Conversion of company into LLP – is it taxable if conditions are not fulfilled?

The Income-tax Act provides for specific exemption from capital gains on conversion of a company into a limited liability partnership. In this article, we have analysed the provisions and the taxability in light of the rulings by various courts in India on the matter.

Limited Liability Partnership (LLP) is a hybrid entity combining advantages of both company and partnership firm. LLP has a flexible internal organisation structure based on the LLP Agreement between partners, rather than the stringent provisions of the Companies Act, 2013. Furthermore, LLP has perpetual succession and offers limited liability for its partners. The Government of India has also brought in clarity on foreign investments in LLPs. Therefore, LLPs have been gaining much traction recently.

Another advantage is that there is no tax implication on distribution of profits by the LLP to its partners, unlike the levy of dividend distribution tax for a company. Hence, LLPs tend to escape additional distribution tax burden.

Although the LLP is not a new concept and is popular in developed countries such as the US, UK, etc., it was introduced in India only in 2009. The pace of incorporation had been slow in India in the initial years, with less than 17,000 LLPs incorporated in the first five years (source: www.mca.gov.in). However, owing to its numerous advantages, interest in LLPs is increasing. During the financial year 2016-17, 29,723 LLPs were registered, compared to 22,934 LLPs in FY 2015-16 and 14,849 LLPs in FY 2014-15 (source: PIB release dated 05 Janurary, 2018). The lack of clarity in the government’s policy towards LLPs, especially taxation, foreign funding, etc., was also responsible for the slow pace in initial years; however, these issues are now resolved.

In India, LLPs can be formed by either incorporation of a new entity as LLP or converting an existing company into an LLP. Conversion of an existing company into an LLP is permissible under the Companies Act, 2013 and under the Limited Liability Partnership Act, 2008. However, it is important to analyse the tax implications around such conversion. There could be tax implications for the converted company (for transfer of business) and its shareholders (for extinguishment of shares held in such company).

The Income-tax Act, 1961 (IT Act) contains specific provisions governing tax implications in case of conversion of a private limited company or an unlisted public limited company into an LLP. Section 47(xiiib) of the IT Act provides that the conversion will be tax neutral for the company and its shareholders, subject to satisfaction of the following conditions:

a. All the assets and liabilities of the company immediately before the conversion become the assets and liabilities of the LLP;

b. 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;

c. 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;

d. The aggregate of the profit sharing ratio of the shareholders of the company in the LLP shall not be less than 50% at any time during the period of five years from the date of conversion;

e. The total sales, turnover or gross receipts in the business of the company in any of the three previous years preceding the financial year in which the conversion takes place does not exceed INR 6 million;

f. 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 financial year in which the conversion takes place does not exceed INR 50 million; and

g. 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.

The aforementioned conditions are required to be fulfilled to qualify as a tax-neutral conversion. The IT Act further provides that if any of the above conditions are not complied in subsequent financial years [mainly conditions (d) and (g)] the exempted capital gains will be subject to tax in the hands of the LLP and its erstwhile shareholders, in the year in which such condition is violated.

Taxation if conditions are violated: If any of the conditions are violated, the IT Act provides that the exemption from capital gains tax will not be allowed. Therefore, the question arises: does such conversion of a company into an LLP qualify as “transfer” in the first place, and thus, is it subject to capital gains tax?

The Memorandum explaining the provisions of the Finance Bill, 2010 (which introduced section 47(xiiib)) stated that, “under the existing provisions of Income-tax Act, conversion of a company into an LLP has definite tax implications. Transfer of assets on conversion attracts levy of capital gains tax….”

The Memorandum seems to suggest that conversion of a company into an LLP is a taxable event.

However, note that a similar issue (conversion of a partnership firm into a company) has been discussed in various judicial forums (before the Bombay High Court in CIT v. Texspin Engg. & Mfg. Works (2003), Gujarat High Court in DCIT v. R L Kalathia (2016) and CIT v. Well Pack Packaging (2014) and the Authority for Advance Rulings in the case of Umicore Finance Luxembourg). The courts were of the view that conversion is not a “transfer” as defined under the IT Act, and hence, no capital gains arise on such conversion.

The Bombay High Court in the Texspin case opined that the conversion of a firm into a company is similar to transmission. Existence of a party and a counter party and incoming consideration qua transferor are the two essential ingredients of transfer. In their absence, there is no transfer of assets. It further held that there is no conveyance of the property of the firm executable in favour of the company. Although, all the properties of the firm are vested to the company, such vesting is not consequent or incidental to a transfer. Therefore, there is no transfer under section 45(1) read with section 2(47) of the IT Act.

The principles from these rulings can be followed for conversion of a company into LLP also. However, there is no Supreme Court judgement on the above matter, and hence, the position is not free from litigation. The tax authorities could argue that since the IT Act is providing a specific exemption from capital gains taxation, non-fulfilment of conditions will lead to taxation.

Another matter requiring consideration is taxability in the hands of erstwhile shareholders of the company. On conversion, the shares held by such shareholders will be extinguished and they will receive partnership interest in the LLP. The question arises if such extinguishment of shares in lieu of partnership interest will be taxable if the conditions specified under section 47(xiiib) of the IT Act are not satisfied? The aforementioned judicial rulings may apply only for determining taxability in the hands of a company and not for its shareholders. Capital gains arising in the hands of the shareholders may still suffer taxation, as extinguishment of shares would fall under the definition of “transfer” under the IT Act.

The views expressed in this article are personal.