Conversion Of Company Into An LLP – Whether Amounts To Transfer U/s 2(47) Giving Rise To Capital Gain?

Shri. S. N. Inamdar, Senior Advocate, has dealt with the controversial topic of whether the conversion of a company into an LLP results in a “transfer” of capital assets and gives rise to capital gains. He has argued that the judgement of the ITAT in ACIT vs. Celerity Power LLP 174 ITD 433 (Mum) is wrong and requires reconsideration. He has made good his submission with a detailed analysis of the statutory provisions and judgements of the High Courts

1. Income Tax Appellate Tribunal, Mumbai Bench-J, in the case of ACIT vs. Celerity Power LLP 174 ITD 433/197 TTJ 45 (Mum) has passed an order dated November 16, 2018 in which Hon. Tribunal has held that the conversion of the company into LLP gives rise to capital gains as there were transfers of capital assets.

2. The Hon. Tribunal posed a question to itself in Para 1, as to whether the transaction involved in conversion of Private Limited Company to Limited Liability Partnership as contemplated U/Sec.47(xiiib) would “though be a transfer”, the sum of cumulative satisfaction of conditions “a” to “f” of proviso 47(xiiib) would not be chargeable to capital gain U/Sec.45.

3. With due respect to Hon. Tribunal, it is difficult to agree either with the reasoning or conclusion drawn by it. It appears that it started with a presumption or conclusion that the transaction involves a transfer and then proceeded to examine whether the condition of Sec.47(xiiib) have been satisfied.

For reaching the conclusion that it involves transfer, it relied on Sec.5 of the Transfer of Property Act, 1882 and stated that transfer of property means an act by which a living person conveys property in present or in future to one or more either living person and to transfer property is to perform such act and therefore it took the view that the transfer of property by the company to the LLP as per Clause 6(b) of the Third Schedule (of LLP Act) would in itself satisfy the requirements of the term transfer.

On the one hand, it stated that the term ‘transfer’ has to be read in the context of the Income Tax Act and cannot be narrowed down to that defined in Transfer of Property Act.

It was obviously an error in observing that unlike the conversion of partnership firm into limited company under Part IX, there is only “vesting” of the property of the partnership in the company. Without explaining further, the Hon. Tribunal observed that “in the backdrop of aforesaid observations it can be safely concluded that conversion of company into a LLP as in the instant case is differently placed in comparison to succession of partnership firm by a company under Part IX”.

Therefore, it concluded that the contention of the assessee that on the conversion of the company into the assessee LLP no transfer of capital asset was involved is not acceptable. The above reasoning appears to be self-contradicting. It will be seen that there is virtually no legal difference between either the wording context or legal effect of Sec.575 of Companies Act, 1956 and provisions of Chapter X of the LLP read with Third Schedule.

4. It is submitted with respect that, the correct position appears to be as under:

4.1 Conversion from private company to LLP is governed by Chapter X. S.56 states that a private company may convert into a limited liability partnership in accordance with the provisions of this chapter and the Third Schedule.

S.58(3) stipulates that upon such conversion on and from the date of certificate of registration, effects of the conversion shall be such as specified in the Second Schedule, the Third Schedule or the Fourth Schedule, as the case may be.

S.38(4)(b) very specifically states that from the date of registration, all tangible (movable and immovable) and intangible property vested in the firm or the company as the case may be and all the assets interests, rights, privileges, liabilities, obligation and the whole of the undertaking of the company shall be transferred to and shall vest in the limited liability partnership without further assurance or act or deed. (Emphasis supplied).

Here the word ‘transfer’ is used not in the sense of transfer of ownership but in the sense of moving from one entity to another entity. The vesting is automatic as a result of statutory provisions and not by any overt act of the parties.

4.2 Therefore there is no transfer involved in conversion u/s.58(4)(b). Second Schedule deals with conversion of firm into LLP, while Fourth Schedule deals with conversion of a unlisted public company into an LLP. Therefore only Third Schedule is relevant for our present purpose. Here, also para 6(b) clearly specifies that on and from the date of registration the same effect as of S.58(4)(b) will take place. In other words there will be automatic statutory vesting of property. Thus there is no transfer within the meaning of s.2(47) of IT Act.

4.3 It is true that, para l(b) of Third Schedule defines the word ‘convert’ to mean transfer of property assets etc., but here again the word transfer is used in the sense of moving from one entity to another entity and not transfer of ownership which is statutory and automatic.

This is supported by the procedure laid down in para 7 which says that LLP shall as soon as practicable after the date of registration take all necessary steps as required by the relevant authority to notify the authority of the conversion. Thus it is only to be notified and not by executing any deed of transfer.

4.4 We have legal precedents. It may be recalled that when a firm was converted into a company under chapter IX of Companies Act 1956, S.575 was worded substantially same terms. Even S.368 of Companies Act, 2013 reads as under:

4.5 All property movable and immovable (including actionable claims) belonging to or vested in the company (i.e. firm) at the date of registration’ in pursuance of this part shall on such registration pass to and vest in the company ………… for all the estate and interest of the company therein.

4.6 Conversion under Chapter IX was considered by the Bombay High Court in CIT v Texspin Engg. & Mfg. Works 263 ITR 345 and it was held that the vesting was statutory and not by a conveyance. There are two conditions for transfer u/s.2(47).

Existence of a party and a counter party and incoming consideration qua the transfer of an asset.

Both these conditions are not satisfied S.575 of 1956 Act though, it used the word ‘pass to & vest in’. Same applies to conversion of a company into LLP.

5. I am therefore, clearly of the opinion that conversion of a private company into an LLP does not involve any transfer within the meaning of S.2(47) of the IT Act.

6.1 Conditions in S.47(xxiib) will get attracted only where otherwise there is a taxable capital gain and a transfer within S.2(47). When conversion is effected at book value there will be hardly any capital gain. But, since, I have taken the view that no transfer is involved on conversion into LLP, I am of the opinion that there will be no tax liability on the company upon such conversion even if conditions of S.47(xiiib) are not satisfied. Law assumes partition of HUF resulting in a transfer and provides for its exemption. Merely because law proceeds on the assumption that a transaction amounts to a transfer it is not necessarily so.

I maintain that the view I have taken above is a better view as it conforms with the object and intent of the statute and is supported by judicial precedents.

6.2 For the reasons stated above, conditions of s.47(xiiib) will step in only if there is a taxable capital gain on conversion and that too if the assessee claims exemption u/s.47(xiiib).

Here assessee’s contention will be that in the absence of transfer u/s.2(47). S.45 itself is not attracted. Hence there is no need to refer to s.47 to claim any exemption. Therefore, there is no tax implication on the shareholders as well as on the company.

7. Merely because Sec.47 begins with the words “the following transfers will not be regarded as transfers”, it cannot be assumed that but for this, the transaction could amount to transfer. Partition of HUF and amalgamation do not involve any transfer but still, they are included in Sec.47. Prior to insertion of Sec.45(4) even, dissolution of the firm was held to be not a transfer.

8. Thus, it will be seen that the Tribunal has not given full effect to the observations of the Hon. Bombay High Court which were admittedly binding on it. In CIT vs. Texspin Engg. & Mfg. Work – 263 ITR 345 (Bom), the Hon. High Court in Para 5 of its judgement observed as under:

In this case, the erstwhile firm has been treated as a Limited Company by virtue of section 575 of the Companies Act. It is not in dispute that in this case, the erstwhile firm became a Limited Company under Part IX of the Companies Act. Now, section 45(4) clearly stipulates that there should be transfer by way of distribution of capital assets.

Under Part IX of the Companies Act, when a Partnership Firm is treated as a Limited Company, the properties of the erstwhile firm vests in the Limited Company. The question is whether such vesting stands covered by the expression “transfer by way of distribution” in section 45(4) of the Act. There is a difference between vesting of the property, in this case, in the Limited Company and distribution of the property. On vesting in the Limited Company under Part IX of the Companies Act, the properties vest in the company as they exist.

On the other hand, distribution on dissolution presupposes division, realisation, encashment of assets and appropriation of the realised amount as per the priority like payment of taxes to the Government, BMC etc., payment to unsecured creditors etc. This difference is very important.

This difference is amply brought out conceptually in the judgment of the Supreme Court in the case of Malabar Fisheries Co. v. CIT [1979]120 ITR 49. In the present case, therefore, we are of the view that section 45(4) is not attracted as the very first condition of transfer by way of distribution of capital assets is not satisfied.

In the circumstances, the latter part of section 45(4), which refers to computation of capital gains under section 48 by treating fair market value of the asset on the date of transfer, does not arise.

9. Thus, in Para 6 of Texspin’s judgement Hon’ble B’bay High Court further observed as under:

“As stated above, section 45(1) is a charging section. Section 45, read with the computation section viz. 48 etc., form one composite scheme. This point is very important. Section 45(1) provides that where any profit, arising from transfer of a capital asset is effected in the previous year then such profit shall be chargeable to income-tax under the head “Capital gains”. The expression “transfer of a capital asset” in section 45(1) is required to be read with section 2(47)( ii) which states that transfer in relation to a capital asset shall include extinguishment of any rights therein.

The moot point which arose on interpretation of section 45(1) in numerous matters was that on extinguishment of the rights in the capital assets, there was a transfer and in certain cases of reconstitution of firms and introduction of new partners, there was a resultant extinguishment of the rights in the capital assets proportionately. In order to get over this controversy, and keeping in mind the object of encouraging Firms being treated as Companies, the controversy is resolved by the Legislature by introducing clause (xiii) in section 47 with effect from 1st April, 1999”.

10. The Bombay High Court further observed that generally in the case of a transfer of the capital asset two important ingredients are existence of a party and counter party and secondly income consideration qua the transferor. In our view when a firm is treated as a company the said two conditions are not attracted.

There is no conveyance of a property executable in favour of the limited company. It is no doubt true that all properties of the firm vests in the LLP company and the firm being treated as company under Part IX of the Companies Act but that vesting is not consequent or incidental to a transfer.

It is a statutory vesting of properties in the company as the firm is treated as limited liability company on vesting of properties all statutorily in the company, the cloak given by the firm is replaced by a different cloak and the same firm is now treated as a company after given date. In the circumstance; in our view there is no transfer of capital asset as contemplated by Sec.45(1) of the Act.

11. The above observation apply mutatis-mutandis to vesting of property when a limited company is converted into LLP by operation of law and not by any conveyance or transfer as understood by Hon. Bombay High Court. No consideration flows from the transferee to the transferor and then computation provision will fail. There is only statutory vesting and no transfer of act of parties as explained in the earlier part of this article. It is significant to note that the Andhra Pradesh High Court’s decision quoted in the Texpin’s judgement observed as under:

“The effect of the section is that there is an automatic vesting and divesting. The old company is divested of the properties and the new company is vested with the properties. The vesting being statutory, no registered instrument of transfer is necessary. See Rama Sundari Rayv. Syamendra Lal Ray, ILR (1947) 2 Cal 1. This was followed by the A.P. High Court in Vali Pattabhirama Rao v. Sri Ramanuja Ginning & Rice Factory (P.) Ltd. [1986]60 Comp. Cas. 568 (DB) (AP) where it was observed:

‘Thus, we hold that if the constitution of the partnership firm is changed into that of a company by registering it under Part IX of the present Act, there shall be statutory vesting of title of all the property of the previous firm in the newly incorporated company without any need for a separate conveyance.’ (Page 580).

A permanent lease of land was taken by a person specifically for the purpose of constructing and running a rice mill and a ginning factory. He formed a partnership for the purpose which carried on the business and ultimately the firm registered itself as a company. ………

It is worthwhile to infer from the above statutory provisions that the property of the private company automatically vests into LLP and no conveyance deed is required for the execution of such a transfer. Such a conversion is even without consideration and is more of a restructuring exercise whereby the ultimate beneficiaries remain (majorly) the same even after conversion”.

12. Conversion of company into LLP also does not require any registered dead as it does not involve transfer and the same is explained by the Andhra Pradesh High Court as well as Hon. Bombay High Court. If it was to be held that it required a registered dead then, there is no effective transfer and there could not have any liability to capital gains.

13.1 One peculiarity of the Tribunal’s order is that in Para 8, it has merely referred to CIT(A)’s conclusion. Then it devoted Para 8 to 13 to discuss whether conversion involved a transfer of assets. Then suddenly in Para 16 it has upheld CIT(A)’s finding that since the (alleged) transfer was at book value, no capital gains actually accrued to the company.

Then one wonders why the Tribunal devoted six long paras to decide whether there was a transfer. It could have simply said without going into question whether there was a transfer and assuming without deciding this issue, it uphold CIT(A)’s finding that since by law, the conversion took place at book value, no capital gains accrued or arose to the company.

13.2 In any case, these observations relating to transfer became obiter-dicta and cannot be binding as an authoritative decision.

13.3 Then the Tribunal makes a bold statement that in the subsequent decision in Umicore’s case that AAR has “observed” that in Texpin’s case the situation whether vesting by operation of law would be a transfer had not been decided by the Bombay High Court.

This is far from truth, which is blindly repeated by the Tribunal. This would be clear from Para 6 of the judgement when the Bombay High Court has expressly held in no uncertain terms that – “In our view there is no transfer of a capital asset as contemplated by Sec.45(1) of the Act. Even assuming for the sake of argument, that there was a transfer of a capital asset U/Sec.45(1) – is this the same thing as the question was not decided?

13.4 Umicore’s case was considered relevant or/ for the invocation of Sec.47A(4) which the Tribunal has also rightly rejected in Para 12 as no exemption was either claimed or allowed U/Sec.47 and there was no case of withdrawing any exemption.

13.5 But Tribunal goes one step further and held that since the Bombay High Court said that it is opined that AAR in a very reasoned order, has taken the view that no capital gains accrued or attracted at the time of conversion of the partnership firm into a private limited company in Part IX of the Companies Act. These observation related to the fact that there was no revaluation and vesting at book value.

13.6 It is submitted that the Tribunal has read too much in the decision in Umicore’s case by the Bombay High Court. Twice or thrice the Tribunal uses the words “it can safely be concluded/gathered”!

13.7 To make the confusion worst confounded the Tribunal concludes in one sentence at end of Para 15 of its order to the effect that “Further we find that as per Sec.170(1)(b) of the Act, a successor entity which continued to carry on the business who has been succeeded (hereinafter referred to as predecessor) shall be liable to be assessed only in respect of the income of the previous year after the date of succession but such liability is subject to an exception where “Predecessor cannot be found”.

13.8 This not only ignores the actual wording of Sec.170, its setting and context, but has taken for granted that the predecessor could not be found. The expression was considered by the Supreme Court in the case of CIT vs. Express News Papers Ltd. (53 ITR 250).

But the Tribunal does not even refer to this decision on the subject but merely proceeds that Sec.170(1)(b) is squarely applicable.

13.9 It is recorded by the Tribunal itself in Para 3 of its order that the predecessor company was succeeded by virtue of conversion only on 28-9-2010 and the Assessing Officer himself had noticed that Return of Income too the period 1-4-2010 to 27-9-2010 was filed (and must be pending for disposal by assessment). In the backdrop of these facts to say that the predecessor could not be found and hence “the same would be subject to liability of the assessee LLP (as a successor entity) U/Sec.170 is un-comprehensibly surprising.

At the end of Para 15, the Tribunal observes that “we thus in terms of our aforesaid observations are of the considered view that though the capital gains if any, involved in the transfer of the capital assets on conversion of the private limited company to the assessee LLP, de hors applicability of Sec.47A(4) to the facts of the case would not be liable to be assessed in the hands of the assessee LLP as per Sec.45 r.w.Sec. 5 of the Act, however, the same (?) would be subject to the liability of the assessee LLP (as a successor entity) U/Sec.170 of the Act.

13.10 When the Tribunal has noticed that the company had filed its Return of Income for the period 1-4-2010 to 27-9-2010, the Tribunal does not care to state what was the fate of that Return. The appeal before the Tribunal was by the LLP against its own assessment. Can Sec.170 be invoked only for discharge of liability of the predecessor?

13.11 It is therefore vital and necessary to examine that provision of Sec.170 closely.

13.12 Sec.170 falls under Chapter XV titled “Liability in special cases – business or profession” and under sub-head “F – Succession to business or profession”.

13.13 Sub-sec(1) contemplates two separate assessments – one in the case of predecessor in respect of income upto the date of succession and one in the case of the successor in respect of income after the date of succession. Sub-sec(2) provides that when the predecessor “cannot be found” assessment of the income upto the date of succession shall be made on the successor in the like manner and to the same extent as it would have been made on the predecessor, and all the provisions of this Act shall so far as may be apply accordingly.

13.14 The wording is identical with the wording of Sec.161 and the context clearly suggests that both the assessments will be separate and distinct. The reason is also obvious that all income of the predecessor upto the date of succession will have to be assessed and liability raised in accordance with the provision of the Act. There the issue whether capital gain, in addition to normal other income of the predecessor company is assessable can be appropriately decided and demand raised and the successor than can be held liable for discharging such liability.

Sub-sec(3) says that where “any sum payable” cannot be recovered from him, the Assessing Officer shall record a finding to that effect and the sum payable by the predecessor, shall thereafter be payable and recoverable from the successor and the successor shall be entitled to recover from the predecessor any sum so paid. The words ‘sum payable’ obviously refers to the liability arising on assessment on the predecessor and not on successors’ regular assessment of its own income.

14. The Tribunal has failed to address to these aspects of Sec.170 and the machinery provided for its applicability and enforcement. It is submitted, with respect, that the Tribunal has oversighted the provisions of Sec. 170(2).

15. Before concluding this Article, I would like to leave some food for thought.

The “food” consists of the last portion of the Supreme Court decision in CIT vs. Malabar Fisheries (120 ITR 49) wherein Supreme Court considered the issue whether the liability on a firm which is dissolved can arise? Readers are requested to apply their minds as to whether some of the observations made by the Hon’ble Supreme Court are relevant while considering conversion of a company into a LLP.

Amen!

S N Inamdar

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