There could be tax implications on the conversion of a Company into LLP (for transfer of business) in the hands of LLP and on 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:
1. All the assets and liabilities of the company immediately before the conversion become the assets and liabilities of the LLP;
2. 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;
3. 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;
4. 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;
5. 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;
6. 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
7. 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.
In the hands of shareholders
Does a question arise whether 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?
On conversion, the shares held by such shareholders will be extinguished and they will receive partnership interest in the LLP. Capital gains arising in the hands of the shareholders may still suffer taxation, as the extinguishment of shares would fall under the definition of “transfer” under the IT Act.
The shares in the hands of the shareholders of the private limited company will be converted as the capital of the LLP. The shareholder will surrender the shares and acquire capital in the LLP. The shareholder has to pay tax on the capital gain arising from him from such transfer. The Value of capital is the consideration for the transfer of shares. The cost of a share is the amount paid by such shareholder at the time of purchase of shares. The receipt of the bonus share will not have any cost since it is out of the reserves of the company.