Introduction of Limited Liability Partnership in India

Limited Liability Partnership (LLP) Act 2008 introduced a new form of organization in India. The year when the LLP Act was introduced there was lack of clarity on its taxability. The question was whether LLP will be taxed like a Domestic Company or Partnership Firm. Finance Act (No.2) of 2009 amended section 2(23) of Income Tax Act, according to which, clause (i) the word “firm” shall include LLP, clause (ii) the word “partner” shall include a partner of LLP and clause (iii) the word “partnership” shall include LLP as defined under LLP Act 2008. Post this amendment LLP became the attractive form of organization as it offered the safety to its partners with the feature of limited liability like a company and the same time it offers ease of operations in introduction and withdrawals of funds in and out of capital account. Further, Dividend Distribution Tax (DDT) not applicable to LLP made it popular form of organization from year 2009 onwards. The new small and medium start ups prefer LLP as it is tax efficient and burden of compliance is lesser as compared to company.

Insertion of section 47(xiiib) in IT Act for conversion in LLP

The taxation issue was about the existing private limited or unlisted public companies who intended to convert to LLP. In order to introduce the taxation on conversion of such companies into LLP, a new clause (xiiib) was inserted in section 47 of Income Tax Act. According to proviso to section 47(xiiib), the conversion of private limited companies and unlisted public companies into LLP is not taxable subject to following conditions:

(a) all the assets and liabilities of the company immediately before the conversion become the assets and liabilities of the limited liability partnership;

(b) all the shareholders of the company immediately before the conversion become the partners of the limited liability partnership and their capital contribution and profit sharing ratio in the limited liability partnership are in the same proportion as their shareholding in the company on the date of conversion;

(c) the shareholders of the company do not receive any consideration or benefit, directly or indirectly, in any form or manner, other than by way of share in profit and capital contribution in the limited liability partnership;

(d) the aggregate of the profit sharing ratio of the shareholders of the company in the limited liability partnership shall not be less than fifty per cent at any time during the period of five years from the date of conversion;

(e) the total sales, turnover or gross receipts in the business of the company in any of the three previous years preceding the previous year in which the conversion takes place does not exceed sixty lakh rupees; and

(f) no amount is paid, either directly or indirectly, to any partner out of balance of accumulated profit standing in the accounts of the company on the date of conversion for a period of three years from the date of conversion.

The conditions mentioned above include the conditions which ensure the continuity of same business by same shareholders.

Possible Litigation on section 47(xiiib) of IT Act.

The additional conditions (e) and (f) are to restrict the tax benefit of this clause to smaller entities and to control evasion of DDT respectively. However the clause (e) in particular may lead to tax litigation. The terms “total sales, turnover or gross receipts in the business of the company” refers to revenue and receipts of the company and not to the income of the company. For instance, the company which is not a real estate company but having some real estate in its balance sheet and is receiving good amount of rent income which exceeds sixty lakh rupees in a year. The company has ceased its business operations and rent income is the only income of the company. The question is whether such company will be eligible for tax benefit under this clause or not. As company is not a real estate company and hence rent income is neither sales/turnover or receipts in the business, the company shall be eligible for tax benefit under this clause even after having good amount of income. The interest or dividend income on investments of the company can also be treated other income not forming part of turnover/sales of gross receipts from business of the company.

Further, clause (f) which restricts distribution of accumulated profits is to ensure that there is no evasion of DDT. Now for instance, a private limited company is having large amount of retained earnings in its balance sheet. If company issues shares by capitalizing retained earnings before conversion of a company in LLP, then there will be nothing left in accumulated profits of the company. The company gets converted into LLP and share capital gets converted into partners’ capital. The partners of the LLP withdraw amounts against their capital accounts. The question is whether such withdrawal will result into denial of tax benefit u/s 47(xiiib) to said LLP. As per clause (f), accumulated profits standing in the accounts of the company on the date of conversion can not be withdrawn for three years. In this case, as retained earnings were capitalized right before conversion, there were no accumulated profits in the balance sheet of the company on the date of conversion. However, tax authorities may even take a position of categorizing this arrangement as colourable device to deny tax benefit.

Proposed amendment in Finance Bill 2016

Finance bill 2016 has proposed another special clause (ea) in section 47(xiiib) to put further restriction on conversion of company into LLP which is as follows:

“(ea) the total value of the assets as appearing in the books of account of the company in any of the three previous years preceding the previous year in which the conversion takes place does not exceed five crore rupees; and;”;

Before introduction of this clause, the benefit of 47(xiiib) was restricted to size of the company having its revenue/turnover and gross receipts from business exceeding sixty lakhs rupees. Now post time proposed insertion, size of assets is an additional parameter to judge the eligibility of the company to claim benefit. Now imagine a company having four crores rupees of book value of real estate in its balance sheet and having no turnover. The said company would have been clearly eligible for benefit of this section before introduction of proposed amendment. The question is meaning of the term “value” used in the proposed clause. The term “value” is different from “fair market value”. The term “fair market value” is defined under section 2(22B) of Income Tax Act as follows:

(i) the price that the capital asset would ordinarily fetch on sale in the open market on the relevant date ; and

(ii) where the price referred to in sub-clause (i) is not ascertainable, such price as may be determined in accordance with the rules made under this Act ;

Thus fair market value can be determined by the qualified valuer. The fair market value will usually be quite higher than the book value in case of real estate and hence company mentioned above may get affected by the proposed amendment. The assessee will always prefer to consider book value as “value” and revenue will always consider it as fair market value. Thus absence of clarity on the term value will lead us to litigation.

Consequences on non compliance of 47(xiiib) of IT Act.

The conversion of a company into LLP not to be considered as transfer for the purpose of capital gains if all the conditions specified under section 47(xiiib) are complied with. Hence if any of the conditions specified is not complied with then the conversion will result into transfer. However there is no clarity about the mechanism of taxing the conversion of company into LLP. The capital gains shall be computed as given in section 48 according to which capital gain shall be computed by deducting cost of acquisition and expenditure from “full value of consideration”. In case of conversion of company into LLP, whether provisions of Section 50B i.e. taxation considering slump sale will be applied or asset wise fair market value will be determined in light of section 50C and 50D of Income Tax Act is not yet clear. Hence special provision specifying taxation of conversion of an entity into other form of entity will clarify the doubts if conditions specified in section 47 of Income Tax Act are not complied with. Section 47A(4) of IT Act according to which, in the case when the conditions of section 47(xiiib) are not complied with then profits and gains arising from transfer of capital asset shall be deemed to be the profits and gains chargeable to tax of the successor LLP or the shareholders of the predecessor company. The wording used is “profits and gains chargeable to tax” and not “be deemed to be capital gains chargeable. The similar view has been taken by Kolkata ITAT in the case of Aravali Polymers LLP.

The conversion into LLP if considered as transfer, still it may not be taxed as capital gains, as what is to be taken as full value of consideration when there is no consideration paid/payable by LLP to company. This view has been recently taken by Hon. Gujarat High Court in the case of R.L.Kalathia (2016) 381 ITR 180 and in the case of Texspin Engineering and Manufacturing works (2003) 263 ITR 0345 (Bombay High Court). However both these rulings pertain to Assessment Year 1996-97. Post introduction of section 50D by Finance Act 2012, fair market value of assets is to be taken as full value of consideration. Hence both these rulings may not support the assessee contention that no consideration has accrued out of the conversion into LLP.    

Taxing the conversion of company into LLP selectively

Overall, taxing the transaction of converting an entity into other form of entity is a debatable point in itself. Capital gain requires two factor viz. Capital asset and transfer. Further transfer also has got two important ingredients viz. Party and counter party. In case of conversion, party and counter party does not exist together at any point of time. Thus there is no transfer at all can also be an argument. Hence conditions to offer tax benefit on conversion to ensure continuity of business and owners is well accepted concept. However offering the benefit based on the size of the entity is certainly going to create tax litigation.