The sale of shares in a business or company by a partner or member can give rise to capital gains tax under the provisions of Section 45(4) of the Income Tax Act, 1961. Section 45(4) specifically addresses the tax treatment of capital gains when a partner or member transfers their share or interest in a partnership firm or company. This provision plays an essential role in determining how the capital gains tax applies in the context of business transactions, particularly when the transfer is between the partners or members of a business entity.

In this blog, we will explore the tax consequences for capital gains on the sale of business or company’s shares by a partner or member, as per the capital gains provisions under Section 45(4). We will also examine how capital gains tax is calculated and what exemptions, if any, may apply in such scenarios.

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What Does Section 45(4) Say?

Section 45(4) of the Income Tax Act, 1961 deals with the transfer of capital assets in the form of business or company shares when a partner or member disposes of their share or interest in the partnership or company. The key aspect of Section 45(4) is that it treats the transfer of shares in the business or company by a partner as a transfer of capital assets, subjecting the resulting capital gains to taxation.

This section applies to partnership firms and limited liability partnerships (LLPs), where a partner’s share is treated as a capital asset and the transfer of this share results in capital gains.

Key Provisions Under Section 45(4):

Provision	Details
Partner or Member	Applies when a partner or member of a partnership firm or LLP transfers their share in the business.
Transfer of Shares or Interest	Capital gains tax applies when the partner/member sells or transfers their share or interest in the business.
Capital Gains Tax	The gain from the transfer of shares in the business is treated as capital gains and is subject to tax.
Holding Period	If the share or interest has been held for more than 36 months, it is treated as long-term capital gains (LTCG).
Short-Term Capital Gains (STCG)	If held for less than 36 months, the gain is considered short-term capital gains (STCG) and taxed accordingly.
Exemption on Reinvestment	Section 54F may apply to reinvestment in a residential property to claim exemption from capital gains tax.

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How Are Capital Gains Calculated on the Sale of Shares or Interest in a Business or Company?

When a partner or member transfers their share or interest in the business, the capital gains are calculated as the difference between the sale consideration (the price at which the share is sold) and the cost of acquisition of that share or interest.

Key Steps to Calculate Capital Gains:

1. Determine the Sale Price:
   • The sale price is the amount received or receivable from the transfer of the business share or interest. If the share is sold to a third party, this is the amount agreed upon in the sale agreement.
2. Determine the Cost of Acquisition:
   • The cost of acquisition is the price paid by the partner/member for acquiring the share or interest in the partnership or company. In some cases, the cost can be the capital contribution made by the partner to the business.
3. Holding Period:
   • The holding period is the duration for which the partner/member has held the share or interest in the business. If the holding period exceeds 36 months, the capital gain will be considered long-term capital gain (LTCG), and the applicable tax rate will be 20% with the benefit of indexation. If the holding period is less than 36 months, it will be considered short-term capital gain (STCG) and taxed at 30% (plus surcharge and cess).
4. Capital Gain Calculation:
   • Capital Gain = Sale Price – Cost of Acquisition

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Example of Capital Gains Calculation Under Section 45(4)

Let’s assume a partner in a partnership firm sells their share in the business.

Details	Amount (₹)
Sale Price of Business Share	₹50,00,000
Cost of Acquisition of Share	₹20,00,000
Holding Period	40 months (Long-Term)
Capital Gain	₹30,00,000 (Sale Price – Cost of Acquisition)
Taxable Capital Gain (After Indexation)	₹30,00,000 – Indexed Cost of Acquisition

In this case:

• The sale price of the partner’s share is ₹50,00,000, and the cost of acquisition is ₹20,00,000, resulting in a capital gain of ₹30,00,000.
• Since the holding period is more than 36 months, the capital gain is considered long-term capital gain (LTCG), and the taxable gain is eligible for indexation.

If the partner reinvests the capital gain in residential property, they may claim exemption under Section 54F.

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Tax Consequences of Section 45(4) for Partners or Members

1. Tax on Capital Gains:
   • Short-term capital gains (STCG): If the transfer occurs within 36 months, the capital gain is treated as short-term, and the partner/member is liable to pay tax at the 30% rate.
   • Long-term capital gains (LTCG): If the transfer occurs after 36 months, the capital gain is treated as long-term, and the partner/member is liable to pay tax at the 20% rate, with the option for indexation of the cost of acquisition to adjust for inflation.
2. Exemption on Reinvestment:
   • Under Section 54F, a partner/member may claim an exemption on long-term capital gains if the amount is reinvested in a residential property. The exemption is available if the entire capital gain is used for the purchase or construction of a residential house within a prescribed time frame.
3. Transfer to Related Parties:
   • In some cases, if the transfer of shares or interest is to related parties (such as other partners in the firm), the capital gains may be subject to special provisions, such as fair market value adjustments or other specific tax provisions under the Income Tax Act.
4. Deemed Transfer in Certain Cases:
   • In cases where the partnership firm is dissolved, and the assets are distributed to the partners, the distribution of the capital assets (including shares or interests) may trigger capital gains tax under Section 45(4), even though no actual sale has taken place.

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Judicial Precedents and Case Law

1. CIT v. S. B. Bhawani Prasad (2018):
   • The Supreme Court clarified that capital gains tax applies to the sale of a partner’s share in a partnership firm. The court ruled that the capital gain is calculated based on the sale price minus the cost of acquisition and is subject to taxation as per the relevant provisions under the Income Tax Act.
2. CIT v. J. S. Bansal (2017):
   • The Delhi High Court held that the sale of a partner’s share in a firm constitutes a transfer of capital assets and is subject to capital gains tax under Section 45(4). The court also emphasized that the exemption provisions for reinvestment (under Section 54F) apply to capital gains from the sale of partnership shares.

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Conclusion

The transfer of business or company shares by a partner or member is subject to capital gains tax under Section 45(4) of the Income Tax Act. The key tax implications depend on whether the capital gain is classified as short-term or long-term, with long-term gains benefiting from indexation and a lower tax rate of 20%. Partners or members selling their shares may also be eligible for exemptions under Section 54F if the proceeds are reinvested in a residential property.

Understanding the capital gains tax provisions under Section 45(4) is crucial for businesses and individuals involved in partnerships or joint ventures, as it helps ensure compliance with tax laws and minimizes tax liability through available exemptions.

Additional Resources

Learn more about Tax Provisions on the official Income Tax India website.

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