Commissioner of Income Tax vs V.K.D. Ramanathan Chettiar and Co.

V. Balasubrahmanyan, J.—This reference under the income tax Act, 1961 (''the Act'') is about the precise tax treatment of a change which

had occurred in a partnership business. Changes in partnership business may arise in various ways and in various forms. A change, for instance,

may occur in the partnership personnel. Sometimes, the partners may remain unchanged, but a change may occur in the profit-sharing ratio inter se

between them. These changes, it will be noticed, need not necessarily bring about any change in the business. The business will remain intact and

what undergoes a change is only in organisation or management. Sometimes the change might affect the very structure of the firm, as when it gets

wholly dissolved. When a firm is dissolved, it may be followed by winding up of the firm''s business, which will mean the end of that business too.

But even in a dissolution, the business may be allowed to remain intact as when, under the scheme of dissolution, the business is parted with as a

going concern for consideration. The business then will continue uninterrupted but under changed hands. This would be so, whether the purchaser

of the business is a third party or one among the partners themselves. In such a case, the firm disappears but the business continues.

Under the pure and unsullied theory of partnerships, every change in the personnel of the firm involves, technically, the end of one firm and the

beginning of a new jural relationship. This is on the principle that when persons come together as partners they do not thereby create a legal entity

separate from themselves, although they may carry on business under a collective name. But modern partnership law, even in England, is no longer

so dogmatic. It recognizes, for instance, the retirement of a partner and the introduction of a new partner during the subsistence of a partnership.

The Indian Partnership Act, 1932, contains provisions for such situations as well as a few others, which can make sense only if we credit the firm

with a limited personality of its own and not dismiss it as a convenient linguistic device intended to refer to the constituent partners in the gross.

Our tax codes prefer to lay taxes on pragmatic considerations by accepting business realities, at any rate, whenever it suits them to do so. This is

very true of the tax treatment of partnerships and changes in partnerships. Under our income tax code, partnership firms are taxable entities as

such, although the revenue can also reach the partners direct. When once a firm is being treated and held responsible as a distinct subject of

charge, the statute must, perforce, also adapt its provisions to suit the various changes to which a partner ship, as a form of business organization,

is susceptible. This is actually reflected in the relevant provisions of the Indian income tax Act, 1922, as well as the income tax Act, 1961. They

show how the Legislature has adopted the taxing provisions to suit the different kinds of changes that might occur in partnership business Broadly

speaking, there is a distinction in tax treatment between a transfer of the business, on the one hand, and a mere change in the constitution of the

firm, on the other. This distinction which is laid down in section 26 of the Indian income tax Act, 1922 (''the 1922 Act'') is maintained in the income

tax Act, 1961 (''the Act'') in two distinct sections, 187 and 188; section 187(1) says that where there is a change in the constitution of the firm, the

assessment must be made on the firm as constituted at the date of the assessment. Section 187(2) lays down that a change in the constitution of the

firm occurs when a partner leaves the firm, when a person enters the firm as a partner and also when there is a reshuffling of the profit-sharing ratio

as between the partners. Section 188 provides for a case where there is a succession to a business from one firm to another, involving the business

changing hands. It is often a matter for consideration whether a change is of the one kind or of the other. The question in such cases would be, has

the firm changed its constitution or has the business changed hands?

The case law on the subject quite clearly illustrates the difference between a change in the constitution of a firm and a transfer of business from

one firm to another. Decided cases also bring into bold relief the distinction between changes in the constitution of a firm and an out and out

dissolution of the firm. Tyresoles (India), Calcutta Vs. Commissioner of Income Tax, Coimbatore, , was a case where the dissolution of an existing

firm was followed by the constitution of a new firm. Referring to this change, Jagadisan, J., observed that it was meaningless to talk of a firm being

reconstituted after dissolution. A firm can change its constitution only if there is no dissolution. Dissolution of a firm and change in its constitution

cannot coexist. If it is the one, it cannot be the other.

Kaithari Lungi Stores Vs. Commissioner of Income Tax, was a case where a partner died, but the partnership articles permitted the surviving

partners to continue the partnership with out dissolution. The Court held that there was a mere change in the constitution of the firm and section

187 would apply.

In MAVUKKARAI (N) ESTATE TEA FACTORY Vs. ADDITIONAL COMMISSIONER OF Income Tax, MADRAS-II., there was a

firm of five partners. Four of them purported to retire leaving the fifth partner to continue the business. He did so by taking in fresh partners. It was

held in the circumstances that there was a dissolution of the firm and section 187 would not apply to that case.

In Additional Commissioner of Income Tax Vs. Thyagasundara Mudaliar and Munuswami Mudaliar and Co., , the Court had to decide whether

section 187 applied to that case. There were only two partners in the assessee-firm. One of them died. The Court had no hesitation in holding that

in a firm of two partners, with the death of one, the firm itself automatically stood dissolved under the law and, hence, section 187 did not apply.

The lesson we learn from these decided cases is that a dissolution unalterably puts an end to the firm. And if the same persons more or less

again come together and continue the same business thereafter, that should not be mistaken for a mere change in the constitution of a firm. In such

cases what we have is the dissolution of a firm, followed by the formation of a new firm, not just a reconstitution of the same firm.

The question in the present case pro pounded for our opinion by the Tribunal is as follows:

Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the provisions of section 187(2) of the income tax

Act, 1961, were not applicable and that for the assessment year 1965-66, assessment should be made only for the period 12-4-1964 to 14-12-

1964 on the ground that consequent to the retirement of one of the partners on 14-12-1964, there was a succession by a new firm to the

predecessor firm?

The assessee-firm consisted of four partners, Karupparangan Chettiar, Ramanathan Chettiar, Varadarajan Chettiar and Krishnaraj till 14-12-

1964. The firm carried on business in cloth under the name of ''V.K.O. Ramanathan Chettiar & Co.'' Gugai, Salem. It was a partnership at will.

From 15-12-1964, the same business was continued by Karupparangan Chettiar, Ramanathan Chettiar and Varadarajan Chettiar. Krishnaraj was

left out. Krishnaraj issued a notice on 15-10-1964 to the other three partners followed by a deed of retirement dated 14-12-1964. Then followed

a regular deed of partnership by the three remaining partners dated 15-12-1964. In that partnership deed, the signatories are Karupparangan

Chettiar, Ramanathan Chettiar and Varadarajan Chettiar.

The assessee''s case was that what happened in this case was an out and out dissolution of the firm of four partners and not the retirement of

Krishnaraj alone. According to the assessee, after the dissolution of the firm of four partners, there was a new partnership of three partners in

which Krishnaraj did not find a place as a partner.

The case of the department was that this notice issued by Krishnaraj was a notice of his own retirement from the partnership and it did not

purport to be a notice of dissolution of the firm nor was there any consequential dissolution following the receipt of notice by the other three

partners.

When the matter came before the Tribunal, the Tribunal had to decide the question whether there was a dissolution as claimed by the assessee

or whether there was some change in the constitution of the firm, as claimed by the department. The Tribunal observed that there was no clear,

unambiguous or properly drawn out deed of dissolution. They, accordingly, proceeded, as they observed, to decide the issue on the basis of the

cumulative effect of the other documentary evidence, attendant circumstances and previous and subsequent conduct of the partners of the

assessee-firm. They also proceeded to observe that if they were to confine themselves to the materials, which had been considered by the ITO,

they should have come to the same finding as was reached by him. It may be observed that the ITO took into consideration the notice of

retirement issued by Krishnaraj and the recitals in the retirement deed and the subsequent partition deed. What the Tribunal regarded as a serious

omission by the ITO in the consideration of the evidence on record was the evidence of certain arbitrators, which was placed before the ITO in the

form of a letter addressed by them to him. According to the Tribunal, a perusal of the order of the ITO shows that he did not give due regard to

the contents of the letter of the arbitrators. The Tribunal themselves have set out the terms of the letter in their order and on consideration of the

contents of that letter, the Tribunal held that what really happened in this case was an out and out dissolution of the partnership of the four partners,

followed closely by the constitution of a new firm consisting of three partners, sans Krishnaraj. The Tribunal also referred to what they regarded as

the subsequent conduct of the parties, when they made mention for the continuance of the registration of the firm and a letter, which was written by

one of the partners even on 12-12-1964 to the effect that the assessee-firm was ''getting dissolved''. According to the Tribunal, the evidence on

record showed that the parties decided to put an end to the dissolution and there was no evidence whatever to show that this intention of theirs

was subsequently changed into one to the retirement of Krishnaraj, alone from the partnership. The Tribunal also referred to the manner of book-

keeping adopted by the partnership firm, both before and after 14-12-1964. The Tribunal noticed that the assessee-firm closed its accounts on

14-12-1964 instead of continuing the account entries unabated till 14-4-1965 which was the date for closing of the accounts, the year of account

being the Tamil year.

Mr. Jayaraman, the learned standing counsel for the department, submitted that the Tribunal was not justified in giving a go-by to the notice

written by Krishnaraj and the retirement deed which, according to him, were the prime movers in the change, which happened on 14-12-1964.

The learned counsel pointed out that in both the documents written by Krishnaraj, viz., notice dated 15-10-1964 and the subsequent retirement

deed dated 14-12-1964, there is no whisper that Krishnaraj intended to get the firm dissolved as a whole. All that is said in the notice was that he

had decided to retire from the partnership firm. The learned counsel also referred to the subsequent partnership deed, in which it was clearly

recited that Krishnaraj had only retired from the firm and after his retirement, the remaining partners continued to carry on the firm''s business.

A reference to the notice issued by Krishnaraj shows that the contentions of the departmental standing counsel is not entirely unfounded. In a

piece of writing called ''Partnership partition document'' subscribed to by Krishnaraj and addressed to his three other partners, Krishnaraj definitely

says that owing to differences between him and the other partners in the firm, he had retired from the partnership with effect from 14-12-1964.

The Tamil equivalent of the expression retirement and its cognate expression is expressly mentioned in more than one place in this document. In the

notice dated 15-10-1964, which is apparently written even in the original in English language, Krishnaraj had declared that he has decided ''to

discontinue partnership''; but he explains what he meant by retiring, the other partners to determine his share of profits and settle his accounts within

a month from the date of that letter. The subsequent deed of partnership is between the three individuals, Karupparangan Chettiar, Ramanathan

Chettiar and Varadarajan Chettiar. There is a clear recital to the effect that Krishnaraj had retired from the partnership on 14-12-1964 and, hence,

the signatories to the document had continued the self-same business under the self-same firm name, as partners at will.

Mr. K. Srinivasan, the learned counsel for the assessee, however, submitted that apparently as a matter of construction of these documents, it

cannot be confidently asserted that Krishnaraj''s notice dated 15-10-1964 and the retirement deed dated 14-12-1964 evidence a clear intention of

a mere retirement on his part from the firm and not to bring about a wholesale dissolution of the partnership. He submitted that the letter of

Krishnaraj dated 15-10-1964 does not express any mention that he was desirous of retiring from the partner ship, but what he said was that the

partner ship should be discontinued. The learned counsel further emphasised that even in the subsequent retirement deed, it is clearly shown as a

dissolution of the firm. (The original expression in Tamil being ''Koottu Kadai Pirivinai Pathiram''. The learned counsel further submitted that a

document employing language of this kind, which was by no means clear, the Tribunal was quite proper in relying more upon the other pieces of

evidence, as such, the letter of the arbitrators, the state of the accounts and the subsequent conduct of the partners for the purpose of deciding the

question whether the firm had been dissolved or it had merely undergone a slight change in its constitution.

We may observe that in this case, it is essential to settle first the question as to what was the real object of the notice given by Krishnaraj to the

other partners. We have earlier referred to the undisputed fact that the firm was a partnership at will. A partner in a partnership at will may issue a

notice to bring about by the unilateral act of issuance of that notice, one of two results. One, of either his own retirement from the firm, or two, the

general dissolution of the firm as such. Section 32(1)(c) of the Indian Partnership Act, 1932, (''the Partnership Act'') confers a right on a partner in

a partnership at will to retire from the partnership by the mere act of giving notice in writing to the rest of the partners. Likewise, section 43(7) of

the Partnership Act enables a partner in a partnership at will to bring about a dissolution of the firm by serving on his other partners a notice in

writing declaring his intention to dissolve the firm. Section 39 of the Partnership Act says that the dissolution of the partnership between all the

partners of a firm is that which is regarded by law as the dissolution of the firm. In the present case, therefore, it is very essential to find out as to

whether the notice, which Krishnaraj had served on his other three partners, was a notice as expressive of his intention to retire or on the contrary

as expressive of his intention to bring about a wholesale dissolution of the firm as between all the partners of the firm. It is clear that there is an

element of difficulty presented by the language of the document. We have earlier referred to the notice issued by Krishnaraj on 15-10-1964, which

did not mention anything about retirement. By way of contract, this deed of retirement dated 14-12-1964 expressly refers to his retirement from

partnership. Similar is the recital in the subsequent partnership deed. The Tribunal, therefore, cannot be regarded as having been gone far wrong in

saying that there is an element of ambiguity in the documents. Nevertheless merely because the language of the document is not clear cut, it is no

reason why any Tribunal of fact should shirk from the responsibility of going into those documents. A perusal of the Tribunal''s order shows that

they preferred to ignore the notice of dissolution written by Krishnaraj to his other partners as well as the recitals in the subsequent deed of

partnership dated 15-12-1964 and the deed of retirement dated 14-12-1964, and put full faith and credit on the other pieces of evidence to the

entire exclusion of these documents. At the assessment level, the ITO had concentrated his attention on the notice of retirement to the exclusion of

the evidence furnished by the letter of the arbitrators. All that we have to consider in this case is as to whether what happened herein was a

dissolution or a mere change in the constitution of the partnership. The first part of the question, which has been asked for our opinion, viz.,

whether the Tribunal was right in holding that section 187(2) was or was not applicable to this case, cannot be answered without a proper

consideration of all facts in the case without omitting any piece of evidence, whether documentary or otherwise. Insofar as the Tribunal had not

addressed its mind to the language of the notice circulated by Krishnaraj to his other partners and also the subsequent deed of partnership, the

Tribunal''s decision cannot be accepted as a proper finding, which would enable us to go into the question propounded for our consideration.

The second part of the question, which we have earlier extracted, really is the other side of the coin, viz., the first part of the question, because

if the conclusion, on a consideration of the evidence in record, is that there was a dissolution of the assessee-firm, followed by the constitution of a

new partnership, then it goes without saying that a succession has taken place within the meaning of section 188 with such consequences in the

assessment as that section demands or requires.

There is yet another question, which has been referred to us by the Tribunal. That is really a concomitance of the decision of the Tribunal on

the first question. This latter question raises a point, whether the ITO was right in refusing registration for the assessment year 1965-66 or whether

the registration should have been granted. On the view taken by the Tribunal that there was a new firm, which had been constituted with effect

from 15-12-1964, and the assessee-firm had ended its career on 14-12-1964, the particular procedure adopted by the assessee for continuance

of the registration of the firm already granted, it must have been followed as the proper procedure. This particular question need not necessarily

carry us further, because it will have to follow the correct finding on facts by the Tribunal, which we have earlier observed as lacking in the case.

The result of the above discussion is, that we should remit these references to the Tribunal without answering the two questions posed for our

decision, but with a direction that the Tribunal should regard its order as having been set aside and go into the question of the applicability of

sections 187(1) and 187(2) by an examination and consideration of all facts on record including the documentary evidence in the case. In the

circumstances, the references are returned to the Tribunal with the directions aforesaid. There will be no order as to costs.