Tax uncertainty continues on LLP conversions

Recently, the Mumbai Bench of the Income Tax Appellate Tribunal (Tribunal) ruled that conversion of a company into an LLP (limited liability partnership) firm would be construed as a transfer and thus, be chargeable to tax on the pretext that specific tax neutrality conditions provided in the Income Tax Act, 1961 (IT Act), are not complied with.  Though the tribunal went on to compute the capital gains tax as Nil, it would be worthwhile to discuss the background of this issue to understand the impact of this judgement.

The LLP Act provides an enabling provision for conversion of a company into an LLP. Since LLPs offer a more flexible mode of carrying on business, along with the fact that they are not liable to a dividend distribution tax as applicable to companies, conversion was considered actively by existing businesses operating as companies. The Finance Act, 2010, introduced Section 47(xiiib) under the IT Act, which provided for compliance with certain conditions to enable tax-neutral conversion of a company into an LLP. These key conditions revolve around the turnover size and asset size prior to conversion, as also the continued majority ownership of existing shareholders and preservation of the existing reserves.

For companies which were not in compliance with the above conditions, a position on non-chargeability of tax was considered, placing reliance on an earlier judgement of the Bombay High Court (HC). The Bombay HC had ruled under the provisions of Part IX of the Companies Act that conversion of a firm into a company does not involve the existence of a party and a counterparty to constitute a transfer and further there is no consideration involved.

However, the Mumbai tribunal has taken a contrary view and distinguished the Bombay HC case on the basis that Part IX of the Companies Act referred to a statutory vesting of the assets and liabilities, whereas the LLP Act (Third Schedule) specifically states that on conversion, the assets and liabilities will be transferred to the LLP. The tribunal also relied on the memorandum explaining the Finance Act, 2010, which specifically laid out that conversion is a transfer, and hence, specific conditions were being introduced to exempt such transfer under Section 47 (xiiib).  

  

However, it is interesting to note that though the tribunal has held the conversion to be taxable, no capital gains arose on actual computation since the consideration received on conversion was considered to be equivalent to the book value of assets.

Another argument put forth by the taxpayer was that the cost of acquisition of the undertaking of the company was not determinable and hence, there can be no computation of capital gains tax. However, the tribunal considered this as a case of succession and held that the cost of acquisition would be the cost to the previous owner i.e. the company. It is interesting to note that there may be a basic anomaly in this observation since capital gains are computed for the company and not the LLP.

It would be meritorious to debate on a few issues that arise out of the tribunal’s decision. While distinguishing the Bombay HC judgement, the tribunal has not dealt with the fact that a transfer requires the existence of both the buyer and the seller at the time of the transfer, which may be ambiguous in the case of conversion of the company into an LLP.  In case the conversion is held to be a transfer, the tribunal’s summary observation that the consideration would be the ‘book value’ of the assets would require further evaluation since such book value recording of assets in the books of the LLP may not necessarily evidence discharge of consideration of equivalent amount. 

An aspect that may need discussion is whether the LLP interest being granted to the shareholders of the erstwhile company can be considered as the consideration for the transfer (a similar theory was propounded by the Delhi HC in a decision where consideration for slump sale was discharged partly to the shareholders of the seller company).  Whether Section 50D could have any application to this subject and could fair market value of the assets transferred be deemed to be the consideration for the transfer.

The taxability of the shareholders of the company undergoing conversion can be another area of tax uncertainty. It can be debated whether the extinguishment of shares and receipt of LLP interest in return can be brought to tax separately in the hands of the shareholders even though Section 47A of the IT Act talks only about taxing either the company or the shareholders. Transfer pricing provisions could also interplay in this regard to determine the arm’s length price in case of non-resident shareholders.

This is an important decision and is likely to have a far reaching impact. However, certain issues would require detailed evaluation before certainty can be obtained on tax treatment of LLP conversions.

Prashant Kapoor is partner, M&A tax, KPMG in India & Kanika Goel, an associate director. Views expressed are personal