Actual transfer of capital asset required for taxability on partner retirement under Section 45(4) | ITAT Pune distinguishes Mansukh Dyeing : ITAT

The Income Tax Appellate Tribunal, Pune Bench upheld the deletion of an addition of Rs.1,44,86,70,156/- made by the Assessing Officer under Section 45(4) of the Income Tax Act, 1961, holding that payment to retiring partners upon reconstitution of a partnership firm does not attract tax in the absence of actual transfer of a capital asset.

Background & Facts

The Dispute

The Revenue appealed against the order of the Ld. CIT(A), Pune-12 dated 15.03.2025 which had deleted an addition of Rs.1,44,86,70,156/- made by the Assessing Officer under Section 45(4) of the Income Tax Act, 1961 for the assessment year 2019-20. The Assessing Officer had treated the payment made to retiring partners of M/s. Jairaj Realty Unit 9 LLP as Short Term Capital Gain.

Key Facts

• The assessee, M/s. Jairaj Realty Unit 9 LLP, is a limited liability partnership engaged in construction and sale of commercial units
• It filed its return of income u/s 139(1) on 31.08.2019 declaring total income at Nil
• The return was processed u/s 143(1) on 19.02.2020 accepting the returned income
• A search and seizure action u/s 132 was conducted on Nyati Group and associated persons on 14.12.2022
• The office premises of the assessee at 7th & 8th Floor, Solitaire World, Mumbai-Bangalore Highway, Pune - 411045 and 6th Floor, VCC Vantage, Mumbai-Bangalore Highway, Pune were covered u/s 133A as part of the search action
• During the survey, incriminating documents/evidences were found suggesting escaped income chargeable to tax
• A notice u/s 148A(b) was issued on 08.01.2024 to show cause why notice u/s 148 should not be issued
• Since the assessee made no submission, an order u/s 148A(d) was passed on 29.03.2024 and notice u/s 148 dated 30.03.2024 was issued
• The assessee filed its return u/s 148 on 29.06.2024 declaring total income at Nil
• The Assessing Officer issued statutory notice u/s 143(2) and notice u/s 142(1) along with a questionnaire
• The assessee firm was originally formed on 02.08.2000 as a partnership firm (Suyog Development Corporation Unit 10)
• It was incorporated as LLP viz. M/s. Jairaj Realty Unit 9 LLP on 24.02.2021
• During FY 2017-18, the partners were Shah Family (43% profit-sharing) and Somji family (57% profit-sharing)
• In FY 2018-19, the three partners of Shah family retired on 28.02.2019 and three new partners were introduced: Jayant Shah, Malav Shah, and Renozo Land Developers LLP
• After restructuring, the profit-sharing was: Lisa Somji, Mohiuddin Somji, Shahanaz Somji (5.98% each), Sabina Lakhani, Suraiya Somji, Shoheb Somji (2.99% each), Jayant Shah, Malav Shah (17.55% each), and Renozo Land Developers LLP (35% profit-sharing)
• The partner's capital increased from Rs.49,42,61,157/- as on 31.03.2018 to Rs.200,07,83,691/- as on 31.03.2019
• The total fixed assets increased from Rs.26,00,91,302/- as on 31.03.2018 to Rs.1,70,87,61,460/- as on 31.03.2019
• An amount of Rs.1,44,92,61,982/- was credited to retiring partners' capital accounts; after adjusting for Rs.5,91,826/- of expenses, the actual payment for retirement was Rs.1,44,86,70,156/-
• As per the Agreement for Settlement of Accounts dated 26.03.2019, the firm agreed to pay retiring partners consideration of Rs.155.02 crores in full and final settlement of their share, right, title, goodwill, and interest
• The total capital standing credit to retiring partners' capital accounts was Rs.10.09 crores
• The difference between settlement amount (Rs.155.02 crores) and existing credit balance (Rs.10.09 crores) amounting to Rs.1,44,86,70,156/- was debited to an account named 'Retiring Partner Payment Account'

Procedural History

• 30.03.2024: Notice u/s 148 issued by Assessing Officer
• 29.06.2024: Assessee filed return u/s 148 declaring Nil income
• 15.03.2025: Ld. CIT(A), Pune-12 passed assessment order u/s 143(3) r.w.s. 147, making addition of Rs.1,44,86,70,156/- under Section 45(4)
• Date unspecified: Assessee filed appeal before Ld. CIT(A)
• 15.03.2025: Ld. CIT(A) allowed the appeal in full, deleting the addition of Rs.1,44,86,70,156/- u/s 45(4)
• Date unspecified: Revenue filed appeal before ITAT
• 29.09.2026: ITAT pronounced order dismissing Revenue's appeal

Relief Sought

The Revenue sought restoration of the addition of Rs.1,44,86,70,156/- made by the Assessing Officer under Section 45(4) of the Income Tax Act, 1961, treating the payment to retiring partners as Short Term Capital Gain chargeable to tax in the hands of the assessee firm.

The Legal Issue

The central question was whether the payment made to retiring partners upon reconstitution of a partnership firm, where the amount was credited to their capital accounts and later withdrawn, constitutes a 'transfer of capital asset' attracting tax under Section 45(4) of the Income Tax Act, 1961 for the assessment year 2019-20, in the absence of a formal revaluation entry and actual transfer of a capital asset in specie.

Arguments Presented

For the Appellant/Revenue

The Revenue contended that the transaction was revaluation-driven, citing the matching increase in fixed assets (Rs.1,44,86,70,158/-) and amount credited to retiring partners' capital accounts (Rs.1,44,86,70,156/-). It argued that the settlement amount was determined after considering the value of the firm's assets, business potential and liabilities, as evidenced by the survey statement and Clause B(ii) of the Settlement Agreement. The Revenue maintained that the 'Retiring Partner Payment Account' was an artificial accounting device lacking commercial substance, and that the subsequent re-routing of the amount to Fixed Assets then to Goodwill/Intangible Asset head demonstrated recognition of enhanced value. It relied on Mansukh Dyeing and Printing Mills, arguing that the principle applies even without a formal revaluation entry, and contended that the Finance Act 2021 amendments substantially codified the principle affirmed by the Supreme Court. The Revenue further argued that permitting a no-tax outcome contradicts the legislative intent of Sections 45(3) and 45(4), and that even if no revaluation occurred, the payout constituted consideration for transfer of partnership rights taxable in the hands of outgoing partners under capital gains.

For the Respondent/Assessee

The assessee argued that there was no formal revaluation of assets in the books, and the increase in Fixed Assets merely reflected the debit balance in the 'Retiring Partners Payment Account' representing money paid out of the firm. It contended that the pre-amended Section 45(4) (prior to 01.04.2021) requires actual transfer of a capital asset of the firm to the retiring partner, and since only cash was paid, no capital asset was transferred in specie. The assessee emphasized that the Finance Act 2021 prospectively substituted Section 45(4) to cover monetary payments, acknowledging legislative uncertainty in the pre-existing law. It pointed out that the land, the only significant asset, was stock-in-trade excluded from the definition of 'capital asset' u/s 2(14), and that the amount distributed was ad hoc and not in any recognisable profit-sharing ratio. The assessee distinguished Mansukh Dyeing on multiple material facts and relied on the binding precedent of Electroplast Engineers, arguing that the Bombay High Court had held Section 45(4) inapplicable where there was no transfer of capital asset. It further contended that Section 68 had no application as there was no unexplained credit (the entries represented money paid out), and that simultaneous action by the Revenue against retiring partners for the same amount would constitute impermissible double taxation.

The Court's Analysis

The ITAT began by noting that the Assessing Officer had invoked Section 45(4) based on the increase in fixed assets and corresponding credit to retiring partners' capital accounts. However, the Tribunal found no formal revaluation entry in the books; the debit balance reflected only settlement payment. Crucially, the amount was credited only to the accounts of the retiring partners, with no credit to the accounts of the incoming partners. This distinguished the case from Mansukh Dyeing where newly inducted partners brought small amounts of capital but immediately received huge credits to their capital accounts, some of which were subsequently withdrawn. In the present case, incoming partners brought Rs.160 crores of fresh capital but did not withdraw any amounts, while retiring partners received their settlement.

The Tribunal further noted that in Mansukh Dyeing, distribution of profits occurred in the profit-sharing ratio, whereas in the present case, the distribution was ad hoc: Bharat Shah, holding a 21% share in the partnership firm, received 75.68% of the surplus. The land was held as stock-in-trade, not as a capital asset, and there was no evidence of a colourable device to avoid tax. The Tribunal held that the decision in Mansukh Dyeing is distinguishable and not applicable to the facts of the present case.

Examining the provision as it stood at the relevant time (applicable to AY 2019-20), the ITAT observed that Section 45(4) requires '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 as the income of the firm...'. The Tribunal emphasized that actual transfer of a capital asset is a prerequisite for attracting tax under this provision. Since no asset was transferred to the retiring partners in the instant case, Section 45(4) was not applicable. The Tribunal further noted that the land being stock-in-trade confirmed it was not a capital asset eligible for Section 45(4). Accordingly, the impugned order of the Ld. CIT(A) deleting the addition was upheld.

"We find in the case of CIT vs. Mansukh Dyeing and Printing Mills (supra), new partners inducted a very little amounts towards capital but immediately benefitted with huge credits whereas in the instant case the incoming partners brought Rs.160 crores of fresh capital and there was no disproportionate benefit."

"In the case of CIT vs. Mansukh Dyeing and Printing Mills (supra), the newly inducted partners had access to the enhanced capital and some withdrew the amounts whereas in the instant case the new partners did not withdraw and the retiring partners received their settlement."

"In the case of CIT vs. Mansukh Dyeing and Printing Mills (supra), there was distribution of profit amongst the partners in their profit sharing ratio whereas in the case in hand there was no such distribution in the profit sharing ratio. In fact Bharat Shah who is holding 21% share in the partnership firm received 75.68% of surplus which demonstrates the adhoc distribution."

"Further, in the instant case the land was held as stock-in-trade and was not a capital asset."

The Verdict

The appeal filed by the Revenue is dismissed. The ITAT upheld the order of the Ld. CIT(A) dated 15.03.2025 which had deleted the addition of Rs.1,44,86,70,156/- made by the Assessing Officer under Section 45(4) of the Income Tax Act, 1961. The assessment order treating the payment made to retiring partners as Short Term Capital Gain was set aside. The total income of the assessee remains at Nil as per the original return filed on 31.08.2019. No costs were awarded.

What This Means For Similar Cases

Actual Transfer of Capital Asset Is Essential

Practitioners must ensure that for Section 45(4) to apply (pre-Finance Act 2021), there is actual transfer of a capital asset in specie, not merely monetary payment. The burden lies on the revenue to establish the real nature of the transaction through contemporaneous evidence such as valuation reports, transfer deeds, or clear documentation showing asset transfer. Mere book entries or artificial accounting heads like 'Retiring Partner Payment Account' will not suffice.

Profit-Sharing Ratio Matters for Distribution

Taxpayers should ensure that any distribution of assets or proceeds upon partner retirement aligns with the existing profit-sharing ratio to avoid scrutiny under Section 45(4). Significant deviations, as seen here where a 21% partner received 75.68% of the surplus, may indicate that the transaction lacks the character of a genuine capital asset transfer and instead resembles a settlement of capital balances.

Land Held as Stock-in-Trade Excludes Section 45(4)

Where the primary asset is land held as stock-in-trade (inventory), Section 45(4) cannot be invoked as land in such character is excluded from the definition of 'capital asset' under Section 2(14) of the Income Tax Act, 1961. Taxpayers engaged in real estate development or trading must carefully characterize their assets to determine eligibility for Section 45(4) benefits.

Contemporaneous Evidence Trumps Post-Hoc Characterization

The Tribunal placed decisive weight on the survey statement and Settlement Agreement Clause B(ii), which recorded that the settlement amount was determined after considering the value of assets, business potential and liabilities. Taxpayers must ensure that such contemporaneous documents accurately reflect the nature of the transaction, as post-hoc explanations or characterizations may be disregarded if inconsistent with the factual matrix.

Double Taxation Risk Must Be Assessed

Before initiating proceedings under Section 45(4), assessing officers should verify whether simultaneous actions are being taken against the retiring partners in their individual assessments for the same amount. If so, proceeding under Section 45(4) may constitute impermissible double taxation, as the Revenue cannot tax the same income in both the firm's and the partners' hands.