By CA Surekha Ahuja
A Critical Commentary with Tax Planning Guidance on Reconstitution Events in Partnership Firms
Introduction
Reconstitution in a partnership firm—whether through partner retirement, introduction of a new partner, or reshuffling of capital interests—has become a carefully scrutinized event under the Income-tax Act, 1961.
The Finance Act, 2021 fundamentally altered the tax consequences of such events through the introduction of Section 9B and substitution of Section 45(4), forming a dual-layered taxing mechanism for transactions involving money or capital asset payouts upon reconstitution of a firm.
This note provides a comprehensive legal and tax analysis of such transactions, particularly focusing on situations where the firm undertakes a revaluation of assets prior to partner exit and where capital settlements exceed book value. The analysis includes judicial guidance, CBDT circulars, and embedded strategic structuring ideas.
Provisions Governing the Transaction
Section 45(4) – Capital Gains on Reconstitution Events
As amended by the Finance Act, 2021, Section 45(4) taxes the firm when a partner (specified person) receives money or capital assets or both upon reconstitution, and such receipt exceeds their capital account balance (excluding revaluation or self-generated goodwill).
Capital Gains = A – B,
where
A = Money received + FMV of capital asset received, and
B = Capital account balance (excluding revaluation and goodwill)
This is a deemed transfer, and the resulting capital gain is taxable in the hands of the firm.
Section 9B – Deemed Transfer of Capital Asset or Stock-in-Trade
Section 9B creates a deemed transfer when the firm distributes a capital asset or stock-in-trade to a partner at the time of reconstitution.
The firm shall be taxed on the FMV of the asset transferred on the date of such event.
Section 9B applies independently of Section 45(4), and both can be triggered in the same transaction, potentially leading to double taxation unless managed carefully.
Section 45(3) – Contribution of Capital Asset by Partner
This section applies when a partner introduces a capital asset into the firm. The transfer is taxable in the hands of the partner, with the FMV on the date of contribution deemed as consideration.
This provision is relevant at the time of formation or capital expansion, not during exit.
CBDT Circular No. 14/2021 – Implementation Guidelines for Sections 45(4) and 9B
This circular is crucial for interpreting computation mechanics, particularly:
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Revaluation gains are to be excluded while computing the capital account balance under Section 45(4)
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Sections 45(4) and 9B operate independently
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Double taxation is permissible under both provisions, subject to adjustment rules under Rule 8AB
Application to Practical Scenarios
Scenario 1: Retirement with Revaluation and Payout from Firm
If a partner retires and the firm has revalued its land/building just prior to retirement, the capital account balance reflects the increased value. However, Section 45(4) requires ignoring such revaluation.
If the payout exceeds the original capital balance (without revaluation), then the firm is taxed on the differential amount as capital gains.
Key Point: Revaluation increases do not shield the firm from tax under Section 45(4).
This is especially critical in real estate-rich firms where revaluation uplift is significant but results in notional gain with real tax liability.
Scenario 2: Distribution of Capital Asset to Retiring Partner
If the firm settles the retiring partner’s dues by transferring land or building, the following apply:
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Section 9B: Deemed transfer by the firm, capital gain computed on FMV – indexed cost
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Section 45(4): If FMV + cash paid exceeds capital account balance (excluding revaluation), additional capital gains taxed in firm’s hands
This leads to dual taxation unless carefully structured and staggered.
Tax Complexity: The firm is taxed on both the deemed transfer (Section 9B) and deemed reconstitution gain (Section 45(4))
Scenario 3: Incoming Partner Pays Retiring Partner Directly
If the incoming partner pays the outgoing partner directly, and the firm is not involved in the payout, then:
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Section 45(4) is not attracted as there is no payment from the firm
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Section 9B is not triggered as the firm is not distributing any asset
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Outgoing partner is taxed under Section 45 on capital gains arising from transfer of partnership interest
Tax Efficiency: This structure is more tax-neutral for the firm, and tax liability arises only in the hands of the retiring partner
Note of Caution: The transaction must have commercial substance. If the firm’s reconstitution is merely a façade to route payment through a new partner, GAAR principles may be invoked.
Judicial and Administrative Guidance
Mohanbhai Pamabhai v. CIT [1973] 91 ITR 393 (Guj) / 165 ITR 166 (SC)
Held that partner’s retirement does not amount to a transfer if no asset is received. However, the new deeming fiction under Section 45(4) overrides this in case of post-2021 transactions.
Dynamic Enterprises v. CIT [2013] 359 ITR 83 (Karnataka HC)
Supported the view that retirement is not a transfer unless capital assets are transferred. Again, no longer applicable post-insertion of Section 9B and amended 45(4).
CBDT Circular No. 14/2021
Clarifies that revaluation of assets is ignored for computing capital account under Section 45(4), and that Section 9B and 45(4) apply independently, which may result in dual capital gains taxation.
Strategic Structuring and Tax-Saving Guidance
Avoid Revaluation Before Partner Exit
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Do not revalue assets immediately before retirement
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Such revaluation is tax-ignored but increases settlement, resulting in tax without real gain
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Keep capital accounts unrevalued for Section 45(4) computation
Prefer Incoming Partner to Pay Retiring Partner Directly
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Keeps the firm tax-neutral
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Retiring partner taxed under capital gains on transfer of partnership interest
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Ensure proper valuation and commercial rationale to avoid anti-avoidance scrutiny
Cap the Settlement to Original Capital + Retained Profits
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Payout from the firm must not exceed the original capital account balance, excluding any revaluation uplift
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Settling only the legitimate capital + accumulated reserves avoids Section 45(4) exposure
If Asset Must Be Transferred – Sequence Carefully
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Stagger events to avoid triggering both Section 9B and 45(4) in the same year
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Alternatively, use a combination of partial cash settlement and deferred compensation to spread tax impact
Document All Valuations and Agreements Meticulously
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Maintain evidence-based valuations for property and business interests
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Clearly document capital account balances, reconstitution deeds, and exit terms
Concluding Observations
Post-2021, the tax treatment of partner exit, reconstitution, and capital restructuring has shifted from being form-driven to substance-driven and value-linked.
Sections 45(4) and 9B are powerful anti-abuse provisions aimed at taxing notional or disguised gains through revalued payouts or asset distributions. However, they also risk taxing legitimate business settlements unless planned with precision.
The guiding principle for tax practitioners and business advisors must be:
Minimise asset-based payouts by the firm,
Avoid revaluation just prior to exit,
Wherever possible, structure exits as direct settlements between partners,
And document everything in line with the current law and commercial substance.
Key References
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Income-tax Act, 1961: Sections 45(3), 45(4), 9B, 10(2A), 48(iii)
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Rule 8AB, CBDT Circular No. 14/2021
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Mohanbhai Pamabhai, Dynamic Enterprises, McDowell & Co. v. CTO
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Relevant sections of Indian Partnership Act, 1932 for defining rights and reconstitution procedures
