Income-tax---

----Revision---Condition precedent---Order must be erroneous and prejudicial to Revenue---Conclusion that order is erroneous and prejudicial to Revenue must be based on proper material---Indian Income Tax Act, 1961, S.263.

It is an essential condition for exercise of the power under section 263 of the Income Tax Act, 1961, that the Commissioner of Income-tax must find that the error, which is found in the order of the Income-tax Officer, is prejudicial to the interests of the Revenue. The conclusion of the Commissioner of Income-tax that the order is prejudicial to the interests of the Revenue is not a matter of subjective satisfaction of the Commissioner. That is to be founded on the objective material after assessing the contentions raised by the assessee on opportunity of gearing being afforded to him before passing the order.

No business commenced for the first time possesses goodwill from the start. It is generated as the business is carried on and may be augmented with the passage of time. Therefore, as a matter of law, no profit or gain could arise to a firm by creation of a goodwill account in the firm or by crediting in the partners' accounts in their profit sharing ratio the amount of such goodwill, which can be subjected to tax. No capital gains arise - on a partner contributing an asset as his capital to the firm of which he is a partner or an asset of firm being distributed amongst partners of which they are otherwise co-owners. According to law as existing prior to its amendment with effect from April 1, 1987, conversion of partnership assets into personal assets on dissolution did not result in transfer of a capital asset for consideration for the purpose of levy of capital gains tax.

(b) Income-tax---

----Revision---Capital gains---Firm---Goodwill---Goodwill which was self generated---Firm debiting goodwill in its accounts, and crediting it in accounts of its partners---Subsequent dissolution of firm and business taken over by one of its partners---Transaction did not result in accrual of capital gains in assessment year 1974-75---Order of revision on the ground that amount relating to goodwill had not been taxed---Not valid---Indian Income Tax Act, 1961, Ss.45 & 263.

The assessee-firm was constituted in November, 1968. Four more partners were inducted in it in November, 1972. Goodwill was debited in the books of the firm and it was credited in the accounts of the old partners' accounts in their profits-sharing ratio. A private -limited company was formed and it became a partner in the firm in October, 1973. The firm was dissolved on February 23, 1974, leaving the private limited company as the sole proprietor thereof. The Income-tax Officer had completed the assessment under section 143(3) of the Act for the assessment year 1974-75. The Commissioner of Income-tax issued a revision notice on the ground that the Income-tax Officer had failed to tax the goodwill amounting to Rs.10,75,000. The Tribunal upheld the order of revision. On a reference:

Held, that there was no material to show that the creation and disbursement of the goodwill account amongst the partners in their profit-sharing ratio would be prejudicial to the interests of the Revenue. No capital gains tax can be charged in respect of self-created goodwill. It was not the case of the Revenue that goodwill account was credited in the books of account on purchase from market. This was a case of debiting goodwill account in the books of the firm for the estimated value of goodwill, which was self-generating and its transfer even for consideration ultimately to the company which had acquired the business of the firm could not have resulted in levy of any tax in respect thereof. This transaction also under the law applicable at the time could not have resulted in any tax liability against the firm, on transfer of goodwill. The order of revision was not valid.

CIT v. B.C. Srinivasa Setty (1981) 128 ITR 294 (SC); Jayantilal Bhtigilal Desai v. CIT (1981) 130 ITR 655 (Guj.) and Sunil Siddharthbhai v. CIT (1985) 156 ITR 509 (SC) ref.

D.A. Mehta for R.K. Patel for the Assessee:

B.J. Shelat for M.R. Bhatt & Co. for the Commissioner.

JUDGMENT

RAJESH BALIA, J.---The Income-tax Appellate Tribunal, Ahmedabad Bench 'A', at the instance of the assessee has referred the following two questions of law arising out of its order in I.T.A. No.420/Ahd. of 1979 relating to the assessment year 1974-75, for the decision of this Court:

"(1)????? Whether, on the ~ facts and in the circumstances of the case, the Tribunal was justified in law in holding that the Income-tax Officer concerned had not at all examined goodwill account and made no inquiry at the time of passing an assessment order and hence his order was erroneous and prejudicial to the interests of the Revenue within the meaning of section 263 of the Act?

(2)??????? Whether the order of the Tribunal justifying the order of the Commissioner under section 263 of the Act is not against evidence on record and unsupported by any evidence and is reasonable?"

The Income-tax Officer had completed the assessment under section 143(3) of the Act for the assessment year 1974-75 in the case of the assessee, a registered firm on January 25, 1977. On December 15, 1978, the Commissioner of Income-tax, Rajkot, issued notice under section 263 of the Income Tax Act, 1961, stating that on going through the case records of the income-tax assessment proceedings of the assessee for the assessment year 1974-75, it was noticed that the assessment made by the Income-tax Officer on January 25, 1977, is erroneous and is prejudicial to the interests of the Revenue on the following grounds:

"(i)??????? that the Income-tax Officer has failed to tax the so-called goodwill amounting to Rs.10,75,000 credited to the accounts of the partner in their profit-sharing ratio;

(ii)??????? that the Income-tax Officer has failed to pass an order under section ???? 185(1)(a) of the Income-tax Act, 1961;

(iii)?????? that the Income-tax Officer has failed to add back the interest ?? payments of Rs.94,631 made to the partners."

The assessee replied. In respect of questions about taxing the goodwill amount, the assessee replied that, the entire matter was scrutinized in detail and accepted while passing the assessment order and, therefore, no action under section 263 can be taken in this regard merely on the basis of change of opinion or any audit objection or because of the change of the Income-tax Officer, there being no transfer much less transfer of capital asset and that too for consideration at any stage during the assessment year in question, no question of making addition of the value of goodwill for the purpose of taxing can arise. The Commissioner of Income-tax rejected the contention of the assessee, vide his order, dated January 23, 1979, and directed the income-tax Officer to thoroughly examine all the relevant transactions and book entries concerning the goodwill amount and its final destination, vis-a-vis, the eventual take-over of the assessee's business by the private limited company. For issuing this direction, the Commissioner reasoned that the assessee created an amount styled as "goodwill account" which was debited by a sum of Rs.10,75,000 and the said amount was transferred to the accounts of the partners of the assessee-firm, after referring to the past record of the business results of the firm and Havala entries in the account of Rayon Silk Mills (Private) Limited. From the assessment records, specially from the assessment order, it is evidence that the Income-tax Officer concerned has not at all examined the goodwill account. With the aforesaid reasoning, the Commissioner further concluded that it is in this context that the Income-tax Officer's Order of assessment is certainly erroneous in so far as prejudicial to the interests of the Revenue which has suffered on account of the Income-tax Officer's omission to examine and visualise the tax implications of the creation of goodwill account and the business ultimately having been transferred in subsequent years. So far the order of the Income-tax Officer being erroneous and prejudicial to the interests of the Revenue on other two counts concerned was not contested by the assessee and we are not referring to those controversies herein. On appeal, the Tribunal affirmed the order of the Commissioner of Income-tax. However, it was observed:

"The Commissioner has not gone into the- fact whether the goodwill should be assessed as such. He has only directed the Income-tax Officer to take all the material facts into consideration while determining the issue. In other words, he has not gone into the merits of its assess ability. We, therefore, do not propose to adjudicate upon the issue whether or not the goodwill of Rs.10,75,000 debited in the books of account with corresponding credits in the accounts of the partners in their profit-sharing ratios is taxable or not taking into consideration the Havala entries and the ultimate transfer of the assets to a limited company which the Income-tax Officer will no doubt consider while framing the assessment de novo. "

We have heard learned counsel for the parties.

In the first instance it was contended by learned counsel for the assessee that the very premise on which order under section 263 was made against the assessee, namely, that the Income-tax Officer has not at all examined the goodwill account is not existent. According to him, it is apparent from the record that the goodwill account was thoroughly examined by the Income-tax Officer before making the assessment and after examining when he accepted the contention of the assessee its discussion did not find place in the assessment order, as no additions were going to, be made or no modifications in the return filed by the assessee were required to be made in that regard.

This contention of the assessee appears to be well-founded. It is true that the assessment order does not speak about the examination of goodwill account as such. However, as we have noticed above, the assessee in his reply to the show-cause notice under section 263 had specifically mentioned that the entire matter was scrutinized and accepted while passing the assessment order. Our attention was also drawn to Annexure "D". A submission made by the assessee to the Income-tax Officer, Surat, dated October 18, 1976, regarding the assessment year 1974-75 giving detailed chronological data of the constitution of the firm on November 11, 1968, induction of four more partners on November 7, 1972, the creation of goodwill in the books of account of the firm by debiting the goodwill account and crediting the old partners' capital accounts in their profit-sharing ratio on that date, formation of a private limited company in the name of Rayon Silk Mills (Private) Limited, and its induction into the firm as partner by the deed of partnership, dated October 27, 1973, and the dissolution of the partnership firm on February 23, 1974, leaving the private limited company as a sole proprietor thereof and the valuation of the business at the book value as on that date. After giving the chronological sequence of events, the assessee also contended in his submission before the Income-tax Officer that there was no actual transfer of any asset inasmuch as when a partner is admitted into the firm no transfer takes place. It was also contended that no cash transfer took place from person to person and the transfer and the dissolution of the firm also did not result in accrual of capital gains. In the face of this material on record, it is difficult to explain that the assessment order was made without making any enquiry into the goodwill account of Rs.10,75,000. On the contrary while the Commissioner of Income-tax in his order, which has been quoted by the Tribunal, took pains to refer to Havala entries in the books of account of other concerns and the business results of the firm in the past years he is conspicuously silent about the relevant dates which had relevant bearing for coming to the conclusion whether the order of the Income-tax Officer for the assessment year 1974-75 on the facts existing during the previous year relevant to the assessment year 1974-75 could be said to be erroneous and prejudicial to the interests of the? Revenue. The accounting year of the assessee is Samvat year closing on Diwali year. Hence, the previous year relevant to the assessment year 1974-75 in the case of the assessee ended with Diwali, 1973. It is fundamental that the assessment of each year is independent of the assessment of other years, the assessment being of a particular assessment year which is in respect of income which has been earned, accrued or received during twelve months comprising the previous year relevant to the assessment year, the assessment has to be framed on the basis of the existing material and which is then existing law applicable for that assessment. From the chain of events, it is apparent that the goodwill account was created on November 7, 1982, that is to say, at the beginning of the previous year relating to the assessment year 1974-75 and on the date when the actual &; count was debited and the accounts of existing partners the induction of new partners were credited. It is also apparent that the business of the firm ultimately became the business of the company only on February 23, 1974, that is to say, after about fifteen months of creation of the goodwill account in the books of the firm and about five months after induction of the private limited company as partner of the firm and about three months after the closure of the previous year. If any capital gains or profit arose to the firm as a result of transfer of business in February, 1974, the same could not be the subject-matter of the scrutiny or enquiry for the assessment year 1974-75. Therefore, it is apparent that the Tribunal and the Commissioner have not looked into the record before coming to the conclusion whether any enquiry into the creation of a goodwill account was made or not and have taken into Consideration the, materials which are irrelevant. We make it clear that the aforesaid observations we have not made to lay down that whenever any enquiry into any aspect of the assessment has been made that cannot be the subject-matter of the proceedings under section 26"s. Even in such cases, if the Commissioner of Income-tax finds the conclusion of the Income-tax Officer erroneous and prejudicial to the interests of the Revenue, he can certainly have recourse to powers under section 263 subject to a limitation appended thereto. However, the powers under section 263 are not conferred on the Commissioner of Income-tax to direct for making an enquiry on mere suspicion to disturb a completed assessment.

In the present case the only ground on which the Commissioner of the Income-Tax has directed the Income-tax Officer to hold an enquiry into the creation of the ?good will account? is for the supposed reason that the Income tax Officer has not examined the issue. It is not founded on the ground that the Income tax Officer has erroneously not taxed the good will amount for the assessment year 1974-75 while it was not taxable.

It is essential, condition of exercise of the power under section 263 that the Commissioner of Income-tax must find that the error, which is found in the order of the Income-tax Officer is prejudicial to the interests of the Revenue. The prejudice which has been held to be contrary to the interests of the Revenue is stated to be the only one, namely, in not holding enquiry into the goodwill account by the Income-tax Officer and not on any other grounds. The conclusion of the Commissioner of Income-tax that the order is prejudicial to the interests of the Revenue is not a matter of subjective satisfaction of the Commissioner. That is to be founded on the- objective material after assessing the contentions raised by the assessee on opportunity of hearing being afforded to him before passing the order.

Apart from the fact that the basic premise on which the order under section 263 has been made does not exist, there is no whisper in the order how on reaching any finding that creation and disbursement of goodwill account amongst the partners in their profit-sharing ratio would be prejudicial to the interest of the Revenue. The period with which we are concerned is the assessment year 1974-75. So far as the charge of any tax on transfer of goodwill is concerned, if creation of a capital asset in the nature of goodwill in the accounts of the firm and its crediting to the partners' capital accounts in the profit-sharing ratios, is treating to be a transfer within the meaning of subsection (47) of section 2 of the Income-tax Act, law is settled on the subject that no capital gain can be charged in respect of self? created goodwill. It is not the case of the Revenue that the goodwill account was credited in the books of account on purchase from the marl is a case of debiting goodwill account in the books of the firm for the estimated value of goodwill which was self-generated and its transfer even for consideration ultimately even to the company which had acquired the business of the firm could not have resulted in levy of any tax in respect thereof. A reference in this connection may be made to CIT v. B.C. Srinivasa Setty (1981) 128 ITR 294 (SC). ? lie Court enunciated the principle that the charging section and the computation provisions together constitute an integrated code. When there is a case to which the computation provisions cannot apply at all, it is evident that such a case was not intended to fall within the charging section. For the purpose of levy of tax on capital gains, the Court said (headnote):

"All transactions encompassed by section 45 must fall under the governance of its computation provisions. A transaction to which those provisions cannot be applied must be regarded as never intended by section 45 to be the subject of the charge. What is contemplated by section 48(ii) is an asset in the acquisition of which it is possible to envisage a cost: it must be an asset, which possesses the inherent quality of being available on the expenditure of money to a person seeking to acquire it. None of the provisions pertaining to the head 'Capital gains' suggests that they include an asset in the acquisition of which no cost at all can be conceived. When goodwill generated in a new business is sold and the consideration brought to tax, what is charged is the capital value of the asset and not any profit or gain. Further, the date of acquisition of the asset is a material factor in applying the computation provisions pertaining to capital gains; but in the case of goodwill generated in a new business it is not possible to determine the date when it comes into existence. "

Discussing the nature of self-generated goodwill, the Court propounded (headnote):

.?????????? "Goodwill denotes the benefit arising from connection and reputation. A variety of elements goes into its making, and its composition varies in different trades and in different businesses in the same trade, and while one element may preponderate in one business, another may dominate in another business. Its value may fluctuate from one moment to another depending on changes in the reputation of the business. It is affected by everything relating to the business, the personality and business rectitude of the owners, the nature and character of the business, its name and reputation, its location, its impact on the contemporary market, the prevailing socio-economic ecology, introduction to old customers and agreed absence of competition. There can be no account in value of the factors producing it. It is also impossible to predicate the moment of its birth. The benefit to the business varies with the nature of the business and also from one business to another. No business commenced for the first time possesses goodwill from the start. It is generated as the business is carried on and may be augmented with the passage of time."

The same view was taken by the Gujarat High Court in the case of Jayantilal Bhogilal Desai v. CIT (1981) 130 ITR 655.

Therefore, as a matter of law, no profit or gain could arise to the firm by creation of a goodwill account in the firm or by crediting the partners' accounts in their profit-sharing, ratio, the amount of such goodwill, which can be subjected to tax. In that view of the settled position of law the assessment order could not have been said to be an order prejudicial to the interests of the Revenue, qua the goodwill account.

Law is also well-settled that no capital gain or transaction resulting it creating a charge under the Income-tax Act arises on a partner contributing an asset as his capital to the firm of which he is a partner or are asset of firm being distributed amongst partners of which they are otherwise co-owners inasmuch as such transaction does not result in passing of any consideration which only can be the foundation for the charge of capital gains. The principle was firmly stated by the Supreme Court in the case of Sunil Siddharthbhai v. CIT (1985) 156 ITR 509, wherein the Court opined that though contribution of a capital asset as capital by a partner who is the partner of the firm is transfer under section 45 but the partner does not receive any consideration within the meaning of section 48 and, therefore, no profit or gain accrues to him for the purpose of capital gains tax levy under section 45. The principle equally applies when at the dissolution of the firm the assets are distributed amongst partners. Therefore, even assuming that the creation of goodwill in the books of account of the firm and its distribution amongst the capital account of the partners be treated as transfer of the capital asset of the firm still it could not have resulted in any revenue under the Income-tax Act.

Much emphasis has been laid by the Commissioner of Income-tax as well as by the Tribunal to find out ultimately how the business has passed on tp the company. Firstly, it is an admitted fact and does not need any enquiry that the .business of the firm was ultimately taken over by the company, which became its partner on November 23, 1973. On the dissolution of the firm on February 27, 1974, this transaction also as per law applicable at the time could not have resulted in any tax liability against the firm, on transfer of goodwill.

As per law as existing prior to its amendment with effect from April 1, 1987, conversion of partnership assets into personal assets on dissolution did not result in transfer of a capital asset for consideration for the purpose of levy of capital gains. Therefore, when the business of the firm came to be vested in the company which was a partner of the dissolved firm on the dissolution of the firm & a result of settlement of accounts between the parties in February, 1974, it also did not give rise to any taxable event. Even if such transfer of business to the company on dissolution of .the firm would have attracted levy of tax, it would not have made the order passed for the assessment year 1974-75 prejudicial to the interests of the Revenue. The event on which much emphasis has been laid by the Tribunal and the Commissioner of Income-tax clearly happened beyond the period, which was under consideration for the assessment year 1974-75. The Revenue Authorities have fallen into error by not noticing the most relevant fact as to when the business of the firm became the business of the company and it consequently failed to appreciate that even that has no bearing as far as the assessment year 1974-75 was concerned.

Therefore, in our opinion, the conclusion of the Tribunal in affirming the decision of the Commissioner of Income-tax that the order of the Income-tax Officer for the assessment year 1974-75 was erroneous for want of making enquiry, and is otherwise prejudicial to the interests of the Revenue is not well-founded in law.

???????????

Accordingly, we answer both the questions referred to us in the negative, this is to say, in favour of the assessee and against the Revenue. There shall be no order as to costs.

M.B.A./1236/FC???????????????????????????????????????????????????????????????????? Reference answered.