The Income-tax Act, 1961 provides for specific exemption from capital gains on conversion of a company into Limited Liability Partnership. Limited Liability Partnership (LLP) is a hybrid entity combining advantages of both company and partnership firm. LLP has a flexible internal organization 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 attraction 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.

CAPITAL GAIN ON CONVERSION OF COMPANY INTO LLP

As per Section 47 of the Income Tax Act, 1961, any transaction concerning transfer of a capital asset or intangible asset by a Private Company or Unlisted Public Company to a Limited Liability Partnership as a result of conversion of the company into a Limited Liability Partnership in accordance with the provisions of section 56 or section 57 of the Limited Liability Partnership Act, 2008 would be exempted from the provision of Capital Gain Tax, only if the following conditions are satisfied:

Exeption ctriteria

Taxation if conditions are violated: If any of the conditions are violated, the Income Tax Act, 1961 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? A new tax ruling threatens to challenge a strategy that allowed thousands of businesses and professionals to reorganize themselves and attract foreign investors. This involved converting closely held companies into LLPs. While LLP was intended to help businesses to scale up, many were also allured by its ability to freely distribute profits to partners as dividend without deducting any dividend distribution tax.

THE DECISION OF THE INCOME TAX APPELLATE TRIBUNAL (ITAT)

The ruling involved Celerity Power, a private limited company that acquired LLP status in September 2010. The tax office did not buy the company’s argument that the conversion of M/s Celerity Power Private Limited into M/s Celerity Power LLP did not involve any transfer of property, assets or liabilities, among others.

The ruling could also draw the attention of the indirect tax authorities, as it challenges an earlier Madras High Court ruling that no stamp duty is levied in case of conversion of a firm into a company.

Smaller companies with less than Rs.60 lakh earnings are exempted from the definition of transfer (and thus, from capital gains tax).

However, even companies with income above the threshold are currently in a position to avoid tax on the back of the CIT vs Texspin Engg & Mfg. Works verdict of the Bombay High Court, which said the conversion was not a transfer. The Income Tax Appellate Tribunal’s ruling on Celerity Power partly takes away that protection that companies enjoyed.

This decision will have far-reaching implications. It will apply to all pending proceedings, could lead to re-assessment and revision of orders passed by tax assessing officers (AO). Future planning of conversion will also be impacted as in many cases, huge liability will arise on the company when assets are transferred at higher than the book value. The ruling lifts the primary shield that was offered by the Bombay High Court in the case of Texspin.

There would be no capital gains tax, as per the tribunal, as long as such a transfer happened at book value. However, many businesses used to convert by valuing the assets higher than book value to strengthen balance sheet of the LLP, borrow funds, attract foreign capital, as well as increase the net worth of the partners in the LLP.

Another significant aspect of the Tribunal ruling is that any tax that had escaped in the hands of the company would now be levied on the limited liability partnership which is construed as the successor. This could make life difficult for many LLPs.

BIBLIOGRAPHY:

https://taxguru.in

https://economictimes.indiatimes.com

CONTRIBUTED BY:

Ms. Jaya Sharma

Ms. Nishita Gandhi

Jaya Sharma and Associates, Practising Company Secretary Firm, Mumbai.

Jaya Sharma & Nishita Gandhi

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3 Comments

  1. vswami says:

    RIDER (pending a study of the case law referred, to share more thoughts, for an independent study)(,
    Look up the Pr. Article @https://taxguru.in/income-tax/taxability-conversion-private-limited-company-llp.html

    Also consider the viewpoints shared, based on THE FIRST PRINCIPLES , founded on common sense reasoning,, in the two articles posted on this website, discussing the better construction to be placed on the concept of ‘TRANSFER’, in a case in which the subject matter is a çapital asset being ‘equity shares’ in a company.

    And do so, with pointed focus on the special definition, of ‘body corporate’, – as to include specifically a LLP,; – which has to be read together / in consonance with the definition of ‘PERSON’ in sec 2 (31) of the IT Act (cluses ((iii) , (iv) , and (v) are of relevance).

  2. vswami says:

    IMPROMPTU
    Good job !

    TAX v “Conversion” ?!> Any comparison to IT Act exemption of Amalgamation, Merger, Demerger – To Probe into ….!

    > “…….A new tax ruling threatens to challenge a strategy that allowed thousands of businesses and professionals to reorganize themselves and attract foreign investors. …”

    “…The ruling involved Celerity Power, a private limited company that acquired LLP status in September 2010. The tax office did not buy the company’s argument that the conversion of M/s Celerity Power Private Limited into M/s Celerity Power LLP did not involve any transfer of property, assets or liabilities, among others……..”

    The developments now referred to and lamented about , – to be precise the irritating controversies and conflicting interpretational views taken by the adjudicating authorities,- are seen to be more or less on the dotted lines, as apprehended and briefly touched upon even when the concept of LLP was in a proposal stage. Refer the two published Articles on the topic of LLP – (2005) 128 Comp. cas (Journal) 1-16; and (2006) 65 SCL 42-47.
    On capital gains aspect, see the specific observations wrt the the then ‘ SECTION 35, INCOME-TAX AND CAPITAL GAINS’ – pgs. 47,48 and 49.

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