Income-tax---

----Income---Income or capital---Firm---Partner---Amount received by partner on account of reduction of his share in firm---Capital receipt.

It is well-settled that when the shareholding of an assessee in any partnership business gets reduced, that reduction without any special features would reflect impairment in his capital asset.

The assessee was a partner in a firm. The firm originally consisted of four partners. In December, 1970, there was a reconstitution of the firm. As a result, the assessee's share in the firm was reduced from 36 per cent. to 5 per cent. The assessee received compensation of Rs.2,05,000 in lieu of reduction of his 31 per cent. share in profit in the reconstituted firm. The compensation was paid by the newly admitted adult partners. The Income-tax Officer held that this sum constituted a revenue receipt but the Appellate Assistant Commissioner and the Tribunal held that it was a capital receipt. On a reference:

Held, that because of the reduction of the share of the assessee in the reconstituted firm from 36 to 5 per cent. the trading structure of the assessee was impaired. There was no material on record to show that the assessee was carrying on the business of entering into partnership business and then walking out from such partnerships. Hence, the compensation received by the assessee was a capital receipt.

Kettlewell Bullen & Co. Ltd. v. CIT (1964) 53 ITR 261(SC) fol.

CIT v. Gangadhar Baijnath (1972) 86 ITR 19 (SC) distinguished.

CGT v. Chhotalal Mohanlal (1987) 166 ITR 124 (SC) and CIT v. Nandiniben Narottamdas (1983) 140 ITR 16 (Guj.) ref.

BJ. Shelat, Advocate instructed by M.R. Bhatt of R.P. Bhatt & Co. for the Commissioner.

K.C. Patel for the Assessee.

JUDGMENT

S.B. MAJMUDAR, J.---In this reference at the instance of the Revenue the Income-tax Appellate Tribunal has referred for our opinion the following question:

"Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in law in holding that the amount of Rs.2,05,000 received by the assessee from the individuals admitted as partners in the firm of M/s. Bharat Salt and Industrial Works, Bhavnagar, was received in lieu of reduction in the assessee's interest in the said firm and that, therefore, it constituted a capital receipt?"

The factual matrix leading to this reference projects the following picture. The assessee is an individual. The assessment year is 1971-72 corresponding to Samvat year 2026, which was spread over from November 10, 1969 to October 30, 1970. Originally, there were four partners in the firm of Bharat Salt and Industrial Works for the accounting years 1964-65 to 1970-71. They comprised the assessee, Dhirajlal Madhavji, Harkishan Ratilal and Gunvantal Madhavji. Harkishan Ratilal retired from the firm at the end of the year of account relevant to the assessment year 1970-71 Thus, at the beginning of the year of account relevant for the present case, i.e., assessment year 1971-72, there remained three partners in the said firm, viz. the assessee, Dhirajlal Madhavji and Gunvantal Madhavji. The year of account relevant to the next assessment year, viz.,1972-73 was Samvat year 2027 which commenced on October 31, 1970 and ended on October 19, 1971. The share ratio of the three partners at the commencement of the said accounting year was as follows:--

There was a change in the constitution of the said firm with effect from December 3, 1970. Gunvantlal Madhavji retired from the firm and seven new partners were admitted. Further, two minors were also added to the business of the partnership. As a result of the reconstitution of the firm, the assessee's share in the profit and loss in the reconstituted firm was reduced from 36 per cent. to 5 per cent. A deed of partnership, dated February 9, 1971, was executed giving effect to the newly constituted partnership from December 31, 1970. As per the relevant clauses of the said partnership deed, the assessee received compensation in lieu of reduction of his 31 per cent. share in profit in the reconstituted firm of an amount of Rs. 2,05,000. The compensation was paid by the newly admitted adult partners.

The Income-tax Officer who had to frame assessment regarding the assessee's returned income for the relevant year, issued a show-cause notice to the assessee to show cause why the receipt of Rs. 2,05,000 should not be brought to tax as a revenue receipt. The Income-tax Officer, in that connection, relied upon a decision of the Supreme Court in the case of CIT v. Gangadhar Baijnath (1972) 86 ITR 19). The assessee resisted this attempt on the part of the Income-tax Officer by contending that the said decision had no application to the facts of the present case and that compensation which the assessee had received was a capital receipt and was not taxable as a revenue receipt. That he was paid this amount on account of reduction of his share in the reconstituted firm from 36 per cent. to 5 per cent. which also included reduction of share in the goodwill and leasehold rights. The Income-tax Officer, however, repelled these contentions and treated this amount as a revenue receipt in the hands of the assessee and framed the assessment accordingly.

The assessee carried the matter in appeal before the Appellate Assistant Commissioner. The Appellate Assistant Commissioner, agreeing with the view of the assessee, held that the receipt of Rs.2,05,000 by the assessee was on account of reduction of his share in the profit from the partnership to the extent of 31 per cent. and for giving up his share in the goodwill and other benefits in the firm. It was, therefore, held by the Appellate Authority that this amount cannot be treated as a revenue receipt. In this connection, the Appellate Assistant Commissioner noted that there was no material on record to show that it was the assessee's business to become a partner in partnership concerns and consequently, this amount cannot be treated as income of a revenue nature in the hands of the assessee.

The Revenue carried the matter in further appeal to the Tribunal. The Tribunal concurred with the view of the Appellate Assistant Commissioner and dismissed the appeal. It is thereafter at the instance of the Revenue that the aforesaid question has been referred for our opinion.

We may mention at the outset certain relevant facts in the background of which this question will have to be answered. For the year of account spreading from November 10, 1969 to October 30, f970, the assessee had earned profit at the rate of 36 per cent. by way of his share from the firm's working. That amount is already brought to tax by the Income-tax Officer as seen from the computation of income by the Income-tax Officer in the Assessee's case at serial No. 2 dealing with the share from Bharat Salt and Industrial Works, being Rs.11,952. Therefore, when, in the next year, the assessee rejoined the reconstituted firm which started its business from December 3, 1970, his share in the reconstituted firm got reduced from 36 per cent. to 5 per cent. That reduction clearly indicated that there was impairment in his capital asset to the extent of 31 per cent. In lieu thereof, he was paid compensation of Rs.2,05,000, which is the disputed amount. Thus, the share in the partnership firm which was an income-yielding asset got reduced to that extent. The compensation for the same would, therefore, partake of the character of a capital receipt in the hands of the assessee. It has to be kept in view that it is not the case of the Revenue and there is no material on record also to show that the assessee was carrying on the business of entering into partnership business and then walking out from such partnerships by carrying various amounts as consideration for walking out of such businesses and was again ploughing back these amounts which he received to join such transaction by entering into further partnerships. In short, the compensation which the assessee received for reduction of his share in the partnership business was never utilised by the assessee as stock-in-trade for his business as an adventurer entering into a number of partnerships for that very purpose.

It is in the background of these facts that the stand of the Revenue placing reliance on the decision of the Supreme Court in Gangadhar' s case (1972) 86 ITR 19) will have to be appreciated. In that case, the Supreme Court was concerned with an assessee, a firm, which consisted of three partners (the Baglas). The assessee carried on business of financing. money-lending, selling agencies and the like pursuits. The assessee was the selling agent of the Swadeshi Cotton Mills Co. Another firm consisting of three partners (the Jaipurias) enjoyed some quota rights in that company. On April 29, 1946, the Baglas representing the assessee firm formed a new firm BJ. & Co. with the Jaipurias. No deed was executed. The Baglas and the Jaipurias were to invest equal amounts to acquire the shares in the Awadeshi Cotton Mills Co. and enjoy the selling agency and quota rights jointly. On July 16, 1946, Swadeshi Cotton Mills Co. appointed BJ. & Co., as its managing agents for a period of twenty years. Thereafter, the partners of the assessee firm retired from the business of BJ. & Co., with effect from October 6, 1964 receiving from the Jaipurias, in addition to their capital investment and interest thereon, a sum of Rs.35,01,000 on account of compensation for surrendering their interest in B.J.? & Co. It was found by the Tribunal that the compensation was partly for the \surrender of the share in the managing agency rights, partly for giving up their selling agency rights, partly for their share in the goodwill and partly for their share of the profits in the firm for the period April 29 to October 5, 1946, but there was no material on which the compensation could be allocated to the several rights. It was also found that the assessee-firm thereafter continued to carry on various business activities and, with the aid of the sum of Rs.35,01,000 received as compensation, acquired the controlling shares in two other companies. BJ. & Co. also continued to be the managing agents of the Swadeshi Cotton Mills Co. In the light of the aforesaid peculiar facts before them, the Supreme Court came to the conclusion that the amount of Rs.35,01,000 constituted business income of the assessee firm in the course of its diverse business of financing, money lending and selling agencies and, therefore, that amount can be treated as business income assessable under section 10. The peculiar facts noted by the Supreme Court in the aforesaid case for reaching this conclusion may be enumerated as under:

(1)??????? There was no deed of partnership which had been entered into between the Baglas and the Jaipurias when they constituted the new firm BJ. & Co.

(2)??????? The partnership was terminable at will and the possibility of the termination of the partnership was inherent in the very course of business.

(3)??????? The assessee firm had various business activities and to join BJ. & Co. was only one such activity.

(4)??????? By walking out of BJ. & Co. the assesee' s business trading structure was not affected. The firm merely replaced one trading activity by another.

(5)??????? By surrender of rights of the partners as representing the assessee's firm in BJ. & Co. in favour of other partners on obtaining certain payment for surrendering these rights, the contract of the assessee firm with the remaining partners of BJ. & Co. got cancelled. Such contract of the assessee firm was entered into in the ordinary course of its business.

(6)??????? Such contracts were liable in the ordinary course of business to be altered or terminated on terms and any payment received in settlement of the right as a result of the termination of the contract really represented profits which the assessee would have made had the contract been performed.

In the light of these facts, the Supreme Court took the view that the entire sum of Rs.35,01,000 received by the assessee firm was a business receipt assessable under section 10. In this connection, the Supreme Court had also taken into consideration the ratio of the earlier decision of the Supreme Court in the case of Kettlewell Bullen & Co Ltd. v. CIT (1964) 53 ITR 261, 282). It has been observed in connection with the said decision that the Court, after considering various decisions rendered by the Courts in U.K. and in this country about the principles which govern the determination of the nature of compensation received on the termination of an agency, had observed (at page 28 of 86 ITR):

"On an analysis of these cases which fall on two sides of the dividing line, a satisfactory measure of consistency in principle is disclosed. Where, on a consideration of the circumstances, payment is made to compensate a person for cancellation of a contract which does not affect the trading structure of his business, nor deprive him of what in substance is his source of income, termination of the contract being a normal incident of the business, and such cancellation leaves him free to carry on his trade (free from the contract terminated); the receipt is revenue; where by the cancellation of an agency, the trading structure of the assessee is impaired, or such cancellation results in loss of what may be regarded as the source of the assessee's income, the payment made to compensate for cancellation of the agency agreement is normally a capital receipt."

It is easy to visualise that the aforesaid decision of the Supreme Court in Gangadhar' s case (1972) 86 ITR 19) proceeds on its own peculiar facts as indicated hereinabove. None of these distinguishing features for treating the amount in the hands of the assessee as business income or as a revenue receipt exists in the present case. On the contrary, the only evidence on record is to the effect that the assessee, during all earlier years, was having 36 per cent. share in profits in the old firm which got reduced to 5 per cent. In the reconstituted firm which was to function in the next year and for giving up his 31 per cent. share, the assessee got compensation of Rs. 2,05,000. In the absence of any other distinguishing features which were found to exist in Gangadhar' s case (1972) 86 ITR 19 (SC), it becomes obvious that such receipt would be capital receipt representing compensation or consideration for impairment of his income-yielding asset suffered by the assessee when his share got reduced from 36 per cent. to 5 per cent. It is now well-settled that even when the shareholding of an assessee gets reduced in any partnership business, that reduction without any special features as were noted by the Supreme Court in Gangadhar' s case (1972) 86 ITR 19), would reflect impairment in his capital asset, meaning an income yielding apparatus which he had with him prior to such reduction. In the case of CGT v. Chhotalal Mohanlal (1978) 166 ITR 124), the Supreme Court took the view, reversing the decision of this Court that when the share of a partner was reduced from 5 per cent to 4 per cent. and two minor sons of his were inducted into the partnership, it would amount to a gift by the partner in favour of the incoming partners as allotment of share would reflect reduction in the light of getting money value of the goodwill and it would amount to gift under the Gift-tax Act. The aforesaid decision of the Supreme Court proceeds on the basis that such reduction in the share capital of a partner does imply impairment of a capital asset or reduction in a capital asset. A similar -view was taken by this Court in CIT v. Nandiniben Narottamdas (1983) 140 ITR 16). P.D. Desai, J., speaking for this Court, while interpreting section 60 of the Act, had to consider the effect of relinquishment of share in a partnership business by a partner. The following observations were made in that connection (at page 28):

"The right to receipt profits and to contribute to losses of the two firms in question constituted the income-producing apparatus or asset and once that stood transferred by way of gift to the beneficiaries, section 60 cannot be invoked."

We, therefore, fully concur with the reasoning of the Tribunal that, on the peculiar facts of this case, the ratio of the decision of the Supreme Court in Gangadhar' s case (1972) 86 ITR 19) cannot be pressed into service by the Revenue. On the contrary, the ratio of the earlier decision of the Supreme Court in Kettlewell' s case (1964) 53 ITR 261) would squarely get attracted. As noted earlier, Kettlewell' s case (1964) 53 ITR 261 (SC) has been noted by the latter decision of the Supreme Court in Gangadhar' s case (1972) 86 ITR 19). However, it-would be profitable to have to look at the said decision to highlight the aforesaid conclusion of ours in the light of the present fact situation. In Kettlewell' s case (1964) 53 ITR 261 (SC) the assessee-firm was formed with the object of carrying on the business of managing agencies and it was the managing agent of six companies including the Fort William Jute Co. The Fort William Jute Co. was thus one of the managed companies of the assessee. The assessee-company entered into an arrangement with one Mugneeram Bangur &, Company. Under the arrangement, the latter agreed (i) to purchase the entire holding of shares of the appellant in Fort William Jute Co., the managed company, (ii) to procure repayment of all loans made by the appellant to that managed company, and (iii) to procure that the managed company will compensate the appellant for loss of office by the payment of the sum of Rs.3,50,000 after the appellant-company resigned its managing agency' and reimburse that amount to the managed company. The appellant-company tendered its resignation of the managing agency and received the sum of Rs.3,50,000. The question was whether the aforesaid amount received by the appellant-assessee-company to relinquish its managing agency of the managed company was a revenue receipt liable to tax. Answering this question in the negative, J. C. Shah, J., speaking for the Supreme Court, made the following pertinent observations (headnote):

"The arrangement with Mugneeram Bangur & Co. was not in the nature of a trading transaction but was one in which the appellant parted with an asset of an enduring value. What the assessee was paid was to compensate it for loss of a capital asset and was not, therefore, in the nature of a revenue receipt. It mattered little that the appellant did continue to conduct the remaining managing agencies after the determination of its agency with the Fort William Jute Co.

Where payment is made to compensate a person for cancellation of a contract which does not affect the trading structure of his business or deprive him of what in substance is his source of income, termination of the contract being a normal incident of the business, and such cancellation leaves him free to carry on his trade (freed from the contract terminated), the receipt is revenue; where by the cancellation of an agency, the trading structure of the assessee is impaired, or such cancellation results in loss of what may be regarded as the source of the assessee's income, the payment made to compensate for cancellation of the agency agreement is normally a capital receipt."

As noted earlier, the said decision of the Supreme Court has been noted by the later decision of the Supreme Court in Gangadhar's case (1972) 86 ITR 19).

As we have discussed earlier, in the absence of the peculiar facts which existed in the case before the Supreme Court in Gangadhar's case (1972) 86 ITR 19), the ratio of the earlier decision of the Supreme Court in Kettlewell's case (1964) 53 ITR 261) would squarely get attracted to the facts of the present case. It cannot be doubted that, because of reduction of the share of the assessee in the reconstituted firm from 36 per cent. to 5 per cent., the trading structure of the assessee was impaired and such cancellation would result in proportionate loss of an income-yielding asset. Consequently, the payment made to him as compensation for such impairment has to be treated as a capital receipt.

For all these reasons, therefore, the question referred to us for our opinion is answered in the affirmative, in favour of the assessee and against the Revenue. There will be no order as to costs.

M.BA./2373/T ??????????????????????????????????????????????????????????????????????????????????? Order accordingly.