The Supreme Court has put an end to a rampant tax dodge, going on for decades, where land parcels, properties, and redevelopment rights worth crores changed hands through partnership firms. Spurred by the apex court’s stand, the Income tax (I-T) department may now turn their glare on past property deals as well.
The trick used till now was holding real estate assets in a partnership structure, revaluing the properties to current market price, bringing in new partners who infused cash in the firm, and the old partners then withdrawing the funds that comes in after their capital accounts were credited —- to the extent of their share in the profits of the firm — as is as allowed in a partnership.
No stamp duty, capital gains and income tax were paid as is required in a plain sale and transfer of property. The partnership entity, through which funds flowed in and out, let a new set of partners control the property.
In a ruling last week, the apex court has held that such revaluation surplus would be taxable in the hands of the firm as transfer and would be subjected to ‘capital gains tax’. Thus, with the firm facing a tax liability post revaluation, the old partners — the ultimate owners of the property or the `sellers’ — can no longer escape tax while taking out funds chipped in by new partners (the ‘buyers’) joining the firm.
“The ruling has profound implications. In real estate deals especially when it came to transfer of land and development rights, revaluation as an instrument was used to thwart the liability. Revaluation as an instrument of tax sparing has been in practice for decades. The court has brought the curtains down on such a mode of planning.. All efforts by the I-T department to plug these loopholes were in vain. Now, since the SC has held in favour of the tax department, the department will start looking into past transactions and reopen past assessments.. This can spell trouble for the real estate industry and other cases of revaluation,” said advocate and chartered accountant K.R. Pradeep.
Re-looking at the law
In challenging the tax department’s stand, the assesse had argued that the amount credited on revaluation to the capital accounts of partners was only a notional or book entry. It also said that Section 45(4) of the I T Act — dealing with tax on gains of a firm or association or body following transfer of capital assets — would not be applicable unless the partnership firm in question is dissolved.
The Supreme Court rejected this, with the case turning in favour of the tax office on the back of two words — “or otherwise” — that were introduced when the law was amended in ’87. According to Section 45(4), “The profits or gains arising from the transfer of a capital asset by way of distribution of capital assets on the dissolution of a firm or other association of persons or body of individuals (not being a company or a co- operative society) or otherwise, shall be chargeable to tax….”.
The apex court in its ruling said, “After detailed analysis of Section 45(4), it is observed and held that the word ‘otherwise’ used in Section 45(4) takes into its sweep not only the cases of dissolution but also cases of subsisting partners of a partnership, transferring the assets in favour of a retiring partner.”
“In 2021, the legislature attempted to plug this loophole and prescribed a formula-based methodology under Section 45(4) of I T Act to tax reconstitution events in the hands of firms. While applying this formula, any revaluation related credits in the partners account were specifically required to be ignored for ascertaining taxes. This SC ruling goes one step ahead and deems the event of revaluation of assets of the partnership firm itself as a taxable event in the hands of the partnership firm, holding that a revaluation of partnership assets is a deemed transfer of its assets in favour of the partners. This ruling will have far reaching effects,” said Ashish Mehta, Partner at Khaitan & Co.