This article has been written by Sumathi Vadlamudi Course, pursuing the Certificate Course in Advanced Corporate Taxation from LawSikho.
Table of Contents
Introduction
The term “Conversion” in general parlance means a change from one form to the other. In legal terms it means a voluntary act by one person inconsistent with the ownership rights of another.
Company
The Companies Act, 2013 defines a Company as “a company incorporated under this Act or under any previous Law”. It can be said that a company is a body corporate formed by a group of individuals called shareholders to achieve certain commercial goals and gain from them. A company may be of any category as provided in the Companies Act namely:
- Public limited Company,
- Private Limited Company,
- Company Limited by Shares,
- Company Limited by Guarantee,
- One person Company (new concept introduced in the Companies Act, 2013), and
- Not-for-Profit Company, whose main objective is charitable activities or up-liftment of the poor etc. which will not involve in any activities of commercial nature.
There are so many advantages a business can benefit from by operating as a company as given below:
- Limited liability
- Perpetual succession
- Separate legal entity
- Issue of shares to public
- No bar on the type of business to be carried except that the same must be legitimate
- Scope for unlimited expansion
- Management
- Books of Accounts
Let us look at each of the above aspects in greater detail:
Limited Liability
Shareholders are liable to contribute to the assets of the company, in case the company goes into winding-up, but only to the extent of unpaid share capital on the shares held by them. For ex. If Mr. P holds 100 shares of K. Ltd, face value of INR 10/- each on which he has a paid INR 8/- per share as called for by the company till date. In case K.Ltd goes into winding-up, liability of Mr. P will be to the extent of unpaid share capital of INR 2/- per share. So, in such case, he needs to contribute only INR 200/- on the shares held by him.
Perpetual Succession
A company will continue to exist irrespective of any event like the death of its shareholders. It can be declared as non-existent only by applying legal provisions to close its operations. This process is known as “Winding Up of Company”.
Separate Legal Entity
This means a company is different from its shareholders and has a separate existence of its own in the eyes of Law. Neither are the shareholders bound by the acts of the company nor is the company bound by the acts of its shareholders.
It can enter, execute and terminate any business contract in its own name and under the Common Seal.
Issue of shares
A company can raise funds from the public subject to the SEBI regulations, issued and amended by Securities Exchange Board of India (SEBI) from time to time in this regard.
No of members
While the minimum no of persons required to incorporate a company is 7, there is no limit on the maximum number of shareholders.
Business
There is no bar on the type of business that can be undertaken by a company except that the same is legitimate and is not prohibited by or under any law for the time being in force in the country.
Scope for unlimited expansion and international presence
There is no limit on the number of shareholders in a public company or the funds that it can raise subject to the SEBI Regulations and other applicable Statutes. So that it can meet its potential for expansion of its operations by raising funds at the times of need. Also, Foreign Direct Investments are also allowed subject to certain conditions.
Indian Companies can also open their branches outside India.
Management
Management of a company is different from ownership. That means day to day business of the company will be taken care of by the competent personnel having required technical and managerial skills. Shareholders need not participate in the day to day operations of the company.
Books of accounts
Separate books of accounts are maintained for the transactions entered into by the company for the purpose of carrying on its business. Different books to be kept and maintained, audit of the same, taxability etc are all governed by the Companies Act 2013, Income Tax Act 1961, FEMA 1992, SEBI Regulations, GST Act 2017, any other Statute as applicable from time to time-based on the nature of business carried on by the company.
Though there are many other advantages of a company form of business along with those mentioned above, the increasing number of compliances under the Companies Act, SEBI and various other Statutes force e entrepreneurs to think of other alternatives which can offer the flexibility of doing business as a company with the least requirement for Legal compliances.
Partnership Firm
As per the Indian Partnership Act, 1932 (Partnership Act) partnership is a relation between the persons who have agreed to share the profits of a business carried on by them all or any one of them acting for all. They are individually called ‘partners’ and collectively called ‘firm’.
If a partnership type of business structure is chosen only due to the lesser compliances, other factors could act as limitations which will not allow the business to grow beyond a certain level. Some features of Partnership can be enumerated as:
- Unlimited liability of partners who are jointly and severally liable to contribute to the assets of the partnership in case of losses exceeding the capital contributed.
- Partners and the firms are one and the same. Partners are collectively referred to as Partnership firms. A partnership firm is not different from its partners.
- All partners are bound by the acts of other partners not only that, partners are jointly and severally liable to contribute to the debts of the firm. Their liability is unlimited that means if their capital is not sufficient to make the losses of the firm good or to discharge the debts of the firm, they have to contribute from their personal assets.
- As the firm and partners are one and the same, all partners can participate in the business of the partnership or any one of them acting on behalf of all the partners. In such cases, acts of managing partners will be binding on all other partners.
- A firm can never ever be allowed to raise funds from the general public for the purpose of carrying or expanding its business.
- A minimum number of persons required to effect a partnership is 2 and maximum number is 50 in case of banking business and 100 in case of any other business.
Hereby emerges the birth of the concept of Limited Liability Partnership, combining the features of both the Company and Partnership Firm.
A limited liability partnership (LLP) is a partnership firm established as per the provisions of the Limited Liability Partnership Act, 2008 (LLP Act).
Features of LLP
Body Corporate
An LLP is a body corporate established under the provisions of LLP Act.
Hence, it’s having legal entities separate from its members and is having perpetual succession.
So admission or retirement of partners will not affect its existence, rights or liabilities.
Not bounded by the Partnership Act, 1932
An LLP is not bound by the provisions of the Indian Partnership Act, 1932.
No of partners
While the minimum number of partners is 2, there is no limit on a maximum number of partners.
Every partner is an agent of LLP but not of the other partners for the purpose of carrying on the business of LLP.
Books of accounts
Separate books of accounts are to be maintained and audited as per the prescribed rules.
Contribution by partners
Obligation of partners to contribute to the assets of LLP will be according to agreement.
Need for conversion
To get free from the unnecessary and costly compliances under the Companies Act and to get benefit from the more convenient way of doing businesses and running professions as offered by the LLP Act, 2008.
Also, the professional practice cannot be in the form of a company. If they form a partnership, the liability is unlimited. So, for them, LLP is nothing less than a boon. Since many of the like-minded professionals can come together to offer specialised professional services while ensuring that their liability is limited. Hence, it is definitely beneficial to do business in the form of an LLP.
Who can convert?
However, if a company is already in existence at the time of the LLP Act coming into effect, does this company have to forego the convenience of carrying on its business as an LLP, just for the reason that it was incorporated during the Pre LLP concept period? The answer is a big NO. This is primarily because the LLP Act came up with a provision for conversion of a private limited company into an LLP. Not only that, even if a private company was established after the LLP Act, 2008 coming into effect, it can at any time convert into an LLP by following the procedure given with respect to the same.
Clause 56 and 57 of LLP Act provides that a private limited company and an unlisted public company can convert into an LLP, if the conditions mentioned in Third and Fourth Schedules to LLP Act are complied with respectively.
As the Third schedule, a private limited company can convert into LLP, if:
- There is no security interest on the assets of the company at the time of making an application for conversion; and
- The partners of LLP are none other than the shareholders of the company.
Similarly, the Fourth schedule provides for the conversion of an unlisted public company into an LLP if:
- There is no security interest on the assets of the company at the time of making an application for conversion; and
- The partners of LLP are none other than the shareholders of the company.
Effect of conversion
On such conversion, all tangible and intangible (whether movable or immovable) property, assets, liabilities, rights and obligations relating to the company and the whole undertaking of the company shall stand transferred to the LLP and vested in LLP.
Effect of conversion in terms of Tax
Now, let us consider the effect of such conversion in terms of taxation. With the introduction of the concept of conversion of a private limited company into an LLP, Income Tax Act, 1961(IT Act) has been amended to deal with the taxability of the said conversion.
Whether conversion constitutes “Transfer”?
Section 45 of the Act provides for various transactions which are considered as transfers for the purpose of imposing tax. Section 47 provides different situations under which the transaction which can otherwise be considered as a transfer, will not be considered so, for the purpose of its taxability. The same has been amended to include the conversion of a private company into an LLP.
As per Sec. 47(iiib):
- any transfer of a capital asset or an intangible asset by a private company or an unlisted public company to a Limited Liability Partnership; or
- any transfer of shares by the shareholders of a private company or unlisted public company by any shareholder as a result of the conversion of them into an LLP;
will not be considered as transfer, if the following conditions are satisfied:
- All assets and liabilities of the company immediately before the conversion shall become the assets and liabilities of the LLP, on such conversion.
- All the shareholders of the company immediately before such transfer, shall become the partners of the LLP.
- The capital contribution and profit sharing ratio of the shareholders in the LLP, on such conversion, shall be in the same proportion as it was immediately before the conversion.
- Shareholders should not receive any consideration other than in the form of share in profits of the LLP and capital contribution in LLP, for transfer of shares held by them in the company.
- Aggregate shareholding of the partners in LLP should not be less than 50% at any time during first 5 years, after the conversion.
- Total sales, Turnover or Gross receipts from the business of the company during any of the three previous years preceding the previous year in which conversion take place shouldn’t exceed INR 60L.
- Total value of the assets as stood in the books of accounts of the company during any of the three previous years preceding the previous year in which conversion take place shouldn’t exceed INR 5Cr.
- Any accumulated reserves shown in the Balance Sheet as on the date of conversion shouldn’t distribute among the partners for a minimum period of 3 years after such conversion.
So, if all the aforementioned conditions are satisfied up to the timelines so mentioned, then there will be no transfer due to conversion.
When the transaction is not considered as transfer, no question of capital gain arises and no tax is payable as a result.
Also, as per provisions of section 72A (6A) of IT Act any brought forward losses and unabsorbed depreciation in the books of accounts of the company can be allowed to be set off against the profits earned by the successor LLP.
Industry-specific deductions allowed under chapter VI of the IT Act will continue to be allowed for the remaining period of tax holiday in the hands of the successor LLP.
Effect of non-compliance of the specified conditions
On LLP
As per section 47A of the Act, if any of conditions which are specified under proviso to Section 47(iiib), which are reproduced above, all profits or gains arising out of transfer of capital assets or intangible assets which are not charged to tax at the time of such transfer, will be deemed to be the profits and gains arising on transfer of such capital asset or intangible assets.
And the same is chargeable to tax in the hands of the successor LLP during the previous year in which requirements, as laid down under proviso to section 47(iiib), are not complied with.
The provisions of section 45 will apply accordingly in that year as if such transfer had taken place in that year.
So, capital gains on/ transfer of capital assets, intangible assets will be computed as per the provisions of section 48 of the Income Tax Act, 1961.
In such a case, cost of acquisition of assets and period of holding of the asset by the predecessor company will be deemed to be the cost of acquisition and period of holding in the hands of LLP.
Sale consideration would be the book value of the assets as stand in the books of accounts of the company immediately before such transfer as the same is brought into books of accounts of the firm. This is because there is only change in the constitution of the business entity but not the business operations.
Mumbai ITAT in the case of ACIT v. Celerity Power LLP (ITA 3637/MUM/2015) has observed that the Memorandum explaining the Finance Act, 2010 provides that the conversion of a private company or an unlisted public company into an LLP attracts tax implications definitely. So transfer of assets on such conversion will attract capital gain tax. Also carry forward and set off of losses and unabsorbed depreciation are not allowed in the hands of successor LLP. However if conditions mentioned therein are complied with, the same was proposed to be not regarded as transfer for the purpose of section 45 of the IT Act. They are:
- Total sales or turnover or gross receipts do not exceed 60 lakh rupees in preceding 3 previous years.
- Shareholders shall become the partners of LLP in the same proportion of their shareholding in the company.
- Partners haven’t received any consideration other than the share in profits and capital contribution of LLP.
- Aggregate profit sharing ratio of all the shareholders of the company in the successor LLP shouldn’t be less than 50% at any time during 5 years after such conversion.
- All assets and liabilities of the company should become that of successor LLP.
- Accumulated profits of the company have not been distributed among the partners for a period of 3 years after such conversion.
If all the aforementioned conditions are fulfilled, then the transaction will not be considered as Transfer, hence no capital gain will occur on transfer of assets. Also, brought forward losses and unabsorbed depreciation are allowed to be carried forward and adjusted against the profits of the successor LLP.
Aggregate depreciation allowable to LLP cannot exceed that allowable to company had there been no such conversion.
The actual cost of the block of assets in the hands of LLP is the written down value (WDV) of the same as on the date of such conversion shown in the books of accounts of the company.
Also, cost of acquisition of assets to the successor LLP will be deemed to be that of the predecessor company.
However, the credit for the tax paid under section 115JB was allowable only to the company but not to the successor LLP.
The aforementioned amendments brought into effect from AYs commencing on or after 01.04.2011.
Hence, in the above mentioned case Hon’ble ITAT held that since one of the required conditions are not complied with, it made the conversion result into transfer and the resulting capital gain is chargeable in the hands of the predecessor.
As the predecessor being the company succeeded by the LLP, the same can be chargeable to tax in the hands of the successor LLP as provided in section 170(2) of the IT Act.
The sale consideration and cost of acquisition are one and the same, the capital gain is nil and accordingly provisions of section 48 for computation of capital gain become unworkable.
On Shareholders
In case of violation of provisions of section 47(xiiib), the partner (earlier Shareholder) needs to compute and pay capital gain tax on the shares held by him in the private company.
In such a case, cost acquisition would be the cost at which the shares are purchased by him. And the sale consideration would be the total consideration received in the form of capital contribution.
There is another argument against this according to which, the shareholders are becoming the partners in the firm and the share capital in the company has become the capital contribution in the LLP. A person won’t get any benefit by selling anything to himself. If so, there shouldn’t be any capital gain and resulting tax arising from such transfer.
Conclusion
Conversion of a private limited company into an LLP will be beneficial considering the ease of doing business and reduced compliances. However, one should need to consider the effect of the same with respect to tax implications as per the provisions of the Income Tax Act, 1961 read with applicable provisions of Companies Act, 2013 and LLP Act, 2008.
If all the specified conditions are complied with up to the given time limits, then the conversion of a private company or an unlisted public company will not be considered as a transfer.
As the said conditions to be complied with are cumulative in nature, failure on the part of successor LLP to comply with at least one such condition can render the exemption allowed non-applicable.
References
- The Companies Act, 2013
- The Indian Partnership Act, 1932
- Limited Liability Partnership Act, 2008
- Income Tax Act, 1961
- ACIT v. Celerity Power LLP (ITA 3637/MUM/2015)
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