[Analysis] Tax Implications on Restructuring or Reconstitution of Firms or LLPs | Direct Tax Issues | Case Studies

By CA Rohan Sogani

Table of Content

1. Retirement or Reconstitution of Firm or LLP
2. Conversion of Company into LLP
3. Conversion of Firm into Company
4. Capital Contribution by Partner to Firm/LLP

1. Retirement or Reconstitution of Firm or LLP

1.1 Section 45(4) [Finance Act, 2021]

Notwithstanding anything contained in sub-section (1), where a Specified Person receives during the previous year:

1. any money or Capital Asset or both (Not SIT)
2. from a Specified Entity
3. in connection with the reconstitution of such Specified Entity, then any profits or gains arising from such receipt by the SP shall be chargeable to income-tax as income of such SE under the head “Capital gains” and
4. Shall be deemed to be the income of such Specified Entity of the previous year in which such money or Capital Asset or both were received by the Specified Person and notwithstanding anything to the contrary contained in this Act, such profits or gains shall be determined in accordance with the following formula, namely:—

A = B + C – D

Where

A = Income chargeable to income-tax under this subsection as income of the SE under the head “Capital gains”;
B = Value of any money received by the SP from the SE on the date of such receipt;
C = The amount of FMV of the CA received by the SP from the SE on the date of such receipt; and
D = The amount of balance in the capital account (represented in any manner) of the SP in the Books of Accounts (BOA) of the SE at the time of its reconstitution:

Provided that if the value of “A” in the above formula is negative, its value shall be deemed to be zero:

Provided further that the balance in the capital account of the SP in the BOA of the SE is to be calculated without taking into account the increase in the capital account of the SP due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset.

Explanation 1.— For the purposes of this subsection,—

1. The expressions “Reconstitution of the SE”, “SE” and “SP” shall have the meanings respectively assigned to them in section 9B;
2. (ii) “Self-generated goodwill” and “Self-generated asset” mean goodwill or asset, as the case may be, which has been acquired without incurring any cost for purchase or which has been generated during the course of the business or profession.

Explanation 2 — For the removal of doubts, it is clarified that–

When a CA is received by a SP from a SE in connection with the reconstitution of such SE, the provisions of this sub-section shall operate in addition to the provisions of section 9B and the taxation under the said provisions thereof shall be worked out independently.

1.2 Section 9B Income on receipt of CA or SIT by SP from SE [Finance Act, 2021]

(1) Where a Specified Person (SP) receives during the previous year:

• any Capital Asset (CA) or Stock In Trade (SIT) or both (NOT CASH)
• from a Specified Entity (SE)
• in connection with the dissolution or reconstitution of such SE, then the SE shall be deemed to have transferred such CA or SIT or both, as the case may be, to the SP in the year in which such CA or SIT or both are received by the SP

(2) Any profits and gains arising from such deemed transfer shall be:

• deemed to be the income of such SE of the PY in which such CA or SIT or both were received by the SP; and
• chargeable to income-tax as income of such SE under the head “PGBP” or under the head “Capital gains”, in accordance with the provisions of this Act

(3) For the purposes of this section, Fair Market Value (FMV) of the CA or SIT or both on the date of its receipt by the SP shall be deemed to be the full value of the consideration received or accruing as a result of such deemed transfer of the CA or SIT or both by the SE

(4) If any difficulty arises in giving effect to the provisions of the section 45(4), the Board may, with the approval of the Central Government, issue guidelines for the purposes of removing the difficulty.

Explanation —For the purposes of this section:—

(I) “Reconstitution Of The SE” Means, where —

•  one or more of its partners or members, of such SE ceases to be partners or members; or
•  one or more new partners or members, are admitted in such SE in such circumstances that one or more of the persons who were partners or members, of the SE, before the change, continue as partner or partners or member or members after the change; or
•  all the partners or member, of such SE continue with a change in their respective share or in the shares of some of them;

(II) “SE” means a firm or other association of persons or body of individuals (not being a company or a co-operative society);

(III) “SP” means a person, who is a partner of a firm or member of other association of persons or body of individuals (not being a company or a co-operative society) in any previous year.]

1.3 Comparative Analysis

1.4 Case Studies

Case Study 1(a)

There are 2 partners “A” and “B” in a firm “ZX”, having 1/2 share Each Partner has a capital balance of ₹100 in a firm. There are 2 lands in the firm-

Case Study 1(b)

After 5 years; 2 new partners are admitted “C” & “D” who bring in the capital of ₹ 1,100 each

Neither 45(4) (CA or Cash) nor 9B (CA or SIT) is applicable on this reconstitution under both old and new law as no transfer from a specified entity of the above said items to a specified person has taken place.

Case Study 1(c)

A & B withdrew cash of ₹1,100 each leading to a Debit balance of their capital accounts-

Now, the cash withdrew by “A” & “B” will become taxable u/s 45(4) as there is:

• Transfer of CASH
• From a Specified Entity (Firm ZX)
• To a Specified Person (Partners “A” & “B”)
• In connection to “RECONSTITUTION” of the firm (Admission of Partner “C” and “D”).
  

Case Study 2(a)

• C” & “D” are outsiders who provide loan of ₹1,100 each to the firm ZX
• Neither 45(4) nor 9B is applicable as the transactions entered are not in connection to reconstitution under both old and new law.
• Neither 45(4) nor 9B is applicable as the transactions entered are not in connection to reconstitution under both old and new law.

Case Study 2(b)

“A” and “B” withdraw the cash received as a loan leading to debit balances of their capital accounts

• Neither 45(4) nor 9B is applicable as the transactions entered are not in connection to reconstitution under both old and new law.
• Neither 45(4) nor 9B is applicable as the transactions entered are not in connection to reconstitution under both old and new law.

Case Study 2(c)

• “C” and “D” become partners and their loan account is converted into their capital balances.

Now the cash withdrew by “A” & “B” will become taxable u/s 45(4) as there is:

• Transfer of CASH
• From a Specified Entity (Firm ZX)
• To a Specified Person (Partners “A” & “B”)
• In “CONNECTION” to the reconstitution of the firm (Admission of Partner “C” and “D”)

Section 48 Mode of Computation

In case of value of any money or CA received by a SP from a SE referred to in sub-section (4) of section 45, the amount chargeable to income-tax as income of such SE under that sub-section which is attributable to the CA being transferred by the SE, calculated in the prescribed manner.

Rule 8AA Method of determination of period of holding of CAs in certain cases

• Capital gain shall be deemed to be STCG if it is attributed to the following assets:

1. 1. STCA at the time of taxation u/s 45(4)
   2. CA part of a block of assets
   3. Self-generated assets and self-generated goodwill

• In the case of assets other than above, the capital gain shall be deemed to be LTCG
  

Rule 8AB Attribution of income taxable u/s 45(4) to the CAs remaining with the SE, u/s 48

Form 5C to be filed by Firm for attribution – before 139(1)

Case Study 3(a)

There are three partners “A”, “B” and “C” in a firm “FR”, having 1/3rd share each. Each Partner has a capital balance of ₹10 Lacs in a firm. There are three land in the firm-

Land “S”, “T” and “U” was purchased 2 years back.

Facts

• Partner “A” wishes to exit.
• On the exit of Partner “A”, firm decides to give him ₹11 Lacs in Cash and Land “U” to settle his capital.
• Subsequently, Land “S” is sold by the firm after 2 year.

Question:

• Work out taxability under various sections of the Income Tax Act, 1961

[Where both Section 9B and 45(4) are applicable, first treatment of 9B is given and then 45(4)]

Tax Treatment in the hands of “FR” u/s 9B and 45(4)

Amount Taxable u/s 9B:

• Section 9B will be invoked as the CA is transferred to the Partner “A”. But it will not be invoked on the cash paid of ₹ 11
• For the purposes of this section, fair market value of the CA on the date of its receipt by the specified person shall be deemed to be the full value of the consideration received or accruing as a result of such deemed transfer of the CA by the specified entity.

Amount Taxable u/s 45(4) :

• Section 45(4) will also be invoked in addition to Section 9B as Partner “A” receives Money and CA when he exits from the firm which results in reconstitution of the firm “FR”.
• For the purpose of this section, we will first calculate Profit After Tax in the Books, on transfer of CA to firm to determine the balance of Partner “A” capital account.
• Net Profit After Tax in the Books

• Balance of Partner “A”

• Against the balance of ₹ 21 Lacs in capital account of Partner “A”, he received ₹ 61 Lacs (₹ 11 Lacs in Cash and Land “U” of FMV of ₹ 50 Lacs).
• Amount taxable u/s 45(4)
  A= B + C – D
  A= 11 Lacs + 50 Lacs – 21 Lacs
  A= 40 Lacs
  Here, A= Income chargeable as per this sub-section under the head “Capital Gain”
  B= Money received by Partner “A”
  C= FMV of Land “U” received by Partner “A”
  D= Balance of Partner “A” capital account
• Since income of ₹ 40 Lacs is charged u/s 45(4) w.r.t. land (CA) “S” and “T” it will be attributed, in proportion to revaluation gain, on land (CA) “S” and “T”

Out of ₹40 Lacs, ₹20 Lacs shall be attributed to Land “S” and ₹20 Lacs to Land “T” shall be charged as LTCG as both land “S” and “T” are Long Term Capital Asset at the time of taxation.

Amount Taxable as per Section 48(iii):

For the purpose of this section, while calculating LTCG on subsequent sale of Land “S” after reconstitution Capital Gain attributed towards Land “S” u/s 45(4) will be deducted.

2. Conversion of Company into LLP

2.1 Key Comparatives – Company vs LLP

2.2 Why Convert to LLP? [Benefits]

• Tax Benefits:

1. Facilitates tax efficient cash extraction
2. Deemed dividend provisions not applicable

• Operational Benefits:

1. Ideal for small to medium scale businesses.
2. Gives utmost flexibility and freedom to partners to manage business affairs as per LLP deed.

• Regulatory Benefits:

1. Easy to set up, reorganize and wind up.
2. Far-lesser compliances to be undertaken as compared to the company.

2.3 Section 47(xiiib) – Conditions for Tax Neutral Conversion of Company into LLP

Conversion of a partnership firm into company shall be tax exempt for the firm provided following conditions are satisfied:

• All the assets and liabilities immediately before the conversion become the assets and liabilities of LLP
• All the shareholders to become partners of LLP; and Contribution and profitsharing ratio (‘PSR’) to be in same proportion as their shareholding in company
• Aggregate of PSR of the shareholders of the company in the LLP shall be at least 50% at any time during the period of 5 years from the date of conversion
• In any of the 3 preceding years: Total Sales/turnover/gross receipts of the company < ₹ 60 Lacs; and Total value of Assets of the company < ₹ 5 crores
• No other consideration is paid to the shareholders except by way of PSR and capital contribution
• No amount is paid to the partners of LLP, directly or indirectly, out of accumulated profit of the company as on the date of conversion for a period of 3 years from the date of conversion

2.4 Other Key Tax Implications

Conversion akin to Transfer?

• Asstt. CIT v. Celerity Power LLP [2018] 100 taxmann.com 129/[2019] 174 ITD 433 (Mum.-Trib.)
• Schedule 3 of LLP Act vs Section 575 of Companies Act, 1956
• Conversion of Company into LLP – would involve transfer

For Company:

• Capital gains exempt from tax on fulfilment of conditions u/s 47(xiiib)

For LLP:

• The actual cost of the block of assets in the case of LLP shall be the written down
  value of the block of assets in the hands of company on the date of conversion.
• In the year of conversion, the aggregate depreciation allowable to the company and
  LLP shall not exceed the depreciation calculated at the prescribed rates as if the conversion had not taken place.
• The cost of acquisition of the capital asset for the LLP shall be equal to be the cost
  for which the company acquired it.

For Partners of LLP:

• Capital gains exempt from tax on fulfilment of conditions u/s 47(xiiib)
• The cost of acquisition of a capital asset being rights of a partner in successor LLP, shall be equal to be the cost of acquisition of the shares in the company immediately before its conversion

Section 72A

• Subject to fulfillment of conditions prescribed under section 47(xiiib) of the IT Act, the accumulated loss and the unabsorbed depreciation of the company, shall be deemed to be the loss or allowance for depreciation of the LLP for the purpose of the previous year in which company was converted into LLP.
• Further, other provisions of the IT Act relating to set off and carry forward of loss and unabsorbed depreciation shall apply accordingly.
• In case any of the conditions as prescribed under section 47(xiiib) of the IT Act are not complied with, any accumulated loss or unabsorbed depreciation utilized in any previous year by the LLP, shall be deemed to be the income of the LLP and chargeable to tax in the year in which such conditions are violated.

Section 47A:

• In case any of the conditions laid down in section 47 (xiiib) are not complied with, the amount of profits or gains arising from the transfer of such capital asset or intangible assets or share or shares shall be chargeable to tax.
• Further, such amount shall be deemed to be the profits and gains chargeable to tax in the hands of LLP or the shareholder of the company, as the case may be, for the previous year in which the conditions prescribed u/s 47(xiiib) are

Section 43CA – Immovable Property as Stock In Trade:

“…(1)Where the consideration received or accruing as a result of the transfer by an assessee of an asset (other than a capital asset), being land or building or both, is less than the value adopted or assessed or assessable by any authority of a State Government for the purpose of payment of stamp duty in respect of such transfer, the value so adopted or assessed or assessable……”

General Anti Avoidance Rules [Chapter – XA]
[Threshold – 3 Cr. Tax Benefit]

Section 96: Impermissible Avoidance Arrangement

• An impermissible avoidance  arrangement  means an arrangement, the main purpose of which is to obtain a tax benefit, and it—

1. creates rights, or obligations, which are not ordinarily created between persons dealing at arm’s length;
2. results, directly or indirectly, in the misuse, or abuse, of the provisions of this Act;
3. lacks commercial substance or is deemed to lack commercial substance u/s 97, in whole or in part; or
4. is entered into, or carried out, by means, or in a manner, which are not ordinarily employed for bona fide purposes.

• An arrangement shall be presumed, unless it is proved to the contrary by the assessee, to have been entered into, or carried out, for the main purpose of obtaining a tax benefit, if the main purpose of a step in, or a part of, the arrangement is to obtain a tax benefit, notwithstanding the fact that the main purpose of the whole arrangement is not to obtain a tax benefit.

2.5 Key Considerations

3. Conversion of Firm into Company

3.1 Section 47(xiii) – Conditions for tax neutral conversion of Partnership Firm (‘PF’) into Company

Conversion of a partnership firm into company shall be tax exempt for the firm provided following conditions are satisfied:

• First Condition: All the assets and liabilities of the firm relating to the business immediately before the succession become the assets and liabilities of the company.
• Second Condition: All the partners of the firm 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 the succession.
• Third Condition: 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.
• Fourth Condition: The aggregate of the shareholding of the partners is at least 50% of the total voting power in the company and their shareholding continues to be as such for a period of 5 years post conversion.

3.2 Why Convert to Company? [Benefits]

1. Ease of fund raising from multiple investors
2. Issue of hybrid instrument possible
3. Attract Foreign Direct Investment (FDI)
4. If promoters  are  wish  to  unlock  value  by  eventually listing its shares on stock exchanges
5. Take advantage of benefits available under IT Act like Lower corporate tax rates, etc

3.3 Other Key Tax Implications

For Company

• The aggregate depreciation allowable to the firm and company shall not exceed, in any previous year, the depreciation calculated at the prescribed rates as if the conversion had not taken place.
• The cost of acquisition of the capital asset for the company shall be deemed to be the cost for which the firm acquired it.

For Partners

• No specific provision has been included with regards to determining cost of acquisition of shares of the company.
• No specific provision has been included with regards to determining the period of holding of capital asset being shares of the company.

Section 72A

• Subject to fulfillment of conditions prescribed under section 47(xiii) of the IT Act, the accumulated loss and the unabsorbed depreciation of the firm shall be deemed to be the loss or allowance for depreciation of the company for the purpose of previous year in which conversion was effected.
• Further, other provisions of the IT Act relating to set off and carry forward of loss and unabsorbed depreciation shall apply accordingly.
• In case any of the conditions as prescribed under section 47(xiii) of the IT Act are not complied with, any accumulated loss or unabsorbed depreciation utilized in any previous year by the company, shall be deemed to be the income of the company and chargeable to tax in the year in which such conditions are violated.

Section 47A

• In case any of the conditions laid down in section 47 (xiii) of IT Act are not complied with, the amount of profits or gains arising from the transfer of such capital asset or intangible assets shall be chargeable to tax.

Further, such amount shall be deemed to be the profits and gains chargeable to tax in the hands of company for the previous year in which the conditions prescribed under section 47(xiii) of IT Act are violated.

4. Capital Contribution by Partner to Firm/LLP

4.1 Section 45(3)

• Inserted vide Finance Act, 1987; Section 45(3):

“…The profits or gains arising from the Transfer of a Capital Asset by a person to a firm or other association of persons or body of individuals (not being a company or a co-operative society) in which he is or becomes a partner or member, by way of capital contribution or otherwise, shall be chargeable to tax as his income of the previous year in which such transfer takes place and, for the purposes of section 48, the Amount Recorded in the Books of Account of the firm, association or body as the value of the capital asset shall be Deemed to be the Full Value of the Consideration received or accruing as a result of the transfer of the capital asset.

• Sunil Siddharth Bhai v. CIT [1985] 23 Taxman 14w/156 ITR 509 (SC). No actual consideration accrued/received on transfer of Capital Asset by Partner to firm.

4.2 Section 45(3) v/s Section 50C Conflict of Deeming Fiction

View 1: Section 50C to Override Section 45(3).

• Section 50C introduced subsequently, later law to override earlier law
• No exclusionary clause for Section 45(3)

View 2: Section 45(3) to override Section 50C.

• Deeming fiction against Deeming
• Sunil Siddharth Bhai v. CIT [1985] 23 Taxman 14w/156 ITR 509 (SC)[Section 50C applicable in case of Actual receipt/Accrual of receipt]
• Favorable Decisions – Network Construction Co. v. ACIT [2020] 119 com 186/185 ITD 318 (Mum.-Trib.), CIT v. Carlton Hotel (P.) Ltd. [2017] 88 taxmann.com 257/399 ITR 611 (AII).

4.3 Section 56 (2)(x)

• Section 56(2)(x) applies where (i) any person receives specified property; and

(ii) such specified property is received without consideration or for a consideration less than the specified value.

• Applicability for Partners – NOT APPLICABLE
• Applicability on Firm – NOT APPLICABLE
• ITO v. Shrilekha Business Consultancy (P.) Ltd. [2020] 121 Taxmann.com 150 (Hyd.-Trib.).
  1. Receipt of Capital Contribution from Partner – Capital Field;
  2. Amount credited in capital account cannot be equated to consideration;
  3. Consideration – Indeterminate, computation mechanism fails