The Hindu Business Line : Conversion of company into LLP

The Limited Liability Partnership Act, 2008 ] was enacted by Parliament and received the assent of the President on January 7, 2009. The LLP Act was notified on March 31 and the first limited liability partnership was registered on April 2; as of August 31, 159 LLPs were registered. An LLP is a body corporate and a legal entity separate from its partners, having perpetual succession.

The tax treatment for LLPs was a subject matter of debate and speculation. The Finance (No. 2) Act, 2009 accorded LLPs the same tax treatment as a partnership firm. In brief, an LLP is treated as a separate taxable entity and the partners of the LLP are exempt from tax in respect of share of profits received from the LLP.

Enabling provisions

The remuneration paid to working partners of the LLP and interest on capital is tax deductible in the hands of the LLP (subject to prescribed limits and conditions) and is taxable in the hands of the partners as business/professional income.

The LLP Act contains enabling provisions for conversion of partnership firms and private limited companies to LLPs, which were notified on May 22 and became effective from May 31.

The Income-Tax Act, 1961, however, does not contain any specific exemption provisions for such conversions. The Memorandum explaining the provisions of the Finance (No. 2) Bill, 2009 however indicates that the conversion from a general partnership firm to an LLP will have no tax implications if the rights and obligations of the partners remain the same after conversion and if there is no transfer of any asset or liability after conversion; it also clarifies that if there is a violation of these conditions, Section 45, dealing with capital gains, shall apply.

In this context, a point to be noted is that the reference to rights and obligations in the Memorandum would typically mean the inter se rights between the partners and not their rights and obligations to third parties.

It is pertinent to note that the Memorandum is silent on conversion from a private limited company to an LLP. The LLP Act provides that on registration as an LLP, all property, liabilities, etc., of the company shall be transferred to and shall vest in the LLP without further assurance, act or deed, that is, by operation of law.

Company dissolved

It may be noted that the company and LLP are never in co-existence (the company is deemed to be dissolved and removed from the records of the Registrar of Companies) and no consideration is received by the company pursuant to the transfer and vesting of assets to the LLP. In this scenario, a company that converts into an LLP cannot be liable to tax.

The removal of the company’s name from the records of the Registrar of Companies and it being deemed to be dissolved cannot be equated with liquidation of a company; moreover, there is no distribution by the company to the shareholders.

Accordingly, the specific provisions relating to liquidation of companies should not apply to conversion of a company into an LLP.

On the same analogy, there cannot be any taxation as deemed dividend on such conversions.

The Andhra Pradesh High Court in its landmark judgment in the V. P. Rao vs Sri Ramanuja Ginning and Rice Factory P. Ltd. (60 COMPCAS 568) case has held that if the constitution of the partnership firm is changed into that of a company by registering it under Part IX of the Companies Act, 1956 (Part VIII of the Companies Act, 1913), there shall be statutory vesting of title of all the property of the previous firm in the newly incorporated company without any need for a separate conveyance.

The Bombay High Court, in the CIT vs Texspin Engineering and Manufacturing Works (263 ITR 345) case, has held that the treatment of a firm as a company under Part IX of the Companies Act, 1956 did not give rise to capital gains.

These judicial pronouncements support the view that the company cannot be taxed on conversion to an LLP.

Effect on shareholders

The other important issue to be considered on conversion of a company to an LLP is the tax treatment for shareholders of the company. Pursuant to treatment of the company as an LLP, the shareholding of the shareholders in the company would cease to exist.

This would amount to a transfer and, in the absence of a specific exemption under law, would potentially give rise to capital gains/loss in the hands of the shareholders. It may however be noted that determination of the consideration for the purpose of computation of capital gains/loss could be a challenge.

The absence of exemption for shareholders on conversion of a company into an LLP coupled with absence of specific exemption for the company leading to a potential challenge by assessing officers (AOs) and an attempt to tax the company is a significant roadblock in conversion of LLPs into companies. Suitable exemptions accordingly need to be provided under law to ensure that income-tax is not a hindrance for such conversions.

It may be noted that the Direct Taxes Code Bill, 2009 also does not address these concerns. Companies desiring to convert into LLPs shall accordingly have to analyse the tax issues in depth and consider the pros and cons of conversion in detail before taking any steps for conversion into an LLP.

(The authors are with Deloitte Haskins & Sells.)