Section 56 [2][vii] and Limited Liability Partnership: New Controversies!

1. At the time of writing this article, the Finance Bill [no. 2] 2009 has been cleared by the Lok Sabha. Some changes have been made in this Bill since its introduction by the Hon’ble Finance Minister, Shri Pranab Mukherjee for purging out anomalies.

This Finance Bill has been widely discussed in professional circles and debated. Several finely scripted articles have also been penned by learned authors in this regard. Though good amount of waters have flowed in these discussions, some deep areas still remain to be waded in. I thought I should venture in to these depths in this article.

2. The issues discussed in this article are in two parts :-

Part – 1:- Whether the amount taxed under the new provisions of section 56 [2][vii] towards inadequacy in consideration for property acquired by an assessee, can be treated as cost of asset acquired in computation of business income? This new issue arises pertinently now because whereas express provisions have been subsequently inserted in the Bill for such treatment in capital gains provisions [viz. in the amended section 49 –cost of acquisition of capital asset], similar provisions are not found in the computational provisions for business income. [para nos. 3 to 8 ]

Part – 2 :- Whether any capital gains tax can result from a transaction involving conversion of a partnership firm in to a limited liability partnership [LLP]? [para nos. 9 to 23]

I have some thoughts on these two issues, which I wish to share with my readers.

Part -1 :- Section 56 [2][vii] – Cost of acquisition in computation of business income ?

3. To begin with, let me consider the new provisions in section 56 [2[vii]. There are some changes in the content of these provisions from the ones when the Bill was initially introduced.

As readers are aware, these new provisions provide that where immovable property is received by an assessee on or after 1st October 2009 without consideration and its stamp duty value exceeds Rs. 50,000, then the stamp duty value will be taxed as income from other sources. Likewise, if the immovable property is received for a consideration, which is less than the stamp duty value of such property by an amount exceeding Rs. 50,000, the excess of the stamp duty value over the consideration paid would be so taxed.

Similar are the provisions regarding movable property with the only difference that instead of the stamp duty value, the fair market value will be taken.

4. At the time of introduction of the Bill, there was a doubt whether the income so taxed would become subsequently available to the assessee as ‘cost of acquisition’ of the property for claiming depreciation or for capital gains purposes as no such express intendments to this effect were found either in the capital gains provisions of Section 49 {cost with reference to certain modes of acquisition}or Section 55{Meanings of cost of acquisition} for capital assets acquired or in the provisions relating business income like section 43 [1] which defines ‘cost of acquisition’ for depreciable assets.

5. It may be noted that even where a property was received for a consideration which was less than its stamp duty value [or its fair market value], the so called difference could have never been taxed in the normal course of law as ‘income’ in the hands of payer unless it is proved by the Revenue with cogent evidence that such difference has been secretly paid by the payer from his undisclosed sources of income. After all, it is not impossible that a property can be given for a lesser consideration because a discount has been allowed in the price. A discount is merely a reduction in the cost paid. It is a component of the cost and it merges in to the cost like sugar in milk. It is therefore not ‘income’ by any standard.

6. In this background, when the Bill was just introduced, a view was being taken that since the amount charged u/s 56 [2][vii] did not involve any physical receipt of money by the assessee, what is charged is only a fictional receipt. In short, what is being taxed, is by a fiction in law. As to what effect, legal fictions carry, has been consistently laid down by the Courts from time to time. The consensus that emerges from these decisions is that the first step should be to determine for what purpose the fiction was created by the Legislature and once that is determined, full effect should be carried to the legal fiction, subject to a caution that the inference that is derived must not be absurd. [State of Bombay vs. Pandurang AIR 1953 SC 244; CIT vs. Teja Singh [1959] 35 ITR 408 {SC}”; Rajputana Trading Co. Ltd. vs. CIT [1969] 72 ITR 286 {SC}].

7. In my view, dear readers, only one objective can be attributed to the introduction of the new provisions in section 56 [2][vii] and that is to tax the ‘assumed’ unaccounted money clandestinely paid for transfer of properties. Therefore, once this ‘assumed’ unaccounted money is treated as paid by this legal fiction, the logical inference that should be permitted to follow is this ‘payment’ must also be assumed to be the price paid for acquiring the property.

Based on the above, a healthy view was being taken that such amount taxed u/s 56 [2][vii] is nothing but the cost paid for acquiring the asset acquired and the fact that there was no express provision in the Act for so treating , should not matter. This was the legal stand that was being taken based on the reading of the provisions in the Bill when it was initially introduced.

8. Now, in the Bill as passed by the Lok Sabha, it is observed that there is an amendment in the provisions of section 49 to the effect that amount taxed in section 56 [2] [vii] would be treated as ‘cost of acquisition’ of the capital asset for capital gains purposes. But, there is no such express amendment regarding allowing the same as cost of asset for depreciation purposes or even stock in trade when computing business income.

According to me, this should not be a problem. We have seen above that even when there was no express provision in the statute to treat the amount taxed u/s 56 [2][vii] as the cost of the asset, the same could be still so treated as a logical inference of a legal fiction based on accepted canons of statutory interpretations. If this is so agreed, then it is possible to take a stand that the amendment in section 49 is merely clarificatory of a pre-existing position in law and no new law is supplied by this amendment.

Therefore, based on the above principles, it could be well said that amount taxed u/s 56 [2][vii] is also available as cost of the asset for depreciation purposes or as cost of stock in trade even without an express provision in the statute to this effect. This should be even more particularly so when there is also no express bar against so claiming.

Part 2 :- Conversion of partnership in to LLP – Whether capital gains accrue ?

9. A limited liability partnership [LLP] is a cross breed offspring of a partnership and a limited company. A partnership is not a distinct legal entity in law and has no separate existence apart from the partners that constitute it. A partnership cannot own property in its name and what is loosely called ‘the estate of the partnership’ is in fact the bundle of all the assets and liabilities owned by the partners together in joint. On the other hand, a limited company is a separate entity distinct from its own shareholders and is legally competent to own properties in its own name as well as transact in its own name. Whereas in a partnership, a partner is personally liable for the firm’s debts, the liability of the shareholder of a limited company to such debts of the company is limited to his shareholdings. Yet, with all these defects, a partnership firm is operationally easier in functioning, whereas a limited company is burdened with too many hassles in legal compliances.

In this scenario, emerged this entity of LLP as a compromise trade off between a partnership and a limited company. LLP is a partnership which has a distinct legal identity in law just like a limited company. The liability of the partner in a LLP is limited to the capital contributed by him. Limited liability partnerships existed all over the world. But, in India, LLP is a new concept and is governed by the Limited Liability Partnership Act 2008.

10. Chapter X of the Limited Liability Partnership Act contains the law and procedure regarding conversion of partnership, private limited company and unlisted public company respectively in to a LLP. As per section 55, a firm may convert in to a LLP in accordance with the provisions of the Second Schedule.

Section 58 requires careful study. Sub-section [1] provides that the Registrar, on being satisfied that the partnership firm has complied with the provisions of the Second Schedule, shall register the LLP.

Sub-section [4] lays down as under :-

“ Notwithstanding anything contained in any other law for the time being in force on and from the date of registration specified in the certificate of registration issued under the Second Schedule, the Third Schedule or the Fourth Schedule, as the case may be :-

[a] there shall be a limited liability partnership by the name specified in the certificate of registration registered under this Act;

[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 undertaking of the firm or the company; as the case may be, shall be transferred to and vest in the limited liability partnership without further assurance, act or deed; and

[c] the firm or the company, as the case may be, shall be deemed to be dissolved and removed from the records of the Registrar of Firms or Registrar of the Companies, as the case may be.”

11. Readers may have noted the expression ‘convert’ as used in section 55 in relation to conversion of firm in to a LLP. This word has been ‘interpreted’ in paragraph1 [b] of the Second Schedule which prescribes the law and procedure regarding conversion of a firm in to partnership.

The same is reproduced below for perusal of the readers.

“Interpretation.

Paragraph 1 . In this Schedule, unless the context otherwise requires :-

[b] ‘convert’, in relation to a firm converting in to a limited liability partnership, means a transfer of the property, assets, interests, rights, privileges, liabilities, obligations and the undertaking of the firm to the limited liability partnership in accordance with this Schedule.”

12. In this background, it needs to be seen whether the conversion of a firm in to a LLP will involve capital gains tax liability under the Income Tax provisions or not ?

Section 45 [1] of the Income Tax Act contains the general capital gains’ taxing provisions. It provides that profits and gains arising from transfer of a capital asset shall be charged to tax in the year of transfer. The concept of transfer is given in section 2 [47], which is an inclusive definition. It has two categories of transfers – actual transfers and ‘deemed’ transfers.

The examples of actual transfers are sale, exchange, relinquishment or extinguishment of assets, compulsory acquisition of assets under any law etc. The ingredients of actual transfer transactions are three – there must be a transferor, a transferee and the process of passing of the property from the transferor to the transferee. It contemplates that the transferor and transferee must co-exist in the process of an actual transfer.

A deemed transfer is a transfer which all these three ingredients are not present, but the law has assumed a transfer by way of fiction. For example, a conversion by an assessee of his capital asset in to stock in trade is treated as a ‘transfer’ u/s 2 [47] even though there are no two parties to this act of conversion and the conversion is effected by only one party and that too to himself.

One may find instances of ‘deemed transfers’ even outside this definition of section 2[47]. For example, under the provisions of section 45 [4], a distribution of capital assets on dissolution of a firm is impliedly treated as a transfer, though under the general law, it is not. The general law on partnerships is clear to the effect that what a partner receives on dissolution is only a realization of his pre-existing right to receive his share of profit and his share in the net assets of the firm. The bible for this authority can be found in the decision of CIT vs. Bankey Lal Vaidya [1971] 79 ITR 594 [SC].

13. In short, readers, unless there is a specific provision in the Income Tax Act treating a ‘non transfer’ as a ‘transfer’, what can be taxed as a capital gains are only transactions involving actual transfers. In an actual transfer, there must be a transferor, a transferee and an act of transfer and if any of these three do not exist , the transaction cannot be treated as a transfer u/s 2 [47] . Needless to say, no transfer means no capital gains liability also.

14. At this juncture, let me refer to a decision of the Bombay High Court in the case of CIT vs. Texspin Engineering and Manufacturing Works [2003] 263 ITR 345 {Bom} as certain principles laid down by it may be useful for the discussion in the article.

In this case, the assessee, a partnership firm, had converted itself in to a limited company under Part IX of the Companies Act. In the process, the assets and liabilities of the firm got vested in the company. The contention of the Revenue was that there was a dissolution of the firm and hence a deemed distribution of assets. Invoking the provisions of section 45 [4], it computed capital gains in the hands of the assessee firm taking the market value of the capital assets as the consideration.

On behalf of the assessee, it was contended that the firm had been treated as company by virtue of the law under Part IX of the Companies Act. When a firm is treated as a company, the firm and company do not co-exist at the same time and hence, as there are no two parties, there cannot be a transfer as between a transferor and a transferee. There cannot be therefore any capital gains under either the provisions of section 45 [1] or u/s 45 [4]. Further, the shares received by the erstwhile partners were in lieu of the capital balances held by them in the firm and in that sense, it cannot be said that the shares formed any consideration to the firm.

The High Court ruled as under :-

[a] There were no party and counter party to the transaction as required to constitute a transfer transaction i.e. a transferor and transferee. The assets which were held by the assessee when it was a firm continued to remain with it when it was treated as a company by the statute. The Court gave the analogy of the cloak of a firm replaced by the cloak of a company on the same person. So section 45 [1] was therefore held not to be attracted.

[b] The provisions of section 45 [4] were also not attracted because there was only vesting of the property in the company and no distribution involved. A distribution presupposes division, realization, encashment of assets and apportionment of the realized amount etc, which acts were absent in that case.

[c] The shares in the new company were received by the partners were in lieu of their capital balances and as the firm does not receive it, the same cannot constitute its consideration.. The firm was found to have not received any consideration thus.

Based on the above findings, it was held that no capital gains accrued to the firm on its conversion to company under Part IX of the Companies Act.

15. With the above discussions in mind, let me proceed to deal with the issue as to whether any capital gains tax can result from a transaction involving conversion of a partnership firm [or a private company or public company] in to LLP.] ?

16. To begin with, let us all settle down in one mind as to what a ‘conversion’ involves in the general sense of its meaning as understood in common parlance. There should be unanimity on the view that it must involve a change in the ‘state’ of a thing or a person. A person or thing must become something what he or it was not originally and this process that causes the change can be understood as ‘conversion’. Yet, the integral subject matter of the conversion remains the same. Such a change may also be understood as a ‘transformation’. The best example, I can give you is of a caterpillar becoming a butterfly. Here, the change is effected by its own biological growth process. A caterpillar and butterfly are not two different beings, but the one and the same in another form. This is the concept of ‘conversion’ I wish to sell to my readers.

17. In context of the Limited Liability Partnership Act, 2008, the expression ‘convert’ has been explained in the Paragraph 1[b] of its Second Schedule. It says – ‘convert’, in relation to a firm converting in to a limited liability partnership, means a transfer of the property, assets, interests, rights, privileges, liabilities, obligations and the undertaking of the firm to the limited liability partnerships in accordance with this Schedule.”

It must be noted that Section 1 carries the title ‘Interpretations’ and not ‘definitions. Interpretation involves ‘understanding and then construing. It must be done in the context of the scheme of conversion of a firm in to a LLP as envisaged in the Limited Liability Partnership Act.

18. The scheme of conversion is very clear about certain things. A firm is eligible to convert in to a LLP only if all the partners of proposed LLP comprise all the partners of the firm. A LLP comes in to existence only on the grant of certificate of registration by the Registrar. On such registration, the partnership firm will automatically dissolve. In short, once the certificate of registration of LLP is given, the LLP and the partnership firm cannot co-exist thereafter. On registration, the assets and liabilities of the firm are ‘transferred to and vest in’ the LLP.

To common sense of a layman, it will logically appear that the same set of people holding the assets and liabilities as a firm continues to hold the same assets and liabilities as LLP and hence, there is no transfer involved. But, from the point of a view of a taxman, some more convincing may be required as the firm and LLP are treated as two different assessees and the word ‘transfer’ has been repeatedly used in the Limited Liability Partnership Act.

19. The issue for consideration is [1] whether the assets are transferred by the firm to the LLP first and then the firm is dissolved or [2] whether the creation of the LLP, the transfer of the assets and liabilities and the dissolution of the partnership takes place simultaneously at the same time ?

Whereas in the first case there is a transfer of assets between two co-existing parties [since the firm dissolves later after the creation of the LLP], in the latter, the creation of the LLP and dissolution of the firm are simultaneous events. In the first case, there is an actual transfer between the transferor and transferee u/s 2 [47] of the Income Tax Act, whereas in the later case, there is no such transfer as the transferor and transferee do not co-exist.

20. It appears to me that looking in to the scheme of conversion in the Limited Liability Partnership Act, the more probable view is that not only both the creation of the LLP and the dissolution of the firm take place at the same time simultaneously, but one of them is occasioned by the other. It may be noted that the registration of the LLP as contemplated in section 55 and the Second Schedule, is not the same thing as the registration of the LLP in the normal course. In section 55 and the Second Schedule, the registration contemplated is by ‘conversion’ as interpreted under paragraph 1 [b] of the Second Schedule as referred above. Paragraph 1 [b] intends that the conversion of the firm into LLP should be done by transfer of all assets and liabilities and till this is done, the ‘conversion’ is not complete.

To say that the LLP is created by conversion means that LLP is created by the transfer of all assets and liabilities of the firm {because convert = transfer under paragraph 1[b]} In short, if it is this transfer that creates the LLP, it would mean that the LLP did not exist at the time of transfer, but was created by the very transfer itself. The LLP is the product or output of the transfer and not a party to the transfer. The LLP is therefore not the transferee in this transfer, but is a creation of the transfer after it is completed.

For that reason, dear reader, it is possible to take a view that there is no transfer between the firm and the LLP and the word ‘transfer’ used is not in the sense of a ‘transfer’ as between a transferor and transferee, but is only meant to emphasize the vesting of the assets and liabilities in the LLP. It can be thus argued that there is no transfer u/s 2 [47] and u/s 45 [1] of the Income Tax Act. Since there is no transfer u/s 45 [1], even question of invoking the provisions of section 50C [treating the stamp duty value of the immovable properties vesting in the LLP on conversion as transfer consideration for computation of capital gains ] should not arise.

21. Let me now consider the issue whether the provisions of section 45 [4] can be invoked in this case. The provisions of section 45 [4] contemplate a situation where there is first a dissolution of the partnership firm resulting in a subsequent distribution of its capital assets. The assets must thus exist on the date of the dissolution and then only one can speak of any distribution on dissolution. In case of conversion of a firm in to a LLP, the dissolution is occasioned by the ‘conversion’ as per paragraph I [b] of the Second Schedule. Once all the assets and liabilities of the firm are transferred, the firm is then automatically dissolved. In short, the assets are first transferred and then the dissolution takes place. We have seen above this ‘conversion’ means the transfer of all assets and liabilities of the firm. When we understand that dissolution of the partnership firm is occasioned by the transfer of its capital asset, it means that there is first a transfer of assets and then dissolution. In other words, there are no capital assets available on dissolution and therefore, no question of its distribution on dissolution. So, section 45 [4] also should not apply.

22. I had given an example above of a caterpillar transforming itself in to a butterfly by its own physiological process. Philosophically seen, in the end of the caterpillar is found the birth of the butterfly. Yet, we never say that the caterpillar is dead and the butterfly is born. What we always say is that the caterpillar has transformed in to a butterfly.

Similar is the transformation of a firm in to a LLP. The spirit behind this conversion that it is, in principle, only a transformation of an entity, has been retained in the law in the Limited Liability Partnership Act by simultaneously timing the events of creation of the LLP, the transfer of assets and liabilities and the dissolution of the firm. What can be seen as the death of the firm can also been seen as the birth of the LLP but without a gap in time between the two events. This also supports my above hypothesis that there is be no transfer of asset assets between two co-existing entities when a firm is converted to LLP. What actually takes, in spirit, is the appropriation of the one’s own assets to one self. It is this self appropriation that has been styled as ‘transfer’.

23. I have thus canvassed to the readers that it is a possible view that there can be no capital gains liability either u/s 45 [1] or u/s 45 [4] of the Income Tax Act when a partnership firm converts in to a LLP under the provisions of the Limited Liability Act 2008. Readers should try to see whether they can agree with me.