© 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated...
© 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated...
© 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated...
© 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated...
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Capital gains exemption is not available on conversion of a private limited company into an LLP if exemption conditions are violated

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Recently, the Kolkata Bench of the Income-tax Appellate Tribunal (the Tribunal) in the case of Aravali Polymers LLP (the taxpayer), held that advancing of loan to its partners by Limited Liability Partnership (LLP) out of reserves and surplus of erstwhile company results in violation of Section 47(xiiib) of the Income-tax Act, 1961 (the Act). Therefore, the benefit of exemption of capital gain under Section 47(xiiib) would not be available to the taxpayer. Since the benefit of capital gain exemption is not available, the provision of Section 47A(4), which withdraws exemption of capital gain, does not apply. Accordingly, the Tribunal held that in the given case capital gains on transfer of assets on conversion of a company into an LLP is to be computed under Section 45 of the Act. The Tribunal sent the matter to AO, with a direction to consider the value at which the assets of the erstwhile company has been acquired or taken over by the taxpayer, as a sale consideration and compute the capital gains accordingly.

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Capital gains exemption is not available on conversion of a private limited company into an LLP if exemption conditions are violated

  1. 1. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. KPMG FLASH NEWS KPMG in INDIA Capital gains exemption is not available on conversion of a private limited company into an LLP if exemption conditions are violated 4 July 2014 22 21 February 2013 Background Recently, the Kolkata Bench of the Income-tax Appellate Tribunal (the Tribunal) in the case of Aravali Polymers LLP 1 (the taxpayer), held that advancing of loan to its partners by Limited Liability Partnership (LLP) out of reserves and surplus of erstwhile company results in violation of Section 47(xiiib) 2 of the Income-tax Act, 1961 (the Act). Therefore, the benefit of exemption of capital gain under Section 47(xiiib) would not be available to the taxpayer. Since the benefit of capital gain exemption is not available, the __________________ 1 Aravali Polymers LLP v. JCIT (ITA No. 718/Kol/ 2014) – Taxsutra.com 2 Capital gain provisions (Section 45 of the Act) shall not apply to any transfer of a capital asset or intangible asset by a private company or unlisted public company to a LLP or any transfer of a share or shares held in the company by a shareholder as a result of conversion of the company into a LLP in accordance with the provisions LLP Act, 2008 provided that – (a)………. (b)………. (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 LLP; (d)………. (e)………. (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. provision of Section 47A(4) 3 , which withdraws exemption of capital gain, does not apply. Accordingly, the Tribunal held that in the given case capital gains on transfer of assets on conversion of a company into an LLP is to be computed under Section 45 of the Act. The Tribunal sent the matter to AO, with a direction to consider the value at which the assets of the erstwhile company has been acquired or taken over by the taxpayer, as a sale consideration and compute the capital gains accordingly. Facts of the case  Aravali Polymers Pvt. Ltd (Company), a private company, was converted into a Aravali Polymers LLP (the taxpayer), in accordance with the provisions of LLP Act, 2008 on 12 August 2010. _______________ 3 Where any of the conditions laid down in the above proviso to Section 47(xiiib) of the Act are not complied with, the amount of profits and gains arising from the transfer of such capital asset or intangible assets or share or shares not charged under Section 45 shall be deemed to be the profits and gains chargeable to tax of the successor LLP or the shareholder of the predecessor company, as the case may be, for the previous year in which the requirements of the said proviso are not complied with.
  2. 2. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.  At the time of conversion, main assets of the Company was investment in 31,84,807 equity shares of East India Hotels Ltd (Shares). The Company also had reserves and surplus of about INR 30 million.  Post conversion, the taxpayer sold the Shares and earned capital gain of INR 530 million which was offered for taxation as long term capital gain.  The taxpayer also gave temporary interest free loans of INR 500 million to its partners in the profit sharing ratio The taxpayer filed its tax return offering long term capital gain on sale of shares and claimed exemption under Section 47(xiiib) of the Act, on conversion.  The Assessing Officer (AO) considered that the loan given to the partners was in violation of Section 47(xiiib) of the Act and therefore, invoking the provisions of Section 47A(4) of the Act, the AO computed capital gain of INR 384.7 million on the basis of market value of shares on the date of conversion. Issues before the Tribunal  Whether on provision of interest free loans by the taxpayer to its partners violates the conditions of Section 47(xiiib) of the Act?  Whether capital gain on transfer of capital assets on conversion is to be computed with reference to the market value of capital assets transferred or with reference to the value at which capital assest is taken over by an LLP? Taxpayer’s contentions  The Loan is receivable and no benefit had been given to the partners. Further no benefits had been received by the shareholders of the erstwhile company. No amount was paid to any partner out of the balance of accumulated profits standing in the accounts of the Company as on the date of the conversion.  Therefore, there was no violation of Section 47(xiiib) of the Act.  There is no provision for deeming market price in respect of assets transferred as consideration. Therefore, the actual value of the asset transferred should be considered.  The asset was transferred at book value. The AO had considered this book value as cost for computation of capital gain.  Therefore, the AO’s computation of capital gains was incorrect. Tax department’s contentions  The taxpayer had provided interest-free loan to the partners out of the reserve and surplus received on the conversion of the Company and violated the Section 47(xiiib) of the Act.  In view of the provisions of Section 47A(4) of the Act, the amount of profit and gains arising from the transfer of the capital assets or shares were chargeable to tax in the hands of the taxpayer.  The capital of INR 384.7 million is to be computed on the basis of market value of share on the date of transfer. Tribunal’s ruling  Clause (c) to proviso to Section 47(xiiib) of the Act provides that the shareholders of the Company shall not receive any consideration or benefit directly or indirectly in any form or manner other than by way of shares in profit and capital contribution in the LLP. The said proviso gives a meaning that both the Company and the LLP must exist for the shareholders of the Company to receive any consideration. In the present case, since the Company did not exist after conversion, question of a violation of proviso (c) to Section 47(xiiib) of the Act did not exist.  Clause (f) to the proviso to Section 47(xiiib), does not allow direct or indirect payment to any partner out of the 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 interest-free loan was given to its partners in profit sharing ratio shows that the amount has been given directly to the partners out of the balance of the accumulated profits standing in the accounts of the Company on the date of conversion. Thus, it was a violation of clause (f) to proviso to Section 47(xiiib) of the Act.  Section 47A(4) of the Act is invoked when provisions of Section 47(xiiib) are available to the taxpayer and the conditions thereunder are not complied with. In the present case, conversion took place in the same year in which the conditions were violated and therefore benefit of provisions of Section 47(xiiib) of the Act was not available to the taxpayer. Therefore, provisions of Section 47A(4) was not applicable to the taxpayer. Accordingly, provisions of Section 45 of the Act were attracted.
  3. 3. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.  Since, conversion of the private limited company into an LLP did not have the protection of Section 47(xiiib), the capital gain on the same is liable to be considered.  For computation of capital gains, the Act does not provide for deeming the sale price in the case of equity shares. The value at which the shares or the assets of the Company was taken over by the taxpayer would be the sale price and the cost of acquisition thereof should be as per books of the erstwhile Company.  The issue regarding computation of capital gains in accordance with provisions of Section 45 was sent back to the AO. Our comments The Kolkata Tribunal held that capital gains exemption is not available on conversion of a private limited company into an LLP if exemption conditions are violated. It seems the Tribunal has proceeded on the basis that the event of conversion triggers taxability of capital gains upon conversion of a company into an LLP. The Tribunal seems to have given importance to the compliance of conditions of specific exemption provisions instead of general principles for non chargeability of capital gain. The Tribunal observed that the provisions of Section 47A(4) of the Act would not attract in the year of the conversion but only in the subsequent year in which the taxpayer violates conditions of Section 47(xiiib) of the Act. It is a welcome observation of the Tribunal that the capital gains if any, should be computed on the basis of actual transfer value and not on the basis of market value as on the date of conversion. Accordingly, if the conversion is made at book value, the capital gains implications would be minimal. It is pertinent to note that in the decision of Texspin Engineering 4 , the Bombay High Court held that there was no transfer on conversion of a firm into a private limited company as it was a statutory vesting of properties in the company. On vesting of all the properties statutorily in the company, the firm was treated as company and hence the cloak given to the firm was replaced by a different cloak. Consequently, there was no transfer as contemplated under Section 45 of the Act. Even if there was a transfer there was no consideration and thus there was no question of capital gains. This argument does not seem to have been tested in this decision, albeit from a perspective of extending the analogy to a case of conversion of a company into an LLP. _______________ 4 CIT v. Texspin Engg. & Mfg. Works [2003] 263 ITR 345 (Bom)
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