[Analysis] Tax Implications on Restructuring or Reconstitution of Firms or LLPs | Direct Tax Issues | Case Studies

Notwithstanding anything contained in sub-section (1), where a Specified Person receives during the previous year:

  1. any money or Capital Asset or both (Not SIT)
  2. from a Specified Entity
  3. in connection with the reconstitution of such Specified Entity, then any profits or gains arising from such receipt by the SP shall be chargeable to income-tax as income of such SE under the head “Capital gains” and
  4. Shall be deemed to be the income of such Specified Entity of the previous year in which such money or Capital Asset or both were received by the Specified Person and notwithstanding anything to the contrary contained in this Act, such profits or gains shall be determined in accordance with the following formula, namely:—

A = Income chargeable to income-tax under this subsection as income of the SE under the head “Capital gains”;
B = Value of any money received by the SP from the SE on the date of such receipt;
C = The amount of FMV of the CA received by the SP from the SE on the date of such receipt; and
D = The amount of balance in the capital account (represented in any manner) of the SP in the Books of Accounts (BOA) of the SE at the time of its reconstitution:

Provided that if the value of “A” in the above formula is negative, its value shall be deemed to be zero:

Provided further that the balance in the capital account of the SP in the BOA of the SE is to be calculated without taking into account the increase in the capital account of the SP due to revaluation of any asset or due to self-generated goodwill or any other self-generated asset.

Explanation 1.— For the purposes of this subsection,—

  1. The expressions “Reconstitution of the SE”, “SE” and “SP” shall have the meanings respectively assigned to them in section 9B;
  2. (ii) “Self-generated goodwill” and “Self-generated asset” mean goodwill or asset, as the case may be, which has been acquired without incurring any cost for purchase or which has been generated during the course of the business or profession.

Explanation 2 — For the removal of doubts, it is clarified that–

When a CA is received by a SP from a SE in connection with the reconstitution of such SE, the provisions of this sub-section shall operate in addition to the provisions of section 9B and the taxation under the said provisions thereof shall be worked out independently.

1.2 Section 9B Income on receipt of CA or SIT by SP from SE [Finance Act, 2021]

(1) Where a Specified Person (SP) receives during the previous year:

(2) Any profits and gains arising from such deemed transfer shall be:

(3) For the purposes of this section, Fair Market Value (FMV) of the CA or SIT or both on the date of its receipt by the SP shall be deemed to be the full value of the consideration received or accruing as a result of such deemed transfer of the CA or SIT or both by the SE

(4) If any difficulty arises in giving effect to the provisions of the section 45(4), the Board may, with the approval of the Central Government, issue guidelines for the purposes of removing the difficulty.

Explanation —For the purposes of this section:—

(I) “Reconstitution Of The SE” Means, where —

(II) “SE” means a firm or other association of persons or body of individuals (not being a company or a co-operative society);

(III) “SP” means a person, who is a partner of a firm or member of other association of persons or body of individuals (not being a company or a co-operative society) in any previous year.]

1.3 Comparative Analysis

2.

3.

Capital gains – as per formula A = B + C – D

5.

Sale consideration FMV of capital asset on date of transfer FMV of capital asset or stock in trade or both on date of receipt by partner

Value of money (B) + FMV of capital asset (C) on date of receipt by partner

8.

Not admissible (i.e. if formula is negative, then CG deemed as Nil)

10.

Cost of capital asset in hands of recipient partner FMV based on general principles FMV based on general principles

FMV based on general principles, also supported by CBDT guidelines

11.

Definition of ‘reconstitution’, ‘specified entity’ and ‘specified person’ Not applicable – Refer to judicial conflict on whether ‘retirement’ falls within scope of Section 45(4) Includes retirement, admission or change in profit sharing ratio

As per Section 9B

12.

CBDT’s power to issue guidelines to remove difficulties Not applicable Exists – Binding on both tax authority and taxpayers on placing before both Houses of Parliament

Exists – Provided in Section 9B

1.4 Case Studies

Case Study 1(a)

There are 2 partners “A” and “B” in a firm “ZX”, having 1/2 share Each Partner has a capital balance of ₹100 in a firm. There are 2 lands in the firm-

Case Study 1(b)

After 5 years; 2 new partners are admitted “C” & “D” who bring in the capital of ₹ 1,100 each

Neither 45(4) (CA or Cash) nor 9B (CA or SIT) is applicable on this reconstitution under both old and new law as no transfer from a specified entity of the above said items to a specified person has taken place.

Case Study 1(c)

A & B withdrew cash of ₹1,100 each leading to a Debit balance of their capital accounts-

Liabilities Book Value (₹) Asset Book Value (₹) Fair Market Value (₹)
C’s Capital

Now, the cash withdrew by “A” & “B” will become taxable u/s 45(4) as there is:

Case Study 2(a)

Liabilities Book Value (₹) Asset Book Value (₹) Fair Market Value (₹)
A’s Capital 100 Land A 100 800
B’s Capital 100 Land B 100 1,400
Loan from C 1,100 Cash 2,200
Loan from D 1,100
Total 2,200 Total 2,200

Case Study 2(b)

“A” and “B” withdraw the cash received as a loan leading to debit balances of their capital accounts

Liabilities Book Value (₹) Asset Book Value (₹) Fair Market Value (₹)
Loan from C 1,100 Land A 100 800
Loan from D 1,100 Land B 100 1,400
A’s Capital 1,000
B’s Capital 1,000
Total 2,200 Total 2,200

Case Study 2(c)

Liabilities Book Value (₹) Asset Book Value (₹) Fair Market Value (₹)
C’s Capital

Now the cash withdrew by “A” & “B” will become taxable u/s 45(4) as there is:

Section 48 Mode of Computation In case of value of any money or CA received by a SP from a SE referred to in sub-section (4) of section 45, the amount chargeable to income-tax as income of such SE under that sub-section which is attributable to the CA being transferred by the SE, calculated in the prescribed manner.

Rule 8AA Method of determination of period of holding of CAs in certain cases

    1. STCA at the time of taxation u/s 45(4)
    2. CA part of a block of assets
    3. Self-generated assets and self-generated goodwill

    Rule 8AB Attribution of income taxable u/s 45(4) to the CAs remaining with the SE, u/s 48

    Increase in value of such CA due to revaluation

    ——————————–Aggregate of increase in value of all CAs due to reval. Or recognition of self generated GW/assets due to valuation

    Relates to valuation of Self generated GW/Assets of the firm Capital gain charged u/s 45(4) x

    Recognition of value of such Self generated GW/Asset due to revaluation

    ———————————Aggregate of increase in value of all CAs due to reval. Or recognition of self generated GW/assets due to valuation

    Form 5C to be filed by Firm for attribution – before 139(1)

    Case Study 3(a)

    There are three partners “A”, “B” and “C” in a firm “FR”, having 1/3rd share each. Each Partner has a capital balance of ₹10 Lacs in a firm. There are three land in the firm-

    Partner Capital Contribution Capital Asset (CA) (Land) Book Value (₹) FMV (₹) Index Cost of Acquisition (ICOA)
    A 10 Lacs Land S 10 Lacs 70 Lacs –
    B 10 Lacs Land T 10 Lacs 70 Lacs –
    C 10 Lacs Land U 10 Lacs 50 Lacs 15 Lacs
    Total 30 Lacs 30 Lacs

    Land “S”, “T” and “U” was purchased 2 years back.

    Facts

    Full value of consideration Index Cost of Acquisition (ICOA)
    100 Lacs 25 Lacs

    Question:

    [Where both Section 9B and 45(4) are applicable, first treatment of 9B is given and then 45(4)]

    Tax Treatment in the hands of “FR” u/s 9B and 45(4)

    Amount Taxable u/s 9B:

    Particulars Amount (₹)
    Sale Consideration (FMV of Land “U”) 50 Lacs
    Less- Index COA (assumed) 15 Lacs
    LTCG 35 Lacs
    Tax on LTCG (assumed) 7 Lacs

    Amount Taxable u/s 45(4) :

    Particulars Amount (₹)
    FMV of Land “U” (a) 50 Lacs
    less- Book Value (b) 10 Lacs
    less-Tax on LTCG (assume) (c) 7 Lacs
    Net Profit After Tax in the Books (d)= (a)-(b)-(c) 33 Lacs
    Particulars Amount (₹)
    Balance given 10 Lacs
    Add- Share in Net Book Profit After Tax (33 Lacs * 1/3) 11 Lacs
    Capital Balance on the date of retirement 21 Lacs
    Land Book Value FMV Revaluation Gain Attribution Proportion
    S 10 Lacs 70 Lacs 60 Lacs 50%
    T 10 Lacs 70 Lacs 60 Lacs 50%

    Out of ₹40 Lacs, ₹20 Lacs shall be attributed to Land “S” and ₹20 Lacs to Land “T” shall be charged as LTCG as both land “S” and “T” are Long Term Capital Asset at the time of taxation.

    Amount Taxable as per Section 48(iii):

    For the purpose of this section, while calculating LTCG on subsequent sale of Land “S” after reconstitution Capital Gain attributed towards Land “S” u/s 45(4) will be deducted.

    Particulars Amount (₹)
    Sale Consideration (FMV of Land “S”) 100 Lacs
    less- Index COA (assumed) 25 Lacs
    Less- Attribution of Capital Gain towards Land “S” u/s 45(4) 20 Lacs
    LTCG 55 Lacs

    Taxmann.com | Research | Income Tax

    2. Conversion of Company into LLP

    2.1 Key Comparatives – Company vs LLP

    2.2 Why Convert to LLP? [Benefits]

    1. Facilitates tax efficient cash extraction
    2. Deemed dividend provisions not applicable
    1. Ideal for small to medium scale businesses.
    2. Gives utmost flexibility and freedom to partners to manage business affairs as per LLP deed.
    1. Easy to set up, reorganize and wind up.
    2. Far-lesser compliances to be undertaken as compared to the company.

    2.3 Section 47(xiiib) – Conditions for Tax Neutral Conversion of Company into LLP

    Conversion of a partnership firm into company shall be tax exempt for the firm provided following conditions are satisfied:

    2.4 Other Key Tax Implications

    Conversion akin to Transfer?

    For Company:

    For LLP:

    For Partners of LLP:

    Section 72A

    Section 47A:

    Section 43CA – Immovable Property as Stock In Trade:

    “…(1)Where the consideration received or accruing as a result of the transfer by an assessee of an asset (other than a capital asset), being land or building or both, is less than the value adopted or assessed or assessable by any authority of a State Government for the purpose of payment of stamp duty in respect of such transfer, the value so adopted or assessed or assessable……”

    General Anti Avoidance Rules [Chapter – XA]
    [Threshold – 3 Cr. Tax Benefit]

    Section 96: Impermissible Avoidance Arrangement

    1. creates rights, or obligations, which are not ordinarily created between persons dealing at arm’s length;
    2. results, directly or indirectly, in the misuse, or abuse, of the provisions of this Act;
    3. lacks commercial substance or is deemed to lack commercial substance u/s 97, in whole or in part; or
    4. is entered into, or carried out, by means, or in a manner, which are not ordinarily employed for bona fide purposes.

    2.5 Key Considerations

    S.No. Question Answer
    1 What constitutes turnover/sales/gross receipts for the purpose of section 47(xiiib)? As per CBDT Circular 1/ 2011, the sales/gross receipts/turnover of the business which is taxable under the head ‘Profits and gains of business or profession’ shall be considered.
    2 Whether MAT credit of company can be utilized by the LLP post conversion? LLP cannot utilize accumulated MAT credit of company post conversion (Section 115JAA of IT Act)
    3 Whether it is necessary to remove charge on the assets of the company prior to conversion into LLP? Yes, as per Third Schedule to LLP Act, 2008 a company may apply for conversion provided no security interest in its asset is subsisting or in force at the time of application
    4 Whether LLP has to re-negotiate existing contracts with customers and vendors? No, as per Third Schedule to LLP Act, 2008 the reference to the company shall be substituted with reference to the LLP as if such LLP was a party to the agreement.

    3. Conversion of Firm into Company

    3.1 Section 47(xiii) – Conditions for tax neutral conversion of Partnership Firm (‘PF’) into Company

    Conversion of a partnership firm into company shall be tax exempt for the firm provided following conditions are satisfied:

    3.2 Why Convert to Company? [Benefits]

    1. Ease of fund raising from multiple investors
    2. Issue of hybrid instrument possible
    3. Attract Foreign Direct Investment (FDI)
    4. If promoters are wish to unlock value by eventually listing its shares on stock exchanges
    5. Take advantage of benefits available under IT Act like Lower corporate tax rates, etc

    3.3 Other Key Tax Implications

    For Company

    For Partners

    Section 72A

    Section 47A

    Further, such amount shall be deemed to be the profits and gains chargeable to tax in the hands of company for the previous year in which the conditions prescribed under section 47(xiii) of IT Act are violated.

    4. Capital Contribution by Partner to Firm/LLP

    4.1 Section 45(3)

    “…The profits or gains arising from the Transfer of a Capital Asset by a person to a firm or other association of persons or body of individuals (not being a company or a co-operative society) in which he is or becomes a partner or member, by way of capital contribution or otherwise, shall be chargeable to tax as his income of the previous year in which such transfer takes place and, for the purposes of section 48, the Amount Recorded in the Books of Account of the firm, association or body as the value of the capital asset shall be Deemed to be the Full Value of the Consideration received or accruing as a result of the transfer of the capital asset.

    4.2 Section 45(3) v/s Section 50C Conflict of Deeming Fiction

    View 1: Section 50C to Override Section 45(3).

    View 2: Section 45(3) to override Section 50C.

    4.3 Section 56 (2)(x)

    (ii) such specified property is received without consideration or for a consideration less than the specified value.

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