Guidelines for Taxing Partnership Firms on its Reconstitution

The Central Board of Direct Taxes (CBDT) has issued guidelines for taxing partnership firms on its reconstitution in respect of the new provisions of section 9B and sub-section (4) of section 45 of the Income-tax Act, 1961 vide a Circular No. 14 dated 2nd July 2021. The capital assets, money, or stock in trade received by a partner in a partnership firm while its dissolution or reconstruction would be considered as a deemed transfer, and profits of gains arising from the transfer would be subject to income tax. The CBDT guidelines clarify the methodology for attribution of income of an entity on its reconstitution and give examples of situations where a partner exits a firm and the organization settles the capital balance.

Synopsis of CBDT Notification

The CBDT Guidelines for Taxing Partnership Firms on its Reconstitution explain how to attribute an entity's income on its reconstitution and provide examples of scenarios where a partner leaves a firm and the organization settles the capital balance.

The guidelines provide the procedure for determining the capital gains as short term or long term at the time of taxability of such income in the hands of the reconstituted entity.
The new section 9B and substituted sub-section (4) of section 45 is applicable for the assessment year 2021-22 and subsequent assessment years

Section 9B Income-tax Act, 1961

If a specified person receives any capital asset or stock in trade or both from a specified entity during the previous year in connection with the dissolution or reconstitution of such specified entity. Then the specified entity shall be deemed to have transferred such capital asset or stock in trade or both, as the case may be, to the specified person in the year in which such capital asset or stock in trade or both are received by the specified person.

Any profits and gains arising from such deemed transfer are deemed to be the income of such specified entity of the previous year in which such capital asset or stock in trade or both were received by the specified person.
Such income is chargeable to income-tax as income of such specified entity under the head " Profits and gains of business or profession" or under the head "Capital gains", following the provisions of the Income-tax Act.
The fair market value of the capital asset or stock in trade or both, on the date of its receipt by the specified person, shall be deemed to be the full value of the consideration received or accruing as a result of such deemed transfer.

Section 45 (4) of the Income Tax Act

Similarly the Finance Act 2021, substituted sub-section (4) of section 45 of the Act. This new section now provides that, if a specified person receives any money or capital asset or both from a specified entity, during the previous year, in connection with the reconstitution of such specified entity, then any profits or gains arising from receipt of such receipt by the specified person shall be chargeable to income-tax as income of the specified entity under the head "Capital gains".

It has been further deemed that this income shall be the income of the specified entity of the previous year in which such money or capital asset or both were received by the specified person.
If the Capital asset is received by a specified person from a specified entity in connection with the reconstitution of such specified entity, the provisions of sub-section (4) of section 45 shall operate in addition to the provisions of section 9B of the Act and the taxation under the said provisions thereof shall be worked out independently.

Guidelines for Taxing Partnership Firms on its Reconstitution

The guidelines for Taxing Partnership Firms on its Reconstitution is as follows:

Attribution of Income of an Entity on its Reconstitution

The amount taxed under sub-section (4) of section 45 of the Act is required to be attributed to the remaining capital assets of the specified entity so that when such capital assets get transferred in the future, the amount attributed to such capital assets gets reduced from the full value of the consideration and to that extent the specified entity does not pay tax again on the same amount.

Capital Assets Forming a Block of Assets

This attribution is given in the IT Act only for 48 of the Act. Section 48 of the Act only applies to capital assets that are forming a block of assets. For capital assets forming a block of assets, there is sub-clause (c) of clause of section 43 of the Act to determine the written down value of the block of asset and section 50 of the Act to determine the capital gains arising on transfer of such assets. However, the Act has not provided that the amount taxed under sub-section (4) of section 45 of the Act can also be attributed to capital assets forming part of a block of assets and which are covered by these two provisions.