No capital gain tax if capital contribution by partner is current asset and not capital asset : ITAT

By | October 25, 2016

Held

The Assessee brought to the notice of the CIT(A) a CBDT Circular subsequent to the insertion of sub-section (3) in section 45 of the Act, viz., circular bearing No. 495 dated September 22, 1987, (1987) 168 ITR (St.) 87, wherein it was stated thus:

“24.2 With a view to blocking this escape route for avoiding capital gains tax, the Finance Act, 1987 has inserted new sub-section (3) in section 45. The effect of this amendment is that profits and gains arising from the transfer of capital asset by a partner to a firm shall be chargeable as the partner’s income of the previous year in which the transfer took place. For purposes of computing the capital gains. the value of the asset recorded in the books of the firm on the dale of the transfer shall be deemed to be the full value of the consideration received or accrued as a result of the transfer of the capital asset. ” (emphasis added)

It was submitted that in the instant case, section 45(3) of the Act had no application in the year of transfer viz. the financial year ended March 31, 2006 since what the partners transferred to the said firm was inventory and not a capital asset. The conversion of inventory into fixed assets was made by the said firm more than two years later during the financial year ended March 31, 2008 as was the revaluation of the converted asset. As submitted hereinbefore, neither such conversion nor revaluation by the said firm during the previous year relevant to the assessment year 2008-09 brought the provisions of section 45(3) of the Act into play for the said year. There was no transfer of any capital asset by the assessee to the said firm during the previous year relevant to the assessment year 2008-09 for section 45(3) to apply. When the partners had no liability for any tax under section 45(3) of the Act, the question of resorting to a device to avoid tax under section 45(3) does not arise.

The assessee did not make any short term capital gains of Rs.96,37,85,635/- taxable under section 45(3) of the Act or otherwise and that on revaluation of its fixed assets by the firm (of its land and building) there was no income that accrued or arose in the hands of the partners and the addition of Rs.37,03,36,187/- on account of alleged revaluation profit is not sustainable and was rightly deleted by the CIT(A).

IN THE ITAT KOLKATA BENCH ‘A’

Income-tax Officer, Ward- 1(4) Kolkata

v.

Orchid Griha Nirman (P.) Ltd.

N.V. VASUDEVAN, JUDICIAL MEMBER
AND DR. ARJUN LAL SAINI, ACCOUNTANT MEMBER

IT APPEAL NO. 2269 (KOL.) OF 2013
[ASSESSMENT YEAR 2008-09]

OCTOBER  19, 2016

Angam Shaiza for the Appellant. J.P. Khaitan, Sr. Advocate, S. Jhajharia FCA and Sujoy Sen, Advocate for the Respondent.

ORDER

N.V. Vasudevan, Judicial Member – This is an appeal by the Revenue against the order dated 23.05.2013 of CIT(A)-I, Kolkata relating to AY 2008-09.

2. The Assessee is a company. For AY 2008-09, the Assessee filed a return of income declaring loss at Rs.58,885/-. The Assessee along with M/S.Command Constructions Pvt.Ltd., M/S.Blue Heaven Griha Nirman Pvt.Ltd., and M/s.Wellgrowth Grha Nirman Pvt.Ltd., were partners in a partnership firm by name M/S.Salarpuria Soft Zone. The income declared by the Assessee was on account of share of exempt profit from the partenership firm M/S.Salarpuria Soft Zone. The return so filed was processed u/s.143(1) of the Income Tax Act, 1961 (Act) on 13.10.2009.

3. Subsequently proceedings u/s.147 of the Act were initiated by issue of a notice u/s.148 of the Act dated 3.11.2011 which was served on the Assessee on 4.11.2011. The reasons recorded by the AO before issuing notice u/s.148 of the Act reads thus:

“It transpires from communication from O/o Joint Commissioner of I. T., Range – 56, Kolkata that M/s. Salarpuria Softzone (PAN ABEFS2661L) had revalued its assets and transferred the revalued reserve to its partners’ account and the assessee as above being a partner itself had received Rs. 37,03,36,187/- on account of such revaluation reserved. I have reason to believe on examination of record that the above has escaped assessment within the meaning of section 147 of the I. TAct, 1961. Notice u/s 148 be issued.”

4. The facts with regard to revaluation of assets by M/S.Salarpuria Softzone, are that one M/s. I Gate Global Solutions Ltd was the owner of industrially converted land mearsuring 3,12,092 sq. ft. in Bellandur Village, Varthur Hobli, Bangalore East taluk (hereinafter referred to as “the said land”). The said land was advertised for sale. The assessee along with two other companies viz. Command Construction Pvt. Ltd. and Blue Haven Griha Nirman Pvt. Ltd. (hereinafter collectively referred to as “the said three companies”) responded by offering a price of Rs.16,94,34,666. Subsequently, there were negotiations between the parties and the price was increased to Rs.22,36,79,266/- on the basis that the said land measured 3,19,086 sq. ft. and accordingly, an agreement was entered into on June 14,2004. However, upon actual measurement the area of the land was found to be 3,12,092 sq. ft. and as such the final price stood at Rs.21,87,76,492/- as per supplemental agreement dated December 28, 2004. The said three companies paid the agreed consideration and received possession. A registered deed of sale was executed in their favour on March 30, 2005.

5. The State Government guideline value for the purpose of registration and stamp duty in respect of the said land was Rs.260/- per sq. ft. whereas the purchase price paid by the said three companies was Rs.70l/- per sq. ft. i.e. more two and half times the stamp value. The total cost of the said land to the said three companies, who had purchased it in equal shares, was Rs.24,54,54,125/- after taking into consideration the stamp duty and registration cost. The said three companies had purchased the said land with the object of developing an industrial park. Each of the said three companies accounted for the said land so purchased as work in progress and reflected it under “Current Assets” in the balance sheet.

6. On January 9, 2006, the said three companies and another company called Wellgrowth Griha Nirman Pvt. Ltd. executed a deed of partnership in terms of which the said three companies transferred the said land to the partnership firm M/s. Salarpuria Soft Zone as their capital contribution. The fourth company was to arrange the entire finance required for the development of the said land. Each of the said three companies had a 10% share in the profit/loss and the fourth company’s share was 70%. The partnership business was deemed to have commenced on and from April 1, 2005. A supplemental deed of partnership was executed on March 13, 2006 between the four partners which inter alia, provided that the said firm can avail loan/credit facilities from commercial banks/financial institutions by mortgaging/charging its movable and immovable properties. The said firm subsequently obtained such loan/credit facilities to the extent of Rs.250 crores.

7. The said three companies transferred the said land to the said firm on January 9, 2006 at cost and such cost was the amount recorded in the books of account of the said firm for the year ended March 31, 2006 as the value of the said land with corresponding credit to the capital accounts of each of the said three companies. Accordingly, the capital account of the assessee was credited by Rs.8,15,00,000/-. The said firm accounted for the said land as work in progress and reflected it under “Current Assets” in its balance sheet. Diverse amounts were thereafter spent by the said firm on the development of the said land as an industrial park including construction thereon. Funds for the said purpose were provided by the fourth partner. The completed industrial park was mostly leased out by March, 2008.

8. On March 30, 2008, the said firm converted the said land, building and its amenities, which were shown as inventory in its accounts, into fixed assets. On March 31, 2008 the said land and building were revalued. Such revaluation was made in order to reflect the-market value of the land and building in the books of account and to justify the bank loan of Rs.250 crores. The values of the land and building before and after revaluation are as under :—

Cost as on 30.03.08 Revalued figure as on 31.03.08 Extent of increase due to revaluation
Rs. Rs. Rs.
Land 25,16,17,696/- 314,29,74,600/- 289,13,56,904/-
Building 119,02,85,430/- 200,22,90,400/- 81,20,04,970/-
Total 370,33,61,874/-

9. The amount of revaluation was credited to the current accounts of the four partners in their profit sharing ratio. Thus, the current account of each of the said three companies was credited by Rs.37,03,36,187/- and that of the fourth company having 70% share by Rs.259,23,53,313/-.

10. On the above facts which are not in dispute, the question before the AO was as to whether the credit to the current account of the Assessee in the partnership firm M/S.Salarpuria Soft Zone of a sum of Rs.37,03,36,187/- gives raise to any income chargeable to tax. The AO in the reassessment proceedings held that: —

(a) Bringing of land into the said firm by way of inventory as part of the project without crediting the partners’ capital accounts and without bringing it as fixed assets cannot be considered as capital contribution by the partners during the financial year ended March 31, 2006. The land was contributed by the said three companies during the previous year ended March 31, 2008 relevant to the assessment year 2008-09 for a sum of Rs.314,29,74,600/- (value of the land on revaluation as on 31.3.2008) by way of capital contribution when it was converted into fixed assets from inventory by the said firm.
(b) Section 45(3) of the Act was applicable in respect of such transfer made during the previous year relevant to the assessment year 2008-09. The revalued figure of Rs.314,29,74,600/- recorded in the books of account of the said firm as on March 31, 2008 was to be deemed as the full value of consideration received or accruing as a result of transfer of the capital asset by way of capital contribution. The revaluation amount of Rs.289,13,56,904/- was the profit which accrued to the said three companies and each of them was liable to be taxed on one-third of such profit i.e. Rs.96,37,85,635/- as short term capital gains.
(c) The land was grossly undervalued till it was part of inventory in the books of the said firm to avoid the market value of the land of Rs.314,29,74,600/- being taken into consideration and consequently to avoid higher taxes on capital gains in the hands of the said three companies.
(d) The revaluation amount of Rs.370,33,61,874/- was real profit and not notional and had been credited to the current accounts of the four partners in their profit sharing ratio each of whom had withdrawn substantial amounts almost equal to the cost of the land/money brought in. The said firm was taxable in respect of its profits but the revaluation profit was not disclosed by it as its income for the assessment year 2008-09 and no tax was paid thereon. Each of the partners was thus liable for tax on its share of revaluation profit. The said three companies were each liable to be taxed on Rs.37,03,36,187/- as partners entitled to 10% share in the partnership land the fourth company having 70% share was liable to be taxed on Rs.259,23,53,313/-.

11. The AO thus computed the total income of the Assessee in the order u/s.147 of the Act as follows:

“Total Income as per I.T.Returns for AY 2008-09 (-) Rs.58,885/-
Add:
(i)  Short Term Capital Gains accrued Rs. 96,37,85,635
(As discussed in above paras)
(ii) Share of “Revaluation Profit” Rs. 37,03,36,187
(As discussed in above paras)
Assesseed Total Income Rs. 133,40,62,937″

12. Before CIT(A) the assessee submitted that initiation of re-assessment proceedings u/s 148 of the Act are not valid. It was contended that the reasons recorded did not spell out the belief of the AO regarding escapement of income chargeable to tax.

13. On the above contention the CIT(A) held as follows :—

“Grounds No. 1 to 5 is regarding validity of re-assessment proceedings. The AO has reopened the proceedings within four years from the end of the assessment year and for intimation u/s 143(1) was issued. The first aspect is as to whether having regard to the reasons recording, the AO was competent to initiate proceedings under section 147 by issue of notice under section 148. The assessment year involved is 2008-09 for which the notice under section 148 was issued within four years on November 3, 2011. There was no assessment in the appellant’s case for the assessment year 2008-09 and its return was processed under section 143(1). It cannot therefore be said that the initiation of proceedings under section 147 was by way of change of opinion. In the absence of an assessment under section 143(3), it cannot be said that the AO formed an opinion which he sought to change. The only question is as to whether the AO formed any belief that any income in respect of which the assessee was chargeable to tax had escaped assessment enabling him to initiate reassessment proceedings.

To decide upon this issue reasons recorded for reopening the assessment needs to be examined and such Reasons are reproduced herewith as follows:

“It transpires from communication from O/o Joint Commissioner of I. T., Range – 56, Kolkata that M/s. Salarpuria Softzone (PAN ABEFS2661L) had revalued its assets and transferred the revalued reserve to its partners’ account and the assessee as above being a partner itself had received Rs. 37,03,36,187/- on account of such revaluation reserved .

I have reason to believe on examination of record that the above has escaped assessment within the meaning of section 147 of the I. TAct, 1961. Notice u/s 148 be issued.”

The reasons recorded do not refer to the provisions of section 45(3) of the Act and it is not suggested in the recorded reasons that any income chargeable to tax under section 45(3) of the Act had escaped assessment. The assumption of jurisdiction under section 147 cannot be justified upon the basis that income chargeable to tax in terms of section 45(3) of the Act had escaped assessment. The only fact referred to in the recorded reasons is the revaluation by the firm of its assets and consequent transfer of the revaluation amount to the partners’ accounts alleged to have been received by the partners. One has to bear in mind the scheme of the Act in the matter of taxation of a Firm and its partners. According to section 10(2A) of the Act the share of a partner in the total income of the firm is exempt in his hands. What is taxed in the hands of the partner is only the amount of interest, salary, bonus, commission or remuneration which has been allowed as a deduction in the assessment of the firm in terms of section 40(b) of the Act. If the revaluation by the firm resulted in any taxable income, such income had to be considered in the hands of the firm alone and the partner’s share in such income would be exempt in his hands. Even if the case made out in the recorded reasons is taken as correct, the AO could not have formed the belief that any income in respect of which the partner was chargeable to tax had escaped assessment in his hands. The AO himself was quite aware of this position as is apparent from the observation made by him in paragraph 7.2 of his order. Even if one proceeds on the basis that the revaluation of assets by the firm gave rise to taxable income, such income can onty be considered in the firm’s assessment. That the firm did not disclose any income on account of revaluation and did not pay any tax on such income does not confer jurisdiction upon the partner’s Assessing Officer to reopen the partner’s assessment on the allegation of escapement of income. In my view, even if the case made out in the reasons recorded is accepted on its face value, no belief could have been entertained by the AO that any”, income in respect of which the partner was chargeable to tax had escaped assessment and the AO acted without jurisdiction by issuing notice under section 148 for making an assessment under section 147 in the partner’s case. Hence, these grounds of the appellant are allowed.”

14. As far as the merits of the addition made by the AO is concerned the assessee submitted that there can be no manner of doubt that the land was transferred by the said three companies by way of capital contribution during the financial year ended March 31, 2006 relevant to the assessment year 2006-07. The partnership deed, which provided that the said three companies would transfer the said land to the said firm as capital contribution, was executed on January 9, 2006. The said deed vide the second recital expressly stated that at or before the execution of the deed the said firm had taken over the said land as part of the assets of the partnership business. The said transfer was given effect in the accounts of the partners for the financial year ended March 31, 2006. The assessee’s balance sheet and profit and loss account for the said financial year showed the said land, which had been reflected as work in progress under “current assets”, was transferred to the said firm as capital contribution. The said land received from the said three companies was shown in the said profit and loss account and balance sheet as work in progress under “current assets” with corresponding credit to the partners’ capital accounts. The purported finding of the ITO that the partners’ capital accounts were not credited during the financial year ended March 31, 2006 for their capital contribution by way of bringing in the said land is contrary to the factual position. That the said land was brought in by the partners as inventory/current assets does not in any way alter the fact that the partners had in fact brought in the land into the partnership business as their capital contribution. It is not a requirement that an asset brought in by a partner by way of capital contribution must be a fixed asset or that a current asset cannot be brought in by a partner as his capital contribution. The books of account of the said firm for the financial year ended March 31, 2006 clearly reflected the receipt of the said land by it by way of capital contribution from three of its partners as also the value thereof with corresponding credit to the partners’ capital accounts.

15. It was further contended that the said land upon purchase was shown by the said three companies as part of their current assets. The said firm upon receipt of the said land during the financial year ended March 31, 2006 also accounted for it as a current asset. The partners transferred the said land at cost. As such, there was no profit in the hands of the partners upon transfer of the said land to the said firm. Section 45(3) of the Act is applicable only in respect of a capital asset. The said provision has no application in the instant case since what was transferred by the partners was a current asset and not a capital asset.

16. It was pointed out that after receiving the said land as capital contribution, the said firm developed the same and expended a substantial amount for the said purpose during the financial year 2005-06 and thereafter. It was only on March 30, 2008 that the said firm converted the developed land including construction thereon held as inventory into fixed assets and thereafter on March 31, 2008 revalued it with consequent credit to the partners’ current accounts. It was submitted that section 45(3) of the Act did not come into operation for the assessment year 2008-09 by reason of conversion of the developed land and building into fixed assets by the said firm or due to revaluation by the said firm of the asset so converted during the previous year ended March 31, 2008. Section 45(3) of the Act is applicable in the year of transfer by the partner of his capital asset to the partnership firm by way of capital contribution. In the instant case, the year of transfer was the financial year ended March 31, 2006. The ITO was wholly unjustified in invoking section 45(3) which had no application in the assessment year 2008-09 or for that matter in the assessment year 2006-07.

17. The Assessee brought to the notice of the CIT(A) a CBDT Circular subsequent to the insertion of sub-section (3) in section 45 of the Act, viz., circular bearing No. 495 dated September 22, 1987, (1987) 168 ITR (St.) 87, wherein it was stated thus:

“24.2 With a view to blocking this escape route for avoiding capital gains tax, the Finance Act, 1987 has inserted new sub-section (3) in section 45. The effect of this amendment is that profits and gains arising from the transfer of capital asset by a partner to a firm shall be chargeable as the partner’s income of the previous year in which the transfer took place. For purposes of computing the capital gains. the value of the asset recorded in the books of the firm on the dale of the transfer shall be deemed to be the full value of the consideration received or accrued as a result of the transfer of the capital asset. ” (emphasis added)

It was submitted that in the instant case, section 45(3) of the Act had no application in the year of transfer viz. the financial year ended March 31, 2006 since what the partners transferred to the said firm was inventory and not a capital asset. The conversion of inventory into fixed assets was made by the said firm more than two years later during the financial year ended March 31, 2008 as was the revaluation of the converted asset. As submitted hereinbefore, neither such conversion nor revaluation by the said firm during the previous year relevant to the assessment year 2008-09 brought the provisions of section 45(3) of the Act into play for the said year. There was no transfer of any capital asset by the assessee to the said firm during the previous year relevant to the assessment year 2008-09 for section 45(3) to apply. When the partners had no liability for any tax under section 45(3) of the Act, the question of resorting to a device to avoid tax under section 45(3) does not arise.

18. It was further contended that even otherwise, section 45(3) seeks to determine the capital gains with reference to the value of the asset recorded in the books of account of the firm. The value so recorded is statutorily deemed to be the full value of consideration received or accruing to the partner as a result of the transfer of the capital asset to the firm. Thus, section 45(3) does not seek to substitute by any other figure the value agreed between the partners at which the asset is transferred by a partner to the firm. The ITO’s actions are completely contrary to the scheme of the statute. It was reiterated that the purported finding of the ITO that the land was grossly under-valued till it was part of inventory in the books of the said firm is without any basis whatsoever. There was no undervaluation of the land when it was held by the said firm as inventory. For accounting purposes, stock is valued at cost or market price, whichever is lower. The market value is taken only when it falls below the cost. Reference in this behalf was made to the judgment of the Hon’ble Supreme Court in Chainrup Sampatram, (1953) 24 ITR 481 (SC). The said firm correctly reflected the land received from its partners by way of capital contribution and held as inventory at cost. It was pointed out that the said three companies in fact paid Rs.21,87,76,492/- for purchasing the said land which was more than two and half times the State Government guideline value for stamp duty purposes at the time of purchase. As stated hereinbefore, the said three companies entered into the agreement for purchase of the said land in June 2004 and conveyance was executed in their favour on March 30, 2005. Subsequent to the said purchase, the area in which the said land was situated underwent major development and became a premium destination for IT and ITES companies. Several IT parks and SEZ as also high end residential projects were developed in the said area. The area which was under gram panchayat came under the limits of the Municipal Corporation of Bangalore. The Municipal Corporation carried out various improvements in the area by constructing several flyovers and under passes. Supply of water was provided and sewerage lines were laid. In June 2007, the comprehensive development plan of Bangalore was revised and the FAR ratio for construction of buildings in the said area was increased from 2.00 to 3.25 because of road width of 150 feet. As a consequence of all such development activities, the land price in the area kept on rising. The State Government revised the guideline value for stamp duty purposes thrice after purchase of the land by the said three companies as follows»

DATE RATE
Residential Commercial
02.08.2004 200 260
14.10.2005 800 1040
19.04.2007 1500 1950
26.09.2007 2200 3080

However, notwithstanding such price rise, in accordance with accounting principles, the land held as inventory could only be shown at its cost. The ITO was wholly unjustified in labeling the accounting made by the said firm in accordance with accountancy principles as gross undervaluation.

19. It was submitted that it was only after conversion of inventory into fixed assets that the said firm revalued the developed land including construction thereon in order to bring it in line with the current market value and for justifying the bank finance of nearly Rs.250 crores. Such revaluation was neither colourable nor a device. It is settled law that revaluation in the books of account of an asset which the assessee continues to own does not result in any profit or income. Revaluation at market value results in notional imaginary profit which cannot be taxed. Revaluation of an asset which an assessee continues to hold is not a taxable event and does not give rise to any taxable income. A person cannot make a profit from himself. Reliance was placed on the following passage from the judgment of the Hon’ble Supreme Court in Sanjeev Wool en Mills v. CIT, [2005\ 279 ITR 434 (at pages 447-8) which takes note of the relevant previous decisions:

“In the present case, the method adopted by the assessee is to value the closing stock at the market value irrespective of the fact whether the market value of the stock at the relevant time is more than the cost value of the stock, which necessarily results in imaginary or notional profits to the assessee which he has not actually received. In fact such a notional imaginary profit cannot be taxed. It is a well settled principle as held in Sir Kikabhai Premchand v. CIT [1953] 24 ITR 506 (SC) the Constitution Bench judgment that the firm cannot make a profit out of itself The transaction which is not business transaction and does not derive immediate pecuniary gain is not subjected to tax. In the present case by showing the market value of the closing stock the assessee has earned potential profit out of itself in as much as the stock-in-trade remained with the assessee at the closing of the accounting year. Secondly, putting the stock at the market value does not and cannot bring in any real profit which is necessary for taxing the income under the Act as is held in Chainrup Sampatram v. CIT [1953] 24 ITR 481 (SC) and CIT v. Hind Construction Ltd [1972 ] 83 ITR 211 (SC). Thirdly, it is a settled principle of income-tax law that it is the real income, which is taxable under the Act. This proposition was enunciated in CIT v. Birla Gwalior (P.) Ltd [1973J 89 ITR 266 (SC), which was pronounced in CIT v.Shoorji Vallabhdas and CO. [1962J 46 ITR 144 (Se).”

It was argued that the above observations with reference to valuation of stock at market value higher than cost are equally applicable in respect of any other asset.

20. It was submitted that revaluation by the said firm was made for financial purposes and no tax advantage of any kind was sought to be derived thereby. The ITO has himself recorded that the said firm did not claim any depreciation in respect of any asset of the developed project. The said firm let out the developed project to different parties and did not sell any part thereof. In the event of sale, in computing the capital gains, only the actual cost of the asset would have been considered as the cost of acquisition and not the revalued cost. Thus, even in case of transfer of the capital asset, the revaluation would not have resulted in any tax benefit or advantage. It was pointed out that the ITO has mentioned that the partners had withdrawn amounts almost equivalent to the cost of the asset/money brought in by them. Such withdrawals were made by the partners from their capital accounts and cannot result in any taxation in their hands. It was submitted that as stated hereinbefore, upon revaluation of the land and building, the consequent credit was made to the partners’ current accounts. The withdrawals were made not from the current accounts but from the capital accounts as aforesaid. The revaluation amount credited to the partners’ current accounts in their respective profit sharing ratio remained untouched. Reference in this behalf was invited to the said firm’s accounts for the previous year ended March 31, 2008. Even according to the ITO, the partners had only withdrawn their investment in the firm.

21. It was further argued that the matter can be looked at from another angle. As on March 31, 2007, the secured loan taken by the said firm from the bank amounted to Rs.57,67,58,719/-. As on March 31, 2008 the amount of secured loans from banks went up to Rs.243,56,03,002.55, that is by Rs.185.88 crores. The withdrawal of capital by the partners amounted to Rs.182.20 crores. It was thus clear that the partners decided to substitute their own funds by borrowed funds. It was submitted that substitution by the partners of their own funds brought in as their capital by borrowed funds and withdrawal of such capital cannot have any tax incidence in the hands of the partners. It is important to bear in mind that the partners were jointly and severally liable to the banks for the money borrowed by the said firm. Under the Act, the firm is taxed as a separate entity. In computing the firm’s income deduction is allowed in respect of interest, salary, bonus, commission or remuneration paid to a partner to the extent indicated under clause (b) of section 40 of the Act. The share of a partner in the total income of the firm is exempt in his hands in terms of section 10(2A) of the Act. The partner is liable for tax only on the amount of interest, salary, bonus, commission or remuneration which has been allowed as a deduction in the assessment of the firm. It is not in dispute that the said firm revalued its assets. If such revaluation resulted in any taxable income (although that cannot be the case), such income was required to be assessed in the hands of the said firm. In terms of section 10(2A) of the Act, the partner’s share in the total income of the firm is exempt from tax in his hands, If according to the Department any amount has escaped assessment in the hands of the said firm it cannot reopen the partner’s assessment for bringing to tax such income alleged to have escaped assessment in the case of the firm.

22. It was reiterated that the assessee did not make any short term capital gains of Rs.96,37,85,635/- taxable under section 45(3) of the Act or otherwise and the addition made on that account by the ITO is wholly unsustainable. Such addition is also beyond the recorded reasons. It was further submitted that revaluation by the said firm of its land and building did not result in any income in the hands of the partners and the addition of Rs.37,03,36,187/- on account of alleged revaluation profit is equally unsustainable.

23. The CIT(A) accepted the contentions of the assessee. He held as follows:—

“2.4. For the sake of completeness, let me consider the question as to whether revaluation of an asset which the owner thereof continues to hold can give rise to any taxable income. This question does not call for much discussion in view of the authoritative pronouncement of the Apex Court in Sanjeev Woolen Mills v CIT, [2005] 279 ITR 434 (SC). In the said decision the Apex Court has taken note of its previous decisions. It has been held by the Apex Court that valuation at market value, where such value is higher than the cost, results in imaginary or notional profits which have not actually been received and that such notional imaginary profit cannot be taxed. Revaluation of an asset is not a business transaction resulting in any pecuniary gain which can form subject matter of taxation. Where the owner accounts for the asset at market value, though he has incurred a lower amount by way of cost to acquire it, there is no real income. At best, it can be said that by showing the market value in the books, the owner has earned potential profit out of himself since the asset is continued to be held by the owner. There can be no taxation of such notional profit. In view of the said decision of the Apex Court, I have no hesitation in concluding that revaluation by the firm of its assets, which it continued to hold, is not a taxable event at all.

2.5. I cannot see any tax advantage to the firm or to any of its partners by reason of revaluation. No depreciation can be claimed under the Act with reference to the revalued figure. It is also not in dispute that the firm did not in fact claim any depreciation in respect of the revalued assets. Let me consider the question as to what would happen if the firm were to sell the revalued assets. In the event of such sale, the firm having converted its stock- in-trade into fixed assets i.e. capital asset, it will be liable for capital gains tax in the year of sale. In computing such capital gains, what would be considered is the cost of acquisition and not the revalued cost. I would tend to agree with the assessee that revaluation was made for other reasons and not for gaining any tax advantage.

2.6 The AO has mentioned that the partners had withdrawn amounts almost equivalent to the cost of the asset/money brought in by them and that they could also make further withdrawals in the future. It has been shown by the assessee from the accounts of the firm as also its own accounts that the revaluation amount was credited to the partners’ current accounts and that no withdrawal was made from the current accounts. What the AO failed to notice was that in effect, the partners had replaced a substantial part of the capital brought in by them by borrowed funds and in respect of such borrowed funds they were jointly and severally liable to the banks from which the borrowings were made. It is not the case that by virtue of the revaluation the firm earned any income which ‘was credited to the partners’ accounts who thereupon withdrew such income. The accounts of the firm for the year ended March 31, 2008 show that the amount of secured loan from the banks went up by nearly Rs.186 crores during the said financial year. At the same time, the partners had withdrawn about RS.182 crores from their capital accounts during the same period. It is clear from the accounts of the firm that the withdrawal by the partners was funded by borrowings from the banks. Withdrawal by the partners of the money brought in by them by way of capital and replacing such capital by borrowed funds cannot have any tax impact in the hands of the partners. I am in agreement with the appellant that substitution of capital by funds borrowed from the banks for which the partners are jointly and severally liable to the banks cannot have any tax incidence in the hands of the partners

2.7. In so far as invocation of section 45(3) of the Act is concerned, I cannot see how the said provision is applicable in the instant case. The accounts of the partners and that of the firm for the financial year ended March 31, 2006 show that the partners held the and acquired by them as stock-in-trade and the firm upon contribution of the land by the partners also accounted for it as stock-In-trade. Section 45(3) is applicable in respect of a capital asset. The definition of capital asset in section 2(14) of the Act expressly excludes stock-in-trade. Conversion of stock-in-trade into fixed assets was made by the firm more than two years after the partners’ contribution. Such conversion of stock-in- trade into capital asset by the firm and its revaluation long after the partners’ contribution cannot bring into operation the provisions of section 45(3). Section 45(3) is applicable for the year in which the partner transfers his asset to the firm. It is clear from the partnership deed that the land was contributed by the partners to the firm during the financial year ended March 31, 2006. The partnership deed which records the factum of such contribution is dated January 9, 2006 and is a registered document. The accounts of the partners and of the firm for the financial year ended March 31, 2006 were drawn up on the basis that the partners had contributed the land held as stock-in- trade to the firm by way of capital contribution with corresponding credit to the partners’ capital accounts and that such land was also accounted for by the firm as stock-in-trade. Thus, transfer of the land from the partners to the firm took place during the financial year ended March 31, 2006 relevant to, the assessment year 2006-07. Capital contribution having been made by the partners during the financial year ended March 31, 2006, it is difficult to uphold the assessment made on the basis as if transfer was effected during the financial year ended March 31, 2008 relevant to the assessment year 2008-09. That apart, the provisions of section 45(3) of the Act do not envisage substitution of the value agreed between the partners in respect of any asset brought by them into the firm by way of capital contribution by any other value. If the partners agree to contribute an asset held by them at cost and such cost is recorded in the books of account of the firm as the value of the assets contributed, it is only such cost recorded in the books of the firm which can be considered for the purposes of section 45(3). Any subsequent conversion or revaluation of the asset by the firm is of no relevance for the purposes of section 45(3) which is applicable only in the year transfer.

2.8 The AO has mentioned that the asset contributed to the firm was grossly under -valued. There is no basis for such observation. The price paid by the partners for purchase of the land has not been disputed by the ITO. There is no suggestion that any under valuation was involved at the time of purchase of the land. On the other hand, the assessee has demonstrated that because of subsequent developments, the price of the and kept on rising, This is adequately borne out from the fact that the guideline value for payment of stamp duty went up by more than 10 times in a span of three years subsequent to the partners’ purchasing the land.

2.9. As noted earlier, the land was held by the partners as stock-in-trade and the firm upon transfer continued to hold the land as stock-in-trade. It is the settled position of law that stock-in-trade has to be valued at cost or market price whichever is lower, As long as the firm held the land as stock-in-trade, it was not possible for it to account for its market value unless such market value fell below the cost. The firm revalued the land and the construction made thereon on the basis of valuation report only after it converted the same from stock-in-trade to fixed asset. As long as the firm held the land and building thereon as stock-in-trade, it could not have accounted for the market value thereof, which was several times higher than the cost. Having regard to the aforesaid position, the explanation of the assessee that revaluation was made for financial purposes in order to justify the large amount of bank loans of more than Rs.240 crores is plausible and acceptable. I do not see the actions of the firm or its partners as being colourable or any sort of device. 2.10 The firm revalued its land as well as construction thereon. The AO taxed 1/3rd of the revaluation amount relating to the land in the hands of each of the 3 partners who had contributed it. The same amount was again taxed in the hands of the 4 partners in their profit sharing ratio. The contention of the assessee as regards addition of the same amount twice over has to be accepted.

I have already discussed and deliberated upon the AO’s action in adding Rs. 96,37,85,635/- as short-term capital gain and Rs. 37,03,36,187/- as share of revaluation profit as unjustified at para 2.3 to 2.10, as the addition so made in respect of both the items is deleted.

Hence, these grounds of the appellant are allowed.”

24. Aggrieved by the order of CIT(A) the revenue has preferred the present appeal before the Tribunal. Grounds of appeal raised by the revenue read as follows:—

“1. The Ld. CIT(A) has erred in law and on the facts & circumstances of the case by adjudicating that the Assessing officer acted without jurisdiction by issuing notice U/s148 of the I.T. Act, 1961 for making assessment U/s147 of the I.T. Act, 1961.
2. The Ld. CIT(A) has erred in law and on the facts & circumstances of the case in deleting the addition of Rs.96,37,85,635/- added as Short Term Capital Gains earned by the assessee on transfer of land property to the Partnership firm as their Capital Contribution, by holding that the provisions of section 45(3) of the I.T. Act, 1961 is not applicable.
3. The Ld. CIT(A) has erred in law and on the facts & circumstances of the case in deleting the addition of share of Revaluation Profit of Rs.37,03,36,187/- received by the assessee by holding that such profit is notional and is not taxable.
4. The Ld. CIT(A) has erred in law and on the facts & circumstances of the case, by holding and adjudicating that addition of Short Term Capital Gains for Rs.96,37,85,635/-and addition of Revaluation Profit received for Rs.37,03,36,187/- has resulted towards additions of the same amount twice where as both the issues of addition are different from each other and have been added back for different reasons.
5. The Ld. CIT(A) has erred in law and on the facts & circumstances of the case in deleting the additions of Rs.96,37,85,635/- added as Short Term Capital Gains and addition of Revaluation Profit for Rs.37,03,36,187/- by not giving cognizance to the issue & fact that this assessee company along with other all of the partner companies and their Partnership Firm has adopted the means of colourable transaction, in collusion with each other, to achieve the purpose of avoiding taxes.
6. The appellant craves leave to amend, modify and alter any grounds of appeal during the course of hearing of this case.

25. We have heard the submissions of the ld. Counsel for the assessee and the ld. DR. The ld. DR relied on the order of AO. The ld. Counsel for the assessee relied on the submissions as were made before CIT(A) and relied on the order of CIT(A). He further placed reliance on the decision of the Hon’ble Supreme Court in the case of Sanjeev Wollen Mills v. CIT 279 ITR 434 (SC) wherein the Hon’ble Supreme Court held that by showing Market value of closing stock, assessee cannot be said to have made profit which was necessary for taxing income under the Act.

26. We have given a very careful consideration to the rival submissions. As far as the validity of initiation of reassessment proceedings u/s.147 of the Act is concerned, we are of the view that the conclusions of the CIT(A) are just and proper and calls for no interference. The reasons recorded by the AO before issuing notice u/s.148 of the Act for making reassessment u/s.147 of the Act, shows that the AO had information that the Partnership Firm had revalued its assets. If at all any income accrues or arises owing to such revaluation, it was an issue which had to be dealt with in the assessment of the firm, which is a separate taxable entity. The Assessee’s source of income is “share income from partnership firm”. Even assuming that income accrued and arose in the hands of the firm consequent to revaluation of the assets by the firm, the income that might accrue in the hands of the partner would be in the nature of “share income from the firm”. In terms of Sec.10(2A) of the Act, partner’s share in the total income of the firm is not to be included in the total income of the partner. Therefore, looked at from any angle, the AO could not on the basis of the reasons recorded formed belief that income chargeable to tax in the hands of the Assessee has escaped assessment. Since the formation of such belief is a requirement for initiating proceedings u/s.147 of the Act and since on the facts and circumstances of the present case such formation of belief does not exist, the initiation of reassessment proceedings, were rightly held to be not valid in law by the CIT(A).

27. As far as the question whether there was short term capital gain of Rs.96,37,85,635/- is concerned, the provisions of Sec.45(3) of the Act have been pressed into service by the Revenue. The provisions of Sec.45(3) of the Act reads thus:

Section: 45(3): The profits or gains arising from the transfer of a capital asset by a person to a firm or other association of persons or body of individuals (not being a company or a co-operative society) in which he is or becomes a partner or member, by way of capital contribution or otherwise, shall be chargeable to tax as his income of the previous year in which such transfer takes place and, for the purposes of section 48, the amount recorded in the books of account of the firm, association or body as the value of the capital asset shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of the capital asset.

Provisions of Section 45(3) of the Act, were inserted by Finance Act, 1987 (w.e.f. 1-4-1988). The facts with regard to purchase of land by the Assessee and two other companies of land at Bangalore and the facts with regard to transfer of the land by the three companies as capital contribution to a partnership firm during the financial year ended March 31, 2006 relevant to the assessment year 2006-07, cannot be disputed. The partnership deed, which provided that the said three companies would transfer the said land to the said firm as capital contribution, was executed on January 9, 2006. The said deed vide the second recital expressly stated that at or before the execution of the deed the said firm had taken over the said land as part of the assets of the partnership business. The said transfer was given effect in the accounts of the partners for the financial year ended March 31, 2006. The assessee’s balance sheet and profit and loss account for the said financial year showed the said land, which had been reflected as work in progress under “current assets”, was transferred to the said firm as capital contribution. The said land received from the said three companies was shown in the said profit and loss account and balance sheet as work in progress under “current assets” with corresponding credit to the partners’ capital accounts. The purported finding of the ITO that the partners’ capital accounts were not credited during the financial year ended March 31, 2006 for their capital contribution by way of bringing in the said land is contrary to the factual position. That the said land was brought in by the partners as inventory/current assets does not in any way alter the fact that the partners had in fact brought in the land into the partnership business as their capital contribution. It is not a requirement that an asset brought in by a partner by way of capital contribution must be a fixed asset or that a current asset cannot be brought in by a partner as his capital contribution. The books of account of the said firm for the financial year ended March 31, 2006 clearly reflected the receipt of the said land by it by way of capital contribution from three of its partners as also the value thereof with corresponding credit to the partners’ capital accounts. The land upon purchase was shown by the said three companies as part of their current assets. The said firm upon receipt of the said land during the financial year ended March 31, 2006 also accounted for it as a current asset. The partners transferred the said land at cost. As such, there was no profit in the hands of the partners upon transfer of the said land to the said firm. Section 45(3) of the Act is applicable only in respect of a capital asset. The said provision has no application in the instant case since what was transferred by the partners was a current asset and not a capital asset. Section 45(3) of the Act did not come into operation for the assessment year 2008-09 by reason of conversion of the developed land and building into fixed assets by the said firm or due to revaluation by the said firm of the asset so converted during the previous year ended March 31, 2008. Section 45(3) of the Act is applicable in the year of transfer by the partner of his capital asset to the partnership firm by way of capital contribution. In the instant case, the year of transfer was the financial year ended March 31, 2006. The ITO was wholly unjustified in invoking section 45(3) which had no application in the assessment year 2008-09 or for that matter in the assessment year 2006-07. Even otherwise, section 45(3) seeks to determine the capital gains with reference to the value of the asset recorded in the books of account of the firm. The value so recorded is statutorily deemed to be the full value of consideration received or accruing to the partner as a result of the transfer of the capital asset to the firm. Thus, section 45(3) does not seek to substitute by any other figure the value agreed between the partners at which the asset is transferred by a partner to the firm. The ITO’s actions are completely contrary to the scheme of the statute. We therefore uphold the order of the CIT(A) in so far as it relates to his conclusion that the AO was not justified in assessing short term capital gain of Rs.96,37,85,635/- in the hand of the Assessee on the ground that:

(a) The partners’ capital accounts were credited during the financial year ended March 31, 2006 for their capital contribution by way of bringing in land at Bangalore and that the books of account of the said firm for the financial year ended March 31, 2006 clearly reflected the receipt of the said land by it by way of capital contribution from three of its partners as also the value thereof with corresponding credit to the partners’ capital accounts. Section 45(3) of the Act is applicable in the year of transfer by the partner of his capital asset to the partnership firm by way of capital contribution. In the instant case, the year of transfer was the financial year ended March 31, 2006. The ITO was wholly unjustified in invoking section 45(3) which had no application in the assessment year 2008-09 or for that matter in the assessment year 2006-07.
(b) The land was brought in by the partners as inventory/current assets does not in any way alter the fact that the partners had in fact brought in the land into the partnership business as their capital contribution. It is not a requirement that an asset brought in by a partner by way of capital contribution must be a fixed asset or that a current asset cannot be brought in by a partner as his capital contribution. The land upon purchase was shown by the said three companies as part of their current assets. The said firm upon receipt of the said land during the financial year ended March 31, 2006 also accounted for it as a current asset. Section 45(3) of the Act is applicable only in respect of a capital asset. The said provision has no application in the instant case since what was transferred by the partners was a current asset and not a capital asset.
(c) section 45(3) seeks to determine the capital gains with reference to the value of the asset recorded in the books of account of the firm. The value so recorded is statutorily deemed to be the full value of consideration received or accruing to the partner as a result of the transfer of the capital asset to the firm. Thus, section 45(3) does not seek to substitute by any other figure the value agreed between the partners at which the asset is transferred by a partner to the firm.

28. As far as the question whether the AO was justified in bringing to tax a sum of Rs.37,03,36,187/- as share of revaluation profit, is concerned, the AO has proceeded to assess the aforesaid sum as income of the Assessee for the previous year relevant to AY 08-09 on the basis of revaluation of the land at Bangalore by the Assessee during the previous year. The law is well settled that for accounting purposes, stock is valued at cost or market price, whichever is lower. The market value is taken only when it falls below the cost. Reference in this behalf was made to the judgment of the Hon’ble Supreme Court in Chainrup Sampatram, (1953) 24 ITR 481 (SC). The firm correctly reflected the land received from its partners by way of capital contribution and held as inventory at cost. The three companies paid Rs.21,87,76,492/- for purchasing the said land which was more than two and half times the State Government guideline value for stamp duty purposes at the time of purchase. The three companies entered into the agreement for purchase of the said land in June 2004 and conveyance was executed in their favour on March 30, 2005. Subsequent to the said purchase, the area in which the said land was situated underwent major development and became a premium destination for IT and ITES companies. Several IT parks and SEZ as also high end residential projects were developed in the said area. The area which was under gram panchayat came under the limits of the Municipal Corporation of Bangalore. The Municipal Corporation carried out various improvements in the area by constructing several flyovers and under passes. Supply of water was provided and sewerage lines were laid. In June 2007, the comprehensive development plan of Bangalore was revised and the FAR ratio for construction of buildings in the said area was increased from 2.00 to 3.25 because of road width of 150 feet. As a consequence of all such development activities, the land price in the area kept on rising. The State Government revised the guideline value for stamp duty purposes thrice after purchase of the land by the three companies as follows»

DATE RATE
Residential Commercial
02.08.2004 200 260
14.10.2005 800 1040
19.04.2007 1500 1950
26.09.2007 2200 3080

However, notwithstanding such price rise, in accordance with accounting principles, the land held as inventory was shown at its cost. Therefore it cannot be said that there was any undervaluation done by the Assessee as alleged by the AO.

29. After conversion of inventory into fixed assets the firm revalued the developed land including construction thereon in order to bring it in line with the current market value and for justifying the bank finance of nearly Rs.250 crores. Such revaluation was neither colourable nor a device. It is settled law that revaluation in the books of account of an asset which the assessee continues to own does not result in any profit or income. Revaluation at market value results in notional imaginary profit which cannot be taxed. Revaluation of an asset which an assessee continues to hold is not a taxable event and does not give rise to any taxable income. A person cannot make a profit from himself. The decision of the Hon’ble Supreme Court in the case of Sanjeev Woolen Mills (supra) wherein it was held that notional imaginary profit cannot be taxed, clearly supports the stand of the Assessee. In fact the observations of the Hon’ble Supreme Court made with reference to valuation of stock at market value higher than cost are equally applicable in respect of any other asset. Revaluation by the firm was made for financial purposes and no tax advantage of any kind was sought to be derived thereby. The firm did not claim any depreciation in respect of any asset of the developed project. The firm let out the developed project to different parties and did not sell any part thereof. In the event of sale, in computing the capital gains, only the actual cost of the asset would have been considered as the cost of acquisition and not the revalued cost. Thus, even in case of transfer of the capital asset, the revaluation would not have resulted in any tax benefit or advantage. There was no withdrawal by the Partners from capital account and therefore there cannot be any income liable to taxation in their hands. We therefore concur with the view of the CIT(A) on this issue also.

30. We therefore confirm the order of the CIT(A) by holding that the assessee did not make any short term capital gains of Rs.96,37,85,635/- taxable under section 45(3) of the Act or otherwise and that on revaluation of its fixed assets by the firm (of its land and building) there was no income that accrued or arose in the hands of the partners and the addition of Rs.37,03,36,187/- on account of alleged revaluation profit is not sustainable and was rightly deleted by the CIT(A).

31. In the result, the appeal by the Revenue is dismissed.

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