Non-compliant Conversion of Private Limited Company to Limited Liability Partnership attracts Capital Gains

Recently, Income Tax Appellate Tribunal (ITAT) Mumbai in ISC Speciality Chemicals LLP held that the non-compliant conversion of a Company into an LLP attracts capital gains.

Background

Assessee, M/s ISC Specialty Chemicals LLP, in the Assessment Year 2018-19, converted a private limited company, M/s ISC Specialty Chemicals Pvt. Ltd., into the aforementioned LLP. The total assets of the Company immediately before conversion was more than INR 5 crore (threshold under Section 47(xiiib) for claiming tax-neutral conversion).

The core issue revolved around whether such a conversion constituted a ‘transfer’ under the Income-tax Act, 1961, and consequently, whether it attracted capital gains tax. The Revenue contended that the Assessee violated the provisions of Section 47(xiiib) of the Act, specifically regarding the conditions for claiming capital gains exemption on such conversions. They asserted that the total value of assets appearing in the books of account of the private limited company exceeded the prescribed threshold of Rs. 5 crore, thereby violating a key condition of Section 47(xiiib). Thus, section 47A(4) comes into play and as a result, the conversion was deemed a taxable transfer chargeable to tax under Section 45 of the Act.

Arguments of the Assessee:

The Assessee argued that the conversion of the company into an LLP did not amount to a ‘transfer’ within the meaning of Section 2(47) of the Income-tax Act, 1961, and therefore, no capital gain tax should be leviable under Section 45. They contended that even if a transfer were assumed, the book value of assets transferred should be considered the full value of consideration for capital gains computation, resulting in no capital gain as assets were vested at book value.

Since no exemption under section 47(xiiib) was claimed either by the predecessor company or the taxpayer, the applicability of section 47A(4), which pre-supposes claim of exemption under section 47(xiiib), was not warranted.

As no consideration was received by the predecessor company at the time of conversion, the computation mechanism for determining capital gains under the Act failed, due to the inability to determine the ‘cost of acquisition’.

Revenue’s Contentions:

The CIT(A) confirmed the action of the Assessing Officer (AO) in considering the conversion as a taxable transfer. The Revenue argued that the Assessee violated the condition of Section 47(xiiib) because the total value of assets appearing in the books of account of the private limited company exceeded Rs. 5 crore. Consequently, they held that the exemption benefit of Section 47(xiiib) was not available to the Assessee, and therefore, Section 45(1) came into play, making the conversion taxable as capital gains.

As transferring of assets at book value itself constituted a benefit, section 47A(4) is triggered upon violation of section 47(xiiib) conditions – even if tax exemption was not explicitly claimed by the taxpayer. In the absence of actual consideration, the book value of the assets (vested into the taxpayer upon conversion) as on the date of conversion was treated as capital gains and taxed in the hands of the taxpayer.

The Tribunal’s Ruling:

The ITAT acknowledged the Assessee’s arguments but ultimately ruled in favour of the Revenue on several key points:

1. Conversion as a ‘Transfer: The Tribunal firmly held that the conversion of a private limited company into an LLP constitutes a ‘transfer’ within the meaning of Section 2(47) of the Act. While previous rulings on firm-to-company conversions might have indicated otherwise, the specific legislative insertion of Section 47(xiiib) for company-to-LLP conversions clarifies the intention to treat such conversions as a ‘transfer’ unless the stipulated conditions for exemption are met.
2. Applicability of Section 47(xiiib): The Tribunal underscored that Section 47(xiiib) is a conditional exemption. The Assessee admittedly failed to fulfill the condition regarding the asset value not exceeding Rs. 5 crore. Therefore, the benefit of exemption under Section 47(xiiib) was correctly denied by the lower authorities.
3. “Book Value” vs. “Full Value of Consideration”: The Tribunal affirmed that the ‘full value of consideration’ for computing capital gains under Section 45 cannot be restricted to the book value. It emphasized that the charging and computation provisions of Sections 45 and 48 must be read together as a single package. The difference between the transfer value and the cost of acquisition would be the capital gain. Since the difference between the transfer value and the cost of acquisition was nil in this case (as per Assessee’s submission), the machinery provision would become unworkable and result in “nil tax”.

Conclusion

The ITAT Mumbai’s decision reinforces the legislative intent behind Section 47(xiiib). While the conversion of a private limited company into an LLP can be tax-neutral, this neutrality is strictly conditional. Since, assets are recorded at book value in the books of the converted LLP, no capital gains arise.

However, there was no discussion on tax applicability in the hands of shareholders/partners. Further, in the presence of significant immovable assets and/or shares or other “properties”, one may need to carefully envisage implications of deeming provisions as well.