2005 (6) TMI 209 - AT - Income Tax

Tribunal: No Capital Gains Tax on Firm's Conversion to Pvt Ltd; Upholds Disallowance of Commission Payments.

Assistant Commissioner Of Income-tax Circle-2 (1), Mangalore. Versus Unity Care And Health Services.

The Tribunal ruled in favor of the assessee regarding capital gains, determining that the conversion of a partnership firm into a private limited company ... Chargeable to tax as income - capital gain - invoking provisions of section 45(4) - Partnership firm - Transfer of assets in the conversion of partnership firm into private limited company - fair market value on the date of the transfer - depreciation on the assets on pro rata basis - HELD THAT:- It is not the case that section 45(1) can be invoked to tax the capital gain in the present situation. The interest of a partner in a firm is not an interest in any specific item of the partnership property. It is a right to obtain his share of profits from time to time during the subsistence of the partnership and on dissolution of the firm or on his retirement from the partnership, to get the value of his share in the net assets of the firm. When, therefore, on dissolution or retirement, a partner's share in the net partnership asset is determined on taking accounts, what he receives is his share in the partnership and not any consideration for transfer of his interest in the partnership. In such a situation, there is no transfer of interest within the definition of section 2(47) of the Act. This proposition are clearly laid down by Hon'ble Supreme Court in the case of Malabar Fisheries Co. v. CIT [1979 (9) TMI 1 - SUPREME COURT] and in the case of CIT v. Mahanbhai Pamabhai [1971 (9) TMI 56 - GUJARAT HIGH COURT] has affirmed by Hon'ble Supreme Court in the case of Addl. CIT v. Mohanbhai Pamabhai [1987 (2) TMI 59 - SC ORDER]. The persons who were either to register under the Partnership Act are now registered under the Companies Act and accordingly, section 45(4) will not apply in such a situation. We accordingly hold that no capital gain is chargeable in such a situation as there is no distribution of capital asset on dissolution of firm or otherwise. When a conversion of a firm into company takes place under the provisions of Companies Law, such conversion can be construed only as occasioned by operation of law. Hence, no controversy can arise on the application of this principle even for purposes of capital gains under section 45(4) of the Act. By insertion of section 47(xiii) in the Act, it cannot be said that the c conversion of a firm into a company under Part IX is to be first treated as dissolution of firm within the meaning of section 45(4) and only if condition as contained in section 47(xiii) are complied, the exemption will be available. Section 47(xiii) applies only to a case of transfer by sale, but there is no authority for capital gain at all in the absence of a transfer under Part IX of the Companies Act inasmuch as such conversions do not fall within the definition of transfer under section 2(47) of the Act. Section 45(4) would have application only when there is distribution of assets to the partners so that its application cannot be justified, firstly because it can apply only, when there is transfer and secondly only when there is distribution of assets to the partners. This is neither in the conversion of a firm into a company. It is also seen that section 47(xiii) is also complied with if it is held that there is transfer of capital asset to a company. All the clauses of section 47(xiii) are fulfilled and thus even if it is held that there is a transfer of capital asset by a firm to a company as a result of succession, the same is not chargeable, as the condition prescribed therein are complied with. Thus, looking at either angle, the capital gain is not chargeable to tax. It is clear that when the depreciation is allowable on the assets to the predecessor and the successor, the depreciation has to be apportioned between the predecessor and successor in the ratio of number of days for which the assets were used by them. This proviso will apply not only when the succession is as per section 47(xiii) and 47(xiv) of the Act but also where succession is as per section 170 of the Act. Clearly, in this case, the firm is entitled to depreciation for the number of days the assets were used by it. We accordingly do not find any reason to dislodge the finding of the learned CIT(A). In the result, the appeal of assessee is partly allowed and that of revenue is dismissed. Issues Involved:1. Charging of capital gain invoking provisions of section 45(4) of the Income-tax Act.2. Disallowance of commission paid of Rs. 1,53,000/-.3. Allowance of depreciation on assets on a pro rata basis.Detailed Analysis:1. Charging of Capital Gain Invoking Provisions of Section 45(4):The primary issue revolves around whether the conversion of a partnership firm into a private limited company constitutes a 'transfer' under section 45(4) of the Income-tax Act, thereby attracting capital gains tax. The assessee argued that the conversion did not involve a transfer of assets and thus should not attract capital gains tax. They relied on the decision of the Bombay High Court in the case of Texspin Engg. & Mfg. Works, which held that such a conversion does not amount to a transfer by way of distribution of capital assets. The CIT(A) disagreed, holding that the conversion amounted to the dissolution of the firm and thus invoked section 45(4), making the market value of the assets transferred equivalent to the value of shares received by the partners. The Tribunal, however, sided with the assessee, stating that the conversion under Part IX of the Companies Act did not constitute a transfer as there was no distribution of capital assets nor dissolution of the firm. They emphasized that both entities (firm and company) do not exist simultaneously, thus no transfer occurs.2. Disallowance of Commission Paid of Rs. 1,53,000/-:The assessee claimed a deduction for commission paid to individuals who helped procure students for their School of Nursing. The CIT(A) disallowed this claim due to a lack of supporting evidence. The Tribunal upheld this disallowance, emphasizing that the burden of proof for the genuineness of the claim rests on the assessee, which they failed to meet.3. Allowance of Depreciation on Assets on a Pro Rata Basis:The revenue challenged the allowance of depreciation on the assets on a pro rata basis, arguing that once the assets were transferred to the company, the firm was no longer entitled to claim depreciation. The CIT(A) allowed the depreciation on a pro rata basis, stating that the firm is entitled to depreciation for the period the assets were used by it. The Tribunal upheld this view, citing the 5th Proviso to section 32(1) of the Income-tax Act, which mandates that depreciation should be apportioned between the predecessor and successor based on the number of days the assets were used by each.Conclusion:The Tribunal ruled in favor of the assessee on the issue of capital gains, holding that no transfer occurred during the conversion of the firm into a company, thus no capital gains tax was chargeable. They upheld the disallowance of the commission paid due to lack of evidence. Finally, they confirmed the allowance of depreciation on a pro rata basis, dismissing the revenue's appeal on this ground. The assessee's appeal was partly allowed, and the revenue's appeal was dismissed.