Various courts and tax authorities have ruled both in favour and against imposition of capital gains in such cases.
Most law firms and professional services firms have a partnership model
In what could impact partnership firms, including those involved in legal and professional services, amendments to the Finance Bill, 2021, propose to impose capital gains tax on any assets or shares received by a partner when he retires. Further, the tax will be levied on the notional gain — that is the difference between fair market value and actual cost in case of asset transfer.
So far, it was not clear whether the capital gains tax would cover retirement of a partner from the firm, where the firm continues to exist without any dissolution even after such retirement. Various courts and tax authorities have ruled both in favour and against imposition of capital gains in such cases. The issue has seen conflicting decisions in various courts.
Amendments to the finance Bill, cleared by Parliament, clarified that where a partner receives any money or other asset at the time of dissolution or reconstitution of the firm/association of persons/body of individuals, the profits or gains that arise shall be chargeable under ‘capital gains’.
Capital gain tax is levied on returns from all equity investment as well as real estate investments.
Further, the finance Bill also amended Section 45(4) to provide a mechanism for computing capital gains arising to a partnership firm on its reconstitution, where capital assets are transferred to the partners as result of the reconstitution. At present, for computing capital gains, the fair market value of the asset on the date of transfer/ distribution by the firm is deemed to be the full value of consideration received by the firm.
For this, section 9B has been introduced, which states that if the partnership firm also transfers stock in trade, then even on such a transfer, the difference in fair market value of such stock in trade or capital asset vis-à-vis its respective cost of acquisition or written down value shall be taxed in the hands of the partnership firm.
Shailesh Kumar, partner, Nangia & Co, said the amendments appear to be clarifications that aim to reduce litigation on this issue and to tax the notional gain in the hands of the partnership firm.
As per the partnership model, partners are required to bring in capital and based on the ratio they split the profits available.
Most law firms and professional services firms have a partnership model. Mostly such settlements happen in firms dealing with real estates. The partner brings in part of the capital and is entitled to a percentage of profits the partnership makes. On retirement or when the partner quits the firm, he is handed over the capital money he had initially brought in.
It further clarifies upon the computation of tax and states that the fair market value of stock transferred to the partner shall be recorded as sale by the firm as it shall form part of the business of the firm and part of capital gains if any capital asset is transferred, he added.
Besides, the amendment to the finance Bill also made certain changes in provision of goodwill, particularly in definition of ‘written down value’ of block of assets, where such written down value includes value of goodwill carried forward from earlier years. The amendment proposed that the written down value of such goodwill carried forward from earlier years will be excluded/ reduced from the written down value of block of assets from assessment year 2021-22.