(2022) 449 ITR 439 (SC)
Capital gains — charging section
Yes. Crediting the revaluation surplus to partners' capital accounts, which they are then entitled to draw, amounts to a distribution of assets and attracts the charge — even though no asset physically leaves the firm.
On reconstitution of a firm, where assets are revalued and the enhanced value is credited to the partners' capital accounts, does a transfer arise attracting capital gains?
A partnership firm admitted new partners. Around the same time it revalued its land and building substantially above book value, and credited the resulting surplus to the capital accounts of the existing partners in their profit-sharing ratio. No asset was physically transferred out of the firm and no dissolution occurred. The Assessing Officer treated the credit of the revaluation surplus as a distribution of capital assets to partners on reconstitution and brought the amount to tax as capital gains in the firm's hands.
The Tribunal and the Bombay High Court decided in the firm's favour, holding that a mere book revaluation on reconstitution was not a transfer. The Revenue appealed to the Supreme Court, which reversed.
For the assessee
Nothing left the firm. The land and building continued to be owned and used by the firm, and the revaluation was an accounting entry reflecting current worth. A distribution requires assets actually to pass to the partners, which did not happen; the provision is directed at dissolution or a genuine handing over of assets.
For the Revenue
By crediting the enhanced value to the partners' capital accounts, the firm conferred on them an immediate and enforceable entitlement to that amount, which they could withdraw. In substance the partners received the benefit of the appreciation, and the incoming partners obtained an interest in assets carrying that uplift. That is a distribution in all but name.
The Court held that the provision is not confined to dissolution but extends to a transfer of capital assets by way of distribution on the reconstitution of a firm. It looked to the substance of what the entries achieved. On revaluation, the surplus was credited to the existing partners' capital accounts, which meant they became entitled to draw those amounts from the firm; correspondingly, the incoming partners acquired rights in assets whose recorded value had been stepped up. The benefit of the appreciation in the land and building therefore passed to the partners, and the firm parted with it. The Court held that it would defeat the provision to require a physical handing over of the asset, since the very purpose of the amendment was to catch arrangements by which appreciation is passed to partners without a conventional transfer. It accordingly held that capital gains arose in the hands of the firm in the year of revaluation and credit.
Capital gains are charged under Section 67 of the IT Act 2025. The decision governs firm and LLP restructurings where revaluation precedes the admission or retirement of partners, a common step in succession planning and in bringing in investors. It makes the timing and accounting treatment of revaluation a live tax question rather than a book entry.