Direct Tax Alert - CBDT notifies Rule and issues guidelines for taxing specified entity in case of its reconstitution or dissolution

Background

The Finance Act, 2021 revamped the entire scheme of taxation of reconstitution of specified entity¹ by introducing a new section 9B of the Income-tax Act, 1961 (IT Act) and substituting the existing section 45(4) of the IT Act. It also made consequential amendment in section 48 of the IT Act.  

Section 9B of the IT Act provides that whenever a specified person² receives any capital asset or stock in trade or both during a fiscal year (FY) from the specified entity in connection with its dissolution or reconstitution then it shall be deemed that the specified entity has transferred such capital asset or stock-in-trade or both to the specified person during such FY and shall be taxed in the said year either as “Capital Gains” or “Business Income”.

The amended section 45(4) of the IT Act provides that if specified person receives during the FY any money or capital asset or both from the 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 as “Capital gains”. The provision also contains formula for computing profit and gains in such cases.

Section 48(iii) of the IT Act which provides for mode of computation of capital gains, provides that for the transactions governed by section 45(4) of the IT Act, the computation methodology shall be prescribed by Central Board of Direct Taxes (CBDT).

In this regard, recently, CBDT has issued a Notification³ prescribing Rule 8AB as well as amending Rule 8AA of the Income-tax Rules, 1962 (IT Rules) prescribing the manner of attribution of capital gains chargeable under section 45(4) of the IT Act to the remaining capital assets remaining with the specified entity. Simultaneously, with a view to address concerns of various stakeholders, the CBDT also issued a Circular⁴ laying down guidelines for taxing specified entity in terms of section 9B and section 45(4) of the IT Act. We, at BDO in India, have analysed and summarised the said notification and circular and provided our comments on its impact hereunder:

Amendment in Rule 8AA

Type of Capital Asset of specified entity	Type of Capital Gains
Capital Asset which is short term capital asset at the time of taxation under section 45(4) of the IT Act; or	Short-term capital gains
Capital asset forming part of block of assets; or
Capital asset being self-generated asset / goodwill
Any other capital asset not covered above and is long term capital asset at the time of taxation of capital gains under section 45(4)	Long-term capital gains

New Rule 8AB - Attribution of income taxable under section 45(4) to the capital assets remaining with the specified entity

• The attribution of income is tabulated hereunder for ease of reference:

Sr. No.	Particulars	Attribution
1.	Capital gain relates to revaluation of any capital asset or valuation of self-generated asset / goodwill of specified entity*	Capital gains charged under section 45(4) of the IT Act	X	Increase in value of such capital asset because of revaluation or valuation
				Aggregate of increase in, or recognition of, value of all assets because of revaluation or valuation
2.	Capital gain relates only to capital asset received by the partner from the specified entity	No attribution
3.	Capital gain does not relate to any of the above	No attribution

* Revaluation or valuation (as the case may be) should be based on a valuation report obtained from a registered valuer as defined in Rule 11U(g) of the IT Rules.

• Revaluation or valuation (as the case may be) does not entitle the specified entity to claim depreciation on increase in value of such capital asset or recognition of self-generated asset/goodwill.
• Specified entity is required to furnish details of such attribution in the Form No. 5C. This Form is to be furnished electronically on or before the due date of filing income tax return.

Guidelines for the purpose of section 9B and section 45(4) of the IT Act

• Section 9B of the IT Act provides for taxation of income of the specified entity on the transfer of capital assets and stock-in-trade whereas section 45(4) of the IT Act provides for taxation of income in the hands of the specified entity.
• The amount taxed under section 45(4) of the IT Act is required to be attributed to the remaining capital assets of the specified entity so that when such capital gets transferred in the future, the amount attributed to such capital assets gets reduced from the value of the consideration and to that extent the specified entity does not pay tax again.
• However, such attribution is given in the IT Act only for the purposes of section 48 of the IT Act which is applicable to capital assets that are not forming block of assets. For capital assets forming block of assets there is a section 43(6)(C) of the IT Act to determine written down value of the block of asset and section 50 of the IT Act to determine the capital gains arising on transfer of such assets.
• Clarified that in case the capital asset remaining with the specified entity is forming part of a block of asset, the amount attributed to such capital asset under Rule 8AB of the IT Rules shall be reduced from the full value of consideration received or accruing as a result of subsequent transfer of such asset by the specified entity. The net value of such consideration shall be considered for reduction from the written down value of such block under section 43(6)(c) of the IT Act or for calculation of capital gains, as the case may be, under section 50 of the IT Act.  
• Thus, Rule 8AB of the IT Rules shall also apply to capital assets forming block of assets. Further, the term capital asset appearing in Rule 8AB of the IT Rules refers to capital asset whose capital gains is computed under section 48 of the IT Act as well as capital asset forming block of assets.

Illustration

For the better understanding of the provision, the guidelines contain following three examples:

1. There are three partners “A”, “B” and “C” in a firm having one-third share each. The details prior to reconstitution are tabulated below:

Liabilities	Amount	Assets	Amount (in millions)
Partner’s Capital		Land
A	1	S	1
B	1	T	1
C	1	U	1
Total	3	Total	3

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• All these 3 lands were acquired by the firm more than two years ago i.e. Long term in nature
• Partner A wishes to exit. The firm decides to settle his capital balance by giving him INR 1.1 million of money and land “U”. The FMV of all three lands are as under:
  • S – INR 7 million
  • T – INR 7 million
  • U – INR 5 million

Tax implication under section 9B of the IT Act

Particulars	Amount
Transfer of Land “U” at FMV to partner “A” by firm	5.0
Indexed cost of acquisition (assumed)	1.5
Long term capital gains chargeable under section 9B of the IT Act in hands of the firm	3.5
Capital gains tax payable by the firm (without surcharge and cess for simplicity)	0.7

For partner “A”, the cost of acquisition of land “U” shall be INR 5 million.

• The firm shall recognise profits on distribution of land “U” to partner “A” in the same manner as firm would have transferred such land in favour of an outsider. The net book profit after tax of INR 3.3 million (capital gains of INR 4 million without indexation less tax of INR 0.7 million) is to be credited in the capital account of each of the three partners, i.e. INR 1.1 million each. Thus, partner “A” capital account would increase to INR 2.1 million.

Tax implication under section 45(4) of the IT Act.

Formula: A= B+C-D

(INR in millions)

Particulars	Amount
B- Money received by partner from firm	1.1
C- FMV of capital asset received by partner from firm	5.0
D- Capital account balance of Partner “A”	2.1
A- Capital gains chargeable to income-tax under section 45(4)	4.0*

*In addition to an amount of INR 3.5 million charged to tax under section 9B of the IT Act.

Attribution in accordance with clause (iii) of section 48 of the IT Act read with Rule 8AB of the IT Rules

Remaining Assets	Book value	Increase	Ratio	Attribution of capital gains charged under section 45(4)
Land S	1	6 (7-1)	50%	2
Land T	1	6 (7-1)	50%	2
	2	12		4

Thus, out of INR 4 million, INR 2 million shall be attributed to land “S” and land “T” each. When either of these lands get sold, this amount attributed to them would be reduced from sales consideration under clause (iii) of section 48 of the IT Act.

• The amount of INR 4 million which is charged to tax under section 45(4) of the IT Act shall be charged as long term capital gains in view of Rule 8AA(5) of the IT Rules, since the amount of INR 4 million is attributed to Land “S” and Land “T” which are both long term capital assets at the time of taxation of INR 4 million.

2. In example 2, everything is same except the fact that in this case, Land “U” is transferred to an outsider instead of Partner “A” and Partner “A” receives INR 6.1 million as settlement money. In example 2, section 9B of the IT Act is not applicable. The normal capital gains tax provisions are applicable at the time of sale of capital asset by the firm to an outsider.

3. There are three partners “A”, “B” and “C” in a firm having one-third share each. The details prior to reconstitution are as below:

                                                                                                                        (INR in millions)

Liabilities	Amount	Assets	Amount
Partner’s Capital		Land S	3.0
A	10.0	Patent T	4.5
B	10.0	Cash	22.5
C	10.0	Self-generated goodwill	0
Total	30	Total	30

• The land was acquired by the firm more than 2 years ago.
• The patent was acquired/developed/registered 1 year back. 
• Partner A wishes to exit. The firm decides to settle his capital balance by giving him INR 7.5 million of money and land “S”. The FMV land and patent is as under:
  • Land S – INR 4.5 million
  • Patent T – INR 6 million

Tax implication under section 9B of the IT Act

Particulars	Amount
Transfer of Land “S” at FMV to partner “A” by firm	4.5
Indexed cost of acquisition (assumed)	4.5
Long term capital gains chargeable under section 9B of the IT Act in hands of the firm	0
Capital gains tax payable by the firm (without surcharge and cess for simplicity)	0

For partner “A”, the cost of acquisition of land “S” shall be INR 4.5 million.

• The firm shall recognise profits on distribution of land “S” to partner “A” in the same manner as firm would have transferred such land in favour of an outsider. The net book profit after tax of INR 1.5 million (FMV of INR 4.5 million less book value of INR 3 million) without indexation is to be credited in the capital account of each of the three partners, i.e. INR 0.5 million each. Thus, partner “A” capital account would increase to INR 10.5 million.

Tax implication under section 45(4) of the IT Act

Formula: A= B+C-D

Particulars	Amount
B- Money received by partner from firm	7.5
C- FMV of capital asset received by partner from firm	4.5
D- Capital account balance of Partner “A”	10.5
A- Capital gains chargeable to income-tax in the hands of firm under section 45(4) of the IT Act	1.5

 

Attribution in accordance with clause (iii) of section 48 of the IT Act read with Rule 8AB of the IT Rules

Remaining Assets	Book value	Increase	Ratio	Attribution of capital gains charged under section 45(4)
Patent T	4.5	1.5 (6.0-4.5)	33.3%	0.5
Self-generate goodwill	0	3 (3-0)	66.6%	1
		4.5		1.5

 

Thus, out of INR 1.5 million, INR 0.5 million shall be attributed to Patent “T” and INR 1 million shall be attributed to self-generated goodwill. INR 0.5 million attributed to Patent “T” shall not be added to block of assets and no depreciation shall be available on the same. When Patent “T” gets transferred subsequently, this INR 0.5 million shall be reduced from full value of consideration and net consideration shall be reduced from WDV of block of intangible assets. Assuming if Patent “T” is sold for INR 2.5 million, INR 0.5 million shall be reduced from INR 2.5 million and balance net consideration of INR 2 million shall be reduced from WDV of block of intangible assets. Similarly, when goodwill is sold subsequently, INR 1 million would be reduced from its sales consideration under section 48(iii) of the IT Act.

Further, in view of Rule 8AA(5) of the IT Rules, the amount of INR 1.5 million shall be chargeable as short-term capital gains since it is attributed to Patent (INR 0.5 million) and goodwill (INR 1 million) which are forming block of assets.

BDO comments

The newly inserted rule will provide a clarity to the taxpayer on the methodology for attributing income and determination of capital gains in the hands of the specified entity. Further, the clarification provided by way of an example will help the taxpayer in understanding the methodology of computing the tax liability.

While the amendments in section 45(4), section 9B and section 48(iii) of the IT Act are effective from 1 April 2021, the Notification is silent on its effective date. Hence, the applicability of Rule 8AB for the transaction undertaken during the period 1 April 2020 and 1 July 2021 could be litigative.