(1985) 156 ITR 509 (SC)
Capital gains — charging section; mode of computation
A transfer does occur, but on the law as it then stood the consideration was not ascertainable — the credit to the capital account is a notional figure whose real worth depends on future events — so no computable gain arose.
When a partner contributes a personal capital asset to a firm as capital contribution, does a taxable capital gain arise, and what is the consideration?
The assessee, a partner, brought shares held by him personally into the partnership as his capital contribution. The value at which the shares were credited to his capital account was higher than his cost of acquiring them. The Revenue treated the difference as a capital gain, arguing that the credit to the capital account represented the consideration received for parting with the shares. The assessee contended that on entering the firm he did not receive any determinate sum, since what he obtained was a right to share in future profits and in the net assets on dissolution.
The matter reached the Supreme Court, which examined both whether a transfer occurred and whether any consideration capable of computation had accrued.
For the assessee
On contributing the asset, the partner's exclusive interest is replaced by a right to a share in the firm, which is neither a definite sum nor capable of valuation at that date. The amount credited to the capital account is a notional entry that may be wholly eroded by losses, drawings or the firm's liabilities. Without an ascertainable consideration, Section 48 cannot operate.
For the Revenue
The asset passed from the partner's exclusive ownership to the firm, which is a transfer. The figure at which it was credited to his capital account is the value the partners themselves placed on it, and there is no reason not to treat that agreed figure as the full value of the consideration.
The Court held that when a partner brings a personal asset into a partnership, the exclusive interest he had is reduced to a shared interest and the asset becomes property of the firm; that satisfies the extended meaning of transfer. But the charge failed on the computation limb. What the partner receives in exchange is a right during the subsistence of the firm to share profits, and on dissolution a share in the net assets after satisfying liabilities — an entitlement whose value cannot be determined at the date of contribution. The credit in the capital account is only a notional figure entered for the purpose of adjusting rights between partners; it does not represent money or money's worth received, since it may be diminished or extinguished by the firm's trading. The consideration therefore being incapable of ascertainment, the computation provisions could not be applied and no chargeable gain arose. The Court added the important qualification that where the transaction is a device or a sham — where the firm is a mere pretext for converting an asset into money without tax — the Revenue may lift the veil and tax the real transaction.
The statutory position has since been overtaken for this specific transaction by provisions deeming the amount recorded in the firm's books to be the full value of consideration, so the result no longer follows. What endures is the reasoning: the analysis of what a partner actually receives, the distinction between a notional book credit and real consideration, and the express reservation permitting a sham arrangement to be looked through. Read it for the principle, and check the current deeming provisions for the outcome.