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