By Prerana Priyanshu
In the past few years, the corporate landscape has witnessed de-corporatisation of many companies, perhaps, because of the regulatory burden imposed on them under the erstwhile and present company laws. With the enactment of the Limited Liability Partnership Act, 2008, a viable option for such de-corporatising entities is to convert themselves into a Limited Liability Partnership (‘LLP’). Conversion into LLP is becoming a popular choice for many existing companies for two broad reasons – (i) ease of conversion, for example, conversion of the assets and liabilities of the predecessor company into the successor LLP without any instrument of transfer, and hence, without any stamp duty liability; and (ii) other benefits after conversion, such as, lighter regulations, no limit to the number of partners in LLP, etc.
An aspect which needs to be looked into apart from examining the conversion from the viewpoint of corporate laws and stamp duty, is the implication under the income tax law. This article discusses a crucial aspect on taxability of conversion of company to LLP – “Whether conversion of company into LLP amounts to ‘transfer’ for the purpose of ‘capital gains’ tax under Section 45 of the Income Tax Act, 1961?”
ACIT v. Celerity Power LLP
The above question is analysed in light of the recent decision of ITAT Mumbai, in the case of ACIT v. Celerity Power LLP [2018] 100 taxmann.com 129 (Mum.-Trib.). The respondent-company converted itself to LLP on 28.09.2010 as per the LLP Act, 2008 as a consequence of which its business, assets and liabilities vested in the newly formed LLP. The AO questioned the failure of the assessee to pay tax on the ‘transfer’, which is as a result of the conversion, under the head ‘Capital Gains’.
The primary contention of the respondent was that during the conversion of company to LLP, property, assets or liability of the company were only vested in the new LLP, and not ‘transferred’. The backbone of this argument is Section 58(4) and Third Schedule of the LLP Act, 2008, which, when summarised, states that on conversion from private limited company to LLP, all tangible and intangible property of the company shall be transferred to and shall vest in the LLP without further assurance, act or deed. The assessee also relied on the decision of Bombay High Court in CIT v. Texspin Engg. & Mfg. Works, [2003] 263 ITR 345 (Bom.), where it was held that conversion of a partnership firm into private limited company would not amount to ‘transfer’ and further that such a conversion also did not involve ‘consideration’ for the purpose of taxation under Section 45 of the IT Act.
The Tribunal put forth that the meaning of ‘transfer’ is to be understood in terms of the IT Act, and not with reference to other Acts such as LLP Act or Transfer of Property Act. It was also observed that every form of conversion is distinct from the other, therefore, the Tribunal declined to follow Texspin Engg. (Supra), where it was a partnership firm to company conversion, and not company to LLP conversion, to decide whether it is a ‘transfer’ or not in the instant case. Thus, in this case, the Tribunal held that a company to LLP conversion is a ‘transfer’.
The Tribunal also looked into Section 47(xiiib). Section 47(xiiib) provides that conversion from company to LLP shall not be transfer subject to fulfilment of certain conditions specified in clause (a) to (f) of the proviso to Section 47(xiiib). In this case, since the respondent-company had failed to satisfy clause (e) pertaining to total receipts or turnover in any of the three years preceding the previous year not exceeding Rs. 60 lakhs it was held that they could not avail the shield under Section 47(xiiib).
To put it simply, the ITAT ruled that conversion of a company to LLP is a ‘transfer’, and upon failure to fulfil conditions under clause (a) to (f) of the proviso to Section 47(xiiib), the newly formed LLP is chargeable to capital gains tax under Section 45 of the IT Act. After holding that the conversion is a ‘transfer’, the Tribunal finally ruled that there would be no capital gains tax payable as the assets are transferred to the assessee LLP at book value.
Analysis of the ITAT ruling
From an academic point of view, reading this order leaves the impression that the question of law before the tribunal was highly crucial, having large scale impact on corporates and other business entities, however, in the opinion of the author, the decision of the Tribunal was not as appositely reasoned as one might have hoped it to be.
The primary question before the Tribunal was whether conversion of company to LLP is a ‘transfer’ for the purposes of Section 45 or not? To decide whether a transaction is ‘transfer’, one may advert to the definition of transfer as is given in Section 2(47). According to the definition under Section 2(47), ‘transfer’ qua any capital asset includes, inter alia, ‘the sale, exchange or relinquishment of the asset’. In context of the present case, the author is of the opinion, that there is no transfer upon conversion of a company to an LLP for two reasons. First, the conversion is by way of operation of law, whereby, the company, as per the LLP Act, changes its character to that of an LLP and there is no transfer of assets from one person to another. It is upon complying with the provisions under the LLP Act qua the conversion that the assets and liabilities of the company automatically vest in the LLP without any transfer taking place. Second, the aspect of sale or exchange or relinquishment primarily requires the existence of two parties, i.e. one who transfers and one in whose favour it is transferred. In case of conversion of company to LLP, there are no two counter parties as the process of conversion only alters the status and character of the existing company, which upon such conversion is treated differently under legal framework. This argument is supported by the decision of the Bombay High Court in in Texspin Engg. & Mfg. Works (Supra).
The conclusion of the Tribunal appears to be that that the company to LLP conversion is ‘transfer’ for reasons that the exclusion provided under Section 47(xiiib) for such a transaction (conversion of company to LLP) leads a presumption that such conversions are ipso facto ‘transfers’. The decision states “…though the transactions referred to in Section 47 are 'transfers', however, the same subject to cumulative satisfaction of the conditions contemplated in the respective sub-sections would fall beyond the sweep of chargeability to income-tax as 'Capital gains' under Sec. 45 of the Act ” (Para 10 of the order). In the opinion of the author, this reverse analogy does not have any concrete basis. The manner to determine whether a transaction is ‘transfer’ is through Section 2(47), and thereafter, once established as ‘transfer’, the second step is to see whether it falls under the exclusion provided under Section 47. The method cannot be vice-versa. It is pertinent to know that by using the words ‘any transfer’ in the opening part of Section 47(xiiib), the law implies only in scenarios where there is a ‘transfer’ in the first place, can one proceed to see if the conditions under proviso to Section 47(xiiib) are fulfilled. If there is no transfer, then, there is clearly no liability under capital gains tax.
The Tribunal also made a broad comparison of Part IX of Companies Act, 1956 with Section 58(4), read with Clause 6 of Third Schedule of LLP Act. The former talks about succession of a partnership firm by a company, wherein, there is a “vesting” of property of the firm in the company from the date of its registration under Section 575 of 1956 Act. Section 575 is extracted below,
"575. Vesting of property on registration - All property, movable and immovable (including actionable claims), belonging to or vested in a company at the date of its registration in pursuance of this part, shall, on such registration, pass to and vest in the company as incorporated under this Act for all the estate and interest of the company therein"
Whereas, Section 58(4), read with Clause 6 of Third Schedule of LLP Act states something similar with respect to company to LLP conversion, as extracted below,
“(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 21 company, as the case may be, shall be transferred to and shall vest in the limited liability partnership without further assurance, act or deed;…”
The conclusion of the Tribunal, after making the abovementioned comparison, is that both these sets of provisions are cumulatively distinct from each other, and therefore, while it is statutory “vesting” in case of Part IX succession, it is “transfer” in case of Section 58(4) read with Third Schedule of LLP Act. However, a close perusal of both these sets of provisions do not provide any basis to make such a distinction, mostly because the same principle flows through both, i.e. vesting of property by operation of law at the time of conversion. The decision does not provide any justification for making this distinction, and consequently labelling company to LLP under Section 58(4) and Third Schedule of LLP, as ‘transfer’.
Celerity Power LLP case is the prevailing judicial precedent in the matter of conversion of company to LLP though, the author is of the view that the position taken in Texspin Engg. & Mfg. Works (Supra) is correct in law and the same principle should apply to transaction of conversion of company to LLP as well. Nevertheless, for all future conversion of company to LLP, the assessee has the uphill task of overcoming the observations made in Celerity Power LLP case in order to demonstrate that the transaction is not a taxable transfer.
[The author is an Associate, Direct Tax Team, Lakshmikumaran & Sridharan, Chennai]
In the past few years, the corporate landscape has witnessed de-corporatisation of many companies, perhaps, because of the regulatory burden imposed on them under the erstwhile and present company laws. With the enactment of the Limited Liability Partnership Act, 2008, a viable option for such de-corporatising entities is to convert themselves into a Limited Liability Partnership (‘LLP’). Conversion into LLP is becoming a popular choice for many existing companies for two broad reasons – (i) ease of conversion, for example, conversion of the assets and liabilities of the predecessor company into the successor LLP without any instrument of transfer, and hence, without any stamp duty liability; and (ii) other benefits after conversion, such as, lighter regulations, no limit to the number of partners in LLP, etc.
An aspect which needs to be looked into apart from examining the conversion from the viewpoint of corporate laws and stamp duty, is the implication under the income tax law. This article discusses a crucial aspect on taxability of conversion of company to LLP – “Whether conversion of company into LLP amounts to ‘transfer’ for the purpose of ‘capital gains’ tax under Section 45 of the Income Tax Act, 1961?”
ACIT v. Celerity Power LLP
The above question is analysed in light of the recent decision of ITAT Mumbai, in the case of ACIT v. Celerity Power LLP [2018] 100 taxmann.com 129 (Mum.-Trib.). The respondent-company converted itself to LLP on 28.09.2010 as per the LLP Act, 2008 as a consequence of which its business, assets and liabilities vested in the newly formed LLP. The AO questioned the failure of the assessee to pay tax on the ‘transfer’, which is as a result of the conversion, under the head ‘Capital Gains’.
The primary contention of the respondent was that during the conversion of company to LLP, property, assets or liability of the company were only vested in the new LLP, and not ‘transferred’. The backbone of this argument is Section 58(4) and Third Schedule of the LLP Act, 2008, which, when summarised, states that on conversion from private limited company to LLP, all tangible and intangible property of the company shall be transferred to and shall vest in the LLP without further assurance, act or deed. The assessee also relied on the decision of Bombay High Court in CIT v. Texspin Engg. & Mfg. Works, [2003] 263 ITR 345 (Bom.), where it was held that conversion of a partnership firm into private limited company would not amount to ‘transfer’ and further that such a conversion also did not involve ‘consideration’ for the purpose of taxation under Section 45 of the IT Act.
The Tribunal put forth that the meaning of ‘transfer’ is to be understood in terms of the IT Act, and not with reference to other Acts such as LLP Act or Transfer of Property Act. It was also observed that every form of conversion is distinct from the other, therefore, the Tribunal declined to follow Texspin Engg. (Supra), where it was a partnership firm to company conversion, and not company to LLP conversion, to decide whether it is a ‘transfer’ or not in the instant case. Thus, in this case, the Tribunal held that a company to LLP conversion is a ‘transfer’.
The Tribunal also looked into Section 47(xiiib). Section 47(xiiib) provides that conversion from company to LLP shall not be transfer subject to fulfilment of certain conditions specified in clause (a) to (f) of the proviso to Section 47(xiiib). In this case, since the respondent-company had failed to satisfy clause (e) pertaining to total receipts or turnover in any of the three years preceding the previous year not exceeding Rs. 60 lakhs it was held that they could not avail the shield under Section 47(xiiib).
To put it simply, the ITAT ruled that conversion of a company to LLP is a ‘transfer’, and upon failure to fulfil conditions under clause (a) to (f) of the proviso to Section 47(xiiib), the newly formed LLP is chargeable to capital gains tax under Section 45 of the IT Act. After holding that the conversion is a ‘transfer’, the Tribunal finally ruled that there would be no capital gains tax payable as the assets are transferred to the assessee LLP at book value.
Analysis of the ITAT ruling
From an academic point of view, reading this order leaves the impression that the question of law before the tribunal was highly crucial, having large scale impact on corporates and other business entities, however, in the opinion of the author, the decision of the Tribunal was not as appositely reasoned as one might have hoped it to be.
The primary question before the Tribunal was whether conversion of company to LLP is a ‘transfer’ for the purposes of Section 45 or not? To decide whether a transaction is ‘transfer’, one may advert to the definition of transfer as is given in Section 2(47). According to the definition under Section 2(47), ‘transfer’ qua any capital asset includes, inter alia, ‘the sale, exchange or relinquishment of the asset’. In context of the present case, the author is of the opinion, that there is no transfer upon conversion of a company to an LLP for two reasons. First, the conversion is by way of operation of law, whereby, the company, as per the LLP Act, changes its character to that of an LLP and there is no transfer of assets from one person to another. It is upon complying with the provisions under the LLP Act qua the conversion that the assets and liabilities of the company automatically vest in the LLP without any transfer taking place. Second, the aspect of sale or exchange or relinquishment primarily requires the existence of two parties, i.e. one who transfers and one in whose favour it is transferred. In case of conversion of company to LLP, there are no two counter parties as the process of conversion only alters the status and character of the existing company, which upon such conversion is treated differently under legal framework. This argument is supported by the decision of the Bombay High Court in in Texspin Engg. & Mfg. Works (Supra).
The conclusion of the Tribunal appears to be that that the company to LLP conversion is ‘transfer’ for reasons that the exclusion provided under Section 47(xiiib) for such a transaction (conversion of company to LLP) leads a presumption that such conversions are ipso facto ‘transfers’. The decision states “…though the transactions referred to in Section 47 are 'transfers', however, the same subject to cumulative satisfaction of the conditions contemplated in the respective sub-sections would fall beyond the sweep of chargeability to income-tax as 'Capital gains' under Sec. 45 of the Act ” (Para 10 of the order). In the opinion of the author, this reverse analogy does not have any concrete basis. The manner to determine whether a transaction is ‘transfer’ is through Section 2(47), and thereafter, once established as ‘transfer’, the second step is to see whether it falls under the exclusion provided under Section 47. The method cannot be vice-versa. It is pertinent to know that by using the words ‘any transfer’ in the opening part of Section 47(xiiib), the law implies only in scenarios where there is a ‘transfer’ in the first place, can one proceed to see if the conditions under proviso to Section 47(xiiib) are fulfilled. If there is no transfer, then, there is clearly no liability under capital gains tax.
The Tribunal also made a broad comparison of Part IX of Companies Act, 1956 with Section 58(4), read with Clause 6 of Third Schedule of LLP Act. The former talks about succession of a partnership firm by a company, wherein, there is a “vesting” of property of the firm in the company from the date of its registration under Section 575 of 1956 Act. Section 575 is extracted below,
"575. Vesting of property on registration - All property, movable and immovable (including actionable claims), belonging to or vested in a company at the date of its registration in pursuance of this part, shall, on such registration, pass to and vest in the company as incorporated under this Act for all the estate and interest of the company therein"
Whereas, Section 58(4), read with Clause 6 of Third Schedule of LLP Act states something similar with respect to company to LLP conversion, as extracted below,
“(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 21 company, as the case may be, shall be transferred to and shall vest in the limited liability partnership without further assurance, act or deed;…”
The conclusion of the Tribunal, after making the abovementioned comparison, is that both these sets of provisions are cumulatively distinct from each other, and therefore, while it is statutory “vesting” in case of Part IX succession, it is “transfer” in case of Section 58(4) read with Third Schedule of LLP Act. However, a close perusal of both these sets of provisions do not provide any basis to make such a distinction, mostly because the same principle flows through both, i.e. vesting of property by operation of law at the time of conversion. The decision does not provide any justification for making this distinction, and consequently labelling company to LLP under Section 58(4) and Third Schedule of LLP, as ‘transfer’.
Celerity Power LLP case is the prevailing judicial precedent in the matter of conversion of company to LLP though, the author is of the view that the position taken in Texspin Engg. & Mfg. Works (Supra) is correct in law and the same principle should apply to transaction of conversion of company to LLP as well. Nevertheless, for all future conversion of company to LLP, the assessee has the uphill task of overcoming the observations made in Celerity Power LLP case in order to demonstrate that the transaction is not a taxable transfer.
[The author is an Associate, Direct Tax Team, Lakshmikumaran & Sridharan, Chennai]