The business form of Limited Liability Partnership (LLP) became available in India when the Limited Liability Partnership Act, 2008 (LLP Act) was enacted. Prior to this, businesses were organised as companies under the Companies Act. Small businesses find LLP to be a preferred form and since the LLP Act has a provision for conversion of a company into an LLP, many companies sought to convert to LLP. However, the question was whether such conversion would attract taxation under the Income Tax Act, 1961 (IT Act).
In this context, the courts have held that conversion of a partnership/LLP firm into a company does not constitute ‘transfer’ and hence is not subject to tax. This was confirmed in 2003 by the Bombay High Court in the case of CIT v. Texspin Engg. and Mfg. Works (2003) 129 Taxman 1 (Bombay HC). While this was indeed in the context of reverse conversion (i.e. conversion of a firm into a company), taxpayers sought to apply this principle even in the case of conversion of a company into an LLP, relying on the fact that only the form of business is changing by the conversion, not the entity itself.
The Finance Act 2010 introduced section 47(xiiib) into the IT Act, under which the conversion of a company into an LLP became tax exempt provided the conditions prescribed thereunder were met. Companies that could not satisfy the conditions prescribed relied on the above mentioned Bombay High Court decision to claim that even if the conditions stipulated in section 47(xiiib) of the IT Act were not satisfied, the conversion should be exempt from tax.
Recently this issue was dealt with by the Mumbai ITAT in the case of Celerity Power LLP v. ACIT, ITAT No. 3637/Mum/2015. The taxpayer relied on the above mentioned Bombay High Court decision and claimed that the conversion of a company into an LLP was not a transfer and hence not taxable even though the conditions prescribed in section 47 were not satisfied.
The ITAT has held that conversion of a company into an LLP would amount to a ‘transfer’. In order to be exempt from tax, it must satisfy the conditions laid down in section 47. However, in the instant case, the ITAT also held that where pursuant to the conversion, assets and liabilities are transferred at book value, there would not be any gains/income that would be subject to tax.
The taxpayer in the case before the ITAT was an LLP, which had been converted from a company, whereby the entire business, assets and liabilities of the erstwhile company had been transferred to the LLP taxpayer. The assessing officer invoked section 47A(4) of the IT Act and held that the benefit of exemption of capital gains tax on the transfer availed by the company was to be deemed as the profits of the successor LLP and accordingly made the relevant additions. On appeal before the CIT (A), it held that the conversion of the company into LLP was a taxable transfer, as the taxpayer failed to comply with the conditions specified in section 47(xiiib) of the IT Act. However, the CIT (A) held that since the assets and the liabilities of the company were vested in the taxpayer at book value, the difference between the transfer value and the cost of acquisition was nil, therefore no tax liability arose from such transfer.
Drawing an analogy from the judgment of Texspin Engg. and Mfg. Works, the taxpayer argued that the conversion of a company into an LLP would not amount to transfer. Alternatively, the taxpayer also stressed the argument that in absence of any consideration, the computation mechanism for computing capital gains would be unworkable and therefore there should not be any tax liability in the hands of the taxpayer.
The ITAT observed that section 47 of the IT Act lists transfers that would not be amenable to capital gains tax, subject to certain conditions. The ITAT held that since conversion of a company into an LLP is a transaction listed in this section as exempt from capital gains tax (subject to certain conditions), it follows that principally the conversion is considered to be a transfer but for this specific exemption. The ITAT also placed reliance on the Memorandum to the Finance Act, 2010, which provided that conversion of a company into an LLP attracted capital gains prior to insertion of the section 47(xiiib) of the IT Act.
The ITAT differentiated the case of Texspin Engg. and Mfg. Works by saying that the issue before the Bombay High Court was in relation to conversion of a partnership firm into company under part IX of the Companies Act, 1956 where it was specified that conversion of a partnership into a company would result in vesting of property of the partnership into a company – i.e. there is statutory vesting of property in the company.
As opposed to that, chapter X of the LLP Act, 2008 provides that under provisions of the LLP Act, the company would ‘convert’ into an LLP. The term convert has in turn been defined to mean transfer of assets and liabilities. Further, the ITAT also relied upon the Authority for Advance Ruling (“AAR”) decision in the case of In re, Umicore Finance Luxembourg (2010) 323 ITR 25 (AAR), (which was upheld by the Bombay High Court), where the AAR observed that the Bombay High Court in the decision of Texspin Engg. and Mfg. Works did not express a final opinion on the point of transfer.
Thus, the ITAT held that the conversion of the company into an LLP is a transfer and the gains arising from such conversion should be taxed as capital gains. By virtue of successor liability imposed under section 170 of the IT Act, the taxpayer, i.e. the LLP, was held to be liable for such capital gains tax on the transferor company.
On the actual tax liability, the ITAT observed that the assets of the company were transferred to the LLP at book value and no consideration was paid for the same. Thus, the ITAT held that the full value of consideration received for the transaction, being defined by the courts as the price bargained for by the parties, would be the book value of the assets. Accordingly, since the difference between consideration received and the cost of acquisition of such assets and liabilities (being the book value) would be nil, there would be no occasion to levy tax.
It may also be pertinent to note that the ITAT also discussed the ability of the LLP to carry forward the erstwhile losses and the deduction under section 80IA of the IT Act. The ITAT decided that the LLP shall not be allowed to carry forward and set off the losses because it had failed to cumulatively satisfy all the conditions laid down in the proviso to section 47(xiiib) of the IT Act. However, on the question of the taxpayer being able to claim a deduction under section 80IA of the IT Act, where it had failed to file the auditor report, the ITAT decided in favour of the taxpayer and held that an audit report is procedural and directive in nature, and the same could also be validly filed by a taxpayer at the appellate stage.
This decision would have negative impact on the ability of taxpayers to justify the tax neutrality of such conversion. They would not be able to rely on decisions such as in the case of Texspin Engg and Mfg. Works. With a judgment directly on the issues, though binding merely within the jurisdiction of the Mumbai ITAT, the taxpayers who have taken such an approach in the past, or whose assessments are pending, may face adverse consequence. It is to be noted that even the ITAT has not actually gone into examining whether the conversion results in transfer under the provisions of the IT Act itself. It has merely relied on the memorandum to the Finance Act 2010 to conclude that the conversion is a transfer
However, this judgment has a silver lining since even though ITAT holds that such conversion amounts to transfer, there would not be any tax liability as long as the conversion is at book value. Thus, the impact of this judgment would be limited to the taxpayers who transfer assets at a value higher than the book value, pursuant to such conversion. Having said the same, it would be very pertinent to structure future transactions, bearing in mind the possibilities of such tax implications.
Further, the issue of taxability in the hands of the shareholder was not before the ITAT, which has left the fate of shareholders hanging. It is possible in the light of such conversion being considered a taxable transfer, the tax authorities may seek to tax capital gains arising in the hands of the shareholders upon alienation shares in return for interest in the LLP. However, if the shareholder is given the same amount of interest in the LLP as it held in the company, the same logic of no capital gains arising to the company on transfer should hold good.
We may expect the higher forums considering this issue, if not in the same case, in some other cases to determine whether in fact such conversion is indeed a transfer