Andhra Pradesh H.C : the closing stock of the firm should be evaluated at cost price for the purpose of determination of income notwithstanding the closure of business by the partnership firm and take over of the business by an independent legal entity, viz., the company

High Court Of Andhra Pradesh

CIT vs. Hansa Footwear

Section : 170

Madan B. Lokur, Cj.And Sanjay Kumar, J.

IT Appeal No. 36 Of 1999

December 26, 2011

JUDGMENT

Madan B. Lokur, CJ. – The substantial question of law framed for our consideration is as follows :

“Whether, on the facts and circumstances of the case, the Appellate Tribunal was correct in holding that the closing stock of the firm should be evaluated at cost price for the purpose of determination of income notwithstanding the closure of business by the partnership firm and take over of the business by an independent legal entity, viz., the company ?”

2. The assessee was in the business of manufacturing footwear. It was initially a partnership firm but subsequently it got converted into a private limited company in accordance with Chapter IX of the Companies Act, 1956. All the partners became shareholders in the company and their respective shareholding was in the same proportion as in the partnership firm.

3. The assets of the partnership firm, i.e., footwear, was taken over by the company and the question that arose before the Assessing Officer was whether the closing stock of the partnership firm should be taken at market value or not. According to the assessee, the closing stock should be taken at the cost price and not at the market value.

4. The Assessing Officer came to the conclusion that the closing stock should be taken at the market value and passed an assessment order accordingly.

5. Before the Commissioner of Income-tax (Appeals), the assessee was not able to succeed and accordingly the assessment order was confirmed by the Commissioner of Income-tax (Appeals).

6. In a further appeal, the Income-tax Appellate Tribunal (for short, “the Tribunal”) decided in favour of the assessee and came to the conclusion that there was no transfer of assets and, therefore, the provisions of section 170 of the Income-tax Act, 1961 (for short, “the Act”) were not applicable inasmuch as there was no capital gain in so far as the assessee is concerned.

7. Section 170(1) of the Act deals with succession to business otherwise than on death and reads as follows :

“170. (1) Where a person carrying on any business or profession (such person hereinafter in this section being referred to as the predecessor) has been succeeded therein by any other person (hereinafter in this section referred to as the successor) who continues to carry on that business or profession,-

(a) the predecessor shall be assessed in respect of the income of the previous year in which the succession took place up to the date of succession ;

(b) the successor shall be assessed in respect of the income of the previous year after the date of succession.”

8. The question of determining capital gains would be referable to section 45 of the Act read with section 47 of the Act.

9. The issue appears to have come up for the first time under the provisions of the Indian Income-tax Act, 1922, when the Supreme Court dealt with the succession of a business from the “transferor” to the “transferee”. In CIT v. K. H. Chambers [1965] 55 ITR 674 (SC) the export business of the father was taken over by the son. The entire business was transferred and the identity of the business was preserved inasmuch as the same business continued. The Supreme Court recognised that succession involves change of ownership, that is, the transferor goes out and transferee comes in ; it connotes that the whole business is transferred, and that substantially the identity and continuity of the business is preserved. In a transfer of business, an arrangement between the transferor and transferee in respect of some of the assets and liability, not with a view to enable the transferor to run a part of the business transferred but to enable the transferee to run the business unhampered by the load of debts or for any other appropriate collateral purpose, cannot detract from the totality of the succession.

10. In this backdrop, the Supreme Court interpreted section 25(4) of the Indian Income-tax Act, 1922, and held that the tests of change of ownership, integrity, identity and continuity of a business have to be satisfied before it can be said that a partner has succeeded to the business of another.

11. Following the decision of the Supreme Court, the Kerala High Court in CIT v. S. Koder [1998] 233 ITR 620 came to the conclusion, based on the facts of that case, that the assets and liabilities of the erstwhile firm were taken over by the company with the same persons as shareholders. Therefore, it was a case of succession of business in its entirety by another entity. Consequently, the question whether the assessee-firm, upon the transfer of its business to a limited company, was obliged to value the stocks as per the market value was answered in the negative.

12. We find from a perusal of CIT v. Texspin Engg. & Mfg. Works [2003] 263 ITR 345/129 Taxman 1 (Bom.) that there is a far more elaborate discussion on the subject taking into consideration the provisions of section 45 of the Act as well as the provisions of Chapter IX of the Companies Act. In this decision, the Bombay High Court noted that section 45(4) of the Act provides for two conditions to be satisfied, namely, that there must be a transfer of assets by way of distribution and, secondly, such transfer should be on dissolution of the firm or otherwise. If these two conditions are satisfied, then for the purposes of computation of capital gains under section 48 of the Act, the market value on the date of transfer shall be deemed to be the full value of the consideration received or accruing as a result of the transfer.

13. On the facts of that case, it was noted that there was no dispute that the erstwhile firm became a limited company under Chapter IX of the Companies Act. The assets of the erstwhile firm vested in the company and as such there was no transfer of assets by way of distribution. The Bombay High Court noted the difference between vesting of property and distribution of property. On conversion of a partnership firm into a company under Chapter IX of the Companies Act, the assets and property of the erstwhile firm vest in the company. On the other hand, distribution or appropriation takes place when the provisions of Chapter IX of the Companies Act are not applicable, such as in a case of dissolution of the firm which presupposes division, realisation, encashment of assets and appropriation of the realised amount. The Supreme Court also made a note of the insertion of clause (xiii) in section 47 of the Act. This sub-section was inserted by the Finance (No. 2) Act, 1998, and although the court was not concerned with the amendment (nor are we concerned with the amendment), it was noted that the amendment provides a clue to the legislative intent with the purpose of encouraging firms to become limited companies.

14. In view of the elaborate discussion undertaken by the High Court, it was held that the Tribunal in that case was justified in holding that the provisions of section 45(1) and 45(4) of the Act were not attracted even though there was a “transfer” of assets from the firm to a newly constituted company on conversion of the firm to a company under Chapter IX of the Companies Act.

15. The view expressed by the Bombay High Court was followed in CIT v. Rita Mechanical Works, which is an unreported decision but is available as “MANU/PH/3828/2010” decided on September 24, 2010, by the Punjab and Haryana High Court. The High Court took the view that in a case where a firm is converted into a company under Chapter IX of the Companies Act, there is no conveyance of property in favour of the limited company and there is only vesting of property in that company. Accordingly, the Punjab and Haryana High Court took the view that the Tribunal was right in holding that taking over of assets of the firm by the company and allotting shares to the erstwhile partners of the firm as per their holdings in the firm did not give rise to profit chargeable to capital gains under section 45(4) of the Act.

16. In so far as the present appeal is concerned, the facts of the case indicate that the firm was converted into a private limited company under Chapter IX of the Companies Act. The shareholding of the erstwhile partnership firm remained the same upon conversion of the firm into a company. Effectively, there was no transfer of assets of the firm to the company. It is only that the business was taken over by the company. That being the position and on the basis of the case law that we have already referred to above, it is quite clear that the closing stock of the erstwhile firm cannot be valued at the market price.

17. Under the circumstances, the Tribunal was correct in coming to the conclusion that both the Assessing Officer as well as the Commissioner of Income-tax (Appeals) had erroneously decided that the closing stock of the erstwhile firm should be valued at the market price.

18. Under the circumstances, the substantial question of law is answered in the affirmative, in favour of the assessee and against the Revenue.

19. The appeal stands disposed of on the above terms.

[Citation : 344 ITR 30]

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