Genuine and Sham Partnerships Under Firm, Partner, Partnership

Under the Income Tax Act, 1961, the concept of firm, partner, and partnership plays a crucial role in determining the taxability of income earned by such firms and partners. One of the key aspects that the Income Tax authorities look at is whether a partnership is genuine or a sham, as it has a significant impact on the tax liabilities of the partners and the firm. In this article, we will delve into the legal framework surrounding genuine and sham partnerships under the Income Tax Act.

The Legal Framework

Definition of Firm, Partner, Partnership

The Income Tax Act, 1961, defines the term “firm” in section 2(23) as “a partnership or a LLP”. Further, the Act defines the term “partner” in relation to a firm as “any person who under the Indian Partnership Act, 1932, has been admitted to the benefits of partnership”. The term “partnership” is defined under section 4 of the Indian Partnership Act, 1932, as “the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all”.

Genuine Partnership

A genuine partnership is one that complies with the requirements specified under the Indian Partnership Act, 1932. The key elements of a genuine partnership include mutual agreement, sharing of profits and losses, joint ownership, and joint management of the business. In a genuine partnership, the partners are actively involved in the conduct of the business, and there is a clear intention to carry on a legitimate business for profit.

Genuine partnerships are recognized and respected by the Income Tax authorities, and the tax treatment of such partnerships is in accordance with the provisions of the Income Tax Act. The income earned by a genuine partnership is taxed at the firm level, and the partners are taxed on their respective shares of profits as per the provisions of the Act.

Sham Partnership

On the other hand, a sham partnership is one that is not genuine and is created for the purpose of evading taxes or achieving some other unlawful or fraudulent objective. Sham partnerships often involve the mere colorable device of entering into a partnership agreement without any real intention of carrying on a business or sharing profits and losses.

The Supreme Court of India, in various landmark judgments, has held that a sham partnership is not entitled to the benefits and privileges conferred by the Indian Partnership Act, 1932, and is not recognized as a legal entity for the purpose of income tax. The income earned by a sham partnership is taxed in the hands of the purported partners or the person who is found to be the real beneficiary of such income.

Determination of Genuine or Sham Partnership

Factors Considered by Income Tax Authorities

The Income Tax authorities carefully scrutinize the nature and conduct of the partnership to determine whether it is genuine or sham. Some of the key factors considered in making this determination include:

Genuineness of the Partnership Deed: The partnership deed is a crucial document that sets out the terms and conditions of the partnership, including the rights and obligations of the partners. The Income Tax authorities examine the genuineness of the partnership deed and look for any indications of fraud or misrepresentation.
Conduct of the Parties: The conduct of the partners, both in their dealings with each other and with third parties, is a significant factor in determining the genuineness of the partnership. The authorities look at whether the partners are actually engaged in the business and whether they are actively involved in managing the affairs of the firm.
Sharing of Profits and Losses: A genuine partnership involves the sharing of profits and losses among the partners as per the terms of the partnership deed. The authorities carefully examine the actual sharing of profits and losses to ensure that it reflects the true intentions of the partners.
Contribution of Capital and Assets: The contribution of capital and assets by the partners towards the business is an important indicator of the genuineness of the partnership. The authorities look at whether the partners have made genuine contributions and whether the capital and assets are actually used in the conduct of the business.
Existence of Business Activities: The authorities assess whether the partnership is actively engaged in business activities and whether it has a genuine commercial substance. They look for evidence of business operations, such as sales, purchases, investments, and other business transactions.
Control and Management of the Business: In a genuine partnership, the partners collectively share the control and management of the business. The authorities examine whether the partners are jointly involved in making business decisions and executing the day-to-day operations of the firm.

Legal Precedents

In the case of CIT v. A.R. Srinivasan, the Supreme Court laid down certain tests to determine the genuineness of a partnership. These tests include the existence of a genuine partnership deed, actual conduct of the partners in carrying on the business, sharing of profits and losses, and the mutual agency among the partners.

Similarly, in the case of Sunil Siddharthbhai v. CIT, the Supreme Court held that the burden of proving the genuineness of a partnership lies on the taxpayer, and if the partnership is found to be sham or bogus, the income will be assessed in the hands of the person who actually earns the income.

Tax Implications

Tax Treatment of Genuine Partnership

A genuine partnership is recognized as a separate legal entity for the purpose of income tax, and the income earned by the firm is taxed at the firm level. The partners are then taxed on their respective shares of profits as per the provisions of the Income Tax Act. This tax treatment is in line with the principle of separate taxation of entities and is designed to prevent double taxation of the same income.

Tax Treatment of Sham Partnership

A sham partnership, being a mere colorable device, is not recognized as a legal entity for the purpose of income tax. The income earned by a sham partnership is not taxed at the firm level but is assessed in the hands of the partners or the actual beneficiaries of such income. The provisions of the Act relating to assessment, appeal, and recovery apply to such cases as if the assessment of the income had been made directly upon the purported partners.

Conclusion

In conclusion, the determination of whether a partnership is genuine or sham plays a crucial role in the taxability of the income earned by such partnerships. The legal framework surrounding genuine and sham partnerships is well-defined under the Income Tax Act and is supported by various judicial precedents. It is important for taxpayers to ensure that their partnerships are genuine and comply with the requirements of the law to avoid adverse tax implications. The Income Tax authorities have the power to scrutinize and disregard sham partnerships and assess the income in the hands of the real beneficiaries, making it imperative for taxpayers to conduct their affairs in a genuine and transparent manner.