I brought my shares into a partnership firm as my capital contribution and the firm credited my account at market value. Am I taxable on capital gains on the appreciation?
No, on the law as it then stood, though for a reason narrower than the taxpayer wanted. The Supreme Court held there was a transfer: the definition in section 2(47) is inclusive, and a partner who brings a personal asset into the firm reduces his exclusive interest to a shared interest, which is a transfer of interest even though it is not a sale. But no capital gain arose. The consideration is only the right to a share of profits and, on dissolution or retirement, to the value of a share in the net assets; the credit in the capital account is a notional figure, not the true consideration. As it cannot be valued under section 48, the case falls outside section 45 altogether.
Decided by the Supreme Court (Supreme Court of India - P.N. Bhagwati CJ, R.S. Pathak and Amarendra Nath Sen JJ; judgment by Pathak J) on 1985-09-27, reported as (1985) 156 ITR 509; 1986 AIR 368; 1985 SCR Supp (3) 102; 1985 (4) SCC 519; (1985) 23 Taxman 14; 1985 SCALE (2) 755; 1985 SCC (Tax) 50. It bears on section 45, section 48, section 2(47) of the Income Tax Act 1961, in Capital Gains matters.
Two propositions of lasting use come out of this. First, transfer in section 2(47) is not confined to the four expressions the definition lists; reducing an exclusive interest to a shared one is a transfer, and the Madras decisions that asked only whether a transaction fitted sale, exchange, relinquishment or extinguishment were held to have overlooked the inclusive character of the definition. Second, the machinery argument from B.C. Srinivasa Setty is applied to consideration rather than to cost: where the consideration received cannot be valued in money terms, section 48 cannot work, and the charge in section 45 does not bite. The Court also drew the line between contribution and distribution - on retirement or dissolution a shared interest in everything is replaced by an exclusive interest in something of equal value, which is the realisation of a pre-existing right, whereas contribution moves in the opposite direction. Finally, the judgment carries an express reservation, quoted as often as the holding, that the authorities may go behind a partnership used as a device to convert a personal asset into money.
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In the lead appeal the assessee was a partner in Suvas Trading Company, a firm constituted by a deed of 27 September 1973. As his contribution to the firm's capital he made over shares of limited companies held by him as capital assets. Their book value in his own accounts was Rs 1,60,279; on the date of contribution he revalued them at the market value of Rs 1,49,819 and debited the difference of Rs 10,460 to his capital account. The Income Tax Officer, assessing him for assessment year 1974-75, did not bring the difference to tax. The Commissioner took the view that the difference between the market value and the cost of acquisition was chargeable as capital gains under section 45, exercised his revisional power, reopened the assessment and remanded it with a direction to compute the capital gain. The Tribunal held that although the transaction was a transfer within section 2(47) it did not give rise to taxable capital gains, and set the officer's order aside. It then referred questions to the Gujarat High Court. A connected appeal raised the same question on a contribution of shares in Ahmedabad Manufacturing and Calico Printing and Karamchand Premchand to a firm in which the assessee's wife was the other partner, where the firm credited his account with the market value. By a common judgment of 30 April and 1 and 4 May 1981 the Gujarat High Court answered in favour of the Revenue in both matters, and the assessees appealed.
The appeals were partly allowed, with no order as to costs, and the questions answered in two parts. First, there was a transfer of the shares when the assessee made them over to the firm as his capital contribution - a transfer of a capital asset within the terms of section 45. On this the Court agreed with the Kerala High Court in A. Abdul Rahim, the Karnataka High Court in M.A.J. Vasanaik and the Gujarat High Court below, and held that the Madras decisions in Abdul Khader Motor and Lorry Service and H. Rajan and H. Kannan had overlooked the inclusive character of section 2(47). Second, on transferring his shares to the firm the assessee received no consideration within the meaning of section 48, nor did any profit or gain accrue to him for the purposes of section 45, so the case falls outside capital gains taxation altogether. The Court also overruled an objection that the no-profit argument had not been referred or argued below, holding it to be one aspect of the questions referred, resting purely on law and fundamental to them. Both answers were given expressly subject to the Court's reservation about sham or device transactions.
The Court accepted the assessee's starting point but not his conclusion. A firm under the Indian Partnership Act is not a distinct legal entity apart from its partners and has no separate right in the partnership assets - the Malabar Fisheries formulation - so when a partner hands over an asset as his contribution there is no sale, as Hind Construction and a line of High Court decisions had held. But the question remained whether it was a transfer of some other kind. Since section 2(47) is an inclusive definition, the enquiry cannot stop at sale, exchange, relinquishment or extinguishment. In its general sense a transfer of property is the passing of rights from one person to another, and that may take the form of the entire bundle passing, or one estate out of many, or the reduction of an exclusive interest into a joint or shared interest. An exclusive interest is the larger; to the extent it is reduced to a shared interest there is a transfer of interest. Addanki Narayanappa supplied the content of what the partner is left with: whatever is brought in ceases to be his exclusive property and becomes a trading asset of the firm, and during the subsistence of the partnership he cannot deal with any portion as his own or assign his interest in a specific item; his right is to his share of profits from time to time and, on dissolution or retirement, to the value of his share in the net assets after liabilities and prior charges. The Court then distinguished the retirement and dissolution cases - Dewas Cine Corporation, Bankey Lal Vaidya, Malabar Fisheries and others - on the ground that there a shared interest in all the assets is replaced by an exclusive interest in an asset of equal value, which is the realisation of a pre-existing right and so no transfer; contribution runs the other way, an individual asset being the sole subject of consideration and an exclusive interest becoming a shared one. On the second question the Court applied B.C. Srinivasa Setty, that the charging section and the computation provisions of a head of income are an integrated code, so that a case to which the computation provisions cannot apply was not intended to fall within the charge. What the partner receives is the right to profits during the partnership and to the value of a share in the net assets on dissolution or retirement. The credit entry in his capital account is notional, made only to adjust the partners' rights inter se; it evidences no debt owed by the firm and may be wiped out by losses even in the same accounting year. At the moment of contribution neither the date of dissolution nor the liabilities and prior charges then existing can be known - all that lies within the womb of the future - so the consideration cannot be evaluated and section 48 cannot operate. On the third point the Court applied the settled principle, drawn from Dhun Dadabhoy Kapadia and a line of cases from Calcutta Co Ltd onwards, that profits or gains must be understood as real profits computed on ordinary commercial principles that no commercial man would misunderstand; on that footing no income or gain in the true commercial sense arises to the partner. Finally it entered its reservation. The decision assumes a genuine firm and a genuine intention to contribute capital for the partnership business. Where the transfer is merely a device or ruse to convert the asset into money that remains substantially available to the assessee free of tax, the authorities may go behind it, considering whether the firm is substantially the assessee with his wife and children, whether the firm sold the asset soon after receiving it, whether it has any substantial business, and whether it had any real need of the capital; in deciding whether a transaction is a sham, the officer is entitled to penetrate the veil covering it and ascertain the truth.
To the extent to which the exclusive interest is reduced to a shared interest it would seem that there is a transfer of interest.
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Handle my notice → Ask a CA on WhatsAppNo, on the law as it then stood, though for a reason narrower than the taxpayer wanted. The Supreme Court held there was a transfer: the definition in section 2(47) is inclusive, and a partner who brings a personal asset into the firm reduces his exclusive interest to a shared interest, which is a transfer of interest even though it is not a sale. But no capital gain arose. The consideration is only the right to a share of profits and, on dissolution or retirement, to the value of a share in the net assets; the credit in the capital account is a notional figure, not the true consideration. As it cannot be valued under section 48, the case falls outside section 45 altogether. This was decided by the Supreme Court (Supreme Court of India - P.N. Bhagwati CJ, R.S. Pathak and Amarendra Nath Sen JJ; judgment by Pathak J) and bears on section 45, section 48, section 2(47) of the Income Tax Act 1961. It is reported as (1985) 156 ITR 509; 1986 AIR 368; 1985 SCR Supp (3) 102; 1985 (4) SCC 519; (1985) 23 Taxman 14; 1985 SCALE (2) 755; 1985 SCC (Tax) 50. Two propositions of lasting use come out of this. First, transfer in section 2(47) is not confined to the four expressions the definition lists; reducing an exclusive interest to a shared one is a transfer, and the Madras decisions that asked only whether a transaction fitted sale, exchange, relinquishment or extinguishment were held to have overlooked the inclusive character of the definition. Second, the machinery argument from B.C. Srinivasa Setty is applied to consideration rather than to cost: where the consideration received cannot be valued in money terms, section 48 cannot work, and the charge in section 45 does not bite. The Court also drew the line between contribution and distribution - on retirement or dissolution a shared interest in everything is replaced by an exclusive interest in something of equal value, which is the realisation of a pre-existing right, whereas contribution moves in the opposite direction. Finally, the judgment carries an express reservation, quoted as often as the holding, that the authorities may go behind a partnership used as a device to convert a personal asset into money. If it applies to you, the first step is this: Check the year first. This holding is on the law before the provision that now fixes the consideration for such a contribution at the amount recorded in the firm's books; for later years the computation problem the Court identified no longer exists.
In the lead appeal the assessee was a partner in Suvas Trading Company, a firm constituted by a deed of 27 September 1973. As his contribution to the firm's capital he made over shares of limited companies held by him as capital assets. Their book value in his own accounts was Rs 1,60,279; on the date of contribution he revalued them at the market value of Rs 1,49,819 and debited the difference of Rs 10,460 to his capital account. The Income Tax Officer, assessing him for assessment year 1974-75, did not bring the difference to tax. The Commissioner took the view that the difference between the market value and the cost of acquisition was chargeable as capital gains under section 45, exercised his revisional power, reopened the assessment and remanded it with a direction to compute the capital gain. The Tribunal held that although the transaction was a transfer within section 2(47) it did not give rise to taxable capital gains, and set the officer's order aside. It then referred questions to the Gujarat High Court. A connected appeal raised the same question on a contribution of shares in Ahmedabad Manufacturing and Calico Printing and Karamchand Premchand to a firm in which the assessee's wife was the other partner, where the firm credited his account with the market value. By a common judgment of 30 April and 1 and 4 May 1981 the Gujarat High Court answered in favour of the Revenue in both matters, and the assessees appealed. The matter was decided on 1985-09-27 by the Supreme Court (Supreme Court of India - P.N. Bhagwati CJ, R.S. Pathak and Amarendra Nath Sen JJ; judgment by Pathak J). On those facts the Supreme Court held as follows. The appeals were partly allowed, with no order as to costs, and the questions answered in two parts. First, there was a transfer of the shares when the assessee made them over to the firm as his capital contribution - a transfer of a capital asset within the terms of section 45. On this the Court agreed with the Kerala High Court in A. Abdul Rahim, the Karnataka High Court in M.A.J. Vasanaik and the Gujarat High Court below, and held that the Madras decisions in Abdul Khader Motor and Lorry Service and H. Rajan and H. Kannan had overlooked the inclusive character of section 2(47). Second, on transferring his shares to the firm the assessee received no consideration within the meaning of section 48, nor did any profit or gain accrue to him for the purposes of section 45, so the case falls outside capital gains taxation altogether. The Court also overruled an objection that the no-profit argument had not been referred or argued below, holding it to be one aspect of the questions referred, resting purely on law and fundamental to them. Both answers were given expressly subject to the Court's reservation about sham or device transactions.
The Court accepted the assessee's starting point but not his conclusion. A firm under the Indian Partnership Act is not a distinct legal entity apart from its partners and has no separate right in the partnership assets - the Malabar Fisheries formulation - so when a partner hands over an asset as his contribution there is no sale, as Hind Construction and a line of High Court decisions had held. But the question remained whether it was a transfer of some other kind. Since section 2(47) is an inclusive definition, the enquiry cannot stop at sale, exchange, relinquishment or extinguishment. In its general sense a transfer of property is the passing of rights from one person to another, and that may take the form of the entire bundle passing, or one estate out of many, or the reduction of an exclusive interest into a joint or shared interest. An exclusive interest is the larger; to the extent it is reduced to a shared interest there is a transfer of interest. Addanki Narayanappa supplied the content of what the partner is left with: whatever is brought in ceases to be his exclusive property and becomes a trading asset of the firm, and during the subsistence of the partnership he cannot deal with any portion as his own or assign his interest in a specific item; his right is to his share of profits from time to time and, on dissolution or retirement, to the value of his share in the net assets after liabilities and prior charges. The Court then distinguished the retirement and dissolution cases - Dewas Cine Corporation, Bankey Lal Vaidya, Malabar Fisheries and others - on the ground that there a shared interest in all the assets is replaced by an exclusive interest in an asset of equal value, which is the realisation of a pre-existing right and so no transfer; contribution runs the other way, an individual asset being the sole subject of consideration and an exclusive interest becoming a shared one. On the second question the Court applied B.C. Srinivasa Setty, that the charging section and the computation provisions of a head of income are an integrated code, so that a case to which the computation provisions cannot apply was not intended to fall within the charge. What the partner receives is the right to profits during the partnership and to the value of a share in the net assets on dissolution or retirement. The credit entry in his capital account is notional, made only to adjust the partners' rights inter se; it evidences no debt owed by the firm and may be wiped out by losses even in the same accounting year. At the moment of contribution neither the date of dissolution nor the liabilities and prior charges then existing can be known - all that lies within the womb of the future - so the consideration cannot be evaluated and section 48 cannot operate. On the third point the Court applied the settled principle, drawn from Dhun Dadabhoy Kapadia and a line of cases from Calcutta Co Ltd onwards, that profits or gains must be understood as real profits computed on ordinary commercial principles that no commercial man would misunderstand; on that footing no income or gain in the true commercial sense arises to the partner. Finally it entered its reservation. The decision assumes a genuine firm and a genuine intention to contribute capital for the partnership business. Where the transfer is merely a device or ruse to convert the asset into money that remains substantially available to the assessee free of tax, the authorities may go behind it, considering whether the firm is substantially the assessee with his wife and children, whether the firm sold the asset soon after receiving it, whether it has any substantial business, and whether it had any real need of the capital; in deciding whether a transaction is a sham, the officer is entitled to penetrate the veil covering it and ascertain the truth. In the words reproduced by the source cited on this page: "To the extent to which the exclusive interest is reduced to a shared interest it would seem that there is a transfer of interest."
It was decided by the Supreme Court on 1985-09-27 and is reported as (1985) 156 ITR 509; 1986 AIR 368; 1985 SCR Supp (3) 102; 1985 (4) SCC 519; (1985) 23 Taxman 14; 1985 SCALE (2) 755; 1985 SCC (Tax) 50. Binding on every court and authority in India. A Supreme Court decision binds every assessing officer, every Commissioner (Appeals), every bench of the Income Tax Appellate Tribunal and every High Court in India. An officer who declines to follow it is acting contrary to law, and that refusal is itself a ground of appeal. On section 45, section 48, section 2(47), the practical question is whether the facts of your own notice match the facts of this case closely enough for the same rule to apply.
It cuts both ways and is cited by both sides. The appeals were partly allowed, with no order as to costs, and the questions answered in two parts. First, there was a transfer of the shares when the assessee made them over to the firm as his capital contribution - a transfer of a capital asset within the terms of section 45. On this the Court agreed with the Kerala High Court in A. Abdul Rahim, the Karnataka High Court in M.A.J. Vasanaik and the Gujarat High Court below, and held that the Madras decisions in Abdul Khader Motor and Lorry Service and H. Rajan and H. Kannan had overlooked the inclusive character of section 2(47). Second, on transferring his shares to the firm the assessee received no consideration within the meaning of section 48, nor did any profit or gain accrue to him for the purposes of section 45, so the case falls outside capital gains taxation altogether. The Court also overruled an objection that the no-profit argument had not been referred or argued below, holding it to be one aspect of the questions referred, resting purely on law and fundamental to them. Both answers were given expressly subject to the Court's reservation about sham or device transactions. It arises in Capital Gains matters, on section 45, section 48, section 2(47) of the Income Tax Act 1961, and was decided by Supreme Court of India - P.N. Bhagwati CJ, R.S. Pathak and Amarendra Nath Sen JJ; judgment by Pathak J. Before relying on it, read the source linked on this page and check whether it has since been distinguished, overruled or overtaken by an amendment to the Income Tax Act. In practice the steps that follow from it are these. If the contribution predates that provision, argue on the consideration, not on the absence of a transfer - the Court decided that a transfer does take place. Make the partnership real and be able to show it: a genuine business, a genuine need for the capital, and no early sale of the contributed asset by the firm, because those are the very indicia the Court listed for scrutiny. Expect a firm made up substantially of the assessee, his wife and children to attract that scrutiny; the Court named that as a relevant factor. Keep this case for the general propositions - the inclusive reach of section 2(47), and the rule that a charge fails where the computation provisions cannot apply - which are used far beyond partnership contributions.
Superseded by amendment. I read most of the judgment, including the whole of the reasoning and the operative order; about 5,400 characters of the middle, covering the questions referred and the facts of the connected appeal, were not reproduced on the harvested page. I checked no later authority. The computation gap this judgment identified was closed by a later provision deeming the amount recorded in the firm's books as the full value of the consideration on a capital contribution to a firm, and taxing the gain in the year of transfer; I state that from my own knowledge and did not verify it in this session, but a reader must find the current provision and the year from which it applies before using the outcome. The holdings on the inclusive scope of section 2(47), on the integrated character of charge and computation, and the reservation about sham partnerships continue to be applied. No source could be cited for that finding. Checking whether an authority still stands matters as much as knowing what it held: a decision may be overruled on one point and survive on another, or the provision it interprets may have been amended since. Read the source and the editor's note on this page before relying on it in a reply to an Assessing Officer or in an appeal.
About 5,400 characters from the middle of the judgment are not reproduced on the harvested page. What is missing is the text of the questions referred by the Tribunal, the facts of the connected appeal as the Court states them, and the opening of counsel's argument on the three conditions for a charge under capital gains; the surviving text resumes in the middle of that argument. The facts here are therefore those of the lead appeal, taken from the judgment, and I have not set out the connected appeal's figures because they appear on the harvested page only in an editorial headnote, which I have not used. The Court decided the case on the assumption that the firm was genuine and did not examine that question on these facts, expressly leaving it open. The later statutory change noted in the validity field is from my own knowledge and was not checked against the statute. This library shows the verification state of every entry openly. This entry has not yet been read in full by a chartered accountant. The summary reflects the sources listed on this page. Read the source before you rely on it in a reply to an Assessing Officer or in an appeal before the Commissioner (Appeals) or the Income Tax Appellate Tribunal.
The appeals were partly allowed, with no order as to costs, and the questions answered in two parts. First, there was a transfer of the shares when the assessee made them over to the firm as his capital contribution - a transfer of a capital asset within the terms of section 45. On this the Court agreed with the Kerala High Court in A. Abdul Rahim, the Karnataka High Court in M.A.J. Vasanaik and the Gujarat High Court below, and held that the Madras decisions in Abdul Khader Motor and Lorry Service and H. Rajan and H. Kannan had overlooked the inclusive character of section 2(47). Second, on transferring his shares to the firm the assessee received no consideration within the meaning of section 48, nor did any profit or gain accrue to him for the purposes of section 45, so the case falls outside capital gains taxation altogether. The Court also overruled an objection that the no-profit argument had not been referred or argued below, holding it to be one aspect of the questions referred, resting purely on law and fundamental to them. Both answers were given expressly subject to the Court's reservation about sham or device transactions.
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