ITAT Chennai – No Capital Gains Tax on amount credited to partner’s current account for reduction in profit-sharing ratio upon admission of a new partner

[ITA No.:1088/CHNY/2025]

Introduction:

In a significant ruling, the Income Tax Appellate Tribunal (ITAT), Chennai has held that the reduction in the profit-sharing ratio (PSR) of an existing partner upon the admission of a new partner in an LLP, does not constitute a transfer of a capital asset under the Income-tax Act, 1961. Accordingly, any amount credited to the current account on account of such reallocation is not liable to capital gains tax in the hands of the partner. The Tribunal further clarified that a mere change in PSR among continuing partners, without any retirement or dissolution of the firm, does not give rise to a taxable transfer.

Facts:

• The assessee was a partner in an LLP, which underwent reconstitution during AY 2017–18 upon admission of a new partner who brought in significant capital contribution. This reconstitution led to a change in the profit-sharing ratios among existing partners. Consequently, the assessee’s PSR was reduced, and an amount was credited to his current account towards the sacrificed share.

• The AO treated the right to receive profits as a capital asset u/s 2(14) and viewed the reduction in PSR as a relinquishment of such right, amounting to a transfer u/s 2(47). Accordingly, the credited amount was treated as consideration for transfer and taxed as STCG. The CIT(A) upheld the AO’s view.

ITAT observation and Ruling

• The ITAT relied on the findings of the decision of Karnataka HC in the case of CIT v. P.N. Panjawani (356 ITR 676), wherein under similar facts it was held as under:

 The Income Tax Act recognises the firm as a distinct legally assessable entity apart from its partners for taxability of income, as evident from Section 2(31), Section 45(1) and (3) of the Act. Section 45(3) applies when a person transfers a capital asset to a firm as capital contribution, taxing the gain in the hands of the partner. Section 45(4) covers cases where the profit arises from transfer of capital assets by way of distribution of capital asset on dissolution of firm, taxing the gain in the hands of the firm.

 The property was owned by the firm, not by the erstwhile partners individually. Upon reconstitution, four new partners were inducted who contributed capital, and the existing partners withdrew equivalent amounts as drawings. The existing partners did not retire from the firm. The inducted partners also became partners in the firm, and the firm continued to own all its assets.

 Since the erstwhile partners did not owned the property, and only experienced a reduction in their PSR, it cannot be said that they transferred their share in the assets of firm in favor of incoming partners and any amount represents the consideration received for such transfer and as such it is liable for Capital gains tax u/s 45 (1) of Act.

• ITAT held as under:
 Mere alteration in the PSR among continuing partners due to induction of a new partner without any retirement or dissolution does not constitute a transfer of a capital asset.

 Partner in an LLP does not hold a defined share in the firm’s assets during its continuance. Therefore, any adjustment in the PSR among the partners does not amount to extinguishment or relinquishment of rights in a capital asset. The amount credited to the partner’s account merely reflects a reallocation of internal profit shares, and not consideration for any transfer. Revaluation of firm assets and corresponding credits to partner’s current account are internal adjustments within the firm, and do not result in any transfer of capital assets from one person to another. Hence, such entries cannot trigger capital gains tax.

 Amendments via section 45(4) and insertion of section 9B (Finance Act, 2021) specifically cover such reconstitution scenarios but apply prospectively from AY 2021–22, and hence are not applicable to the AY in question.

Conclusion:

The ITAT Chennai reaffirmed that mere reduction in a partner’s PSR, in the absence of retirement or transfer of capital asset, does not constitute a taxable transfer under Section 45(1). This ruling aligns with established jurisprudence distinguishing rights in firm profits from ownership in firm assets. Notably, capital gains tax cannot be levied on such reallocation for assessment years prior to AY 2021–22, especially where the transaction is a result of internal reconstitution and not an actual transfer of capital assets.