the IT Act further provides that where the value adopted or assessed or assessable by the stamp duty authority does not exceed 105% of the consideration received or accruing as a result of such transfer, the consideration so received or accruing shall, for the purposes of Section 48, be deemed to be the full value of the consideration and, therefore, capital gains shall be computed on the basis of such full value of the consideration.
The proposed budget for 2020-2021 has increased the above threshold; hence, if the value adopted by the stamp duty authority does not exceed 110% of the consideration received or accrued, Section 50C will not be attracted.
The question that arises is: what is the amount on which the tax is payable by the partner when the said partner contributes immovable property to the firm’s capital, given that the contributing partner receives no actual consideration. Per applicable law, the book value (i.e., the amount recorded in the books of the firm) or the assessed value (i.e., the value for the purpose of stamp duty), as aforesaid, could be taken into account for the purpose of calculation of Capital Gains.
The authorities have, however, adopted different positions on this point. Some have held that the value of the capital asset recorded in the firm’s books to which the contribution has been made will be considered for the purpose of determining the quantum of tax payable. For instance, the Chennai Bench of the Income Tax Appellate Tribunal (in the matter of Shri Sarrangan Ashok Vs. the Income Tax Officer, Non Corporate Ward, Chennai; I.T. A. No.544/Chny/2019) held that Capital Gains would be applicable on the amount recorded in the firm’s books which is to be considered as the full value of consideration deemed to have been received by such assessee, as stipulated in Section 45(3) of the IT Act. Others have ruled that the value assessed to stamp duty would be considered instead of the value recorded in the books of the firm.
Given the implications of contrary positions can be significant, it is important to evaluate these issues to ensure clarity while proceeding with such investment structures. If a partner’s contribution attracts tax, the manner in which the investment is structured could be significantly different as the contributing partner would require funds initially to meet the income tax liability. Devoid of such liability, partners would be free to structure the transaction as per their commercial negotiations.
Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house
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