Income Tax Implication of conversion of Partnership Firm / Proprietorship Firm in to Private Limited Company
Overview:
When converting an existing Partnership Firm or Proprietorship Firm into a new private limited company, there is a change in ownership on paper, but the implications in reality is quite considerable. It raises questions regarding whether such a transaction falls under the definition of “Transfer” and whether resulting Capital Gain (if any) is taxable or exempt. Clarification on these points is essential for understanding the legal and tax implications of such conversions.
Context from the view point of Income Tax Act, 1961:
- Converting an existing Partnership firm or Proprietorship firm into a Private Limited Company triggers a meticulous examination of the definition of transfer under section 2(47) of the Act. Consequently, Section 45 of the Act is directly applicable in this scenario.
- However, it is pertinent to note that such transactions fall within the purview of Section 47 of the Act, which explicitly outlines “Transactions not regarded as transfer.” Therefore, these transactions are now being exempted from being considered as transfers under section 45 of the Act. This exemption provides a crucial legal framework for understanding the implications of converting a partnership or proprietorship firm into a private limited company.
For Partnership Firm converted into a Private Limited Company [Refer Section 47(xiii)]
(xiii) any transfer of a capital asset or intangible asset by a firm to a company as a result of succession of the firm by a company in the business carried on by the firm, or any transfer of a capital asset to a company in the course of demutualisation or corporatisation of a recognised stock exchange in India as a result of which an association of persons or body of individuals is succeeded by such company:
Provided that:
(a) All the assets and liabilities of the firm or of the association of persons or body of individuals relating to the business immediately before the succession become the assets and liabilities of the company;
(b) All the partners of the firm immediately before the succession become the shareholders of the company in the same proportion in which their capital accounts stood in the books of the firm on the date of the succession;
(c)the partners of the firm do not receive any consideration or benefit, directly or indirectly, in any form or manner, other than by way of allotment of shares in the company; and
(d)the aggregate of the shareholding in the company of the partners of the firm is not less than fifty per cent of the total voting power in the company and their shareholding continues to be as such for a period of five years from the date of the succession;
(e) the demutualisation or corporatisation of a recognised stock exchange in India is carried out in accordance with a scheme for demutualisation or corporatisation which is approved by the Securities and Exchange Board of India established under section 3 of the Securities and Exchange Board of India Act, 1992 (15 of 1992);
For Sole Proprietor Concern converted into a Private Limited Company [Refer Section 47(xiv)]
(xiv) Where a sole proprietary concern is succeeded by a company in the business carried on by it as a result of which the sole proprietary concern sells or otherwise transfers any capital asset or intangible asset to the company:
Provided that—
(a) All the assets and liabilities of the sole proprietary concern relating to the business immediately before the succession become the assets and liabilities of the company;
(b) the shareholding of the sole proprietor in the company is not less than fifty per cent of the total voting power in the company and his shareholding continues to remain as such for a period of five years from the date of the succession; and
(c) The sole proprietor does not receive any consideration or benefit, directly or indirectly, in any form or manner, other than by way of allotment of shares in the company.
Understanding: When a Partnership Firm or a Proprietorship Firm is converted into a Private Limited Company through succession, and the newly formed company’s primary business aligns with that of the transferring Partnership Firm or Sole Proprietorship Concern, certain conditions under sections 47 (xiii) and 47 (xiv) must be met. Upon meeting these conditions, exemption from capital gains will be granted. These conditions are presented below in a simplified format for easy reference.
Cumulative Summary of conditions laid in Section 47(xiii) & 47(xiv):
| Sr. No. | Partnership Firm to Private Limited Company [Section 47(xiii)] | Proprietorship Concern to Private Limited Company [Section 47(xiv)] |
| 1 | Assets & Liabilities shall be transferred from Partnership Firm to Company before succession | Assets & Liabilities shall be transferred from Sole Proprietorship Concern to Company before succession |
| 2 | Shareholding as such Voting Powers of >= 50% shall remain with existing partners for period of 5 years from Date of succession | Shareholding as such Voting Powers of
>= 50% shall remain with Sole Proprietor for period of 5 years from Date of succession |
| 3 | Partners of the Firm shall not receive any consideration/benefits other than the allotment of shares | Sole Proprietor shall not receive any consideration/benefits other than the allotment of shares |
| 4 | All the Partners of Firm shall become shareholders of the company in the proportion of their capital account in firm | |
| 5 | Demutualisation or Corporatisation of RSE shall be done in accordance with scheme approved by SEBI |
So, the next question is what if the condition laid down above were not satisfied?
Section 47A(3) of the Income Tax Act, 1961 comes into a role now:
47A. [Withdrawal of exemption in certain cases. [Inserted by Act 67 of 1984, Section 13 (w.e.f. 1.4.1985).]
(3) [ Where any of the conditions laid down in the proviso to clause (xiii) or the proviso to clause (xiv) of section 47 are not complied with, the amount of profits or gains arising from the transfer of such capital asset or intangible asset not charged under section 45 by virtue of conditions laid down in the proviso to clause (xiii) or the proviso to clause (xiv) of section 47 shall be deemed to be the profits and gains chargeable to tax of the successor company for the previous year in which the requirements of the proviso to clause (xiii) or the proviso to clause (xiv), as the case may be, are not complied with.] [Inserted by Act 21 of 1998, Section 22 (w.e.f. 1.4.1999).
Understanding: If any of the conditions specified in Section 47(xiii) or Section 47(xiv) are not met, Section 47A(3) explicitly states that the exemption on gains arising from the transfer of such capital or intangible assets, previously not taxed under Section 45 due to compliance with conditions in Section 47(xiii) or Section 47(xiv), will be treated as taxable profits and gains in the year when these conditions are not fulfilled.
CERTAIN JUDGEMENTS RELATED TO SECTION 47(XIII), SECTION 47(XIV), SECTION 47A(3):
| Sr. No. | Case Law Name | Synopsis of the Case Law |
| 1. | CIT vs. Texspin Eng. & Mfg. Works (263 ITR 345) (Bombay HC)
Well Pack Packaging Vs. DCIT (2003)78TTJ(AHD)448 (Guj. HC) |
Conversion of partnership firm to company will not attract provisions of Section 45(4) as there is no distribution of capital asset on dissolution and provisions of Section 45(1) also does not apply as the vesting of the properties of the firm in the company was not consequent or incidental to a transfer as contemplated u/s
45(1). Therefore non-compliance of conditions laid down in Section 47 (xiii) shall not result into adverse tax implications |
| 2. | Ruling by ITAT (Tribunal) Ahmedabad Bench* | Tribunal held that there is no requirement under section 47(xiii) of the Income-tax Act, 1961 (Act) that a firm should be ‘converted’ into a company. Further it says that if existing company acquires partnership firm / proprietorship firm assuring that condition laid down in Section 47(xiii) & Section 47(xiv) has been duly care of and satisfied, then such exemption shall be granted for the transfer. |
BENEFITS OF TRANSFERRING PARTNERSHIP/PROPRIETORSHIP TO PRIVATE LIMITED COMPANY:
1. Benefits of Tax Rate in a Firm Vs. Company:
| Nature of Business | Partnership Firm | Private Limited Company | Benefit of Income Tax
(in case of Private Limited Company) |
||
| Total Income upto 1 Crore | Total Income exceed 1 Crore | Any amount of Income | Total Income upto 1 Crore | Total Income exceed 1 Crore | |
| If incorporated as Manufacturing Unit after 01.10.2019 up to 31.3.2024 | 30*1.04 = 31.20% | 30*1.12*1.04 = 34.94% | 15*1.10*1.04 = 17.16% | 31.2 – 17.16 = 14.04% | 34.94 – 17.16 = 17.78% |
| Other than above | 30*1.04 = 31.20% | 30*1.12*1.04 = 34.94% | 22*1.10*1.04 = 25.17% | 31.2 – 25.17 = 6.03% | 34.94 – 25.17 = 9.77% |
2. Taxation Benefits & Impact of Conversion:
- The transfer of property from a Partnership firm to a Company is exempt from Capital Gains tax.
- The accumulated loss and unabsorbed depreciation of the Partnership firm are considered as the loss/depreciation of the successor company in the year of conversion. This allows the successor to carry forward such losses for up to eight years.
- All assets and liabilities of the Partnership firm at the time of conversion become those of the Company.
- The goodwill and brand value of the Partnership firm remain intact, providing continuity and legal recognition to its past success.
- The Company automatically inherits all movable and immovable properties of the Partnership firm without the need for a transfer instrument, thus exempting it from stamp duty payments.
Synopsis: The conversion of a partnership or proprietorship firm into a Private Limited Company presents advantageous prospects from an income tax standpoint, primarily due to potential tax savings. This strategic shift not only alters the business structure but also offers avenues for tax optimization. By transitioning to a Private Limited Company, the entity gains access to various tax incentives and allowances available exclusively to corporate entities, thereby potentially reducing its tax liabilities. This strategic move is thus recommended for firms seeking to optimize their tax position while ensuring compliance with the Income Tax Act of 1961 and all other relevant statutory act(s).
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