CAPITAL GAINS ON CONVERSION OF PARTNERSHIP FIRM INTO A PRIVATE LIMITED COMPANY

Introduction

The partnership firm and a private limited company are two different legal entities, with different legal liability.  The liability of a partner is different from that of the liability of a director in a
company.  The company has an independent legal entity, de hors its shareholders, whereas the partnership firm has no such independent existence, de hors the partners. On conversion of a firm into a private limited company the following benefits are available to them:

limited liability of the shareholders,
widening of capital base,
easy expansion and diversification,
convenience in getting loan or finance from the banks and financial institutions,
change in shareholding and management possible without disrupting the business,
immovable property is held by company, the same can be transferred by mere transfer of shares and thus one may save stamp duty as well as avoid other complications,
easy transfer of interest possible as the investment is in the form of shares, whereas in case of partnership reconstitution is required whenever any partner retires or a new partner joins.
However, the decision of converting the firm into a company should be taken after considering all pros and cons.

Modes of conversion

The following modes may be adopted for converting a firm into a company depending upon the suitability in the circumstances of the persons concerned:

Conversion by first making the company a partner in the firm and then making dissolution by retirement of all other partners except the Company.
By outright sale of the firm as a going concern.
By selling the assets of the partnership firm to the company at the specified price for each asset.
By conversion of the firm into a company under the provisions of Part IX of The Companies Act, 1956.
Effect of tax on conversion

In this article the effect of tax on conversion of the firm into a company under the provisions of Part IX of the Companies Act, 1956 is discussed with reference to the provisions of Income Tax Act, 1961 and decided case laws.

Capital gains

Section 45(1) of the Income tax Act, 1961 provides that any profits or gains arising from the transfer of a capital asset effected in the previous year shall, save as otherwise provided in sections 54, 54B, 54D, 54E, 54EA, 54EB, 54F, 54G and 54H, be chargeable to income-tax under the head "Capital gains", and shall be deemed to be the income of the previous year in which the transfer took place.

Before a levy on the capital gain can be imposed, it must be ensured that, such a gain has arisen from the disposal of the asset by any one of the mode, referred to in the definition of the term ‘transfer’ in Section 2(47) of the Income Tax Act, 1961.

Section 2(47) of the Income Tax Act, 1961 (‘Act’ for short) defines the term ‘transfer’ in relation to capital asset, as including-

the sale, exchange or relinquishment of the asset ; or
the extinguishment of any rights therein ; or
the compulsory acquisition thereof under any law ; or
in a case where the asset is converted by the owner thereof into, or is treated by him as, stock-in-trade of a business carried on by him, such conversion or treatment
the maturity or redemption of a zero coupon bond; or
any transaction involving the allowing of the possession of any immovable property to be taken or retained in part performance of a contract of the nature referred to in section 53A of the Transfer of Property Act, 1882 (4 of 1882) ; or
any transaction (whether by way of becoming a member of, or acquiring shares in, a co-operative society, company or other association of persons or by way of any agreement or any arrangement or in any other manner whatsoever) which has the effect of transferring, or enabling the enjoyment of, any immovable property.
Section 45(4) provides for the chargeable of the tax on the transfer of a capital asset of a firm or other association of persons or body of individuals.  The Section provides that the profits or gains arising from the transfer of a capital asset by way of distribution of capital assets on the dissolution of a firm or other association of persons or body of individuals (not being a company or a co-operative society) or otherwise, shall be chargeable to tax as the income of the firm, association or body, of the previous year in which the said transfer takes place and, for the purposes of section 48, the fair market value of the asset on the date of such transfer shall be deemed to be the full value of the consideration received or accruing as a result of the transfer.

Under Section 45(4) of the Act two conditions are required to be satisfied for the levy of tax on capital gains-

transfer by way of distribution of capital assets;
such transfer should be on dissolution of the firm or otherwise.
Transformation of a partnership into a company

Section 575 of the Companies Act, 1956 provides that all property, movable and immovable (including actionable claim), belonging to or vested in a company at the date of registration in pursuance of Part IX, shall, on such registration, pass to and vest in the company as incorporated under this Act for all the estate and interest of the company therein.

Partners’ rights

In ‘Malabar Fisheries Co. V. Commissioner of Income Tax’ – 1979 (9) TMI 1 - SUPREME Court the Supreme Court held that firm’s assets all that is meant is property of assets in which all the partners have a joint or common interest.  The firm has no separate rights of its own in the partnership assets but it is the partners who own jointly or in common the assets of the partnership, and therefore, the consequences of the distribution, division or allotment of assets to the partners which flows upon dissolution after discharge of liabilities is nothing but a mutual adjustment of rights between the partners and there is no question of any extinguishment of the firm’s rights in the partnership assets amounting to a transfer of assets within the meaning of Section 2(47) of the Act.  The Supreme Court held that there is no transfer of assets involved in the partnership assets when distribution takes place upon dissolution.

Difference between vesting and distribution of the property

In ‘Commissioner of Income tax V. Texspin Engineer and Manufacturing Works’ – 2003 (3) TMI 56 - BOMBAY High Court the High Court held that there is a difference between vesting of the property 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, realization, encashment of assets and appropriation of the realized account as per the priority like payment of taxes to the Government, payment to unsecured creditors etc.,

Transfer of capital asset

In ‘Assistant Commissioner of Income Tax V. Unity Care and Health Services’ – 2005 (6) TMI 209 - ITAT BANGALORE-A the High Court held that when a partnership is transformed into a company, there is no transfer of capital asset, as the transfer is by operation of law.

In ‘Commissioner of Income Tax V. Rita Mechanical Works’ – 2012 (6) TMI 647 - Punjab and Haryana High Court the High Court is concerned with a partnership firm being treated as a company under the statutory provisions of Part IX of the Companies Act. The Court observed that generally, in the case of a transfer of a capital asset, two important ingredients are-

existence of a party and a counter-party; and
incoming consideration qua the transferor.
The High Court is of the view that when a firm is treated as a company, the above said two conditions are not attracted.  There is no conveyance of the property executable in favor of the limited company.   It is no doubt true that all the properties of the firm vest in the limited company on the firm being treated as a 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 a limited company. On the vesting of all the properties statutorily in the company, there is no transfer of a capital asset as contemplated under Section 45(1) of the Act.

In ‘L.K.S. Gold House (P) Limited V. L.K.S. Gold Palace Application’ – 2004 (3) TMI 432 - HIGH COURT OF MADRAS the High Court held that conversion of a firm into a private Limited company under Part IX of the Companies Act, 1956 statutorily vests all assets of such erstwhile firm into that private limited company under Section 575 of the Act without involving any transfer.

Therefore it is clear that there was no transfer of assets of the partnership firm to a company, no capital gain tax is warranted.  Where the shares were issued by the company not to the firms, but to the individuals, who were partners of the erstwhile form and became shareholders of the company, the provisions of Section 45 of the Act will not be applicable.

Capital gains

In ‘CADD Centre V. Assistant Commissioner of Income Tax’ – 2016 (5) TMI 422 - MADRAS HIGH COURT the appellant, erstwhile registered firm, is engaged in the business of training and trading of software.  The appellant firm was constituted in the year 1988 vide deed of partnership dated 20.10.1988.  The firm consisted of only two partners who were holding equal stakes in the firm.  During the year 1991 the partners of the firm felt the necessity of having a corporate identify and decided to incorporate a private limited company and vest the business of the firm along with the assets in the newly formed private limited company, viz., M/s CADD Centre India Private Limited which was incorporated on November 21, 1991.  All the partners of the firm immediately before the succession became the shareholders of the company in the same proportion, in which, the capital account stood in the books of the firm on the date of succession.  The partnership business was converted into the business of a private limited company as a going concern.  All the assets of the firm got vested as assets of the private limited company.

The appellant filed its return for the year 1992 – 93 on 23.10.1992.  The Assessing Officer found that the accounts of the appellant firm were closed on 30.11.1991 and existing business was taken over by a private limited company. He came to the conclusion that the transfer of business would constitute distribution of assets and would attract capital gains as contemplated under Section 45(4) of the Act and that the assessee is liable to pay on ‘capital gains’.  The Commissioner (Appeals) allowed the appeal holding that when a partnership firm is transformed into a private limited company, there is no transfer of capital assets as contemplated under Section 45(4) of the Act.

The Revenue preferred the appeal before the Tribunal.  The Tribunal held that the transfer of assets of a partnership firm, without dissolution, to a private limited company falls within the expression ‘otherwise’ as contemplated under Section 45(4) of the Act.  The Tribunal held that the appellant is liable to pay tax. The appellant filed appeal before the High Court in which the appellant submitted the following:

all the assets of the firm got vested with the private limited company and on succession of the firm by a private limited company, there was no transfer of assets;
therefore capital gains as contemplated under Section 45(4) would not be attracted and the appellant is not liable to pay any tax on capital gains;
Section 45(4) will be applicable only when the firm is dissolved or when there is distribution of assets and not otherwise.
Further Section 47(xiii)provides that the nothing contained in Section 45 shall apply to any transfer of a capital asset or intangible asset by a firm to a company as a result of succession of the firm by a company in the business carried by the firm, or any transfer of a capital asset to a company in the course of demutualization or corporatization of a recognized stock exchange in India as a result of which an association of persons or body of individuals is succeeded by such company;
There is no dissolution of the partnership and therefore there is no transfer of capital assets and hence the appellant is not liable to pay tax on capital gains.
The Revenue submitted the following:

When the partnership firm, without dissolution, get transferred into a private limited company, the process involves the transfer of asset;
It would fall within the expression ‘otherwise’ as contemplated under Section 45(4) of the Act;
When the partnership firm becomes a limited company, the rights of partners in those assets in the partnership fir, get extinguished and there is transfer of title in favor of the shareholders of the company which fell within the expression ‘otherwise’ and therefore it is a deemed transfer, attracting capital gains.
The legislature has used the expression ‘or otherwise’ and not ‘and otherwise’; therefore the intention of the Legislature is to cover cases of capital gains even where is no dissolution of the firm at all and when the transfer takes place in other mode also.
The assessee is, therefore, liable to pay the tax on capital gains on the transfer of assets.
The Revenue relied on various judgments to support their arguments.  The High Court distinguished all the judgments relied on by the Revenue since the same are not relevant to the facts of the present case.

The High Court observed that that there is no case law supporting the proposition that even in case of subsisting partnership firm transferring assets to a private limited company, there would be a transfer, covered under the expression ‘otherwise’.  The High Court held that it when a partnership firm is transformed into a private limited company, there is no distribution of assets and as such, there is no transfer and therefore, the assessee is not liable to pay any tax on capital gains.  So far as this concerned, there is no transfer asset as-

No consideration was received or accrued on transfer of assets from the firm to the company;
The firm has only revalued its assets which will not amount to transfer;
The provision of Section 45(4) of the Act is applicable only when the firm is dissolved.
In the present case, there is no distribution of asset, but only taking over the assets from the firm to the company.  The High Court allowed the appeal and set aside the order passed by the Tribunal.

Conclusion

In case of conversion of a proprietorship concern or a partnership firm into a company no capital gain shall arise if the following conditions are fulfilled:-

all assets and liabilities of the firm relating to the business immediately before the succession shall become the assets and liabilities of the company.
all the partners of the firm immediately before the succession become the shareholders of the company in the same proportion in which their capital accounts stood in the books of the firm on the date of succession.
the partners of the firm do not receive any consideration or benefit, directly or indirectly in any form or manner other than by way of allotment of shares in the company.

The new Companies Act, 2013 has a similar provision under Section 368 to that of Section 575 of the Companies Act, 1956