Tax implications arise when a new partner is admitted, or an existing partner retires from a partnership firm/LLP/AOP/BOI. These implications become relevant when the partner receives stock-in-trade, capital assets or money from the entity. These are governed by Section 9B read with Section 45(4) and Section 48 sub clause (iii) of Income Tax Act, 1961 in accordance with rule 8AB of Income Tax Rules, 1962 with effect from April 1, 2021, as specified in Finance Act, 2021. They apply in situations when cash/capital assets/stock-in-trade are received by a partner from a firm at a time of dissolution or reconstitution.

The following terms appear in the blog and here’s what they mean:

  1. Specified Entity means a firm or association of persons or body of individuals
  2. Specified Person is a partner of a firm or member of association of persons/body of individuals
  3. Firm shall have the meaning assigned to it in the Indian Partnership Act, 1932 and Limited Liability Partnership Act, 2008
  4. Partner shall have meaning assigned to it in Indian Partnership Act, 1932 and shall include the following:
    i) Any person who, being a minor, has been admitted to benefits of partnership
    ii) Partner under Limited Liability Partnership Act, 2008

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  5. Reconstitution of specified entity means the following:
    i) One or more partners/members of such specified entity ceases to be partners/members
    ii) One or more new partners/members are admitted in such specified entity
    iii) Partners/members of such specified entity continue with a change in their respective shares

Section 9B of Income Tax Act, 1961

Income on receipt of capital asset or stock in trade by specified person from specified entity

  1. Capital assets and or stock in trade received by a specified person in connection with dissolution or reconstitution of specified entity shall be considered as deemed transfer in year in which such capital asset or stock in trade is received by specified person.
  2. Profits and gains arising on such deemed transfer shall be:
    Deemed income of specified entity in the year of receipt by the specified person
    In case of stock in trade, it is taxable under profits and gains of business or profession
    In case of capital assets, it is taxable under capital gains
  3. Fair market value as on date of receipt by specified person shall be deemed full value of consideration of capital assets and/or stock in trade for specified entity.

Section 45(4) of Income Tax Act, 1961

Attribution of Income taxable to capital assets remaining with specified entity

1) In the case of reconstitution of a specified entity during the previous year, profits and gains of business or profession arising to specified entity on receipt of money or capital asset by specified person shall be deemed taxable income under capital gains.

2) Such profits or gains shall be computed with the following formula

A = B + C – D

Where, A is Income taxable under capital gain of the specified entity

B is Value of money received by specified person from specified entity on date of such receipt

C = Amount of fair market value of capital asset received by specified person from specified entity on date of such receipt

D = Amount of balance in capital account of specified person in books of account of specified entity at time of its reconstitution

(Balance in capital account of a specified person in the books of account of specified entity is to be computed without considering the increase in capital account of specified person due to revaluation of any assets or due to self-generated goodwill/asset.)

3) The amount taxed under Section 45(4) of Income Tax Act, 1961 is required to be attributed to remaining capital assets of specified entity, so that when such capital assets get transferred in future, the amount attributed to such capital assets gets reduced from full value of consideration.

4) The specified entity shall furnish the details of amount attributed to capital assets remaining with the specified entity in Form No.5C before the due date of filing of return of income under Section 139(1) of Income Tax Act, 1961.

Determination of period of holding for classification of capital gain under Section 45(4) read with rule 8AA of Income Tax Rules, 1962

1) Capital gain shall be deemed to be short-term capital asset if it satisfies any conditions:

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i) It is short-term capital asset at the time of taxation of amount under Section 45(4)

ii) Capital asset forming part of block of assets

iii) Capital asset being self-generated asset and self-generated goodwill

2) Capital gain shall be deemed to be long-term capital asset at time of taxation under Section 45(4)

Insertion of new sub clause (iii) to Section 48

Attribution of Income taxable under Section 45(4) to capital assets remaining with specified entity

Clause (iii) of Section 48, where amount is chargeable to tax under Section 45(4), amount which is chargeable to tax shall be attributed to remaining capital assets of specified entity is as follows:

Sr. No.  Capital gains charged under Section 45(4) relates to  Capital gains to be attributed to remaining capital assets of specified entity 
1  Relates to revaluation of any capital asset or self- generated goodwill/asset of specified entity 
Capital gains charged under Section 45(4)   X  Increase in value of such capital asset because of revaluation 

__________________________ 

Aggregate of increase in value of all capital assets because of revaluation, or recognition of value of all assets 

 
2  Relates only to capital asset received by specified person from specified entity   

No attribution 
3  Does not relate to any revaluation of any capital asset or self-generated asset or self-generated goodwill of specified entity   

No attribution 

 

Application of Section 9B, Section 45(4) & Section 48 sub clauses (iii) can be summarized as follows:

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  1. Step 1 – Determine the capital gains or business income under Section 9B
  2. Step 2 – Compute taxable income of specified entity till date of reconstitution
  3. Step 3 – Compute tax on total income as computed in step 2
  4. Step 4 – Compute net income [step 3 – step 2]
  5. Step 5 – Credit income computed in step 4 to partner capital account in their profit-sharing ratio
  6. Step 6 – Determine amount of deemed capital gains either short term or long term as per Rule 8AA (5) taxable under Section 45(4)
  7. Step 7 – Attribute amount taxable under Section 45(4) to assets remaining with firm as per Rule 8AB

Comparison between Section 9B & Section 45(4) of Income Tax Act, 1961

Sr. No.  Particular  Section 9B  Section 45(4) 
1  Application  Apply upon receipt of capital asset or stock in trade or both by a specified person from specified entity in case of reconstitution or dissolution  Apply upon receipt of capital asset or money or both by specified person from specified entity in connection with the reconstitution of specified entity 
2  Stock in trade  Stock in trade is covered  Stock in trade is not covered 
3  Computation  Fair Market Value is deemed to be full value of consideration and chargeable to tax under profits and gains of business or profession or capital gain  A = B + C – D 

 

Applicability of the Section 9B & Section 45(4) of Income Tax Act, 1961

Sr. No.  Particular  Section 9B  Section 45(4) 
1  Reconstitution  Applicable Applicable 
2  Dissolution  Applicable  Not Applicable 
3  Money to specified person  Not Applicable  Applicable 
4  Capital asset to specified person  Applicable  Applicable 
5  Stock in trade to specified person  Applicable  Not Applicable 

Conclusion

The above mentioned are the scenarios in which a firm is liable to pay tax at the time of reconstitution or dissolution of firms when capital assets or stock in trade or cash are transferred to its retiring partner or new partner.

Why Choose InCorp Global?

At InCorp, our dedicated team of experts simplifies the process and analysis of various types of scenarios in which reconstitution or dissolution of firms takes place, taxability of the firms, drafting of partnership/LLP deeds and addenda deeds. We provide clear guidance and the way forward to ensure accurate tax computation and filing of forms for taxpayers. If you have any questions or require assistance regarding our process, please write to us at info@incorpadvisory.in or reach out to us at (+91) 77380 66622.

Authored by:
Nilay Jhaveri | Taxation

FAQs

1. When was Section 9B of the Income Tax Act, 1961 introduced, and can it apply prospective or retrospective?

Section 9B of the Income Tax Act, 1961 is introduced vide Finance Act, 2021 which is applicable for Financial Year 2020-21 (Assessment Year 2021-22). Section 9B of Income Tax Act, 1961 is applicable from prospective for Financial Year 2020-21 (Assessment Year 2021-22). The Central Board of Direct Taxes has prescribed guidelines under Section 9B and Section 45(4) of the Income Tax Act, 1961 vide Circular No. 14 of 2021 dated July 02, 2021.

2. Who is liable to pay tax under section 9B of the Income Tax Act, 1961?

The Specified Entity is liable to pay tax under Section 9B of the Income Tax Act, 1961 at the time of reconstitution or dissolution of the specified entity. Specified entity means any firm or LLP or association of persons or body of individuals. The fair market value of the capital asset or stock in trade will be consideration received and any profits arising from such deemed transfer to the specified person by the specified entity will be taxable in the hands of specified entity as “Capital Gains” or Profits and gains of business or profession. 

3. How is Fair Market Value computed?

Section 2 (22B) of Income Tax Act, 1961, Fair Market Value in relation to capital asset, means:

  1. The price that the capital asset would ordinarily fetch on sale in the open market on the relevant date
  2. Where the price is not ascertainable, such a price may be determined in accordance with the rules made under the Income Tax Act, 1961.
4. Whether section 9B of the Income Tax Act, 1961 is applicable to distribution of assets without reconstitution or dissolution of the specified entity?

No Section 9B of the Income Tax Act, 1961 is only applicable on reconstitution or dissolution of the specified entity.  

5. Whether Section 9B of the Income Tax Act, 1961 is applicable to payment made to legal heirs of the deceased specified person?

There is no clarification for this effect. Assuming a deeming provision must be strictly a “legal heir” is not within the definition of a specified person. Therefore, it is a debatable issue. Therefore, it can be argued that the provision of Section 9B of the Income Tax Act, 1961 may not be applicable when payments are made to legal heirs.  

6. Whether Section 9B of the Income Tax Act, 1961 is applicable to cash payment?

No, as per Section 9B of the Income Tax Act, 1961 is not applicable to cash payment. It is only applicable at the time of distribution of capital assets or stock-in-trade, or both on reconstitution and dissolution of the specified entity.

7. Whether Section 9B of the Income Tax Act, 1961 is applicable to transfer of rural agricultural land?

As per Section 9B (2) of the Income Tax Act, 1961, the deemed transaction shall be 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”. Therefore, since transfer of rural agricultural land is not a capital asset, distribution/deemed transfer of the same would not attract any capital gain tax on the specified entity.