Distribution of capital assets on a firm’s dissolution [Section 45(4)] under Scope and year of chargeability [Section 45] :

The profits or gains arising from the transfer of capital assets by way of distribution of capital assets on the dissolution of a firm or AOP or BOI or otherwise shall be chargeable to tax as the income of the firm etc. of the previous year in which such transfer takes place. For this purpose, the fair market value of the asset on the date of such transfer shall be the full value of consideration.

The Bombay High Court made a landmark judgment in Commissioner of Income-tax v. A.N. Naik Associates (2004) 136 Taxman 107. The Court applied the “mischief rule” about interpretation of statutes and pointed out that the idea behind the introduction of sub-section (4) in section 45 was to plug in a loophole and block the escape route through the medium of the firm. The High Court observed that the expression ‘otherwise’ has not to be read ejusdem generis with the expression ‘dissolution of a firm or body of individuals or association of persons’. The expression ‘otherwise’ has to be read with the words ‘transfer of capital assets by way of distribution of capital assets’. If so read, it becomes clear that even when a firm is in existence and there is a transfer of capital asset, it comes within the expression ‘otherwise’ since the object of the amendment was to remove the loophole which existed, whereby capital gains tax was not chargeable. Therefore, the word ‘otherwise’ takes into its sweep not only cases of dissolution but also cases of subsisting partners of a partnership, transferring assets in favour of retiring partners.