Provisions of Section 45 of the Income-tax Act, 1961 (‘the Act’) provides for charging of Capital Gains Tax on account of transfer of capital asset in the previous year subject to provisions of Section 54 – 54H of the Act under the head ‘Capital Gains’ and shall be deemed to be the income of the previous year in the year in which the transfer takes place.
Conversion of Company into LLP
The Finance Act, 2009 provided for the taxation of LLPs on the same footing as that applicable to partnership firms. However, the Act did not address the issue of taxation in case of conversions to LLP.
Whether the same was excluded from the purview of taxable transfers was not addressed. Thus, there were issues w.r.t. taxing the conversion of Private Limited Companies or unlisted public companies into an LLP.
The Finance Act, 2010 provided for an exemption in such cases by insertion of the new Clause xiiib to Section 47 of the Act provided for the exemption on conversion of a Private Limited Company or an unlisted Company into an LLP, subject to cumulative satisfaction of conditions deeming the same to not constitute a transfer.
Conditions Precedent
a.There is a transfer of capital asset by Co. to an LLP.
b. All assets of Co. become assets of the LLP.
c. All the shareholders of the company, immediately before the conversion, become the partners of the LLP in the same proportion as their shareholding in the company on the date of conversion.
d. 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 Limited Liability Partnership.
e. The total sales, turnover, or gross receipts in the business of the company in any of the three previous years preceding the previous year in which the conversion takes place does not exceed 60 Lakh rupees.
f. 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 previous year in which the conversion takes place does not exceed 5 crore rupees.
Read: Force of Attraction (FoA) Clause in Tax Treaties
Condition Subsequent
a. The aggregate of the profit-sharing ratio of the shareholders of the company in the LLP shall not be less than fifty per cent at any time during the period of five years from the date of conversion.
b. 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.
What happens if any of the conditions of Section 47(xiiib) are not fulfilled or violated?
Section 47A(4) of the Act provides for withdrawal of exemption in case of violations of the provisions / conditions mentioned under Section 47(xiiib) of the Act.
The section provides that where any of the conditions laid down in the proviso to Clause (xiiib) of Section 47 are not complied with, the amount of profits or gains arising from the transfer of such capital asset or intangible assets or share or shares not charged under Section 45 by virtue of conditions laid down in the said proviso shall be deemed to be the profits and gains chargeable to tax of the successor Limited Liability Partnership or the shareholder of the predecessor company, as the case may be, for the previous year in which the requirements of the said proviso are not complied with.
Whether a contrary view can be taken?
At the outset, it may be pertinent to analyse the definition of transfer as provided u/s 2(47) of the Act. Provisions of Section 2(47) of the Act is an inclusive definition which provides transfer to include transfer by way of sale, exchange, relinquishment of rights, compulsory acquisition under any law, conversion of capital assets into stock in trade etc.
Further, any transfer of assets whether movable, immovable, tangible, intangible, voluntary, involuntary involves a contract to sell / transfer such property.
Therefore, a reference to provisions of the Indian Contract Act, 1872 may also be made. Provisions of Section 10 of the Indian Contract Act require existence of two or more persons as parties to an agreement and lawful consideration amongst others for an agreement to be a valid contract.
Can conversion be considered equivalent to a transfer?
In the case of ACIT v Celerity Power LLP [2018] 100 taxmann.com 129 (Mumbai – Trib.), the Hon’ble Mumbai Tribunal had a contrary view to the above arguments made, as discussed above. The Mumbai ITAT made the following important observations while rejecting the arguments –
The transaction of vesting of assets from a company to a firm / LLP would constitute a transfer. Section 47 opens with the words “nothing contained in Section 45 shall apply to the following transfers” and Clause (xiiib) provides for the conversion of a company to an LLP subject to cumulative satisfactions of conditions mentioned therein.
From a bare reading of the provisions, a clear manifest is that certain transfers would not be chargeable to Capital Gains Tax under Section 45 on the satisfaction of conditions mentioned in Section 47, though the same originally constitute a transfer.
“Memorandum to FB, 2010 observed the introduction of Clause (xiiib) to Section 47 aimed to exempt the conversion of a company into an LLP from Capital Gains Tax which was otherwise subject to capital gain.”
Further, Sections 56 and 57 of the LLP Act, 2008 provide for conversion of a Private Limited Company into an LLP in accordance with the provisions of Chapter X of the Limited Liability Partnership Act, 2008 and the Third Schedule.
The word ‘Convert’ is defined under Clause 1(b) of the 3rd Schedule which reads as under and consciously rejected the argument that automatic vesting of property vide Clause 6(b) of the 3rd Schedule of the LLP Act would not constitute transfer as per TOPA, 1882.
Further, the ‘full value of consideration’ used in Sec. 48 cannot be construed as the ‘market value’ of the asset on the date of transfer, relying on the Hon’ble Apex Court judgements in the case of (i) CIT v. George Henderson and Co. Ltd. [1967] 66 ITR 622 and (ii). CIT v. Gillanders Arbuthnot and Co. [1973] 87 ITR 407 (SC), where it was observed that the ‘full value of the consideration’ as appearing in Section 48 of the Act shall mean “the price bargained for by the parties to the transaction and not market value”.
Conclusion
The observations made by the Hon’ble ITAT while adjudicating the above case of ACIT v Celerity Power LLP (supra), seem reasonable.
The findings made in the case of ACIT v Celerity Power LLP (Supra) are based on various references to statutory material available i.e., the Memorandum to Finance Bill, and the explanatory notes which give more reliable inference as to the intention of statute than the judicial precedents.
One may therefore safely adopt the findings made in the ACIT v Celerity Power LLP (Supra).
However, alternative arguments can be pleaded and explored before authorities as there is no settled principle or any judicial precedent of higher authorities, namely the High Courts and the Supreme Courts adjudicating this section of the Income Tax in particular.