Key Takeaways
- The Finance Act 2021 (effective AY 2021-22) rewrote Section 45(4) and inserted Section 9B, splitting the old single provision into two distinct charges on the firm.
- Section 9B applies when a specified person receives a capital asset or stock-in-trade on dissolution or reconstitution: the firm is deemed to transfer it at fair market value (FMV) and pays capital gains (or business income for stock).
- Section 45(4) applies when a specified person receives money or a capital asset on reconstitution in excess of the balance in his capital account: that excess is taxed in the firm's hands as capital gains.
- The charge under 45(4) is computed as A = B + C - D, where the capital account balance (D) is calculated ignoring revaluation gains and self-generated goodwill.
- Rule 8AA decides whether the 45(4) gain is short-term or long-term; Rule 8AB attributes the gain to the firm's remaining assets so there is no double taxation between 9B and 45(4).
- "Reconstitution" covers retirement, admission and a change in profit-sharing ratio; "dissolution" winds up the firm entirely.
- The new Income Tax Act 2025 carries these provisions forward without changing the substance.
What is Section 45(4) of the Income Tax Act? Section 45(4) taxes a partnership firm on capital gains when a partner receives money or a capital asset on reconstitution of the firm in excess of the balance standing in his capital account. The excess, computed after ignoring revaluation and self-generated goodwill, is the firm's chargeable gain.
When a partner retires, a new partner joins, or the profit-sharing ratio changes, value moves between the firm and its partners. For decades this was a grey zone fought through litigation. The Finance Act 2021 settled much of it by replacing the old Section 45(4) and adding a companion provision, Section 9B, with effect from assessment year 2021-22. The result is a two-track system that catches both the handing over of assets and the handing over of money or assets beyond what a partner has actually contributed.
This guide explains what each provision covers, how the two interact so the same gain is not taxed twice, and how to run the computation with a worked example. It is written for working partners, family firms and LLPs planning a clean exit or restructuring.
What Section 45(4) Says Today
After the 2021 overhaul, Section 45(4) reads, in substance: where a specified person receives, during a previous year, any money or capital asset (or both) from a specified entity in connection with the reconstitution of that entity, and the value received is in excess of the balance in that person's capital account, the excess is deemed to be the income of the firm chargeable as capital gains in the year the money or asset is received.
A specified person is a partner of a firm or a member of an AOP/BOI. A specified entity is the firm or AOP/BOI itself. The charge falls on the firm, not the retiring partner. The partner's own receipt is generally not taxed again in his hands; the cost of taxation has been shifted to the entity. This is why the firm, not the exiting individual, must budget for the liability.
The provision targets the real economic event: a partner walking away with cash or property worth more than the capital he leaves behind on the books.
Pre-2021 vs Post-2021: The Split into 9B and 45(4)
The old Section 45(4) (in force until AY 2020-21) taxed the firm on capital gains when capital assets were distributed to partners on dissolution of the firm. FMV on the date of transfer was deemed the consideration. It said nothing clear about retirement settlements paid in money, which is exactly where most disputes arose.
The Finance Act 2021 replaced this with two provisions:
| Feature | Section 9B | Section 45(4) (new) |
|---|---|---|
| Triggering event | Distribution of capital asset OR stock-in-trade to a partner on dissolution or reconstitution | Receipt of money or capital asset by a partner on reconstitution in excess of capital account balance |
| What is deemed | Firm deemed to transfer the asset to the partner at FMV | The excess (money + FMV of asset received over capital balance) is deemed the firm's income |
| Head of income | Capital gains (for capital asset) or business income (for stock-in-trade) | Capital gains |
| Who is taxed | The firm | The firm |
| Covers dissolution? | Yes | No (reconstitution only) |
| Covers money payouts? | No (money is not an "asset" being transferred) | Yes |
| Effective from | AY 2021-22 | AY 2021-22 |
The design is deliberate. Section 9B catches the physical movement of assets out of the firm; Section 45(4) catches the value gap when a partner is paid out beyond his capital. Both can apply to the same reconstitution, which is why Rule 8AB exists to prevent overlap (discussed below).
Retirement (Reconstitution) vs Dissolution: Which Provision Applies
The two key terms are defined in Section 9B's explanation:
- Reconstitution means a partner ceases to be a partner (retirement or death), or a new partner is admitted while one or more existing partners continue, or there is a change in the profit-sharing ratio. The firm survives.
- Dissolution means the firm itself ceases to exist and its affairs are wound up.
How the provisions map:
- On dissolution, where the firm hands over capital assets or stock to partners, Section 9B applies. The firm pays tax on the deemed FMV transfer.
- On reconstitution (retirement, admission, ratio change), if a partner takes a capital asset or stock, Section 9B applies to that asset. Separately, if the partner receives money or a capital asset in excess of his capital balance, Section 45(4) applies to the excess.
- A retiring partner paid purely in cash up to his capital balance triggers neither charge. The charge under 45(4) bites only on the excess.
For the related question of whether the firm can deduct what it pays a continuing partner as salary or interest, see our note on the Section 40(b) limits on partner remuneration.
How to Compute Under Section 45(4): The A = B + C - D Formula
The charge is computed as:
A = B + C - D, where A is the income chargeable as capital gains; B is the value of money received by the partner; C is the FMV of the capital asset received by the partner; and D is the balance in the partner's capital account (in the books of the firm) at the time of reconstitution.
When computing D, the capital account balance must be taken before giving effect to any revaluation of assets and before crediting self-generated goodwill or any other self-generated asset. Firms often inflate a retiring partner's capital by revaluing land or recognising goodwill so the payout looks like a return of capital. The law strips out exactly those credits, so revaluation does not shelter the gain. If A works out negative, it is treated as nil; there is no negative capital gain under this section.
Two rules notified by CBDT in 2021 complete the mechanism:
- Rule 8AA characterises the gain under Section 45(4) as short-term or long-term. To the extent the gain is attributable to capital assets that are short-term (or to which Sections 48/49 do not apply), it is short-term; the balance attributable to long-term capital assets is long-term. This matters because LTCG and STCG carry different rates.
- Rule 8AB governs attribution of the 45(4) gain to the firm's remaining capital assets under Section 48. The gain is added to the cost of the specified remaining assets, so when the firm later sells them the same value is not taxed again. Where it cannot be attributed to a specific asset, it is treated as a gain from transfer of a self-generated asset.
A Worked Example
Mehta & Associates is a firm of three partners, A, B and C. Partner C retires. On the date of reconstitution, C's capital account balance, before any revaluation, stands at Rs 40 lakh. To settle C, the firm pays him Rs 60 lakh in cash and transfers a plot of land with FMV Rs 50 lakh (the firm acquired it years ago for Rs 20 lakh).
There are two separate charges on the firm:
| Step | Provision | Computation | Amount |
|---|---|---|---|
| Transfer of the plot to C | Section 9B | FMV Rs 50 lakh minus indexed cost Rs 20 lakh | Rs 30 lakh LTCG |
| Money + asset received over capital | Section 45(4) | A = B (Rs 60L) + C (FMV Rs 50L) - D (Rs 40L) | Rs 70 lakh |
The Section 9B gain of Rs 30 lakh is taxed as the firm's long-term capital gain on the plot.
The Section 45(4) charge is A = 60 + 50 - 40 = Rs 70 lakh. Rule 8AA then splits this Rs 70 lakh into STCG/LTCG by reference to the nature of the underlying assets. Rule 8AB attributes the Rs 70 lakh to the firm's remaining capital assets, increasing their cost base so that future sales are not taxed twice on the same value.
Note that the FMV of the plot (Rs 50 lakh) appears in both computations. That apparent overlap is exactly what Rule 8AB neutralises, explained next.
Interaction Between 9B and 45(4): No Double Taxation
Read literally, the plot's value drives both the Section 9B charge (on the firm transferring it) and the Section 45(4) charge (as part of "C", the FMV received by the partner). Without a correction the firm would be taxed twice on the same economic value.
Rule 8AB is the corrective. The amount charged under Section 9B (here Rs 30 lakh, the gain already taxed on the plot) is excluded from the attribution of the Section 45(4) gain to the remaining assets. In effect, the value already brought to tax under 9B does not get loaded again onto the firm's other assets under 45(4). The two provisions are stitched together so the firm pays once on the 9B gain and once on the genuine "excess over capital" under 45(4), with the attribution rule ensuring the remaining assets' cost is stepped up by the correct, non-overlapping figure. CBDT issued an illustrative guidance circular alongside the rules in 2021 working through exactly this kind of fact pattern.
Planning Considerations for Family Firms, Retirements and LLPs
- Reconstitute on a clean capital account. The single biggest mistake is revaluing land or booking goodwill just before a retirement to make a large cash payout look like a return of capital. Section 45(4) ignores those credits, so the strategy fails and can invite scrutiny. Settle on the real book capital.
- Cash up to capital is safe. Paying a retiring partner cash up to his genuine capital balance triggers neither 9B nor 45(4). Structure family exits within that ceiling where commercially possible.
- Document the FMV. Both 9B and 45(4) run on FMV. Get a defensible valuation (registered valuer for property) on the reconstitution date and keep it on file.
- LLPs are covered. An LLP is a "firm" for these provisions. Conversions, partner exits and capital reductions in an LLP attract the same analysis.
- Plan the attribution. Rule 8AB lets you load the 45(4) gain onto specific remaining assets. Choosing how it attaches affects the firm's future capital gains, so model the next likely sale before finalising.
- Reinvestment relief downstream. The firm's resulting capital gains may be eligible for exemptions; see our guide to capital gains exemptions under Sections 54, 54F and 54EC for the reinvestment routes.
The firm reports the whole transaction in Schedule CG of ITR-5. Our ITR-5 filing guide for AY 2026-27 walks through the partnership and LLP return in detail.
New Income Tax Act 2025 Mapping
The Income Tax Act 2025, which replaces the 1961 Act, carries the same scheme forward. The substance of Section 9B (deemed transfer of capital asset or stock to a partner on dissolution/reconstitution at FMV) and Section 45(4) (charge on money or capital asset received in excess of capital balance on reconstitution) is retained, with the A = B + C - D mechanism and the Rule 8AA/8AB framework continuing in equivalent form. The section numbering is renumbered under the new code, but firms and LLPs should expect no change in how a partner exit or restructuring is taxed. Confirm the exact renumbered references against the notified Act before filing once it is in force.
Frequently Asked Questions
Who pays the tax under Section 45(4), the firm or the retiring partner?
The firm. Both Section 9B and the new Section 45(4) place the charge on the specified entity (the firm, LLP or AOP/BOI), not on the partner who receives the money or asset. The retiring partner's receipt is generally not taxed again in his own hands, so the firm must budget for the liability before agreeing a settlement.
What is the difference between Section 9B and Section 45(4)?
Section 9B applies when a partner receives a capital asset or stock-in-trade on dissolution or reconstitution; the firm is deemed to transfer it at fair market value. Section 45(4) applies when a partner receives money or a capital asset on reconstitution in excess of the balance in his capital account; the excess is the firm's capital gain. Both can apply to the same reconstitution.
Are revaluation gains and self-generated goodwill counted in the capital account balance?
No. When computing D (the capital account balance) in the A = B + C - D formula, you must ignore any increase from revaluation of assets and any credit for self-generated goodwill or other self-generated assets. This stops firms from inflating a partner's capital to shelter a large payout from tax.
Does Section 45(4) apply when a partner is paid only in cash equal to his capital?
No. If a retiring partner receives money up to his genuine capital account balance and no more, the formula A = B + C - D produces nil or negative, which is treated as nil. The charge bites only on the excess over the capital balance, and only on reconstitution, not on a return of actual capital.
What do Rules 8AA and 8AB do?
Rule 8AA characterises the Section 45(4) gain as short-term or long-term by reference to the nature of the underlying capital assets. Rule 8AB attributes the gain to the firm's remaining capital assets under Section 48, stepping up their cost base, and excludes the amount already taxed under Section 9B so the same value is not taxed twice.
Do these provisions apply to LLPs?
Yes. An LLP is a firm for the purposes of Sections 9B and 45(4). Partner retirements, admissions, changes in profit-sharing ratio and capital reductions in an LLP are tested under the same rules as a traditional partnership firm.
A partner exit or firm restructuring is a taxable event for the firm, even when no third-party sale takes place. The Finance Act 2021 closed the old loopholes by taxing both the handing over of assets (Section 9B) and the payout of value beyond a partner's capital (Section 45(4)), with Rules 8AA and 8AB making the two provisions work together. The safest path is to settle on genuine book capital, value any assets defensibly, and run the A = B + C - D computation before the deed is signed rather than after the assessment notice arrives.
This guide is verified against Section 45(4) and Section 9B of the Income Tax Act 1961 as substituted and inserted by the Finance Act 2021 (effective AY 2021-22), and Rules 8AA and 8AB of the Income-tax Rules 1962 notified by CBDT in 2021, together with the accompanying CBDT guidance on attribution. Always confirm the capital account figures, fair market valuations and the exact assessment year against the partnership deed and your firm's books before filing.
