Income Tax Taxation

ITAT Upholds Income Tax Liability – Conversion of Company into LLP Constitutes Transfer

Recently Mumbai bench of the Income Tax Appellate Tribunal (ITAT) held that the conversion of a company into LLP constitutes “transfer” therefore, liable to capital gain tax. Further, the ITAT clarified that in case conditions prescribed under Section 47 (xiiib) of the Income Tax Act do not comply, then in such case under Section 45, the transaction is chargeable to ‘capital gains’. In fact, there is no capital gain in case the assets and liabilities of the company are vested at book value in LLP.

Before moving forward, we will understand the basic terms for your better understanding of this article.

Conversion of Company into LLP

 Several companies prefer to convert them into LLP because of the ease of doing business and the ease of regulations. A limited liability partnership (LLP) is a type of business entity which is a hybrid of a partnership firm and a company. The limited liability partnership (LLP) came into existence at the time Limited Liability Partnership Act, 2008, was enacted. It is a preferable type of business structure as there are fewer regulations in comparison to companies.

To convert a company into LLP, a procedure is followed as per the Companies Act, 2013. While there are some benefits of conversion, there are operational bottlenecks on the taxation part, and questions arise that whether conversion attracts taxation under the Income Tax Act 1961.

Tax implication in case of Conversion of Company into LLP

Section 47 (xiiib) was introduced by the Finance Act 2010 into the Income Tax Act. As per section 47 (xiiib) if certain conditions are satisfied, then transfer on conversion will be exempt from the applicability of capital gains while provisions of capital gains would be attracted in case any of the conditions were not met and in case of breach of one of the conditions.

This article is an attempt to bring the recent ruling of Income Tax Appellate Tribunal (ITAT) in your knowledge regarding a case under which an assessee was aggrieved by the order of the assessing officer under which the assessee was liable to pay tax on the conversion of the company into the LLP. Under Sec. 45 of the Act, the same would be a taxable transfer.

Framework of Ruling

 Previously in the year 2003, in the case of CIT v. Texspin Engg. and Mfg. Works (2003) 129 Taxman 1 (Bombay HC[1]), the Bombay High Court held that conversion of an LLP into a company does not constitute ‘transfer’ and, therefore, it is not subject to capital gain tax.

Recently in the case of Celerity Power LLP v. ACIT, ITAT No. 3637/Mum/2015, Mumbai ITAT held that if the conditions prescribed under section 47 were not satisfied, then the conversion would be construed as transfer while the company was making an argument on the decision of Bombay High Court as per which conversion of a company into an LLP was not a transfer and therefore not taxable even if the conditions of section 47 were not satisfied.

In this case, the taxpayer is LLP as there was a conversion of the company into LLP the entire assets and liabilities of the company had been transferred to the LLP. Section 47A (4) of the IT Act, invoked by the assessing officer and held that the exemption of capital gains tax availed by the company on the transfer is profits of the successor LLP; therefore, relevant additions have been made.

However, no tax liability arose from the transfer as the value of the assets and the liabilities of the company were vested in the LLP at book value, and the difference between the transfer value and the cost of acquisition was nil.

The taxpayer argued that the conversion of a company into an LLP would not be construed transfer on the basis of the judgment of Texspin Engg. And Mfg. Works. Besides this, the taxpayer also argued that where there is no consideration, the computation mechanism would be unworkable; therefore, in the hands of the taxpayer, there should not be any tax liability.

The decision of the Income Tax Appellate Tribunal (ITAT)

 As per the tribunal, income tax shall be chargeable in the hands of the ‘transferor’ under the head Capital Gains in relation to profits or gains arising from the ‘transfer’ of the capital assets affected in the previous year. As per the observation of the Income Tax Appellate Tribunal (ITAT), it has been found that transactions related to the conversion of the company into an LLP do not comply with the conditions mentioned under section 47(xiiib); therefore, it will be constituted as the transfer of capital assets.

Takeaway on Ruling

A new tax ruling is going to challenge an approach under which thousands of business entities and professionals reorganize themselves and attract foreign investors. Limited Liability Partnerships (LLPs) is a type of business structure which helps businesses to grow and distribute dividends among partners without deducting any dividend distribution tax. However, this new ruling will surely force many companies to change tack.

However, there is still a question mark on the decision of the Bombay High Court as per which conversion of the firm into a company does not amount to ‘transfer’ and involves no ‘consideration.’ The new ruling lifts the decision taken by the Bombay High Court in the case of Texspin.

As long as the transfer took place at book value, there would be no capital gains tax. In order to strengthen the balance sheet of the LLP, borrow funds, attract foreign capital and to increase the net worth of the partners in the LLP, businesses used to convert on a value higher than the book value. Another very important aspect of this ruling is that now tax would be levied on the limited liability partnership, which escaped into the hands of the company as it is construed as the successor.

This ruling was made by the tribunal on the case Celerity Power Private Limited, which acquired the status of LLP in the year 2010. In this case, the argument of the company was concerned with the conversion of M/s Celerity Power Pvt Ltd into M/s Celerity Power LLP as there is no transfer of property, assets or liabilities, among others. 

This ruling also challenged an earlier ruling of the Madras High Court under which no stamp duty is levied in case of conversion of a firm into a company. It could have drawn the attention of the indirect tax authorities. Companies having earnings of less than Rs 60 lakh are outside the purview of transfer and thus exempted from the capital gain tax. While companies whose income is above the threshold limit are in a position to avoid tax on the basis of the ruling of the Texspin verdict of the Bombay High Court, according to which conversion constitutes a transfer.

The ruling of the Income Tax Appellate Tribunal^[1] on Celerity Power steals the protection provided to the companies. As long as a transfer from a company to LLP takes place at a value not higher than the book value, post-ruling can be avoided.

Higher forums may consider the issue in the future, whether in this same case or in any other case, regarding the determination of such conversion is indeed a transfer.

Read our article:Conversion of LLP into Company as per Companies Act 2013