[2017] 81 taxmann.com 1 (Article)
Introduction
Section 47(xiii) was introduced by the Finance (No. 2) Act, 1998 w.e.f. 1 April 1999. The said section provides that transfer of a capital asset or intangible asset by a partnership firm to a company as a result of conversion of the firm into a company is not regarded as "transfer". The said exemption is subject to the fulfilment of certain conditions as contained in the proviso to section 47(xiii). Recently, the Mumbai High Court had the occasion to deal with the exemption provision in the case of CIT v. Umicore Finance Luxemborg [2017] 244 Taxman 43/[2016] 76 taxmann.com 32 (Bom.). The Hon'ble Courtheld that violation of condition as laid down in section 47(xiii) of the Income Tax Act, 1961 will not lead to taxation of capital gain tax since such conversion do not trigger the charging section 45(1) of the Act. The Mumbai High Court held that upon conversion the assets vest in the company by operation of law and therefore there is no "transfer" involved. The said decision of Mumbai High Court raises a query as to whether the exemption section 47(xiii) is otiose. As a corollary whether the provisions of section 47(xiii)(b) providing exemption to conversion of company into LLP is also otiose.
Lets analyse.
Facts of the Umicore case
| (i) | Â | A private limited company M/s. Anandeya Zinc Oxides Private Limited ('Anandeya' in short) was incorporated on 13.09.2005 succeeding erstwhile partnership firm M/s. Anandeya Zinc Oxides under part IX of the Indian Companies Act 1956. The company claimed exemption from capital gain tax under section 47(xiii) of the Act by fulfilling the conditions laid down in the said provision. One of the condition being condition (d) is that the aggregate of shareholding of the erstwhile partners in the company should not be less than 50% of the total voting power in the company and their shareholding should be continued for a period of 5 years from the date of succession. |
| (ii) |  | If any of the conditions are not complied with, the amount of profits or gains arising from the transfer of such capital asset or intangible asset not charged under section 45 by virtue of section 47(xiii) shall be deemed to be the profits and gains chargeable to tax in the hands of a successor company under section 47A(3) of the Act in the year in which the said condition is violated. |
| (iii) | Â | The Respondents a non-resident company incorporated under the laws of Luxembourg entered into a Share Purchase Agreement on 01.07.2008 with Anandeya for purchase of 100% equity shares which was completed on 12.08.2008 i.e. within 5 years of date of conversion into a company. |
| (iv) | Â | Since the Respondent had purchased 100% shares of Anandeya within 5 years of succession, the Respondent filed an application before the AAR seeking a ruling on question as to notwithstanding the non-compliance with clause (d) of proviso to section 47(xiii), whether it was liable to pay capital gain tax. |
| (v) | Â | The AAR noted that the Respondent had clarified that whilst converting the partnership firm into a company, there was no revaluation of the assets and the assets and liabilities of the firm as also the partners' capital and current accounts were taken at their book value in the accounts of the company. It was in such circumstances the AAR ruled that there were no capital gains accrued or arose at the time of conversion of partnership firm into a private limited company under part IX of the Companies Act and, therefore, notwithstanding the non-compliance with clause (d) of the proviso to Section 47(xii) of the Income Tax Act, even by reason of premature transfer of shares the said company is not liable to pay capital gains tax. |
| (vi) | Â | Being aggrieved by the said assessment, the Income Tax Department filed a writ before the Bombay High Court raising a question as to whether upon violation of clause (d) of section 47(xiii), the exemption from capital gain enjoyed by the firm upon conversion into private limited company stands withdrawn in view of section 47A(3) of the Act? |
Decision of Mumbai High Court in Umicore
| (i) | Â | The Mumbai High Court analysed the decision of the AAR and observed that the fact that conditions (a) to (c) are satisfied, is not in dispute. The first part of clause (d) has also been satisfied since the partners held more than 51% shares at the time of conversion into company. The requirement of second part of clause (d) i.e. the shareholding of 51 per cent or more should continue to be as such for the period of five years from the date of succession, has not been fulfilled in the instant case by reason of the transfer of shares by the Indian Company to the assessee before the expiry of five years. |
| (ii) | Â | The High Court also noted that the consequences of violation of those conditions have been specifically laid down in sub-section (3) of Section 47A which was also introduced by the same Finance Act. |
| (iii) |  | The High Court placed reliance upon the decision of the earlier decision in the case of CIT v. Texspin Engg. & Mfg. Works [2003] 263 ITR 345/129 Taxman 1 (Bom.) and observed that by such reconstitution of the Company under part IX of the Companies Act, the assets automatically vests in the newly registered Company as per the statutory mandate contained in section 575 of the Companies Act. Therefore, it cannot be said that the partners have made any gains or received any profits from themselves. |
| (iv) | Â | It was also noted that worth of the shares of the company was not different from the interest of partners in the existing firm. In part IX of the Companies Act, therefore, notwithstanding the non-compliance with clause (d) of the proviso to section 47(xiii) by premature transfer of shares, the Respondent is not liable to pay capital gains tax since no capital gain actually arises. These findings have been arrived at essentially looking into the fact that there was no revaluation of assets at the time of conversion of the firm "Anandeya". |
| (v) | Â | The High Court further held that even if such conversion is held to lead to transfer of assets from firm to company, yet liability to pay capital gains would not arise because the "full value of consideration" as provided in basic charging section 45(1) will be the book value of assets in absence of revaluation. The expression "full value of consideration" in computation section 48 cannot be the market value of the capital asset on the date of transfer but is the value as agreed upon. Therefore there would be no capital gain at all to bring it in tax net. |
Therefore, one could assume that where in the process of conversion the assets have not been revalued and basic conditions have been fulfilled, the courts will lean in favour of the proposition that there is no "transfer" involved in conversion due to operation of law and accordingly section 45(1) is inapplicable. This leads to a conclusion that in such a situation the provisions of section 47(xiii) would become redundant since the conversion from firm to company do not involve "transfer" of assets to bring it within the chargeable section 45(1) of the Act but there is vesting of assets in the hands of company by operation of law.
Whether Conversion of Company into LLP is Pari Materia
| (i) | Â | It was for the first time by introduction of Limited Liability Partnership Act, 2008, a company was allowed to be converted into an LLP. Accordingly, the legislature to bring in parity introduced the concept of conversion of Company into LLP in the Income Tax Act and therefore section 47(xiiib) was inserted by the Finance Act, 2010, w.e.f. 1-4-2011. The said provision grants conditional exemption from capital gain tax when a company is converted into an LLP. The following two important conditions besides others are the same as in section 47(xiii): |
| (a) | Â | All the shareholders of the company immediately before the conversion shall become the partners of the limited liability partnership and their capital contribution and profit sharing ratio in the limited liability partnership shall be in the same proportion as their shareholding in the company on the date of conversion. |
| (b) | Â | The aggregate of the profit sharing ratio of the shareholders of the company in the limited liability partnership shall not be less than fifty per cent at any time during the period of five years from the date of conversion. |
| (ii) |  | Section 47(xiii)(b) has been introduced much after the decision of Mumbai High Court in the case of Texspin Engg & Mfg. Works (supra) as mentioned earlier. While introducing section 47(xiiib) the legislature did not bring in a separate charging section taxing the gain on transfer of assets from erstwhile company to new LLP. The conditional exemption provision presupposes a tax on conversion which, in authors opinion is against the law as laid down in Texspin Engg & Mfg. Works(supra). |
| (iii) |  | In the case of Texspin Engg & Mfg. Works (supra) the Mumbai High Court had deliberated on a similar issue and had held that generally, in the case of a transfer of a capital asset, two important ingredients are : |
| a. | Â | existence of a party and a counterparty and, |
| b. |  | incoming consideration qua the transferor. |
| (iv) | Â | When a firm is treated as a Company, the said two conditions are not attracted. There is no conveyance of the property executable in favour of the Limited Company. It is no doubt true that all properties of the Firm vests 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 vesting of all the properties statutorily in the Company, the cloak given to the Firm is replaced by a different cloak and the same Firm is now treated as a Company, after a given date. Accordingly, the High Court held that in these circumstances, there was no transfer of a capital asset as contemplated by section 45(1) of the Act. |
| (v) |  | Conversion of a company into LLP is carried out under section 56 read with Third Schedule of the Limited Liability Partnership Act, 2008. The relevant provision of Third Schedule which is relevant for our discussion reads as under : |
| Â | "6. Effect of registration : | |
| Â | (b) All tangible (movable or immovable) and intangible property vested in the company, all assets, interests, rights, privileges, liabilities, obligations relating to the company and the whole of the undertaking of the company shall be transferred to and shall vest in the limited liability partnership without further assurance, act or deed." | |
| (vi) |  | The recent decision of Mumbai High Court in Umicore Finance Luxemborg as discussed above reiterates the law laid down in Texspin Engg & Mfg. Works (supra) and holds that where the law does not treat the transaction to result in tax, the conditions for exemption have no meaning. Thus Mumbai High Court has rendered section 47(xiiib) otiose in absence of a specific charging section. The Mumbai High Court has held that the contention of the department that in view of the violation of clause (d) of Section 47(xiii), the exemption from capital gains enjoyed by the firm upon conversion into a Private Limited Company, ceases to be in force cannot be accepted. It further examined that there are no capital gains which have accrued on account of such incorporation. Thus, there was no capital gains payable at the time of the incorporation of the Company from the erstwhile partnership firm. |
Conclusion
The above decision of the Mumbai High Court in the case of Umicore Finance Luxemborg (supra) lays down an important proposition and leads to a compelling argument of casus omissus by the legislature since section 45(1) does not apply to vesting of property by operation of law and absence of a counterparty. Its to be seen whether the highest judiciary thinks otherwise or, whether an amendment is brought in.