By S Sriram, Neha Sharma
Indian Union Budget 2021-22: The Limited Liability Partnership Act, 2008 (“LLP Act”) introduced a hybrid of partnership and a company, in the form of an LLP, having lesser compliances and limited liability, making it a sought-after business structure. Under the said Act, a partnership firm and a company have been permitted to convert themselves into an LLP. Though the LLP Act seeks to migrate smaller businesses into LLPs, the tax implications that may follow such conversion have not been much deliberated upon.
The Income-tax Act, 1961 (“IT Act”) seeks to tax all ‘gains’ that ‘accrue’ on ‘transfer’ of an asset. The word ‘transfer’ has been widely defined and interpreted by Courts – to the extent that conversion of a partnership into an LLP may be regarded as ‘transfer’. Such interpretation read with certain deeming fictions in the IT Act relating to determination of consideration on certain transfers, can result in significant tax liability on conversion, both in the hands of the partners as well as the firm.
Also Read: Union Budget 2021 Live Updates
While the IT Act specifically states that the conversion of a company into an LLP will be exempt from capital gains taxation, no such express exemption has been provided in relation to conversion of a partnership firm into an LLP. However, the Explanatory Memorandum to Finance (No.2) Bill 2009 provides that since an LLP and a firm are treated as equivalent, the conversion from partnership firm to an LLP will have no tax implication, if the rights and obligation of the partners remain the same after conversion and if there is no transfer of any asset or liability after conversion.
On first principles, for capital gains to arise, there should be a transfer of a capital asset. The basic characteristics of the transactions included in the definition of ‘transfer’ like the sale, exchange or relinquishment of the asset, requires the existence of two parties (the transferor and the transferee), and the incoming consideration qua the transferor. In the case of conversion, however, it is only the status and character of a partnership firm that gets transformed into an LLP. That is to say, at the time of conversion, there are no two parties to the transaction, viz. transferor and transferee. It is only when the transferor loses its identity as a partnership firm that transferee comes into existence as an LLP, as per provisions of the LLP Act.
ALSO READ | Budget 2021 Income Tax Live Updates
Further, the capital gains are computed by deducting the cost of acquisition of the assets from the full value of consideration. Therefore, even if the conversion is considered a ‘transfer’, the machinery provisions for computation of capital gains would fail since no consideration flows to the partnership firm on account of transfer of its assets to the LLP. When the computation provisions cannot be applied, the charge to tax would itself fail. Accordingly, the conversion may not be taxable under the IT Act.
In light of the foregoing, while a position may be taken as to non-taxability of the conversion of a partnership firm into an LLP, it nonetheless remains a contentious issue in the absence of any specific provision under the IT Act providing so. A bare perusal of the Explanatory Memorandum to Finance (No.2) Bill 2009 also indicates the intention of the law makers that, in the case of a conversion of a partnership firm into an LLP, there is no transfer of an asset to a third party so as to fall within the ambit of taxation.
Accordingly, it would be helpful to the stakeholders if specific provision treating the conversion of a firm into an LLP as a non-taxable transfer is provided for under the IT Act. This would lead to certainty as regard the tax implications and would further assist the stakeholders in making an informed decision in relation to the conversion of an entity.
(S. Sriram is Joint Partner, and Neha Sharma is Senior Associate, Lakshmikumaran & Sridharan Attorneys. The views expressed are the authors’ own.)
