Conversion or succession of entities not regarded as transfer

Introduction

Any transfer of capital asset on conversion of an entity into another form of entity is not regarded as transfer if the specified conditions in respect of such transactions are satisfied. However, if any condition is not subsequently complied with, the exemption shall be withdrawn.

1. About

The term 'transfer' has been defined under Section 2(109) of the Income-tax Act. The definition has been explained in an inclusive manner. It covers all deemed transactions prescribed in that provision besides what is otherwise understood as transfer in common parlance. However, certain transactions as provided in Section 70 are not regarded as transfer for the purpose of computing the capital gains tax. Therefore, any profit or gain arising from these transactions are not chargeable to tax under the head Capital Gains. One of such transactions is conversion of entities provided the prescribed conditions are also satisfied.

2. Succession of firm by company [Section 70(1)(zd)]

Where a firm is succeeded by a company in the business carried on by it, any transfer of capital asset or intangible asset by the firm to the company is not treated as transfer provided the following conditions are satisfied.

2.1. Whole business devolves

The whole business of the firm devolves on the successor company and the same business should be carried on by the company. The successor company may be a new one or an existing one. It may be an Indian company or foreign company.

This exemption is available when a firm engaged in business is succeeded by a company. A professional firm or a consultancy firm is not covered under this provision.

2.2. All assets & liabilities are taken

All the assets and liabilities of the firm should be taken over by the company. However, contingent liabilities are not liabilities and, therefore, the benefit is available even if such liabilities are not taken over.

2.3. Partners become shareholders

All partners of the firm should become shareholders of the successor company in the same proportion in which their capital accounts stood in the books of the firm on the date of succession. Where a partner has got debit balance, such partner either has to contribute fresh capital or settle his account before succession.

2.4. 50% Shareholding for 5 years

The aggregate shareholding of partners of firm in the company should not be less than 50% of its total voting power and the partners should continue to hold 50% voting power in the company for a period of 5 years.

"Shareholding" implies that shares could be equity or preference but "voting power" is vested only with equity shares. Therefore, so long as all the partners together hold 50% of the total voting power in the company, the condition is satisfied even if a part of the shareholding may be of preference shares. Aggregate shareholding of the partners also include the shareholding of a minor where he was admitted for benefits.

Transfer of shares by a partner may not affect the exemption if aggregate shareholding is maintained at 50%. Where a partner transfers his shares within the lock-in-period but the remaining partners continue to hold 50% of the voting power in the company, the benefit of exemption cannot be withdrawn. There is no bar that the voting power cannot be increased in the lock-in-period. In the event of any increase in the voting power, the partners—shareholders should continue to hold 50% of the increased voting power.

2.5. Consideration in shares only

The Partners of the firm should not receive any consideration or benefit, directly or indirectly, other than by the way of allotment of shares (equity or preference shares) in the company.

Example, if compensation is given to the partners for not competing with the company in the same business, it may also be treated as consideration justifying the denial of exemption. Similarly, where partners are paid royalty for use of the trade name belonging to the partners, it would also justify the denial of exemption. However, remuneration paid to partners as directors cannot be treated as a benefit/consideration within the meaning of this clause.

3. Conversion of Company into LLP [Section 70(1)(ze)]

Any transfer of a capital asset on conversion of Private Company or unlisted Public Company into a Limited Liability Partnership ('LLP') or transfer of shares by the shareholder on such conversion is not treated a 'transfer', if the following conditions are satisfied.

3.1. Turnover or receipt should be below threshold limit

The total sales, turnover or gross receipts in the business of the company during any of the 3 years preceding the tax year in which the conversion takes place does not exceed Rs. 60 lakhs.

3.2. Value of asset should be below threshold limit

The total value of the assets as appearing in the books of account of the company in any of the three tax years preceding the tax year in which the conversion takes place does not exceed Rs. 5 crores.

3.3. All assets & liabilities are taken

All the assets and liabilities of the company, immediately before the date of conversion, become the assets and liabilities of the LLP. However, contingent liabilities are not liabilities and, therefore, the benefit is available even if such liabilities are not taken over.

3.4. Shareholders become partners

All shareholders of the company, immediately before the conversion, become the partners of the LLP and their capital contribution and profit-sharing ratio in the LLP are in the same proportion as their shareholding in the company on the date of the conversion.

3.5. 50% Partnership for 5 years

The aggregate of profit-sharing ratio of shareholders of the company in the LLP is not less than 50% at any time during the period of 5 years from the date of conversion.

3.6. Consideration in shares only

The shareholders of the company do not receive any consideration or benefit, directly or indirectly, in any form or manner, other than by way of share in profit and capital contribution in the LLP. Further, no amount is paid, directly or indirectly, to any partner out of the balance of accumulated profit, standing in the accounts of the company on the date of the conversion, for 3 years from the date of conversion.

4. Succession of proprietary concern by company [Section 70(1)(zf)]