Conversion of Firms and LLPs into Companies: Understanding the tax nuances under the Income-tax Act
Converting a partnership firm or LLP into a company is often seen as a natural step in a business’s growth journey. While the process appears straightforward from a corporate law standpoint, the income-tax implications can get difficult. Whether such conversion is a “tax-neutral succession” or a “transfer giving rise to capital gains” depends on how conditions are met and how the transaction is implemented.
1. The Legal Framework — Section 47(xiii) and Its Rationale
Section 47(xiii) of the Income-tax Act, 1961 exempts from capital gains any transfer of capital assets or intangible assets by a firm (or LLP) to a company upon conversion, provided certain conditions are fulfilled. Prescribed conditions under Section 47(xiii) are:
1. all the assets and liabilities of the firm relating to the business immediately before the succession become the assets and liabilities of the company;
2. 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;
3. 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
4. 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;
If the above conditions are satisfied, the conversion is not regarded as a “transfer” for capital gains purposes.
The legislative intent — as explained in the Memorandum to the Finance (No. 2) Bill, 1998 was to encourage genuine business reorganisations and facilitate corporatization of firms without a tax burden, and not merely devices to secure tax advantage.
2. The Concept of “Statutory Vesting” — When Conversion isn’t a Transfer at All
A true conversion under Chapter XXI of the Companies Act, 2013 (or Part IX of the 1956 Act) operates through statutory vesting, which means all assets and liabilities of the firm or LLP automatically vest in the new company without any conveyance deed or separate transfer. Courts have likened this to a mere “change of cloak”: the entity continues in another legal form.
One of the most important and widely quoted judicial pronouncement is the decision of Bombay High Court in the matter of CIT v. Texspin Engg. & Mfg. Works [2003] 263 ITR 345. In this judgement, Bombay HC held that where a Firm is succeeded by a company in the business, the transaction shall not be treated as a transfer, although the judgment was related to a tax year prior to the insertion of clause (xiii) in section 47.
The reasoning is simple — there is no two-party transaction, no consideration and no extinguishment of rights; it is a continuation of the same business under a new legal wrapper. Thus, even if a taxpayer does not specifically invoke section 47(xiii), the transaction may still getaway with tax liability because, in substance, there is no “transfer” to begin with.
3. What Happens if the Conditions Are Breached?
The immunity under section 47(xiii) is not unconditional. Section 47A(3) provides a clawback mechanism: if any of the conditions under section 47(xiii) (especially the 50% shareholding continuity for five years) are breached, the exemption availed is withdrawn. The profits or gains that were not taxed earlier are then deemed to be the income of the successor company in the year of breach. However, the tax will be levied on the successor company and not on the erstwhile firm or its partners.
However, if the original conversion was a true statutory vesting (not a “transfer” at all), courts have held that the clawback does not operate, because no capital gains had ever arisen in the first place. A notable judgment was announced by Bombay High Court in the matter of CIT v. Umicore Finance Luxembourg [2016] 76 taxmann.com 32, wherein despite non-fulfilment of conditions of section 47(xiii), the Hon’ble Court held that conversion of firm into company did not amount to transfer at all.
4. Computation of Capital Gains — If Conversion is taxable
If the conversion does not qualify under section 47(xiii) (say, due to non-fulfilment of conditions or a non-statutory mode of transfer), the firm or LLP may be liable to capital gains tax. The computation then depends on the factual structure:
Sale consideration: In the absence of actual consideration, courts have repeatedly held that the “full value of consideration” cannot be substituted by market value. The allotment of shares to partners in exchange for their capital accounts is not “consideration” to the firm. However, if cash or other benefits are distributed, or if the transaction is structured as a slump sale, fair market value (FMV) principles under section 50B or rule 11UAE may apply.
Cost of acquisition: The original cost or the written down value (WDV) of assets in the firm’s books is taken as cost.
Revalued assets: Pre-conversion revaluation and crediting the difference to partners’ accounts can create exposure under section 45(4) (tax on distribution of assets) if those balances are paid out or adjusted before conversion. However, the decision of Ahmedabad ITAT in case of Vishal Engineering and Galvanizers [ITA No. 2316/Ahd/2014] affirms the position that for invoking section 45(4) of the Income-tax Act, a distribution of capital asset of the firm on dissolution thereof is necessary. It impliedly confirms that the conversion of a firm into a company only results in vesting of property and may not tantamount to transfer, and thus, is not liable for capital gains tax.
In essence, conversions carried out strictly at book value are typically safe, whereas revaluation or partner withdrawals before conversion can complicate the tax position.
5. Characterization and Period of Holding
Where the conversion is tax-neutral, the company inherits both the cost of acquisition and period of holding of the assets from the predecessor firm under section 49(1)(iii)(a) and Explanation 1(b) to section 2(42A). Thus, if the firm held the assets for more than 36 months, any future sale by the company would result in long-term capital gain.
For partners, the shares received are new assets, and their holding period starts from the date of allotment. Any gain on sale of those shares will be computed separately when sold.
6. Whether Partners can also be taxed?
This has been a matter of debate, but judicial consensus and legislative intent both favour non-taxability. In Umicore Finance and Texspin, it was held that partners do not become “richer” on conversion — the worth of the shares allotted to the erstwhile partners do not distinct from the interest of the partners in the extinct firm when quantified in terms of money.
In fact, taxing partners would contradict the policy objective behind section 47(xiii), which mirrors section 47(xiv) (exemption for proprietorship conversions). Both provisions were introduced together to promote corporatisation of existing businesses.
7. LLPs — Same Logic, Same Comfort
Though section 47(xiii) specifically refers to “firms,” courts and the CBDT have recognised that the same rationale extends to LLPs converting into companies. The conversion process under section 366 of the Companies Act, 2013 operates through similar statutory vesting. Therefore, if all assets and liabilities vest by operation of law and no consideration passes, the tax position remains identical. The recent Mumbai ITAT ruling in ISC Specialty Chemicals LLP v. ITO [ITA No. 457/Mum/2025] has also reaffirmed this position.
8. Practical and Litigation Considerations
While the legal position is well-settled, the following practical issues often invite scrutiny:
- Pre-conversion revaluation or distributions: Revaluing assets or distributing reserves to partners before conversion may indicate value extraction and setback exemption
- Allotment mismatch: Shares must be allotted in the exact proportion of partners’ capital accounts (including both fixed and current capital)
- Loss carry-forward: Unabsorbed losses and depreciation can be carried forward by the successor company only if the conversion satisfies section 47(xiii) and section 72A(6)
- Procedural aspects: Separate PAN/TAN, separate return filings for the pre and post conversion periods and apportionment of depreciation for the year of conversion are necessary
- GAAR exposure: If the conversion is followed by immediate merger, sale or distribution, authorities may invoke GAAR or treat it as colourable restructuring
9. Key Judicial Pillars
- CIT v. Texspin Engineering & Mfg. Works (Bom HC) – Statutory vesting is not a transfer; no capital gains arise
- Umicore Finance Luxembourg (Bom HC) – Partners receive no benefit; exemption available
- CADD Centre v. ACIT (Mad HC) [383 ITR 258] – No transfer of assets; section 45(4) inapplicable
- United Fish Nets (AP HC) [(2015) 372 ITR 67] – Reinforces non-taxability on conversion
- ISC Specialty Chemicals LLP – LLP to company conversion under section 366 also not a transfer; no capital gain arises and conversion at book value meant that the full value of consideration equaled the cost of acquisition, rendering Section 48 (computation) unworkable
10. Conclusion
In essence, conversion of a firm or LLP into a company, when executed through statutory vesting under Chapter XXI and satisfying the four conditions of section 47(xiii) is a tax-neutral reorganization. It just represents continuity of the same business and not a transaction of transfer or sale. Breach of conditions may attract tax only in the hands of the successor company under section 47A(3), not the partners.
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