Taxation of partnerships revamped

Interestingly, the new provisions address taxability from the perspective of both the Firm and its Partners, and along the way pose a number of new questions. While we have used the context of a Firm and Partners to talk through these provisions, it extends to Association of Persons (AoP) and Body of Individuals (BoI) too.

The new section 9B taxes the Firm in the year when a capital asset or stock in trade is received by Partners from the Firm, whether on account of dissolution or reconstitution of the Firm. While consideration is deemed to be the fair market value (FMV) of such asset on date of receipt by the partner, no method has been specified to compute FMV. Tax will apply assuming capital gains (for capital assets) or profits and gains of business or profession (for stock in trade). Essentially, this is a tax on the Firm for ‘transferring’ assets to a Partner.

2. Tax on the Firm again: The revised section 45(4) levies another tax (capital gains tax) on the Firm when a Partner receives money or capital asset from the firm, in case of reconstitution of the Firm (but not dissolution). Profit is computed as the difference between the FMV of capital asset plus money received and the balance in the Partner’s capital account. To deal with the scourge of inflating capital account balances by crediting revaluation profits, the section specifically requires that it be ignored while determining the balance of capital account. This second tax appears to be a tax on the Partners for ‘transferring’ their stake in the Firm, though tax is paid by the Firm.

In the above tax working, the nature of capital gains (long term or short term) is determined by reference to the period of holding of the asset being revalued at the time of reconstitution. The gains are taxable as short term if they relate to revaluation of self-generated asset or goodwill or capital asset forming part of block of assets or any other asset classified as short term. The gains are taxable as long term if they relate to revaluation of assets classified as long term at the time of relaxation and does not belong to any of the asset categories discussed above.

3. Enabling flow of credit: The new provisions try to avoid double taxation in two ways. First, once the Firm pays taxes under section 9B, the profit on distribution is credited to the Partners’ capital accounts, thereby reducing profit while computing tax under section 45(4). Second, the amount of capital gains offered to tax by the Firm under section 45(4) is allowed as a reduction while computing capital gains on transfer of any remaining capital asset by the Firm in future (section 48(iii)). However, the income taxed under section 45(4) is attributed to the remaining assets in proportion of the increase in value of that particular asset to the aggregate increase in value of all assets because of the revaluation.

While the new provisions are complex, they appear to be well constructed and the release of clarifications by CBDT helps taxpayers understand the impact. Inevitably though, the devil is in the detail and here is where a few areas deserve further thought:

• Tax impact and accounting treatment are closely interwoven, meaning that divergence in accounting could lead to differing tax outcomes.

• A clear process for determining FMV should be specified, since a change in valuation method can affect the quantum of profit/ tax.

• Since the same transaction is taxed twice (albeit from different perspective), double taxation will be avoided only if entire credit is enabled. In some situations, credit may be delayed or incomplete, leading to lethargic flow of credit and hardships for taxpayers.

• In case of a difference in timing (between the first tax event and the eventual offset of credit), benefit of indexation should be provided.

• The option of saving capital gains (e.g.: section 54F) should be made available to Partners/ Firm, which will encourage re-investment of capital.

In conclusion, the new provisions indicate a comprehensive approach to dealing with an old and admittedly vexed tax question. However, the impact on small and medium enterprises (which often use non-corporate formats for their business) needs to be carefully considered, since the provisions are complex, and non-compliance might lead to a fresh wave of litigation.

Moreover, the provisions take effect from April 1, 2020, meaning that we are already past the deadline when it comes to reviewing shortfalls in past transactions, even one as simple as admitting a new partner.