Computation of income on reconstitution of Firm, AOP or BOI
Introduction
Where any partner or member receives capital asset, money or stock-in-trade in connection with reconstitution of firm (or AOP/BOI) profit and gains arising from such receipt shall be taxable as income of such firm in the tax year in which such money or capital asset is received by such partner (or member).
1. About
In the event of reconstitution of the firm (including AOP or BOI), the firm may distribute capital asset or other assets to the partners (or members). Such distribution of asset to the partner may give rise to the capital gains (if capital assets are distributed) and the business income (if other assets are distributed). Further, capital gains arising to partner on receipt of capital assets or money or both shall also be chargeable to tax in the hands of firm. The computation of income from such distribution shall be made as per the provisions of Section 8 and Section 67(10).
1.1. Meaning of reconstitution
Reconstitution of a firm means, where:
(a) One or more of its partners (or members) ceases to be partners (or members);
(b) One or more new partners (or members) are admitted in firm (or AOP or BOI). In such a circumstance, at least one existing partner should continue to be partner of firm after admission of the new partner(s); or
(c) All the partners continue with a change in their respective share or in share of some of them.
1.2. Applicability of Section 8
Section 8 deals with the taxability of the income arising to the specified entity on the transfer of any capital asset or stock-in-trade to a specified person in connection with dissolution or reconstitution of a specified entity.
"Specified entity" means a partnership firm or Association of Persons (AOP) or Body of Individuals (BOI) [not being a company or a co-operative society] (Hereinafter collectively referred as 'Firm').
"Specified person" means a person who is a partner of a firm or member of AOP or BOI (not being a company or a co-operative society) in any tax year (Hereinafter collectively referred as 'Partner').
1.3. Applicability of Section 67(10)
Section 67(10) deals with the income arising to a partner on receipt of money or capital asset in connection with the reconstitution of the firm. Though the income arises to the partner under this provision on reconstitution, but the liability to pay tax on such income is on the firm.
1.4. Section 67(10) v. Section 8
When a capital asset is received by a partner from a firm in connection with the reconstitution of such firm, taxability will arise both under the provisions of Section 67(10) and under the provisions of Section 8. It has been clarified
2. Computation of income under Section 8
The taxability of a firm under Section 8 arises if a partner receives any capital asset or stock-in-trade or both from a firm in connection with the reconstitution of such firm. In such a situation, the firm shall be deemed to have transferred such capital asset or stock-in-trade or both, as the case may be, to the partner in the year in which such capital asset or stock in trade or both are received by that partner.
2.1. How to compute income taxable under Section 8?
Any profits and gains arising from transfer of capital asset or stock in trade or both, as the case may be, to the firm on reconstitution shall be deemed to be the income of the firm of the tax year in which stock or capital asset were received by the partner. It shall be chargeable to income-tax under the head 'Profit and Gains from Business or Profession' or 'Capital Gain' in accordance with the provisions of the Act.
2.1-1. In case of stock-in-trade
Profit and Gains arising from transfer of stock-in-trade shall be charged to tax under the head "Profit and Gains from Business or Profession". For computing such profit and gains, fair market value of such stock on the date of its receipt by the partner shall be deemed to be the full value of consideration.
2.1-2. In case of capital asset
Profit and gains arising from transfer of capital asset shall be charged to tax under the head "Capital Gain". For computing such profit and gains, fair market value of such capital asset on the date of its receipt by the partner shall be deemed to be the full value of consideration.
The computation of capital gain under this provision shall be as follows:
| Particular | Amount |
Full value of consideration received or accrued (FMV of capital asset) Less: (a) Expenditure incurred wholly and exclusively in connection with transfer (b) Cost of Acquisition (c) Cost of improvement (d) The amount chargeable to tax as income of firm under Section 67(10)[see note] which is attributable to capital asset being transferred by the firm (e) Exemption for reinvestment of capital gains or sales consideration to the extent of net result of above calculation |
xxx (xxx) (xxx) (xxx) (xxx) (xxx) |
| Income taxable under the head capital gains | xxx |
It is important to note that the firm cannot apply indexation when computing the capital gain.
Note: While computing capital gains arising from transfer of capital asset, profit and gains chargeable to tax under Section 67(10), which is attributable to capital asset being transferred by the firm shall also be allowed as deduction under Section 72(5), if the following conditions are satisfied:
(a) There should be a reconstitution of the partnership firm;
(b) Capital asset or money or both should be given to the partner on such reconstitution;
(c) Capital gain is computed and taxed in the hands of the firm under Section 67(10); and
(d) The book value (or historical value or WDV) of at least one of the capital assets remaining with the firm after such reconstitution should be less than fair market value. It also includes the valuation of a self-generated asset.
The rate at which such capital gain shall be charged to tax will be depend on the nature of capital asset transferred and period for which such asset is held by the firm.
3. Computation of income under Section 67(10)
Where a partner receives any capital asset or money or both from a firm in connection with the reconstitution, then any profit and gains arising from such receipt by partner shall be deemed to be the income of the firm under the head "Capital Gains". It shall be charged to tax in the tax year in which such capital asset or money or both were received by the partner.
3.1. How to compute capital gains under Section 67(10)?
The profit and gains arising from receipt of such capital asset or money or both shall be computed in the following manner:
| Particulars | Amount |
Value of money received by partner on the date of such receipt Add: FMV of the capital asset received by the partner on the date of such receipt Less: Balance in the capital account (represented in any manner) of the partner in the books of account of the firm at the time of reconstitution |
xxx xxx (xxx) |
| Capital gains taxable under Section 67(10) (if positive) | xxx |
| * If the result of above computation is negative, it shall be deemed to be nil. |
3.2. How to compute partner's capital balance for Section 67(10)?
While computing the balance in the capital account of partner in the books of account of firm, increase in capital account due to the following shall not be taken into account:
(a) Revaluation of any asset;
(b) Self-generated goodwill (goodwill acquired without incurring any cost for purchase or which has been generated during the course of business or profession);
(c) Other self-generated assets (Assets acquired without incurring any cost for purchase or which has been generated during the course of business or profession).
As the revaluation gain is being reduced from the partner's capital account while computing capital gain under section 67(10), the revaluation gains attributable to assets that are not transferred to the partner at the time reconstitution is also getting taxed in the hands of the firm. This would result in double taxation when the firm transfers its remaining asset in the future. To remove the impact of such double taxation, an additional deduction has been allowed under Section 72(5) in respect of the capital gains charged to tax under section 67(10), which is attributable to the capital asset remaining with the firm. In other words, a portion of the capital gains so taxed under Section 67(10) shall be reduced from the full value of consideration of the capital asset remained with the firm after reconstitution. The CBDT is empowered to prescribe the method of such attribution. In exercise of such power, CBDT has inserted a new Rule 50.
3.3. How to compute the deduction under Section 72(5)?
Main article: Determination of amount to be attributed under Section 72(5)
Rule 50 provides that where the amount chargeable to tax under Section 67(10) relates to revaluation of any capital asset (or valuation of self-generated asset or self-generated goodwill), it shall be attributed to the capital asset remaining with it as per the following formula:
Where the amount chargeable to tax under Section 67(10) does not relate to the revaluation of any capital asset (or valuation of self-generated asset or self-generated goodwill), or relate only to the capital asset received by the partner from the firm, the amount charged to tax under Section 67(10) shall not be attributed to any capital asset for the purposes of Section 72(5).
The CBDT has also clarified that Rule 50 is also applicable to the capital assets forming part of a block of assets. The partnership firm is required to furnish the details of the amount attributed to the capital asset remaining with it in Form No. 27.
3.4. Nature of capital gains taxable under Section 67(10)
The capital gains or part of it shall be deemed to be from the transfer of short-term capital asset if it is attributed to:
(a) A capital asset which is a short-term capital asset at the time of taxation of amount under Section 67(10); or
(b) A depreciable asset; or
(c) A capital asset being a self-generated asset and self-generated goodwill.
However, such capital gains or part of it shall be deemed to be long-term if it is attributed to a capital asset not covered above and is a long-term capital asset at the time of taxation under Section 67(10).
As multiple capital assets (both long-term and short-term) could be given to the partners on reconstitution, the provisions prescribed under rule does not provide any guidance on the ultimate nature of the resultant capital gains. In such a situation, resultant capital gains can be bifurcated into short-term and long-term in proportion to the full value of consideration of each such asset (i.e., FMV on the date of reconstitution). However, clarity in this regard should be sought from the CBDT.
3.5. Issue of guidelines
The CBDT is empowered to issue guidelines, with prior approval of the Central Government, for removing difficulties arising in giving effect to the provisions of this section. Every such guidelines shall be laid before each house of parliament. The Parliament has the authority to review, amend, or even annul the guidelines issued by the board, but whatever has already been done in accordance with the guidelines shall remain valid and lawful.
3.6. Examples
| A, B, C, and D are equal partners in a partnership firm. Each having a capital balance of Rs. 10 lakhs. A decides to retire from the firm on 1Nature of Asset | Book Value/Written Down Value (in lakhs) |
| Land | 40 |
| Building | 25 |
| Cash | 140 |
Situation A: Firm revalued its land and building at Rs. 50 lakhs and Rs. 35 lakhs respectively. The firm gives Rs. 10 lakhs and land to Mr. A. Such land was acquired by the firm 3 years ago.
(a) Taxability under Section 8
| Particulars | Amount (in lakhs) |
| FMV of land [A] | 50 |
| Book value of land [B] | 40 |
| Long-term capital gains in the hands of Firm [C = A – B] | 10 |
| Tax rate [D] | 12.5% |
| Tax on capital gains [E = C * D] | 1.25 |
| Amount to be attributed to partners account [F = C – E] | 8.75 |
(b) Taxability under Section 67(10)
| Particulars | Amount (in lakhs) |
| FMV of land [A] | 50 |
| Money [B] | 10 |
| Total consideration received [C = A + B] | 60 |
| Opening balance in capital account [D] | 10 |
| Attribution due to transfer of land [E = 8.75 * ¼] | 2.1875 |
| Capital balance at the time of reconstitution [F = D + E] | 12.1875 |
| Deemed Capital Gains in the hands of Firm [G = C – F] | 47.8125 |
| Tax rate* | 12.5% |
| Tax on deemed capital gains | 5.9765 |
* Since the capital gains are attributable to the land, which is a long-term capital asset, the nature of capital gains would be long-term.
Since the firm has revalued building in addition to land, Rule 50 would be applicable, and entire capital gains of Rs. 47.8125 lakhs would be attributable to the building. The firm shall furnish the details of such attribution electronically in Form No. 27.
Situation B: Firm revalued its land and building at Rs. 50 lakhs and Rs. 35 lakhs respectively. The firm gives both land and building to Mr. A. The land was acquired 3 years ago, and the building was acquired 6 months ago.
(a) Taxability under Section 8
| Particulars | Amount (in lakhs) |
| Land | |
| FMV of land [A] | 50 |
| Book value of land [B] | 40 |
| Long-term capital gains in the hands of Firm [C = A - B] | 10 |
| Tax rate [D] | 12.5% |
| Tax on capital gains [E = C * D] | 1.25 |
| Amount to be attributed to partners account [F = C – E] | 8.75 |
| Building | |
| FMV of building [A] | 35 |
| WDV of building [B] | 25 |
| Short-term capital gains in the hands of Firm [C = A - B] | 10 |
| Tax rate [D] | 30% |
| Tax on capital gains [E = C * D] | 3 |
| Amount to be attributed to partners account [F = C – E] | 7 |
(b) Taxability under Section 67(10)
| Particulars | Amount (in lakhs) |
| FMV of land [A] | 50 |
| FMV of building[B] | 35 |
| Total consideration received [C = A + B] | 85 |
| Opening balance in capital account [D] | 10 |
| Attribution due to transfer of land [E = 8.75 * ¼] | 2.1875 |
| Attribution due to transfer of Building [F = 7 * ¼] | 1.75 |
| Capital balance at the time of reconstitution [G = D+ E + F] | 13.9375 |
| Deemed capital gains in the hands of Firm [H = C – G] | 71.0625[See Note] |
| Capital gains attributable to long term capital asset [I = H * A/(A+B)] | 41.8015 |
| Capital gains attributable to Short term capital asset [J = H * B/(A+B)] | 29.2610 |
| Tax on long term capital gains [K = I * 12.5%] | 5.225 |
| Tax on Short term capital gains [L = J * 30%] | 8.778 |
Note: Since the capital assets received by a specified person are both short-term and long-term capital asset, the capital gains is bifurcated into short-term and long-term gains on the basis of FMV of the assets.
Since the amount chargeable under Section 67(10) relate only to the capital asset received by the partner from the firm, the amount charged to tax under Section 67(10) shall not be attributed to any capital asset. The specified entity shall not be required to file Form No. 27.
(See also Computation of income on dissolution of Firm, AOP or BOI)
References
Circular No. 14 of 2021, dated 02-07-2021
This article is general information and not tax advice. Provisions change. Confirm your position with a qualified professional before acting.