Capital Gain Tax on Conversion of private company into LLP?

Clause (xiiib) of section 47 read with sub-section (4) of section 47A of the Income Tax Act, 1961, inserted by the Finance Act, 2010, with effect from assessment year 2011-12 provide that the transfer of a capital asset or intangible asset to LLP or any transfer of share or shares held in the company by a shareholder on conversion of a private company or unlisted company into an LLP in accordance with sections 56 and 57 of the Limited Liability Partnership Act, 2008 shall not be regarded as a transfer for the purposes of capital gains tax, subject to the following conditions :

(i) the total sales, turnover or gross receipts in business of the company do not exceed Rs. 60 lakhs in any of the three previous years preceding the previous year in which conversion takes place;

(ii) all the shareholders of the company immediately before the conversion become partners of the LLP. Their capital contribution and profit sharing ratio should be in the same proportion as their shareholding in the company as on the date of the conversion;

(iii) the shareholders of the company do not receive any consideration or benefit other than share in profit and capital contribution in the LLP;

(iv) the aggregate of the profit-sharing ratio of the erstwhile shareholders of the company in the LLP shall not be less than 50% of the profits of the LLP at any time during the period of 5 years from the date of conversion;

(v) all assets and liabilities of the company immediately before the conversion become the assets and liabilities of the LLP; and

(vi) no amount is paid, either directly or indirectly, to any partner out of the accumulated profit standing in the account of the company as on the date of conversion for a period of 3 years from the date of conversion.

If all of the above conditions (i) to (vi) are complied with, the conversion shall not attract capital gains tax either for the company or the successor LLP or for the shareholders of the company (who become partners in the successor LLP and get share of profits and capital in the LLP in lieu of their shares in the company).

Further, where any of the conditions as specified above are not complied with, the amount of capital gains arising from the transfer of such capital asset or intangible asset or share or shares not charged under section 45 by virtue of the said conditions shall be deemed to be taxable capital gains of the successor LLP or the shareholders of the predecessor company in the previous year in which such non-compliance takes place.

In this regard, the present article attempts to analyse the essential elements contained in provisions mentioned supra.

1. Effective date of conversion: The date of conversion is the date of registration mentioned in the certificate of conversion issued by Registrar of Company in Form 19 of the LLP Rules, 2009. Thus, the previous year in which conversion takes place as mentioned in condition (i) above signifies the previous year in which the date of conversion takes place.

2. Computation of total sales, turnover or gross receipts which shall not exceed Rs. 60 lakhs in respect of 3 preceding years: If this condition is not satisfied, then the amount of capital gains arising from the transfer of such capital asset or intangible asset or share or shares not charged under section 45, shall be deemed to be taxable capital gains of the successor LLP or the shareholders of the predecessor company in the previous year in which such non-compliance takes place. The following points need utmost consideration in this regard:

• The turnover in the previous year of conversion is immaterial and the turnover in any of the three preceding previous years shall not exceed Rs. 60 lakhs;
• In CIT v. Dr. K. Satish Shetty [2010] 108 Taxman 32, the Karnataka High Court held that in case assessee is carrying on many businesses, then all businesses are not required to be consolidated for working out the aggregate of turnover.

3. All the shareholders of the company shall become partners of the LLP: The expression “all the shareholders” will cover equity shareholders as well as preference shareholders. Further as upheld by SC in Rameshwarlal Sanwarmal v. CIT [1980] 122 ITR 1, the word “shareholder” can only mean a registered shareholder. A beneficial owner of shares whose name does not appear in the register of shareholders cannot be said to be a “shareholder”.

4. Aggregate Profit Sharing Ratio of shareholders shall remain at least 50% for a period of 5 years: The aggregate of the profit-sharing ratio of the erstwhile shareholders of the company in the LLP shall not be less than 50 per cent of the profits of the LLP during the period of 5 years from the date of conversion. The Law is silent about a moot question as to what would happen if due to death of one of the partners, the share of profits in the LLP of the erstwhile shareholders (who became partners in the LLP) falls below 50% before the expiry of 5 years from the date of conversion.

5. Other Issues:

• All assets and liabilities immediately before conversion should become assets and liabilities of LLP. The Law is silent about whether there is no requirement that these assets should not be transferred after conversion.
• The provisions contained in clause (xiiib) supra are also silent about the meaning of the expression ‘accumulated profits’. In its cognate accounting sense it means that the accumulated profits which are lying in reserve or in the profit and loss (surplus) balance as on date of conversion should not be distributed to any partner or transferred to their capital accounts until 3 years from date of conversion. The fog on this provision is about what purpose would be served by the retaining the identity of these accumulated profits in books of account of LLP.

The above article is contributed by CA Kamal Garg having professional and academic interests in IFRS, Accounts, Auditing and Corporate Laws arenas. He can be approached atcakamalgarg@gmail.com