Designed with the advantages of a flexible organisational structure, perpetual succession, limited liability and tax efficient distribution of profits to partners, Limited Liability Partnerships (LLPs) have become one of the most popular modes of doing business in India. With greater clarity in the government’s policy towards LLPs and efforts to promote foreign funding in LLPs, interest in LLPs as business models is on the rise. LLPs can come into existence either by incorporation or by conversion of an existing entity into an LLP.
The Income-tax Act, 1961 (Act) through section 47(xiiib) exempts the conversion of a private limited company or an unlisted public limited company into an LLP from capital gains tax liability, subject to compliance with certain conditions mentioned therein. If an assessee fails to comply with these conditions, section 47A(4) of the Act brings to tax the profits and gains in the hands of the successor LLP in the year in which such conditions are violated. The tax outcome of conversions, wherein an assessee does not comply with the conditions of section 47(xiiib) or chooses not to claim specific exemption of that section has been the subject matter of debate for a long time.
The recent judgement of the Mumbai Bench of Income Tax Appellant (Mumbai Tribunal) in the case of M/ s Celerity Power LLP (the Assessee)[i] has attempted to cover the income tax implications arising on the conversion of a private limited company into an LLP comprehensively. In this case, the Assessee being a private limited company engaged in the business of power generation acquired the status of an LLP by converting into an LLP. The Assessee did not claim specific exemption under section 47(xiiib) of the Act, as it was not in a position to comply with one of the specified conditions. The question arose whether such conversion could be brought to tax.
The Mumbai Tribunal observed that but for a specific exemption under section 47, the law seeks to treat the conversion as transfer taxable under section 45 of the Act. Further reliance was also placed on the memorandum explaining the Finance Act, 2010, in which section 47(xiiib) of the Act was introduced. The memorandum stipulated that such conversion involves the transfer of assets and can lead to tax implications. In addition, since the term “convert,” in relation to a private limited company into an LLP includes a “transfer of the property” in the Limited Liability Partnership Act, 2008, the Mumbai Tribunal held that the conversion of a company into an LLP is tantamount to transfer and should be subject to capital gain tax.
In reaching this finding, the Mumbai Tribunal has distinguished the earlier decisions of the Bombay High Court in the matter of Texspin Engg.[ii] and Umicore Finance Luxembourg[iii] and the decision of the Gujarat High Court in R L Kalathia.[iv] In these decisions, the Court had opined that the existence of a party and counter party, and incoming consideration, are two essential ingredients for conversions to qualify as a “transfer.” In their absence, the High Court held that the conversion of a firm into a company cannot be regarded as a “transfer” under the Act. However, the Mumbai Tribunal has observed that the succession of a partnership firm by a company is a statutory vesting of properties in the company from the date of its registration, whereas the conversion of a company into an LLP is different, and thus, confirmed the inapplicability of the judgement of Texpin Engg.
Having treated the conversion as a transfer, the Mumbai Tribunal observed that since the company had not availed the benefits of exemption under section 47(xiiib) of the Act, the provisions of section 47A(4) of the Act are not applicable to determine a relevant assesse for bringing the gains to tax. Instead, the Mumbai Tribunal applied the provisions of section 170(2) in the hands of the successor LLP, as the erstwhile private limited company had ceased to exist pursuant to conversion.
The Mumbai Tribunal further held that the “market value” of the assets on the date of transfer cannot be considered as the “full value of consideration.” Relying on the principles laid down in various jurisprudence, the Tribunal emphasised that the “full value of consideration” does not mean the “market value” of the assets transferred; instead, it shall mean the price bargained for by the parties to the transaction. Since the assets and liabilities of the private limited company were vested in the assesse LLP at their “book values,” such book value was considered as the full value of consideration for the purpose of computation of capital gain tax.
The Mumbai Tribunal applied the provisions of section 49(1)(iii) of the Act and allowed the cost at which the assets were acquired by the erstwhile private limited company, as the deemed cost of acquisition for computing capital gain tax.
Since the difference between the full value of consideration and the deemed cost of acquisition was nil, the Mumbai Tribunal held that the machinery provisions for computing capital gains were rendered unworkable, and hence, no taxability arises in the hands of the Assessee.
This judgement raises several questions with regard to the tax implications of conversions. The judgement applies a deeming fiction to say that the value recorded in the books of the successor LLP shall be taken to be the “full value of consideration” for the purposes of computation of capital gain. The Act does not expressly provide for such deeming provisions, unlike section 45(3), where on contribution of capital asset, the amount recorded in the books of accounts of the firm or LLP is deemed to be the full value of consideration received or accruing as a result of such transfer. Further, the judgement has not dwelled upon the principles laid down in the Bombay High Court’s decision in Texpin Engg. & Mfg. Works that “transfer” requires the existence of two essential conditions, the existence of a party and counter party and incoming consideration qua the transferor to qualify as a “transfer.” In addition, in light of various judicial precedents, in the absence of consideration received by the transferor company for the transfer in the form of money or money’s worth, the determination of the full value of consideration can be unworkable.
Without prejudice to the above qualifying principles laid down by the Bombay High court for a “transfer,” in light of this ruling by the Mumbai Tribunal, it is necessary to consider the tax implications and litigation that could arise, especially while recording assets in books of the successor LLP at respective fair values, pursuant to the conversion of a private limited company into an LLP.
However, if the assets are recorded at book value, the provisions of section 50C and 50CA of the Act could also be invoked if the assets of the company consist of immovable property or unlisted shares, respectively. Section 50C seeks to treat the stamp duty value of immovable property as minimum consideration for the transfer of immovable properties. Similarly, section 50CA seeks to treat the values determined under Rule 11UA as the minimum consideration for the transfer of shares in an unlisted company. In the hands of recipient, i.e., the LLP, if the specified assets are recorded at less than the prescribed valuation, taxability can also be invoked under section 56(2)(x) of the Act. The Mumbai Tribunal has not dealt with the tax implications in the hands of shareholders of the company. Considering that the conversion is a transfer, tax authorities may also seek to levy tax in the hands of shareholders receiving the interest in LLP in lieu of their shareholding in the Company. Furthermore, stamp duty authorities may seek to levy duty on the conversions by treating them as transfer. This may lead to undue hardships and costs for the entities.
With conflicting judgements to categorise a conversion as “transfer,” this judgement is expected to bring far-reaching implications on the pending proceedings, increase in reassessments or revision of orders already passed.
[i] ACIT v. M/ s Celerity Power LLP (ITA No. 3637/ Mum/ 2015)
[ii] CIT v. Texspin Engg. & Mfg. Works ((2003) 129 Taxman 1 (Bom.))
[iii] CIT v. Umicore Finance Luxembourg ((2016) 76 Taxmann.com 32)
[iv] DCIT v. R L Kalathia & Co. ((2016) 66 Taxmann.com 249 (Gujarat))
The views expressed in this article are personal. This article includes inputs by Manthan Bavishi – Manager, M&A Tax, PwC India, Nehal Thakkar – Associate – M&A Tax, PwC India.