Converting into a Limited Liability Partnership - India tax implications

Published: May 13, 2019

By Namrata Arora and Kanika Dhawan

A Limited Liability Partnership (LLP) is a new form of business entity recently introduced as an alternative to carry on business in India. It is a hybrid form of existence with the features of both a company as well as a partnership firm, thereby reaping the benefits, inter-alia, of capital contribution with varying ratio of profit sharing along with limited liability of the partners / owners. It offers ease of incorporation (in comparison to a company) and at the same time, allows its members the flexibility of organising their internal management based on a mutually agreed arrangement, as is the case in a partnership firm.

Such benefits of LLP make it one of the most sought after form of doing business in India presently, due to which many new businesses are being established in the form of LLP, in place of a private limited company.

The Limited Liability Partnership Act, 2008 (LLP Act) permits conversion of a private company or an unlisted public company into an LLP. Therefore, many companies have opted to convert to LLP.The LLP Act also provides that all the assets and liabilities of the Company shall be transferred to and shall vest in the LLP as on the date of registration.

With the growth of such conversions of companies into LLPs, the moot point is whether the conversion of company into an LLP would have any tax implications in the hands of the Company or the newly converted LLP? Moreover, what would be the impact of such conversion on shareholders.

The existing provisions of the Income Tax Act, 1961 (Act)have given benefit of exemption from taxation of such conversion as a transfer and thus not taxable as a capital gain, provided the conditions stipulated in law are satisfied.

Section 47(xiiib) of the Act provides that the transfer of capital asset or intangible asset by a company to an LLP (in accordance with the provisions of LLP Act) shall not be regarded and therefore is not liable to capital gains tax provided the following conditions are satisfied:

  • all the assets and liabilities of the company immediately before the conversion become the assets and liabilities of the LLP
  • all the shareholders of the company immediately before the conversion become the partners of the LLP and their capital contribution and profit sharing ratio in the LLP are in the same proportion as their shareholding in the company on the date of conversion
  • the shareholders of the company do not receive any consideration or benefit, directly or indirectly, in any form or manner, other than by way of share in profit and capital contribution in the LLP
  • the aggregate of the profit sharing ratio of the shareholders of the company in the LLP shall not be less than fifty per cent at any time during the period of five years from the date of conversion
  • the total sales, turnover or gross receipts in the business of the company in any of the three previous years preceding the previous year in which the conversion takes place does not exceed sixty lakh rupees
  • the total value of the assets as appearing in the books of account of the company in any of the three previous years preceding the previous year in which the conversion takes place does not exceed five crore rupees
  • no amount is paid, either directly or indirectly, to any partner out of balance of accumulated profit standing in the accounts of the company on the date of conversion for a period of three years from the date of conversion

While the Act provides for specific exclusion / exemption in case of LLP conversion, which satisfies prescribed conditions, however, there is no specific guidance under the law as to what would be the tax implications if the conversion is not compliant with any of the said conditions. Therefore, in order to ascertain tax implications in case of conversion of a company into LLP, which is, not complaint with the prescribed conditions (hereinafter referred as non-compliant conversion), reliance is being placed on the jurisprudences available on conversion of a partnership firm into the company in light of the limited / no guidelines available for a non-compliant conversion.

Accordingly, placing reliance on judicial precedents wherein the courts have held that conversion of a firm into a company does not constitute transfer,the view that is being taken by companies in relation to such non-compliant conversions is that such conversion should not be considered as transfer and thus should not be liable to capital gains tax.

The Mumbai Tribunal, in its recent ruling, in the case of Celerity Power LLP has dealt with this issue at length and provided a ruling in respect of tax treatment of such transfers.

A brief gist of the judgement pronounced by the Tribunal (along with the facts) is as under:

Facts in brief

•  Taxpayer converted from company into an LLP, as a result of which entire business, assets and liabilities of the company were transferred to the LLP.

•  It claimed the conversion of the company into an LLP did not involve any 'transfer' of property, assets, liabilities, etc thus not liable to tax.

•  One of the conditions prescribed under section 47(xiiib)(e) of the Act was not satisfied i.e. total sales in the business of the company exceeded the prescribed limit of INR 60 lakhs in one of the three preceding previous years.

•  The tax officer invoked section 47A (4) and considered the conversion to be a ‘transfer' and taxable as ‘capital gains'.

•  Taxpayer filed an appeal before the CIT (A), which held that on conversion of a company to a LLP, there was a transfer of assets from the erstwhile private limited company to the LLP as one of the conditions prescribed for a tax neutral transfer was not fulfilled.

However, since the difference between the transfer value and the cost of acquisition was Nil (both being at book values), the machinery provision contemplated in section 48 of the Act for computing the capital gains were rendered unworkable.


Contentions of the taxpayer before the Tribunal

• Referring to section 58(4) and the Third schedule to the LLP Act, the taxpayer contended that the conversion of a company into a LLP results in statutory vesting of assets and liabilities and not ‘transfer'.

• Relied on the judgement of the Hon'ble Bombay High Court in the case of CIT vs. Texspin & Engg. Works - 2003-TIOL-369-HC-MUM-IT, wherein it has been held that there was no ‘transfer' of assets on conversion of a firm to a company under Part IX of the Companies Act,1956

• No consideration is involved in the transaction of conversion; hence, the machinery provision for computing the capital gains was rendered as unworkable.

• Even if there is a 'transfer', then what has been transferred is the ‘undertaking', which had no determinable cost of acquisition. Therefore, on the said count also no 'capital gain' is chargeable in the hands of the taxpayer

• Section 47A(4) of the Act can be invoked only when exemption under section 47(xiiib) is first claimed by the taxpayer and there has been subsequent violation of the conditions mentioned therein. In the instant case, the company has not claimed exemption u/s 47(xiiib) of the Act, hence, question of withdrawal of benefits of said exemption by invoking section 47A of the Act does not arise

• Support drawn from the judgement of Hon'ble High Court of Bombay in the case of CIT vs. Umicore Finance Luxemborg [2016] 76 taxmann.com 32/244 Taxman 43 (Bom.) to contend that even otherwise Sec. 47(xiiib) r.w.s 47A cannot be construed to read a fiction, to the effect that the income which is not liable to be taxed as capital gains can be deemed as 'capital gains'.

 

Decision of the Tribunal

• The Tribunal opined that the transaction involving conversion of a private limited company or an unlisted public company to a LLP would be regarded as a ‘transfer'. However, on cumulative satisfaction of the conditions (a) to (f) prescribed in section 47(xiiib) of the Act, the same would not be chargeable to capital gains tax

• The Tribunal observed that the judgement of Texspin Engg & Mfg. Works is in context of conversion of private limited company to a LLP hence distinguishable on facts

• On a perusal of the definition of the term "convert" as defined in clause 1(b) of the Third Schedule' to the LLP Act, it can be gathered that the conversion of a private company into a LLP involves transfer of the property, assets etc.

• Unlike the conversion of a private limited company into a LLP, in the case of succession of a partnership firm by a company as per Part IX, there is only "vesting" of the property of the partnership firm in the company from the date of its registration as per Sec. 575 of the Companies Act, 1956

• The Tribunal observed that section 47A(4) of the Act comes into play only for the purpose of withdrawing an exemption earlier availed under section 47(xiiib), and deeming the same as the profits and gains of the successor LLP or the shareholder of the predecessor company, as the case may be, for the previous year in which the requirements of the said proviso are not complied with.

• Though the "capital gains", if any, involved in the transfer of the capital assets on conversion of the private limited company to a LLP, would not be liable to be assessed in the hands of the taxpayer LLP as per section 45 r.w.s 5 of the Act, the same would be taxable in the hands of the taxpayer LLP as a ‘successor entity' to the erstwhile company under section 170 of the Act

• The conversion of the assets and liabilities of the erstwhile company to the LLP took place at the ‘book value' itself and therefore, no separate cost other than the ‘book value' is attributable to the individual assets and liabilities.

• As the assets and liabilities of the erstwhile private limited company were vested in the LLP at their 'book values', hence such 'book value' could only be regarded as the 'full value of consideration' for the purpose of computation of 'capital gains'.

• The Tribunal agreed with the view taken by the CIT (A), that though there is a transfer of assets from the erstwhile private limited company to the taxpayer LLP, however, as the difference between the transfer value and the cost of acquisition is Nil, therefore, while computing the capital gains the machinery provision is rendered as unworkable.

While the Tribunal has set the path on taxability of non-compliant conversion of a company into LLP, following points merit further consideration -

Though this judgement has provided some guidance on the taxability of non-compliant conversion of company into a LLP, however, the following arguments merit further evaluation:

a) Conversion of a company into LLP - Is it really a ‘Transfer'

- The Tribunal opined that the transaction referred to in section 47 are ‘transfers' and would not be chargeable to capital gains tax on cumulative satisfaction of conditions prescribed in respective sub-sections. Considering that conditions prescribed in section 47(xiiib) are not cumulatively satisfied, therefore, the conversion of company into LLP would be regarded as ‘transfer' and thus liable to capital gains tax. This view of the Tribunal may require further evaluation in view of the following:

- This contention differs from the views expressed in income tax commentaries and the interpretation given by court in Texspin ruling.

- Generally, transfer involves two important ingredients -

  • existence of a party and a counter-party; and
  • Incoming consideration to the transferor.

- In the case of conversion of a company into LLP, clearly both the conditions are not satisfied as the LLP succeeds the company and the transferor / transferee are never in co-existence as the company ceases to exist the moment LLP is registered and also the company (so called transferor of the business) does not receive any consideration for conversion.

b) Tribunal's observation on AAR judgement in the case of Umicore Finance

The Tribunal has given an observation taking reference from the Umicore AAR Ruling that the question whether vesting by operation of law would be a ‘transfer' or not has not been decided by the Court in the case of Texspin Ruling. However, it is pertinent to note that there is a specific finding in Texspin Ruling that conversion of partnership firm into a company under Part IX provisions of the Companies Act, 1956 would not amount to transfer under the Act. Therefore, the observation made by Tribunal requires further consideration.

c) Cost of acquisition - reference made to section 49

The reference to section 49 to determine the cost of the acquisition appears unclear as the cost is being ascertained for the purpose of determining capital gains in the hands of the company and not the LLP. Therefore, cost to previous owner is only when the LLP in turn would transfer the capital asset.

d) Provisions of Companies Act, 1956 are similar to the provisions of LLP Act, 2008

The Tribunal observed that unlike the conversion of a private limited company into a LLP, in the case of succession of a partnership firm by a company as per Part IX, there is only 'vesting' of the property of the partnership firm in the company from the date of its registration under the Companies Act, 1956. Section 575 of the Companies Act, 1956 states that all property, movable and immovable (including actionable claims), belonging to or vested in a company at the date of its registration in pursuance of this part, shall, on such registration, pass to and vest in the company as incorporated under this Act for all the estate and interest of the company therein. In the backdrop of the aforesaid observations it is concluded that conversion of a company into a LLP, is differently placed as in comparison to succession of a partnership firm by a company under Part IX of the Companies Act, 1956.

However, it may be noted that there is a similarity between the provisions of Part IX and conversion of a company into an LLP that the property vests in and divested in both cases on account of statutory vesting which does not require a separate instrument of transfer.

Takeaways

This decision would have a favourable consideration in cases where, due to non-satisfaction of conditions laid down under section 47(xiiib) of the Act, the conversion is regarded as transfer. However, consideration and cost are considered as book value leading to Nil capital gains tax. On the other hand, the taxpayers who have claimed that the conversion of company into LLP does not amount to transfer when the conditions stipulated under section 47(xiiib) are not satisfied, and placed reliance on Texspin ruling, may face adverse consequences before income tax authorities. Further, this ruling is silent on shareholder taxation. However, the tax authorities may apply the above findings given by the Tribunal to levy capital gains tax in the hands of shareholders.

[Namrata Arora is Senior Manager & Kanika Dhawan is Deputy Manager at Deloitte Haskins & Sells. The views expressed are strictly personal.]

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