Introduction

Business exigencies and corporate structures have been evolving around the world, whereby several countries have accommodated hybrid structures such as Limited Liability Corporation, Limited Partnerships, etc. and there was a need for the Indian Government to facilitate a structure which would provide benefits of a corporate structure while at the same time providing flexibility and benefits of partnership firms as well.  This led to the legislation of ‘Limited Liability Partnership’ in the year 2008.

The legislation was targeted towards corporatization of small businessmen/ professionals, who were carrying out business in the form of sole proprietorship or partnerships.  While companies with relatively low turnover were also considering conversion into LLPs, the activity was mostly restricted to domestic companies as Foreign Direct Investment (‘FDI’) was not permissible in LLPs in the initial years.  However, gradually, the norms for FDI were relaxed for LLPs and with the inherent tax advantage available to LLPs (as the profit distributions were tax-free), more and more companies started considering converting into LLPs.

On account of rising popularity of the LLPs, several tax and regulatory issues have arisen which have been addressed in this article.

COMPANY Vs. LLP

Considering the existing tax rates, an LLP (taxed at 30%) would generally be a better vehicle vis-à-vis a company (taxed at 22% or 25% as the case may be), primarily due to there being no tax on profit distributions in case of a LLP and the effective tax rate would be lower in case of an LLP (where profit is sought to be distributed to the partners) although the headline tax rate would be lower in case of a company.  Also, in case of an eligible new manufacturing company, a further reduced tax rate of 15% would be applicable which would make the comparison a more detailed exercise considering the relevant facts of the case.

For instance, an LLP would be entitled to claim other tax benefits such as additional depreciation, Chapter VI -A benefits, etc. which a company with concessional tax regime is not entitled to.  Although LLPs are subject to an Alternate Minimum Tax of 18.5%, LLPs may still be beneficial considering tax-free distribution.

Further, sale of a company’s share is subject to valuation under income-tax provisions and could lead to unfavorable tax consequences in case the valuation norms are not met.  Section 50CA of the Income-tax Act, 1961 (‘the Act’) deals with valuation in case of sale of a company’s share, and section 56(2)(x) of the Act deals with valuation in case of receipt of a company’s shares. This leads to adverse consequences in case the Company is in a distressed state and the actual valuation is much lower than its asset valuation.  There are no such valuation norms in the case of an LLP.

LLPs provide greater operational flexibility as compared to companies as in certain cases requiring urgent decision making, the same could be taken by partners without there being any need for convening Extraordinary General Meetings, giving notices in advance, etc.

All the above aspects are benefits available to LLP vis-à-vis a company.  Certain disadvantages of LLP could be non-availability of weighted deduction for in-house R&D. In case of companies, only substantial change in shareholding will lead to the losses getting lapsed. Further non-tax factors such as a strong governance in case of companies, certain performance linked conditions restriction of FDI in LLP as compared to that of the Company, etc. are some of the aspects wherein the LLP lag the Company structure. External investors (mainly foreign investors) generally prefer a company compared to LLP due to governance and other business considerations.

Though prima facie it appears as though LLP scores over the Company structure, both have their own pros and cons based on the business needs and strategies around the formal structure.

In this context, we have covered certain important aspects in this article along with the judicial precedents relevant in the context of conversion of Company into LLP.

CONVERSION OF COMPANY INTO LLP

The Finance Act 2009 introduced the taxation of LLPs on similar lines as applicable to partnership firms. However, no specific provisions were inserted with respect to conversion to LLP.  This was addressed by the Finance Act 2010 by amending section 47 of the Act through insertion of clause (xiiib) prescribing conditions, on satisfaction of which, the conversion of a Company into LLP would not constitute as a taxable transfer.

The Limited Liability Partnership Act, 2008 contains enabling provisions under section 56 read with Schedule III and Rule 39 of the Limited Liability Partnership Rules, 2009 pursuant to which a private company or unlisted public company (incorporated under Companies Act, 1956 or Companies Act, 2013) would be able to convert themselves into LLPs.

RATIONALE FOR BUSINESSES CONVERTING FROM COMPANY TO LLP

• One of the pivotal reasons for converting company into the LLP is to facilitate the tax efficient cash extraction which is ideal for owners who anticipate profit upstreaming at regular intervals. Absence of profit distribution tax equivalent to dividend tax plays a key role in this regard.
• For small and medium scale businesses, complying with various compliances which are mandatory for a company under the Company law is not cost effective. The LLP structure is advisable if the operational benefits from the LLP are greater and there is no legal binding for a corporate governing structure like a private limited company or public limited company. Further, it provides utmost flexibility and efficiency to partners to manage commercial affairs basis the LLP deed and flow of cash.
• Similarly, in case of professionals such as Chartered Accountants in practice, operating a company was not permitted by the Institute of Chartered Accountants of India (“ICAI”), whereas an LLP structure is permitted by the ICAI.
• Setting up, re-organize and wind up is relatively easier for a LLP. Further, there are thresholds of turnover less than INR 40 lakhs or contribution less than INR 25 lakhs for statutory audit, therefore for start-ups and small-scale businesses, focus can be maintained on business operations rather than undertaking mandatory compliances.

NON-TAXABLE TRANSFER U/S 47 (xiiib)

Section 47(xiiib) of the Act was introduced vide Finance Act, 2010. The legislative intention was to tax LLPs at par with that of partnership firms. Therefore, conversion of the Company into LLP would attract levy of capital gains tax and similarly, carry forward of business losses and unabsorbed depreciation would not be available to the successor LLP.  Therefore, it was proposed to introduce a new sub-clause to section 47of the Act.  The memorandum to Finance Bill, 2010 explicitly concluded that the conversion of private limited company or unlisted public company into LLP is a taxable transfer which would not be considered a taxable transfer subject to fulfillment of certain conditions.

The aforesaid provision clearly brings out mandatory cumulative conditions for tax exemption for company and its shareholders on conversion of the Company into LLP –

• All assets and liabilities immediately before conversion should become the assets and liabilities of the LLP.
• All the shareholders to become partners of the LLP and contribution and profit-sharing ratio (‘PSR’) to be in same proportion as their shareholding in the Company.
• Aggregate of PSR of the shareholders of the Company in the LLP shall be at least 50% at any time during the period of 5 years from the date of conversion.
• In the 3 preceding years:

Total sales or turnover or gross receipts of the Company is less than or equal to 60 lakhs.

Total value of assets of the Company is less than or equal to 5 crores.

• No other consideration is paid to the shareholders except by way of PSR and capital contribution.
• No amount is paid to the partners of LLP, directly or indirectly, out of accumulated profit of the Company as on the date of conversion for a period of 3 years from the date of conversion.

(Emphasis supplied)

Thus, the conversion from a company to LLP would not be regarded as a transfer only if all the above conditions are cumulatively satisfied, i.e., if any one of the conditions is not satisfied, then it will amount to taxable transfer and Company and shareholders would be taxed for such conversion.

Key considerations in the above context are –

• In case of company being converted into the LLP, Capital gains will be exempt from tax on fulfilment of above conditions laid down under section 47(xiiib) of the Act.
• The LLP which acquires the assets and liabilities on conversion will record the actual cost of the block of assets at the written down value of the block of assets in the hands of company on the date of conversion.
• Further, in the year of conversion, the aggregate depreciation allowable to the Company and LLP shall not exceed the depreciation calculated at the prescribed rates as if the conversion had not taken place. Furthermore, the cost of acquisition of the capital asset for the LLP shall be equal to be the cost for which the Company acquired it and indexation benefit will be available for resident shareholders having long term capital asset consequent to such conversion.
• In case of the Partners of the LLP (shareholders of the Company), capital gains will be exempt from the tax on fulfilment of conditions and the cost of acquisition of a capital asset being rights of a partner in successor LLP, shall be equal to the cost of acquisition of the shares in the Company immediately before its conversion.

If in case the aforesaid conditions are not complied with post claiming exemption u/s 47(xiiib) of the Act, the sub-section 4 to section 47A of the Act lays down the provisions to address this issue which has been reproduced as under –

….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.

(Emphasis supplied)

Therefore, if any of the conditions mentioned above are not complied with, the exemption granted above will be withdrawn and the amount of profits or gains arising from the transfer of such capital asset or intangible assets or share or shares shall be chargeable to tax.  Further, such amount shall be deemed to be the profits and gains chargeable to tax in the hands of the LLP or the shareholder of the Company, as the case may be, for the previous year in which the conditions prescribed u/s 47(xiiib) of Act are violated.

KEY ISSUES

The above withdrawal provisions caused taxpayers to raise a moot question before the judiciary for consideration as to whether the exemption may be withdrawn in the same financial year in which conversion has taken place on account of not fulfilling any one or more conditions mentioned in the proviso to section 47(xiiib) of the Act.

The issue has been discussed in the case law of ACIT v. Celerity Power LLP[1] wherein, the entire business of the Company including all its assets and liabilities were transferred to the resultant LLP and assessee’s contention was that conversion of the Company into LLP did not involve any transfer of property, liabilities, assets, etc. and therefore, capital gains, if any, could be brought to tax only in the hands of the erstwhile company. However, the Assessing Officer (‘AO’) argued that the benefit availed by the Company was to be deemed as profits and gains of the successor LLP as per provisions of section 47A (4) of the Act and therefore, taxable in the hands of the LLP.

Some of the principal aspects of the ruling covering arguments of the Assessee and the Revenue are as under:

Whether conversion of company into LLP without adhering to the conditions mentioned in section 47(xiiib) of the Act, to regarded as transfer.

There have been arguments wherein questions raised as to whether conversion of equity shares held by shareholders in a private limited company into partnership interest in the LLP consequent upon the conversion would be regarded as a transfer under section 2(47) of the Act. The shares held by the shareholders in the Company will no longer be in existence on conversion and the partnership interest in the LLP in return could not be considered as independent of its shareholding in the company. On conversion of company into LLP, the company is dissolved, and shareholding replaces with partnership interest. The definition of transfer u/s 2(47) is inclusive and therefore it extends to disposing or parting with an asset or any interest therein i.e., extinguishment of shareholder’s interest on conversion.

The contention is that to be regarded as transfer and chargeable as capital gains, there has to exist two parties at a time was not accepted by the Bombay High Court decision in case of Texspin Engg. & Mfg. Works[2]. It was further held that the Act does not require the existence of a counterparty for taxation purpose. Further, in case of AAR ruling on the decision of the Supreme Court in case of Grace Collis[3], it was observed that the expression extinguishment of any rights as occurring in section 2(47) of the Act extends to mean extinguishment of rights independent of or otherwise than on account of transfer.

In the case of CADD Centre[4] and Unity Care and Health Services[5], the issue involved was conversion of partnership firm into company. It was held that the word ‘transfer’ presupposes existence of transferor and transferee simultaneously. Further, if the firm was held to be the transferor, then, the transferee company was not in existence on that date. On the other hand, if the transferee was the company which came into existence on certain date, then the firm i.e., the transferor was not in existence as on the said date. It was accordingly concluded that conversion of partnership firm into a company was not a case of transfer by one person to another and that it was a mere change under the relevant Act under which the persons are registered to carry on the business.

Referring to the case of Domino Printing Science Plc.[6], the assessee raised substantial arguments with regard to various limbs of transfer under the Act before the AAR –

• There cannot be ‘sale’ or ‘exchange’ of shares of Indian company since the same person cannot sell or exchange the shares with itself.
• The percentage of holding in the Indian company remains same as that of partnership interest in the LLP in the same proportion which should not be regarded as extinguishment of right in shares in Indian company.

The tax authorities in the context of above, further argued that the transaction should be considered as ‘exchange’ as two separate persons i.e., Private limited company and the LLP are involved in the arrangement and shares of Indian company have been exchanged by Indian company for interest in the LLP. Also, since Indian company would be deemed to be dissolved on conversion into LLP, therefore, it will be regarded as extinguishment of rights in shares of Indian company. Wherein the AAR distinguished the Bombay High Court in decision of Texspin where it was held that the conversion of a partnership firm into a company does not amount to ‘transfer’. However, in respect of section 47(xiiib) of the Act, the AAR relied on the decisions of Mumbai Tribunal in case of Celerity Power LLP and Aravali Polymers[7] where it was observed that conversion of a company into LLP which does not satisfy the conditions of exemption was to be treated as ‘transfer’ of capital assets.

Although the AAR ruling is not binding on other assessees and it does have persuasive value in court of law, the tax authorities are more likely to take support of the ruling and apply it in pending tax litigations in similar circumstances. Whilst the ruling could be challenged by the concerned taxpayer before higher forums, it plays a pivotal role and cast uncertainty of tax litigation where companies seek to convert themselves into LLP without complying conditions for explicit exemption.

Whether transaction of conversion of the Company into LLP is taxable transfer or not

Section 47 of the Act commences with –

“Nothing contained in section 45 shall apply to the following transfers …”

(Emphasis supplied)

Therefore, it could be understood that section 47 covers transactions that are transfers but are not considered as taxable transfer subject to fulfillment of certain conditions mentioned in the said section.  Therefore, it could be argued, without going into the merits of the case, that conversion of the Company into LLP is a transfer. Whether the same is subject to tax or not depends on the fulfillment of conditions mentioned in the respective sub-sections.

The arguments and subsequent ruling of the Hon’ble ITAT emphasized on the intention of the provisions laid down and held that the purpose and intent behind enactment of section 47(xiiib) of the Act was that since the ‘transfer’ of assets on conversion of the Company into LLP resulted in levy of capital gains tax, the sub-section was proposed to be introduced to exempt such conversion subject to fulfillment of certain conditions.

Without prejudice to the above, one should consider the definition of the term ‘convert’ as mentioned in Clause 1(b) of the Third Schedule of the LLP Act, 2008, which stipulated that the conversion of a private company into LLP involves transfer of property, assets, etc. and the term ‘transfer’ has to be read only in context of provisions of the Act. Further, conversion of the Company into LLP is differently placed as in comparison to succession of a partnership firm by a company under Part – IX of the Companies Act, 1956.

In the light of above discussions, it could be inferred that the conversion of Company into LLP is to be regarded as involving transfer of capital assets.

Whether transaction of conversion of a Company into LLP involves any capital gain or not

Since conversion of a Company into LLP is to be considered a transfer, the next question which pops up was whether conversion of the Company into LLP involved any capital gain or not.

Basis the first condition laid down in proviso section 47(xiiib) of the Act that the conversion of the Company into LLP shall take place at ‘book value’. During the process of conversion, the entire ‘undertaking’ of the erstwhile company transferred into LLP and therefore, ‘book value’ was the only cost attributable to the individual assets and liabilities. Therefore, there is no need to determine fair market value of such assets and the provisions of section 50C, section 50CA, section 50D and section 56(2)(x) of the Act which refers to the fair market value to compute the taxable income, do not stand while transferring such assets and liabilities to the LLP on conversion. The total value of assets appearing in the books of account of predecessor company would become value of assets in the books of the successor LLP.

If in case, the transfer of assets and liabilities is contemplated not at a book value but at fair market value computed basis provisions of section 50D of the Act, then one of the conditions mentioned in the proviso to section 47(xiiib) of the Act will not be complied which result into withdrawal of such exemption available to the Company and its shareholders.

Some of the important principles which were placed in above rulings including Celerity Power LLP, such as charging section and computation section have to be read together as both would constitute one single package. The consideration for transfer of capital asset is what the transferor receives in lieu of the assets he parts with, in the form of cash or in kind, and therefore, the asset transferred or parted with cannot be considered for the transfer, meaning that the expression full value of consideration cannot be construed as having reference to market value of the asset transferred. It was further observed and held that the expression full value of consideration as per provisions of section 48 of the Act cannot be construed as the market value of the asset on the date of transfer. The meaning of full value of consideration was cited by the Hon’ble Apex court as the price bargained for by the parties to the transaction[8].

Thus, as the assets and liabilities of the erstwhile company had got vested in the LLP at their ‘book values’, hence such ‘book value’ could only be regarded as the ‘full value of consideration’ for the purpose of computation of ‘capital gains’ under section 48 of the Act.

Entitlement to carry forward losses and unabsorbed depreciation: –

Section 72A(6A) of the Act relating to carry forward and set off of accumulated loss and unabsorbed depreciation allowance in case of reorganization of business inter alia provides as under –

…Where there has been reorganisation of business whereby a private company or unlisted public company is succeeded by a limited liability partnership fulfilling the conditions laid down in the proviso to clause (xiiib) of section 47, then, notwithstanding anything contained in any other provision of this Act, the accumulated loss and the unabsorbed depreciation of the predecessor company, shall be deemed to be the loss or allowance for depreciation of the successor limited liability partnership for the purpose of the previous year in which business reorganisation was effected and other provisions of this Act relating to set off and carry forward of loss and allowance for depreciation shall apply accordingly:

Provided that if any of the conditions laid down in the proviso to clause (xiiib) of section 47 are not complied with, the set off of loss or allowance of depreciation made in any previous year in the hands of the successor limited liability partnership, shall be deemed to be the income of the limited liability partnership chargeable to tax in the year in which such conditions are not complied with….

(Emphasis supplied)

On plain reading of the above provision, wherein a private company or an unlisted public company is converted into LLP fulfilling all the conditions mentioned in the proviso to section 47(xiiib) of the Act, then accumulated losses and unabsorbed depreciation of the predecessor company shall be deemed to be accumulated losses and unabsorbed depreciation of the successor LLP from the previous year in which such conversion took place to the extent of conditions are fulfilled, if not, the said loss would be regarded as deemed income of the LLP in the previous year in which conditions are not complied with.

However, the arguments were raised in view of provisions of section 58(4) of the LLP Act, 2008 where sub-section (b) of section 58(4) states that –

…..(b) all tangible (movable or immovable) and intangible property vested in the firm or the Company, as the case may be, all assets, interests, rights, privileges, liabilities, obligations relating to the firm or the Company, as the case may be, and the whole of the undertaking of the firm or the Company, as the case may be, shall be transferred to and shall vest in the limited liability partnership without further assurance, act or deed…

(Emphasis suppled)

The above arguments held between section 58(4) of the LLP Act and section 72A(6A) of the Act have been reviewed by judicial precedents wherein the Hon’ble ITAT ruled that as section 58(4) of the LLP Act is only in the context of tangible and intangible property, interests, rights, etc. and has got nothing to do with the carry forward of losses and the same is a part of the Act.

Thus, section 72A(6A) of the Act is in clear and loud in terms of precondition by a statutory requirement that the assessee should have complied with the conditions of the proviso to section 47(xiiib) of the Act.

The conversion of equity interest of shareholder in the Company into partnership interest in the LLP to be considered as a transfer: –

As discussed in above paras, the definition of ‘transfer’ as per section 2(47) of the Act is an ‘inclusive’ definition and therefore, extends to events and transactions which may not otherwise be transfer according to its ordinary, popular and natural sense. Thus, preliminary view could be adopted that the extinguishment of shareholder’s interest in the Company in lieu of partnership interest in the LLP would be regarded as transfer u/s 2(47) of the Act on account of conversion of the Company into the LLP.

The transfer includes disposing of or parting with an asset or any interest therein or creating any interest in any asset in any manner whatsoever.  On conversion of the Company into LLP, all tangible and intangible property vesting in the Company to be transferred and vests in the resultant LLP. Therefore, on such vesting, not only the share capital, but also the shareholder’s interest in shares of the Company get extinguished. Relying on various judicial precedents[9] and also the AAR in case of Domino Printing Science Plc., Authority for Advance Rulings, New Delhi ruling held that the expression ‘extinguishment of any rights therein’ as occurring in section 2(47)(ii) extends to mean extinguishment of rights independent of or otherwise on account of transfer and both should be looked at independently and not united.

However, the extinguishment of shareholder’s interest in the Company in lieu of partnership interest in the LLP is one of the conditions for claiming exemption as mentioned in the proviso to section 47(xiiib) of the Act. Though, extinguishment of equity interest into partnership interest to be regarded as a transfer within the meaning of section 2(47) of the Act, the same is not taxable as laid down in section 47(xiiib) of the Act.

The computation mechanism provided in section 48 of the Act are workable and is capable of being implemented or not: –

On conversion of company into LLP, value of partnership interest in the LLP may not be equal to value of shareholders’ interest in the Company and therefore, value of partnership interest in LLP cannot be taken as cost of acquisition of shares. Further, the full value of consideration of the shares foregone would be equivalent to value of partnership interest in LLP.

The computation mechanism encompasses a situation which may be tax neutral. However, the same cannot be considered as rendering provisions of section 48 of the Act unworkable and not capable of being implemented even though the amount considered for the partnership interest in the LLP has been derived by the book value of assets and liabilities of the LLP. Thus, based on the above reasonings, computation provisions laid down in section 48 is workable and capable of being implemented at the time of transfer of partnership interest in the LLP by partners at the time of exit.

What constitutes turnover / sales / gross receipts for the purpose of section 47(xiiib) of the Act: –

Per CBDT Circular 1/2011 – explanatory notes to the provisions of the Finance Act, 2010 clarifies that the sales /gross receipts / turnover of the business which is taxable under the head ‘Profits and gains of business or profession’ shall be considered as turnover or sales or gross receipts for the purpose of computing the threshold of INR 60 lakhs in order to comply with the conditions of section 47(xiiib) of the Act.

Allowability of Minimum Alternate Tax (‘MAT’) credit to resultant LLP –

One of the important questions raised by the shareholders of the Company was whether the resultant LLP would be eligible to claim MAT credit of the Company post conversion. In this regard, section 115JAA (7) of the Act wherein sub-section 7 of the said section addresses such issue by clarifying that –

…In case of conversion of a private company or unlisted public company into a limited liability partnership under the Limited Liability Partnership Act, 2008 (6 of 2009), the provisions of this section shall not apply to the successor limited liability partnership.

Therefore, basis provisions of the Act, the LLP cannot utilize accumulated MAT credit of company post conversion.

Whether it is necessary to remove charge on the assets of the Company prior to conversion into LLP and whether the LLP has to re-negotiate existing contracts with customers and vendors: –

As per Third Schedule to LLP Act, 2008 a company may apply for conversion provided, no security interest in its asset is subsisting or in force at the time of application for conversion from the Company into LLP with Registrar of Companies. Further, the reference to the Company shall be substituted with reference to the LLP as if such LLP was a party to the agreement.

CONSEUQNCES WHERE EXEMPT TRANSFER CONDITIONS NOT SATSIFIED:

Section 47A(4) of the Act provides that if any of the conditions specified in proviso to section 47(xiiib) of the Act are not complied with, the exemption granted on such conversion will be withdrawn and the amount of profits or gains arising from the transfer of such capital asset or intangible assets or share or shares shall be chargeable as deemed income in the hands of the LLP or the shareholder of the Company, as the case may be, for the previous year in which the conditions prescribed u/s 47(xiiib) of Act are violated.

The conditions mainly aim at ensuring continuity of the same business by the same shareholders on a going concern basis.

Certain key issues arise on withdrawal of the benefit of exempt transfer as contemplated under section 47(xiiib) of the Act which have been discussed hereunder:

if capital gains are not chargeable under section 45 of the Act, whether the same can be taxed under section 47A of the Act.

The above question was raised before the AAR and then upheld by the Bombay High Court in case of Umicore Finance[10] wherein it was held that in order to bring chargeability of capital assets under section 47A of the Act, there should be profit / gains arising from the transfer of such capital asset under section 45 of the Act.  The deeming provisions in section 47A (3) of the Act are not absolute. The principle discussed in the said decision is that if the taxpayer did not have the benefit of capital gains accrued under section 47(xiiib) of the Act at the time of conversion and even if there is non-compliance, the provisions of section 47A (4) of the Act will not apply.

In order to determine whether the pre-requisite of section 47(4) of the Act to charge profits and gains resulting from transfer of capital assets are fulfilled or not, the basic provisions of section 45(1) of the Act and section 48 of the Act need to be referred. Section 47A (4) of the Act cannot be read on standalone basis.

On the contrary, as observed in case of Aravali Polymers LLP wherein the LLP post conversion has provided interest free loan facility to partners out of reserves and surplus before conversion thereby, violating the proviso (f) of section 47(xiiib) of the Act. The Kolkata ITAT held that since one of the conditions stipulated in section 47(xiiib) of the Act was not fulfilled, it would not be entitled to the benefit of exemption and revoked capital gain exemption claimed on conversion and remanded for re-computation of capital gains u/s 45 of the Act.

Further, the AAR in case of Domino Printing Science Plc. (DIPL), ruling held that the provision of section 47A (4) of the Act stipulates for charging capital gains tax on failure to comply with the conditions prescribed in section 47(xiiib) of the Act. In the case of DIPL, the requirement of the proviso to section 47(xiiib) was not complied in the year of conversion of the company into LLP itself. Therefore, the profit or gain arising in the hand of the shareholder on sale of shares of DIPL was chargeable to capital gains tax by deducting from the full value of consideration of the shares in the transfer pursuant to conversion and also the cost of acquisition of those shares in the year of conversion of the company into LLP.

In the light of above views, the issue is still debated and on the plain reading of section 47A(4) of the Act, a position could be adopted that if any of the conditions are not satisfied as mentioned in section 47(xiiib) of the Act, the exemption will be withdrawn and profits and gains on transfer of assets on account of conversion of the Company into LLP will be chargeable as deemed income in the hands of successor LLP and shareholders of the Company.

Sale consideration of transfer of shares by shareholders of the Company and transfer of assets by the Company into LLP on conversion for computation of capital gains under section 48 of the Act:

The AAR in case of DIPL held that the shareholders acquire partnership interest as consideration for relinquishing shares in the Company. In such case, the full value of consideration for purposes of section 48 of the Act would be the value of partnership interest in LLP. Therefore, the incidence of capital gains tax in the hands of shareholders on transfer of shares, pursuant to conversion, cannot be ruled out.

In case the value of consideration is not ascertainable, section 50D of the Act provides the fair market value to be deemed as the full value of consideration.

However, the impact of DTAA would have to be considered where the shares of the Company have been acquired by a non-resident residing in Singapore/ Mauritius and acquired or purchased shares of Indian Company prior to April 01, 2017.  Article 13 of India -Singapore DTAA and India – Mauritius DTAA, had provided that capital gains arising on transfer of shares in an Indian Company which have been acquired prior to April 01, 2017, shall not be taxable in India. Similarly, provisions of applicable DTAA should be reviewed to explore potential benefits as compared to the provisions of the Act.

Capital gains involved in transfer of capital assets on conversion of private limited company to LLP, would be subject to liability of assessee LLP (as a successor entity) under section 170 of the Act.

Section 170(1)(b) of the Act, a ‘successor entity’ which continues to carry on the business of the person who has been succeeded (predecessor) shall be liable to be assessed only in respect of the income of the previous year after the date of succession. However, the said liability of a successor entity is subject to an exception carved out in section 170(2), as per which, where the predecessor cannot be found, there the assessment of the income of the previous year in which the succession took place up to the date of succession, and of the previous year preceding that year shall be made on the successor in the like manner and to the same extent as it would have been made on the predecessor, and all the provisions of this Act shall, so far as may be, apply accordingly.

Thus, in terms of the aforesaid provision, it can be inferred that though the Capital gains, if any, involved in the transfer of the capital assets on conversion of the private limited company to the assessee LLP, de hors applicability of section 47A(4) of the Act, would not be liable to be assessed in the hands of the LLP as per section 45 read with section 5 of the Act, however, the same would be subject to the liability of the assessee LLP (as a successor entity) under section 170 of the Act.

Recognition of goodwill in the books of the LLP post conversion, not forming part of block of asset for income-tax purposes would not amount to violation of condition prescribed under section 47(xiiib) of the Act.

It is pertinent to note that the conditions stipulated under the Act should be strictly construed and adhered to. Further, no new words can be incorporated in the statute which /can give unintended interpretation against the spirit of the law.

The Mumbai ITAT in the case of Brizeal Realtors and Developers LLP[11]s held that if the shareholders of the Company have not received any thing more than their share capital in the LLP on the date of conversion and if the accumulated profits did not include the amount of Goodwill in the books of the predecessor company, there cannot be said to be any violation of clause (f) of section 47 (xiiib) of the Act. Further, the conversion of the Company into LLP as per the provisions of the LLP Act, 2008 and commercial decision taken after such conversion cannot be seen as a colourable device.

Where the LLP fail to satisfy conditions laid down in proviso to section 47(xiiib) of the Act, whether ‘carry forward’ of losses would be declined of erstwhile company by the LLP.

Section 72A(6A) of the Act entitles the LLP to carry forward business losses of erstwhile private limited company for the balance number of financial years and the unabsorbed depreciation of the private limited company would be allowed to be set off for the indefinite period by the successor LLP. It is in clear and loud terms preconditioned by a statutory requirement that LLP should have complied with conditions of proviso to section 47(xiiib) of the Act.

It is inferred in the case law of Celerity Power LLP that the claim of the LLP as regards carry forward of the loss of the erstwhile private limited company, de hors satisfaction of the conditions laid down in the proviso to section 47(xiiib) of the Act, clearly militates against the statutory provision, thus, the right to claim such carry forward of business losses and unabsorbed depreciation of the erstwhile company by the LLP will be denied.

GAAR IMPLICATIONS ON ACCOUNT OF CONVERSION

Today, the focus of legislators is clearly anti-avoidance and economic substance. In many instances, courts have primarily held that the legal form of a transaction has to be respected (cases such as Vodafone International Holdings B.V. v Union of India (2012), and CIT v High Entergy Batteries (India) Ltd. (2012)) to achieve tax efficiency, whereas, in certain transactions, courts have applied GAAR principles to disregard the transaction or to deny tax benefits (cases such as Mc Dowell & Co. Ltd. v CTO (1985), and Ajanta Pharma Mumbai, NCLT (2018)).

GAAR should be made applicable to arrangements where the main purpose (and not one of the main purposes provided in Finance Act 2012) is to obtain tax benefit and there should be an intent and purpose of tax avoidance and the same should be backed by an element of repercussions that are often a result of such tax avoidance arrangement.

Reorganization of structure i.e., conversion from the Company into LLP is generally driven by commercial considerations and not by the motive to obtain a tax benefit. The arrangement should be looked at in a holistic manner and not in a dissecting manner. The corporate veil may be lifted if facts and circumstances reveal that the arrangement or corporate structure is a sham intended to evade taxes. The onus is on the Company / owners to demonstrate with sufficient and adequate documentation as to why any arrangement / reorganization of the Company should not be treated as IAA.

It is required to understand that the intention of promoters to convert the Company into a LLP. If the intention of the promoters to convert the Company into LLP in the financial year so as to make such conversion tax neutral, it could be considered as a colourable arrangement in absence of commercial justification. The Income-tax authorities may raise objections / questions to test the arrangement as an IAA that the intention of promoters to convert Company into LLP is to obtain tax-free share of profit in future vis-à-vis dividend / bonus pay-outs which would be chargeable to tax.

PARTING THOUGHTS –

With the trend of conversion of the Company into LLP booming where such restructuring and reorganization are surpassing all records, it is essential for the owners to look at the commercial substance and intention behind such conversion. Corporates need to assess whether the conditions laid out under Section 47(xiiib) of the Act could be complied with by them or not upon conversion of the company to an LLP. If not, then the tax cost accruing as a result of conversion needs to be weighed against other benefits that the businesses sought to achieve through such restructuring in order to make a rational decision.

[1] ACIT v. Celerity Power LLP [2019] 174 ITD 433 (Mumbai)

[2] CIT v. Texspin Engg. & Mfg. Works, [2003] 263 ITR 345 (Bombay)

[3] CIT v. Grace Collis [2011] 115 taxmann 326 (SC)

[4] CADD Centre v. ACIT, City Circle – II, Chennai [2016] 65 taxmann.com 291(Madras)

[5] ACIT, Circle -2 (1), Mangalore v. Unity Care & Health Services [2006] 103 ITD 53 (BANG.)

[6] Domino Printing Science Plc. [2021] 433 ITR 215 (AAR – New Delhi)

[7] Aravali Polymers LLP v. JCIT [2014] 65 SOT 11 (Kolkata ITAT) – Appeal No. 242/CIT(A)-xx/Range 34 Dt. 10.04.2014

[8] (i) CIT vs George Henderson and Co. Ltd., [1967] 66 ITR 622 (SC) and (ii) CIT vs Gillanders Arbuthnot and Co. [1973] 87 ITR 407 (SC).

[9] CIT vs Grace Collis [2001] 248 ITR 323 (SC), Kartikeya V. Sarabhai vs CIT [1997] 94 Taxman 164 (SC) and Anarkali Sarabhai vs CIT [1997] 90 Taxman 509 (SC)

[10] Umicore Finance Luxembourg [2010] (323 ITR 25) (AAR-New Delhi) and CIT v. M/s Umicore Finance (2016) 76 taxmann.com 32 (Bombay HC)

[11] ITO v. Brizeal Realtors and Developers LLP [2023] 146 taxmann.com 109 (Mumbai – Trib.)