MAY 24, 2016

By T V Suresh Kumar, Adv.

NORMALLY,a small-scale business will start as Proprietorship or Partnership Firm. When the business is growing, corporate form of business is considered good model in the eyes of public and the financial institutions. Also, there is a demarcation of personal liability and business liability when it comes to corporate form of business. However, before converting from one form of business to another, lot of aspects need to be considered, including taxation aspects.

The Companies Act, 2013 provides for conversion of Partnership Firm in to a Company under Section 366 of the Companies Act 2013 (Part IX Conversion under the Companies Act, 1956) after complying with certain conditions.

Under this method, the Partnership Firm will be converted as a limited company after getting itself registered with the Registrar of the Companies. After registration, the nature of entity will change from Partnership Firm to Company. As a consequence of such change, the partners of the Partnership Firm will become shareholders of the company. The assets and liabilities of the Partnership Firm will be vested with the company.

Whether the above conversion will attract Capital Gain Tax under the Income Act 1961

The Section 45 of the Income Tax Act, 1961 is a charging provision for Capital Gain. Section 45 reads as follows:

(1) Any profits or gains arising from the transfer of a capital asset effected in the previous year shall, save as otherwise provided in sections 54, 54B, 54D, 54E, 54EA, 54EB, 54F, 54G and 54H, be chargeable to income-tax under the head "Capital gains", and shall be deemed to be the income of the previous year in which the transfer took place.

(1A) …………………

(2) ………………..

(2A) …………………

(3) …………………

(4) The profits or gains arising from the transfer of a capital asset by way of distribution of capital assets on the dissolution of a firm or other association of persons or body of individuals (not being a company or a co-operative society) or otherwise, shall be chargeable to tax as the income of the firm, association or body, of the previous year in which the said transfer takes place and, for the purposes of section 48, the fair market value of the asset on the date of such transfer shall be deemed to be the full value of the consideration received or accruing as a result of the transfer.

"Transfer of Capital Assets"

From the above provisions, it is very clear that the “Transfer of Capital Asset” is a pre-condition for levying capital gain tax. The term “Transfer” has been defined under section 2(47) of the Income Tax Act, 1961. As per the definition, transfer means the sale, exchange or relinquishment of the asset, the extinguishment of any rights and the compulsory acquisition. The conversion of partnership firm into company under Part IX of the Companies Act, 1956 is not a transfer. It is a mere conversion.The nature of entity alone has been changed from firm to company. Under this process the Firm is transformed into a company. In any transfer there must be a two parties, viz transferor and transferee. In case of the above conversion, there is no such two parties. The partnership firm will get itself registered with Registrar of Companies under the Companies Act. After registration, the Firm takes another form i.e Company. Instead of Partnership Act, 1932, the Companies Act 1956 or 2013 (as the case may be) will apply.

It is true that there is vesting of properties. The vesting of properties are different from transfer of properties. Therefore the conversion of Partnership Firm into company under Part IX of the Companies Act, 1956 or Section 366 of the Companies Act, 2013, will not be qualified as Transfer. Further in terms of sub section 4 of Section 45 of Income Tax Act, 1961 the transfer of capital asset by way of distribution of capital assets is taken place on the dissolution of a firm. As above said the conversion is not a transfer and on conversion the firm will be treated as company. Hence there is no dissolution of the firm at all.

The conversion of Firm is not qualified under Transfer of capital asset which is outside the purview of levy. It is also to be noted that the Finance Act 2001, has amended Section 47 (iii). Section 47 of the Income tax Act 1961 is the exemption provision for levying capital gain tax. In other words, the transaction mentioned under Section 47 of the Income tax Act 1961, is not regarded as transfer.

It is the view of the Author that once the conversion of firm into a company is not qualified under Section 45 of the Income Tax Act 1961 i.e charging provision itself has excluded the above said transaction (conversion), then it is not necessary to see the exemption for levying capital gain tax. Hence the conversion of Partnership Firm into a Company is not a Transfer and no capital gain tax will attract.

Following recent judgements of various High Courts also conform to the above view:

1. The Hon'ble High Court of Gujarat in the case of Deputy Commissioner of Income Tax Verus R.L Kalathia& Co, - 2016-TIOL-572-HC-AHM-IT - Date of Judgement : 08.01.2016.

2. The Hon'ble High Court of Madras in the case of CADD Centre Versus Assistant Commissioner of Income Tax, City Circle-II (2) - 2015-TIOL-3027-HC-MAD-IT –date of judgement : 01.12.2015.

3. The Hon'ble High Court of Delhi in the case of Union of India & another Versus M/s Mahalakshmi Saw Mills P Ltd,Date of Judgement:23.12.2015.

4. The Hon'ble High Court of Bombay in the case of Commissioner of Income Tax Versus Texspin Engineering and Manufacturing works, - 2003-TIOL-369-HC-MUM-IT.

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