ASSESSMENT OF FIRMS

The term firm is defined in section 2 clause 23 of the Income-tax Act, 1961 (the ‘Act’). It
includes not only partnership firm as defined in the Indian Partnership Act, 1932 (9 of 1932),
and shall include a limited liability partnership as defined in the Limited Liability
Partnership Act, 2008. Similarly, the term "partner" shall have the meaning assigned to it in
the Indian Partnership Act, 1932 (9 of 1932), and shall include (a) minor admitted to the
benefits of partnership and a partner of a limited liability partnership.

Firm is nothing but a collective name given to partners. Although firm is taxable as separate
assessee, but it is nothing but a collection of persons coming together as partners. Therefore,
the nature of income in the hands of partners remains the same as in the hands of firm. (R.M.
Chidambaram Pillai (Supreme Court))

Conditions for a valid firm (Section 184) - A firm shall be assessed as a firm for the
purposes of this Act, if—
(i) the partnership is evidenced by an instrument; and
(ii) the individual shares of the partners are specified in that instrument.
(iii) A certified copy of the instrument of partnership shall accompany the return of
income of the firm in respect of which assessment as a firm is first sought.
(iv) The copy of the instrument of partnership shall be certified in writing by all the
partners (not being minors).
(v) Where any change takes place in constitution, the firm shall furnish a certified copy
of the revised instrument of partnership along with the return of income in the year of
change;
(vi) The firm must not commit any default mentioned in section 144;

Note: As per section 185, where a firm does not comply with the provisions of section 184
for any assessment year, the firm shall be so assessed that no deduction by way of any
payment of interest, salary, bonus, commission or remuneration, by whatever name called,
made by such firm to any partner of such firm shall be allowed in computing the income
chargeable under the head "Profits and gains of business or profession";

Change in Constitution of firm (section 187)

Change in constitution means if one or more of the partners cease to be partners or one or
more new partners are admitted, in such circumstances that one or more of the persons who
were partners of the firm before the change continue as partner or partners after the change;
or where all the partners continue with a change in their respective shares or in the shares of
some of them;

Succession means where the firm is succeeded by another firm (i.e. none of the partners
continue or all partners change)
Note: In case of constitution change, the firm (before reconstitution and post reconstitution)
is assessed as one entity. In case of succession, the predecessor and successor are assessed
as different entities.

Example:
Existing Partners Reconstituted partners Remarks

A, B, C A, B, X Change in Constitution

A, B, C, A, X, Y Change in Constitution

A, B, C X, Y, Z Succession

A, B, C (33:33:33) A, B, C (60:20:20) Change in Constitution

Note: In case of dissolution, since going concern assumption is violated, stock in trade must
be valued at Fair Market Value itself (ALA Firm (SC)). However, in case the business of firm
is taken over by one of the partner (as sole proprietor), then going concern assumption is not
violated, and therefore, the stock must be valued at cost itself. (Sakthi Trading Co (SC)).
However, in order to neutralise this decision of Supreme Court, ICDS – II states that in case
of dissolution of firm, stock must be valued at NRV whether or not business is discontinued;

Note: As per Section 188A, partners of firm have joint and several liability towards tax
department. Even if firm is dissolved, partners continue to be responsible for actions of firm
conducted when it was in existence.

Section 40(b) – Allowability of remuneration and interest to partners

Conditions for allowability of Conditions for allowability of interest**

remuneration* to partners to partners

1. Salary must be paid only to working Interest may be paid to any partner
partner****

2. Salary must be authorised by the deed Interest must be authorised by the deed

3. Deed cannot provide retrospective Deed cannot provide retrospective

payment of remuneration payment of interest

4. Maximum allowable remuneration is as Maximum allowable interest shall be at

under: the rate of twelve per cent simple
interest per annum

On first 6,00,000 book-profit*** or in the

case of loss – Rs. 3,00,000 or 90 per cent
of book-profit, whichever is more
 On balance - @ 60%

* The term remuneration includes salary, bonus, commission or remuneration, by whatever

name called;
** Interest may be on capital account, current account, loan account etc. (Novel
Distribution Co (Kerala High Court))
*** For the purposes of this clause, "book-profit" means the net profit, as shown in the profit
and loss account for the relevant previous year, computed in the manner laid down in
Chapter IV-D as increased by the aggregate amount of the remuneration paid or payable to
all the partners of the firm if such amount has been deducted while computing the net profit.

**** "Working partner" means an individual who is actively engaged in conducting the
affairs of the business or profession of the firm of which he is a partner;

Examples:

1. Calculate maximum allowable remuneration in the following cases:

Book Profit Maximum allowable remuneration

Rs. 10,00,000 90% of 6 l + 60% of 4 l = 7,80,000

Rs. 76,00,000 90% of 6 l + 60% of 70 l = 47,40,000

Rs. 68,00,000 (loss) Rs. 3,00,000

2. In the above example, what is the allowable remuneration if actual remuneration

provided in books is as under:

Actual remuneration Allowable u/s. 40(b)

Rs. 7,00,000 Rs. 7,00,000

Rs. 50,00,000 Rs. 47,40,000

Rs. 4,00,000 Rs. 3,00,000

3. Great City Manufacturing Company Limited (Allahabad High Court)

Section 40(b) was introduced to do away with the subjectivity of Section 40A(2).
Hence, Section 40(b)(v) prescribes the limit of remuneration to working partners, and
deduction is allowable up to such limit while computing the business income. If the
remuneration paid is within the ceiling limit provided u/s 40(b)(v), then, recourse to
provisions of section 40A(2)(a) cannot be taken.
4. M/s. XYZ & Co provides interest @ 15% on partner remuneration. The deed was
amended on 1st June 2025 w.r.e.f. 1st April 2025. The Interest provision made for the
year F.Y. 2025-26 is Rs. 15 lakhs. Please compute allowable interest u/s. 40(b) of the
Act.
Ans: Interest for 12 months --- Rs. 15,00,000
Hence, interest for April & May 2025 (i.e. 2 months) ---- Rs. 2,50,000 (disallowed
being retrospective)

Interest for balance 10 months = Rs. 12,50,000 (15 – 2.50)

This interest is provided @ 15%, we can allow only 12%. Therefore, balance 3% is
equal to = Rs. 2,50,000 (12,50,000 X 3/15) (disallowed being in excess of 12%)
Total disallowance = Rs. 5,00,000
Allowable interest u/s. 40(b) = Rs. 10,00,000

5. Steps to solve question:

First – always conduct all other PGBP adjustments (except remuneration and interest
point)
Second – make adjustment for interest u/s. 40(b)
Third – make adjustment for remuneration--- add back actual remuneration debited
to P&L account. This gives us book profits and now calculate, the maximum
remuneration as per limits allowable u/s. 40(b)

6. Remuneration is taxable for partners u/s. 28(va)

Any interest, salary, bonus, commission or remuneration, by whatever name called,

due to, or received by, a partner of a firm from such firm shall be regarded as PGBP
Income.

However, where any interest, salary, bonus, commission or remuneration, by

whatever name called, or any part thereof has not been allowed to be deducted under
clause (b) of section 40, the income under this clause shall be adjusted to the extent
of the amount not so allowed to be deducted;

Ex. 1: M/s. XYZ paid remuneration of Rs. 10 lakhs to Mr. A. Allowable amount u/s. 40(b) is
Rs. 7 lks. In such case, only Rs. 7 lks shall be regarded as income taxable in the
hands of Mr. A

Ex. 2: In above example, what if the entire remuneration was paid in cash? In such a
scenario, even though Rs. 7 lks also would get disallowed for the firm, still Rs. 7 lks
will be taxable u/s. 28 for the partner, since section 28(v) provides adjustment only
for amount disallowed u/s. 40(b) and not any other clause

8. Section 194-T: Payments to partners of firms.

 194T.(1) Any person, being a firm, responsible for paying any sum in the nature of
salary, remuneration, commission, bonus or interest to a partner of the firm, shall, at
the time of credit of such sum to the account of the partner (including the capital
account) or at the time of payment thereof, whichever is earlier shall, deduct income-
tax thereon at the rate of ten per cent.
(2) No deduction shall be made under sub-section (1) where such sum or the
aggregate of such sums credited or paid or likely to be credited or paid to the partner
of the firm does not exceed twenty thousand rupees during the financial year.]

9. UAD vs. Business loss in calculation of book profits

Ex1: M/s. XYZ pays remuneration of Rs. 10 lakhs to Mr. A, partner. Net Profit as
per P&L is Rs. 67,00,000. The firm has brought forward unabsorbed
depreciation of Rs. 7 lakhs.
Ans: Book Profit = 67,00,000 (-) 7,00,000* (+) 10,00,000 = Rs. 70,00,000
*Since UAD is set off u/s. 32(2), which forms part of Chapter IV-D

Allowable u/s. 40(b) = Rs. 43,80,000

Actual remuneration = Rs. 10,00,000
Lower of the above = Rs. 10,00,000

Total Income = Book Profit – allowable remuneration = Rs. 60,00,000

Ex.2: In Ex.1, what if Rs. 7 lakhs was brought forward business loss instead of UAD
Ans: Business loss is set off under chapter VI. For calculating Book Profits, we
need to make adjustments of chapter IV-D. Hence, Business loss will not be
considered for computation of book profit

Book Profit = 67,00,000 (-)0 (+) 10,00,000 = Rs. 77,00,000

Maximum allowable u/s. 40(b) = Rs. 48,00,000
Lower of actual or maximum = Rs. 10,00,000

Computation of total income:

Net Profit as per Profit & Loss account Rs. 67,00,000

(+) Actual remuneration Rs. 10,00,000
Sub-total (Book profits) Rs. 77,00,000
(-) Allowable remuneration u/s. 40(b) Rs. 10,00,000
(-) Brought forward Business loss Rs. 07,00,000
Total Income Rs. 60,00,000

Note: Unabsorbed depreciation is covered u/s. 32(2), which forms part of Chapter IV-D.
Hence, it is considered for computation of book profits. However, Brought forward
 business loss is covered under chapter VI and therefore, not considered for
computation of book profits.

Ex.3 Suppose in Ex.1, there is brought forward business loss of Rs. 50 lakhs and brought
forward UAD of Rs. 40 lakhs.
Ans: Computation of Book Profits u/s. 40(b)
Net Profit as per P&L Account Rs. 67,00,000
(-) Business loss set off in order to enable
absorption of UAD Rs. 50,00,000
Sub-total Rs. 17,00,000
(-) UAD Rs. 17,00,000
Sub-total Rs. 0
(+) Actual remuneration debited to Profit & Loss Rs. 10,00,000
(+) Business loss being added back, which was artificially
Set off above Rs. 50,00,000
Book Profits Rs. 60,00,000

Allowable remuneration u/s. 40(b) Rs. 37,80,000

Computation of Total Income

Net Profit as per P&L Account Rs. 67,00,000

(+) Actual remuneration debited to Profit & Loss Rs. 10,00,000
(-) Allowable remuneration (Rs. 10,00,000)

Less: Business loss being set off u/s. 72 Rs. 50,00,000

Less: unabsorbed depreciation Rs. 17,00,000
Total Income Rs. NIL

10. Section 78

Note: Where an individual is a partner in a firm on behalf, or for the benefit, of any other
person (such partner and the other person being hereinafter referred to as "partner in
a representative capacity" and "person so represented", respectively),—
(i) interest paid by the firm to such individual otherwise than as partner in a
representative capacity, shall not be taken into account for the purposes of
this clause;
(ii) interest paid by the firm to such individual as partner in a representative
capacity and interest paid by the firm to the person so represented shall be
taken into account for the purposes of this clause.
Example: If Mr. A becomes representative partner on behalf of XYZ Limited in a firm
ABC & Co. Now if A provides a loan to the firm from his own funds, then
provisions of section 40(b) will not apply on the interest paid.

Note: Where an individual is a partner in a firm otherwise than as partner in a

representative capacity, interest paid by the firm to such individual shall not be taken
into account for the purposes of this clause, if such interest is received by him on
behalf, or for the benefit, of any other person.

Example: If Mr. A becomes partner in his personal capacity in a firm ABC & Co. Now if
A obtains loan from Mr. XYZ and provides the same to the firm, then
provisions of section 40(b) will not apply on the interest paid.

Note: Salary paid to representative partner is also covered u/s. 40(b) Rasiklal & Co HUF
(Supreme Court)

Note: Can royalty paid to partner be covered u/s. 40(b)?

As per Andhra Pradesh High Court in the case of CIT vs. Chitra Kalpana Talkies,
royalty paid to partner is not covered u/s. 40(b), since the partner was performing a
function, which he is not generally required to perform as per his obligations to the
firm. Hence, the royalty was for services, rendered in capacity other than as partner.
However, a contrary view has been taken in Madras High Court decision for M/s.
Packwell Karnataka Industries. (ICAI treats royalty payment to partner as
remuneration for the purposes of section 40(b))
https://www.casemine.com/judgement/in/5608f6f4e4b014971113ecba

CS – 13 from MCQ booklet & Question 12 from Assessment of Various entities (module)

Section 9B of the Income-tax Act, 1961

Logic for insertion of Section 9B r.w.s. 45(4)

Mr. X, Mr. Y and Z are partners in a firm. The firm owns a large parcel land in Vikhroli,
Mumbai. The land was acquired in 1975 for Rs. 100,000. The fair market value of land today
is Rs. 100 crores. The partners want to avoid paying capital gains tax. Pre-2021, tax
advisors gave the following structure: Let the firm identify potential buyer, let us say Mr. A,
B & C are interested to purchase the land. The existing partners revalue the land @ Rs. 100
crores and their capital balance stands increased due to revaluation profit. Each partners’
capital balance becomes Rs. 33 crores. Now the new partners A, B & C introduce Rs. 33
crores each as capital. The old partners withdraw this money and retire from the firm. The
land continues to be owned by the firm. Hence, this was a perfect, legitimate tax avoidance
exercise.

Provision: (Section 9B)

1. "Specified person" means a person, who is a partner of a firm or member of other
association of persons or body of individuals. "Specified entity" means a firm or other
association of persons or body of individuals;

2. Where a specified person receives during the previous year any capital asset or stock
in trade or both from a specified entity in connection with the dissolution or
reconstitution of such specified entity, then the specified entity shall be deemed to
have transferred such capital asset or stock in trade or both, as the case may be, to
the specified person in the year in which such capital asset or stock in trade or both
are received by the specified person.

3. If stock in trade is transferred -----Business Income

If Capital asset is transferred -----Capital Gains

4. For the purposes of this section, fair market value of the capital asset or stock in
trade or both on the date of its receipt by the specified person shall be deemed to be
the full value of the consideration received or accruing as a result of such deemed
transfer of the capital asset or stock in trade or both by the specified entity.

Note: The Government has introduced purposeful double taxation through amendments in
section 45(4). Hence, although capital gain arises under section 9B of the Act but
again tax is levied u/s. 45(4) of the Act as under:

(a) Where a specified person receives during the previous year any money or capital
asset or both from a specified entity in connection with the reconstitution of such
specified entity, then any profits or gains arising from such receipt by the specified
person shall be chargeable to income-tax as income of such specified entity under the
head "Capital gains" and shall be deemed to be the income of such specified entity of
the previous year in which such money or capital asset or both were received by the
specified person, and notwithstanding anything to the contrary contained in this Act,
such profits or gains shall be determined in accordance with the following formula,
namely:—

A=B+C-D

Where,
A = income chargeable to income-tax under this subsection as income of the specified
entity under the head "Capital gains";
B = value of any money received by the specified person from the specified entity on
the date of such receipt;
C = the amount of fair market value of the capital asset received by the specified
person from the specified entity on the date of such receipt; and
 D = the amount of balance in the capital account (represented in any manner) of the
specified person in the books of account of the specified entity at the time of its
reconstitution:

(b) If the value of "A" in the above formula is negative, its value shall be deemed to be
zero;

(c) The balance in the capital account of the specified person in the books of account of
the specified entity is to be calculated without taking into account the increase in the
capital account of the specified person due to revaluation of any asset or due to self-
generated goodwill or any other self-generated asset.

(d) Explanation 2.—For the removal of doubts, it is clarified that when a capital asset
is received by a specified person from a specified entity in connection with the
reconstitution of such specified entity, the provisions of this sub-section shall
operate in addition to the provisions of section 9B and the taxation under the said
provisions thereof shall be worked out independently.

Now, double taxation is not a good thing!! Right !!!

So, to neutralise, the government has brought yet another amendment in section 48, which
states as under:

(1) For the purposes of clause (iii) of section 48, where the amount is chargeable to
income-tax as income of specified entity under sub-section (4) of section 45, the
specified entity shall attribute such amount to capital asset remaining with the
specified entity in a manner provided in rules.
(2) Where the aggregate of the value of money and the fair market value of the capital
asset received by the specified person from the specified entity, in excess of the
balance in his capital account, chargeable to tax under sub-section (4) of section 45,
relates to revaluation of any capital asset or valuation of self-generated asset or self-
generated goodwill, of the specified entity, the amount attributable to the capital asset
remaining with the specified entity for purpose of clause (iii) of section 48 shall be
the amount which bears to the amount charged under sub-section (4) of section 45 the
same proportion as the increase in, or recognition of, value of that asset because of
revaluation or valuation bears to the aggregate of increase in, or recognition of,
value of all assets because of the revaluation or valuation.
(3) Where the aggregate of the value of money and the fair market value of the capital
asset received by the specified person from the specified entity, in excess of the
balance in his capital account, charged to tax under sub-section (4) of section 45
does not relate to revaluation of any capital asset or valuation of self-generated asset
or self-generated goodwill, of the specified entity, the amount charged to tax under
sub-section (4) of section 45 shall not be attributed to any capital asset for the
purposes of clause (iii) of section 48.
(4) Notwithstanding anything contained in sub-rule (2) or (3), where the aggregate of the
value of money and the fair market value of the capital asset received by the specified
person from the specified entity, in excess of the balance in his capital account,
charged to tax under sub-section (4) of section 45 relate only to the capital asset
received by the specified person from the specified entity, the amount charged to tax
under sub-section (4) of section 45 shall not be attributed to any capital asset for the
purposes of clause (iii) of section 48.
(5) The specified entity shall furnish the details of amount attributed to capital asset
remaining with the specified entity in Form No. 5C. Form No. 5C shall be furnished
on or before the due date referred to in the Explanation 2 below sub-section (1) of
section 139 for the assessment year in which the amount is chargeable to tax under
sub-section (4) of section 45.
Explanation 2.—For the removal of doubt it is clarified that revaluation of an asset or
valuation of self-generated asset or self-generated goodwill does not entitle the specified
entity for the depreciation on the increase in value of that asset on account of its revaluation
or recognition of the value of self-generated asset or self-generated goodwill due to its
valuation.

Steps to solve questions:

(1) Find out whether question is for dissolution of firm or reconstitution. In case of
dissolution, provisions of 9B only shall apply (i.e. no double taxation). If
reconstitution, find out if only money is given or capital assets also. If capital assets
are given, then both section 9B and 45(4) shall apply (purposeful double taxation)

(2) Calculate capital gains tax u/s. 9B (including surcharge & Cess). Consider FMV of
asset as FVOC;

(3) Find out (FMV – Cost – Tax) = Net Profit and distribute that to all partners in
PSR. Capital Balance stands increased to that extent;

(4) Now, calculate tax again u/s. 45(4) =FMV of Assets (+) Money received by partner
(-) Capital balance calculated in step 3

(5) Find out, which balance assets remain in the firm ----Find out ratio of increase in
their value due to revaluation and apportion the capital gains to balance assets in
same ratio;

(6) If balance capital assets are long-term, then the capital gains calculated in step 4
shall also be long term. If the balance capital assets are short-term or self-generated
or forming part of block of assets, then the capital gains computed u/s. 45(4) shall be
deemed as short-term in nature
Example 1: There are three partners "A", 'B" and "C" in a firm "FR", having one third
share each. Each partner has a capital balance of Rs. 10 lakh in the firm.
There are three pieces of land "S", "T" and "U" in that firm and there is no
other capital asset in that firm. Book value of each of the land is Rs. 10 lakhs.
All these three lands were acquired by the firm more than two years ago.
Partner "A" wishes to exit. The firm revalues its land based on valuation
report from a registered valuer, as defined in rule 11U of the Rules, and as
per that valuation report fair market value of lands "S" and "T" is Rs 70 lakh
each, while fair market value of land "U" is Rs. 50 lakhs. On the exit of
partner "A", the firm decides to give him Rs. 11 lakhs of money and land "U"
to settle his capital balance. Let us assume that the indexed cost of acquisition
of land "U" is Rs. 15 lakhs. (assume no surcharge or cess just for ease of
calculation and illustration purposes)

Answer: Step1: Since Capital Asset, being Land “U” is given on reconstitution of firm,
provisions of section 9B and 45(4), both, shall apply;

Step2: Computation of Capital Gains tax u/s. 9B:

F.M.V. (FVOC) of asset 50,00,000
(-) Indexed Cost 15,00,000
Long Term Capital Gains 35,00,000
Tax @ 20% 07,00,000

Step3: FMV (50 lakhs) – Cost (10 lakhs) – Tax (7 lakhs) = Rs. 33 lakhs
Each partner’s share is 1/3rd. Hence, Rs. 11 lakhs is added to the
capital balance. Capital Balance of A becomes Rs. 10 + 11 = Rs. 21
lakhs

Step 4: Capital Gains u/s. 45(4) = Money + FMV – Capital Balance

11 + 50 - 21
= Rs. 40 lakhs

Step 5: find out the nature of remaining capital assets with the firm
- If remaining capital asset is long term, then the capital gains
calculated in step 4 becomes long term
- If remaining capital asset is short term, or depreciable asset, or
self-generated or no other capital asset, then capital gains of step
4 becomes short term

In the above example, firm is left land “S” & “T”, which are long
term. Hence, the capital gains of step 4 is also regarded as long term;

Step 6: In order to remove or neutralise double taxation, the capital gains

calculated in Step 4, is apportioned to the remaining assets, S & T in the ratio
 of increase in their value due to revaluation. Hence, the book value of each
land was Rs. 10 lakhs. Revaluation is Rs. 70 lakhs. Hence, increase in value of
S & T is by Rs. 60 lakhs each. i.e. 1:1

Therefore, Rs. 40 lakhs, will be apportioned as Rs. 20 lakhs each to S & T.

When S & T are sold, a deduction will be allowed of Rs. 20 lakhs while
calculating capital gains.

Answer: In accordance with the provisions of section 9B of the Act, it would be deemed
that the firm " FR" has transferred land "U" to the partner "A" at its fair
market value of Rs. 50 lakhs. Now on account of the deeming provisions of
section 9B of the Act, it is deemed that the firm "FR" has transferred land "U"
to partner "A". Thus, an amount of Rs. 50 lakhs less Rs. 15 lakhs would be
charged to tax in the hands of firm "FR" under the head "Capital gains". For
partner "A", the cost of acquisition of this land would be Rs. 50 lakhs. Hence,
the amount of Rs. 35 lakh is charged to long term capital gains and let us
assume that the tax is Rs. 7 lakhs.

This, net book profit after tax of Rs. 33 lakhs (capital gains of 40 lakhs
without indexation less tax of Rs. 7 lakhs) is to be credited in the capital
account of each of the three partners, i.e. Rs. 11 lakhs each. Thus partner "A"
capital account would increase to Rs. 21 lakhs. This exercise is required to be
carried out since section 9B of the Act mandates that it is to be deemed that
the firm " FR" has transferred the land " U" to partner "A" and the long-term
capital gains of Rs. 35 lakh is chargeable to tax in the hands of the firm "FR".

As against capital balance of Rs. 21 lakhs, partner "A" has received Rs. 61
lakh Rs. 11 lakhs of money plus land " U" of fair market value of Rs. 50
lakhs). Thus Rs. 40 lakhs is required to be charged to tax under subsection (4)
of section 45 of the Act. This shall be in addition to an amount of Rs. 35 lakhs
charged to tax under section 9B of the Act.

On account of clause (iii) of section 48 of the Act, read with rule 8AB of the
Rules, this Rs. 40 lakh is to be attributed to the remaining assets of the firm
"FR" on the basis of increase in their value due to revaluation based on the
valuation report of registered valuer. In this case as per revaluation there are
only two capital assets remaining; lands "S" and "T". In both cases the value
has increased by Rs. 60 lakh each. Thus, out of Rs. 40 lakhs, Rs. 20 lakhs shall
be attributed to land "S" and Rs. 20 lakhs to land "T".

When either of these lands gets sold, this amount attributed to them would be
reduced from sales consideration under clause (iii) of section 48 of the Act.
 The amount of Rs. 40 lakh which is charged to tax under sub-section (4) of
section 45 of the Act shall be charged as long-term capital gains in view of
sub-rule (5) of rule 8AA of the Rules, since the amount of Rs. 40 lakh is
attributed to land "S" and land "T" which are both long term capital assets at
the time of taxation of Rs. 40 lakhs under sub-section (4) of section 45 of the
Act.

Example 2: There are three partners "A", "B" and "C" in a firm " FR", having one third
share each. Each partner has a capital balance of Rs. 10 lakhs in the firm.
There are three pieces of lands "S", "T" and " U" in that firm and there is no
other capital asset in that firm. All these three lands were acquired by the firm
more than two years ago. Book value of each of the land is Rs. 10 lakhs.
Partner "A" wishes to exit. The firm sells land "U" for its fair market value of
Rs. 50 lakhs. Let us assume that the indexed cost of acquisition of land "U" is
Rs. 15 lakhs. Thus, an amount of Rs. 50 lakhs less Rs. 15 lakhs would be
charged to tax in the hands of firm "FR" under the head "Capital gains".
Hence, the amount of Rs. 35 lakhs is charged to long term capital gains and
let us assume that the tax is 7 lakhs (assume no surcharge or cess just for ease
of calculation and illustration purposes). This, net book profit after tax of Rs.
33 lakhs (capital gains of Rs. 40 lakhs without indexation less tax of 7 lakh) is
to be credited in the capital account of each of the three partners, i.e. Rs. 11
lakhs each. Thus, partner "A" capital account would increase to Rs. 21 lakhs.

Partner "A" decides to exit the firm " FR". The firm revalue its lands " S" and
"T" based on valuation report from a registered valuer, as defined in rule 11U
of the Rules, and as per that valuation report fair market value of lands "S"
and "T" is 70 lakh each. On the exit of partner "A", the firm decides to give
him ~ 61 lakh of money to settle his capital balance. Thus, as against capital
balance of ~21 lakh, partner "A" has received ~61 lakh of money. Thus ~40
lakh is required to be charged to tax under sub-section (4) of section 45 of the
Act. This will be in addition to ~35 lakh already charged to capital gains. On
account of clause (iii) of section 48 of the Act, read with rule 8AB of the
Rules, this Rs. 40 lakh is to be attributed to the remaining assets of the firm
"FR" on the basis of increase in their value due to revaluation based on the
valuation report of registered valuer. In this case as per revaluation there are
only two capital assets remaining; lands "S" and "T". In both cases the value
has increased by ~60 lakh each. Thus, out of ~40 lakh, ~20 lakh shall be
attributed to land "S" and ~20 Lakh to land ''T''. When either of these lands
gets sold, this amount attributed to them would be reduced from sales
consideration under clause (iii) of section 48 of the Act. The amount of~40
lakh which is charged to tax under sub-section (4) of section 45 of the Act
shall be charged as long-term capital gains in view of sub-rule (5) of rule 8AA
of the Rules, since the amount of ~40 lakh is attributed to land "S" and land
 "T" which are both long term capital assets at the time of taxation of Rs. 40
lakhs under sub-section (4) of section 45 of the Act.

Note: The final result in both example I and 2 is same due to the operation of section 9B of
the Act.

Example 3: There are three partners "A", "B" and "C" in a firm "FR", having one third
share each. Each partner has a capital balance of Rs. 100 lakhs in the firm.
There is a piece of land "S" of book value of Rs. 30 lakhs. There is patent "T"
of written down value of Rs. 45 lakhs. And there is cash of Rs. 225 lakhs. The
land was acquired by the firm more than two years ago. The patent was
acquired / developed / registered one year back.

Balance Sheet of Firm FR

Liabilities Rs. in lakhs Assets Rs. in lakhs

Capital Balance Land S 30

A 100 Patent 45

B 100 Cash 225

C 100

Total 300 300

Partner "A" wishes to exit. The firm revalue its land and patent based on
valuation report from a registered valuer, as defined in rule 11U of the Rules,
and as per that valuation report fair market value of land "S" is Rs. 45 lakh
and fair market value of patent "T" is Rs. 60 lakhs. As per the valuation report
there is also self-generated goodwill of Rs. 30 lakhs. On the exit of partner
"A", the firm decides to give him Rs. 75 lakhs in money and land "s" to settle
his capital balance. Let us assume that the indexed cost of acquisition of land
"S" is Rs. 45 lakhs.

Step1: Since the question is based on reconstitution and capital asset is also
given to partner A, provisions of section 45(4) and 9B both shall apply;

Step2: Computation of Capital Gains u/s. 9B:

FVOC (FMV of asset) Rs. 45 lakhs
(-) Indexed Cost Rs. 45 lakhs
Long Term Capital Gains Rs. Nil
Tax Rs. Nil
Step 3: FMV (45) – Cost (30) – Tax (0) shall be distributed to all partners in
PSR = Rs. 15 lakhs in PSR. I/e. Rs. 5 lakhs each. Capital Balance of partner A
shall stand increased to Rs. 105 lakhs (100 + 5)

Step 4: Computation of gains u/s. 45(4)

FMV + Money – Capital Balance = Rs. 45 + 75 – 105 = Rs. 15 lakhs

Step 5: What are the remaining Capital Assets?

Patent (depreciable)
Goodwill (self generated)
Hence, the entire capital gains of step 4 shall be regarded as short term

Step 6: Apportion the capital gains to remaining assets:

Goodwill – Revalued figure – Cost as per books = 30 – 0 = Rs. 30

Patent – Revalued figure – Cost as per books = 60 – 45 = Rs. 15

Hence, the ratio is 2:1

The capital gains of Rs. 15 lakhs shall be distributed as under:

Goodwill – Rs. 10 lakhs
Patent Rs. 5 lakhs

CBDT Answer:
In accordance with the provisions of section 9B of the Act, it would be deemed
that the firm " FR" has transferred land "S" to the partner "A" at its fair
market value of Rs. 45 lakhs. Now on account of the deeming provisions of
section 9B of the Act, it is deemed that the firm " FR" has transferred land "S"
to partner "A". However, since the sale consideration is equal to indexed cost
of acquisition, there will not be any capital gains tax. For partner "A", the
cost of acquisition of this land would be 45 lakhs. The net book profit 15 lakh
(capital gains 15 lakh without indexation) is to be credited in the capital
account of each of the three partners, i.e. Rs. 5 lakh each. Thus partner "A"
capital account would increase to Rs. 105 lakhs. This exercise is required to
be carried out since section 9B of the Act mandates that it is to be deemed that
the firm " FR" has transferred the land "S" to partner "A". Thus, any gain in
the books is to be apportioned to partners' capital accounts. As against
capital balance of Rs. 105 lakh, partner "A" has received Rs. 120 lakhs
(money of 75 Lakhs plus land "S" of fair market value of Rs. 45 lakh). Thus,
Rs. 15 Lakh is required to be charged to tax under subsection (4) of section 45
of the Act.

On account of clause (iii) of section 48 of the Act, read with rule 8AB of the
Rules and this guidance note, this Rs. 15 lakh is to be attributed to the
 remaining capital assets of the firm "FR" on the basis of increase in the value
due to revaluation of existing capital assets, or due to recognition of the value
of self-generated goodwill, based on the valuation report of registered valuer.
In this case as per this report the value of patent 'T " has increased by Rs. 15
lakhs and the self-generated goodwill value has been recognised at Rs. 30
lakhs. Thus, one third on Rs. 15 lakhs (i.e. Rs. 5 lakhs) would be attributed to
patent "T", while two third of Rs. 15 lakhs (i.e. Rs. 10 lakhs) would be
attributed to self-generated goodwill.

Rs. 5 lakhs attributed to patent "T" shall not be added to the block of the
assets and no depreciation shall be available on the same. When patent "T"
gets transferred subsequently, this Rs. 5 Lakh attributed shall be reduced from
the full value of the consideration received or accruing as a result of transfer
of patent "T" by the firm " FR", and the net value shall be considered for
reduction from the written down value of the intangible block under sub-
clause (c) of clause (6) of section 43 of the Act or for calculation of capital
gains, as the case may be, under section 50 of the Act. (Refer guidance in
paragraph 5 of this circular).

Let us say that Patent T is sold for Rs. 25 lakhs. Rs. 5 lakhs shall be reduced
from Rs. 25 lakh and only net amount of 20 lakhs shall be considered for
reduction from the written down value of the intangible block under sub-
clause (c) of clause (6) of section 43 of the Act or for calculation of capital
gains, as the case may be, under section 50 of the Act. Similarly, when
goodwill gets sold subsequently, Rs. 10 lakhs would be reduced from its sales
consideration under clause (iii) of section 48.

The amount of Rs. 15 lakhs which is charged to tax under sub-section (4) of
section 45 of the Act shall be charged as short-term capital gains, as Rs. 5
lakh is attributed to the Patent "T" which is part of block of assets and Rs. 10
lakhs is attributed to self-generated goodwill. In accordance with sub-rule (5)
of Rule 8AA of the Rules, both of these are to be characterised as short-term
capital gains.

Note: For the purpose of calculation of depreciation under section 32 of the

Act, the written down value of the block of asset " intangible" of which Patent
"T" is part, would remain Rs. 45 lakhs and would not be increased to Rs. 60
lakhs due to revaluation during the year.

Further, section 32 of the Act does not allow depreciation on goodwill. If in the given
example "self-generated goodwill" is replaced by "self-generated asset", even then the
depreciation will not be admissible on the amount of Rs. 30 lakhs recognised in valuation. In
this regard it may be highlighted that the above-mentioned provisions, in the immediately
preceding paragraph, are also applicable to "self-generated asset" and since there is no
actual cost to assessee in case of " self-generated asset", depreciation is not allowable under
section 32 of the Act on an asset whose actual cost is nil.