2014 (4) TMI 308 - AT - Income Tax

Tribunal decision: No capital gains tax on revaluation reserve from partnership firm conversion

The Tribunal upheld the reopening of the assessment under Section 147 but dismissed the addition of capital gains tax on the revaluation reserve. It ... Validity of reopening of assessment u/s 147 of the Act - The original assessment was not framed u/s 143(3), there was merely processing of return u/s 143(1) – the return of assessee was just processed u/s 143(1), there is nothing wrong in the initiation of reassessment proceedings - ground taken by the assessee challenging the validity of reopening u/s 147 is dismissed. Revaluation of capital network rights – Capital gain in the hands of the partner - Revaluation reserve was credited to partners’ capital account and the assets account was debited in the books of the partnership firm – Held that:- There is neither division of assets nor any realsiation of assets - there is no official dissolution of the firm and distribution on assets of the firm among the partners, even the provisions of Section 45(4) will not be applicable to the firm or to the partner - there is absence of word “transfer” as envisaged u/s 2(47), the charging provisions of Section 45(1) will not be applicable, since the vesting of property in the company from the firm is not consequent to a transfer - crediting the amount of revaluation reserve to partners’ capital account does not amount to transfer of partnership firm’s assets to the individual partner. During continuation of partnership, partners do not have separate rights over the assets of firm in addition to interest in the share of profits – the rights were property of partnership firm till the date of conversion into the company by operation of law as per Part IX of the Companies Act - Relying upon CIT Vs. Texspin Engineering and Manufacturing Works [2003 (3) TMI 56 - BOMBAY High Court] - Section 45(4) is not attracted as the very first condition of transfer by way of distribution of capital assets is not satisfied – thus, the latter part of Section 45(4), which refers to computation of capital gains u/s 48 by treating fair market value of the asset on the date of transfer, does not arise - there was no merit in the action of the lower authorities for brining gains on revaluation under the tax net on revaluation of assets of partnership firm, which was distributed to the partner and partnership firm was converted into company by operation of law under Part IX of the Companies Act – Decided partly in favour of Assessee. Issues Involved:1. Validity of reopening the assessment under Section 147.2. Taxability of revaluation reserve credited to partners' capital accounts.3. Applicability of Sections 45(1), 45(3), and 45(4) of the Income Tax Act.4. Interpretation of 'transfer' under Section 2(47) in the context of partnership firm conversion to a company.Issue-wise Detailed Analysis:1. Validity of Reopening the Assessment under Section 147:The assessee challenged the reopening of the assessment, arguing that the reasons recorded by the AO were vague and unsustainable. The AO had cited three reasons: no capital gain tax was paid on the distribution of revaluation reserve, the amount distributed was liable to capital gains, and the assessee received unsecured loans. The assessee contended that the AO's reasons lacked clarity and were factually incorrect. However, the Tribunal found that since the original assessment was not framed under Section 143(3) and only processed under Section 143(1), the initiation of reassessment proceedings was valid. Thus, the ground challenging the validity of reopening under Section 147 was dismissed.2. Taxability of Revaluation Reserve Credited to Partners' Capital Accounts:The AO treated the revaluation reserve credited to the partners' capital accounts as short-term capital gains. The assessee argued that the revaluation of assets did not amount to a transfer and hence, no capital gains tax was applicable. The Tribunal agreed with the assessee, stating that the revaluation of assets and the credit of the revalued amount to the partners' capital accounts did not entail any transfer as defined under Section 2(47). The Tribunal concluded that merely crediting the revaluation reserve to the partners' capital accounts did not result in a transfer of partnership firm's assets to the individual partners, and thus, no capital gains tax was applicable.3. Applicability of Sections 45(1), 45(3), and 45(4) of the Income Tax Act:The assessee argued that Sections 45(1), 45(3), and 45(4) were not applicable as there was no transfer of assets from the firm to the partners. The Tribunal found that the provisions of Section 45(4) were not applicable since there was no official dissolution of the firm and no distribution of assets among the partners. Furthermore, the charging provisions of Section 45(1) were not applicable as the vesting of property in the company from the firm was not consequent to a transfer but was a statutory vesting by operation of law. Consequently, the Tribunal held that no capital gains tax could be charged under these sections.4. Interpretation of 'Transfer' under Section 2(47) in the Context of Partnership Firm Conversion to a Company:The Tribunal examined whether the conversion of the partnership firm into a private limited company constituted a 'transfer' under Section 2(47). The Tribunal referred to the decision of the Hon'ble Bombay High Court in CIT v. Texspin Engineering and Manufacturing Works, which held that the vesting of property in a company upon conversion of a partnership firm under Part IX of the Companies Act did not constitute a transfer. The Tribunal noted that the conversion resulted in the statutory vesting of properties in the company, not a transfer. Therefore, the revaluation of assets and subsequent conversion did not attract capital gains tax.Conclusion:The Tribunal allowed the assessee's appeal in part, concluding that the revaluation of the partnership firm's assets and the crediting of the revaluation reserve to the partners' capital accounts did not result in a taxable transfer. The reopening of the assessment under Section 147 was upheld, but the addition of capital gains tax on the revaluation reserve was dismissed. The Tribunal emphasized that the conversion of the partnership firm into a company by operation of law did not constitute a transfer under Section 2(47), and thus, no capital gains tax was applicable.