LAW MANTRA

THINK BEYOND OTHERS

(National Monthly Journal, I.S.S.N 23216417)

"COMPUTATION OF TAX ON LLPS AND CRITICAL APPRAISAL." 1 INTRODUCTION The Limited Liability Partnership (LLP) is viewed as an alternative corporate business vehicle that provides an alternative to the traditional partnership, with unlimited personal liability on the one hand, and, the statute-based governance structure of the limited liability company on the other.2 LLP is a body corporate formed and incorporated under the Limited Liability Partnership Act, 2008 and is a legal entity separate from that of its partners.3 It has perpetual succession.4 Also any change in the partners of a LLP does not affect the existence of rights or liabilities of the LLP.5 Further, at its outset the LLP Act has also provided that Partners are the agents of LLP for the purpose of its business but are not of one another. 6 Also any obligation of the LLP, arising in contract or otherwise, is solely the obligation of the LLP.7 A partner is not personally liable, directly or indirectly for any obligation solely by reason of being a partner of the LLP.8 However, the liability of the LLP and the partners who acted with intent to defraud creditors or for any fraudulent purpose is be unlimited.9 MCAs Press Note, dated 10-7-2009 explains the concept of LLP and its Legislative framework as under: LLP is a new corporate form that enables professional expertise and entrepreneurial initiative to combine, organise and operate in an innovative and efficient manner. In India, this need has long been recognised for businesses which may require a framework that provides flexibility suited to requirements of service, knowledge and technology based enterprises. Services sector is playing a major role in the national economy and
1 2

Shruti Sethi, III year, BA.LLB. (Hons.), Hidayatullah National Law University, Raipur Ministry of Corporate Affairs, Government of India, The New Corporate Form- LLP, available at http://www.mca.gov.in/Ministry/pdf/LLP.pdf (Last visited on August 21, 2013). 3 LLP Act, 2008, 3(1). 4 LLP Act, 2008, 3(2). 5 LLP Act, 2008, 3(3). 6 LLP Act, 2008, 26. 7 LLP Act, 2008, 27(3). 8 LLP Act, 2008, 28(1). 9 LLP Act, 2008, 30.

there is growing diversity in the range of services being offered. The services sector also finds this form very useful.10 The concept of LLP is a direct outgrowth of the collapse of real estate and energy prices in the late 1980s and the concomitant disaster that befell Texass banks and savings and loan associations.11 The United States, which was the epicentre of that financial crunch, as it has been for most other, including the sub-prime credit crunch, spearheaded the process of legislating the concept of LLPs.12 Then came on the statute book, the first law on LLP with Texas enacting the Texas House Bill 278 on 26 August 1991.13 With the promulgation of the Revised Uniform Partnership Act (RUPA) in the US in 1994, a number of states permitted the formation of LLPs, which was followed by the incorporation of comprehensive provisions dealing with LLPs in the RUPA in 1997.14 By the end of 2001, the concept of LLPs had spread to all 50 jurisdictions of the US. 15 In UK as in the US, this form of partnership was introduced because of liability concerns of large professional firms. 16 This was achieved by a campaign in the 1990s calling for proportional liability in partnership firms.17 All the efforts of these major accounting firms finally led to the enactment of the Limited Liability Partnership Act, 2000.18 The UK LLP Act is based on three broad principles- limited liability, corporate personality and partnership flexibility.19 However the British LLP is very different from LLPs found in the US because the rules that apply to LLPs in Britain are adaptation of the rules that apply to Limited
10

Taxation of Limited Liability Partnerships {press note, dated 10-7-2009) available at http://taxguru.in/partnership-act/press-note-on-taxation-of-limited-liability-partnerships.html (Last visited on August 21, 2013). 11 Hamilton, Robert W., Registered Limited Liability Partnership: Present at the Birth (Nearly), 66 University of Colorado Law Review 1065, 1069. 12 Sachdeva, Sachin and Sachdeva, Amit M., The Indian LLP Law: Some Concerns for Lawyers and CAS (May 25, 2009). SEBI & Corporate Law, Vol. 92, No. 6, 2009. Available at SSRN: http://ssrn.com/abstract=1423766.(last visited on August 26, 2013). 13 Weidner, Pitfalls in Partnership Law Reform: Some United States Experience, 26 Journal of Corporation Law 1031. 14 Amendment to Uniform Partnership Act, 1996 leading to the Uniform Partnership Act, 1997. 15 Nivedita Sen & Neha Mathen, Decoding The New Business Vehicle Of India: The Limited Liability Partnership, 4 NUJS L. Rev. 669 (2011), 673. 16 The Law Commission describes the rationale for the Limited Liability Partnership Act 2000 as follows: The Act is a response to pressures from large professional firms, which are concerned about the unlimited liability of partners for very large legal claims, particularly for professional negligence. In large partnerships one partner may have no opportunity to assist another partner to avoid such claims. Partners may not know each other and one partner may have no knowledge of the other partners specialism. The result which is proposed is an entity giving limited liability to the partners other than the negligent partner. 17 Ashish Ahuja, Limited Liability Partnership Act, 2008Some Issues, available at http://www.bcasonline.org/webadmin/res_material/resfiles/LM%20Ashish%20Ahuja%204Feb09.pdf (Last visited on Aughust 26, 2013). 18 Limited Liability Partnership Act 2000, available at http://www.legislation.gov.uk/ukpga/2000/12/contents. (Last visited on August 21st, 2013). 19 Nivedita Sen & Neha Mathen, Decoding The New Business Vehicle Of India: The Limited Liability Partnership, 4 NUJS L. Rev. 669 (2011), 672.

Companies, rather than that of general partnership rules.20 In Singapore, LLPs are governed by the LLP Act 200521. This legislation draws on both the US and UK models. II. LIMITED LIABILITY CONCEPT IN INDIA: During the process of the revision of the Indian Partnership Act, 1932 in 1957, a suggestion was made by the merchants of the iron, steel and hardware industries to include a provision for limited liability in partnerships.22 This was for the simple reason that the Companies Act had too many restrictions and was proving to be very cumbersome, especially for small businesses.23 This suggestion was rejected by the 7th Law Commission.24 It was the Naresh Chandra Committee Report in 2003 that highlighted the grave need to introduce LLPs in the service industry, which finally succeeded in launching the concept of LLPs in India. 25 This was soon followed by the recommendations of the J. J. Irani Expert Committee on Company Law in 2005 to enact a separate legislation for LLPs in India, and also to extend the scope of LLPs to the small enterprises.26 Pursuant to the recommendations of the J.J. Irani Committee and the Naresh Chandra Committee-II and the feedback received on the Ministry of Company Affairs Concept Paper on LLP, a draft LLP Bill was prepared. The news about the drafting of the LLP Bill first became official around the mid of September 2006. The bill was introduced in the Rajya Sabha on December 15, 2006.27 Subsequently, the Bill was referred to the Department Related Parliamentary Standing Committee on Finance. The Committee submitted its Report to both the Houses of Parliament on November 27, 2007, recommending some changes in the draft LLP Bill, 2006.28 The Standing Committee (Finance and Corporate Affairs) then submitted the final version of the Limited Liability Partnership Bill to the Ministry for Corporate Affairs.29

20

Bradley & Caroline, Twenty-First Century Anglo-American Partnership Law, 30 Comm. L. World Rev. 330(2001), 338. 21 Limited Liability Partnership Act 2005, available at http://statutes.agc.gov.sg/aol/search/display/view.w3p;page=0;query=DocId%3A6f2b2128-60fe-43b1-89d729c6748e6bb4%20%20Status%3Ainforce%20Depth%3A0;rec=0 (Last visited on August 21, 2013). 22 Law Commission of India, Seventh Report on Partnership Act, 1932, 1957, 8 available at http://lawcommissionofindia.nic.in/1-50/Report7.pdf (Last visited on August 21, 2013). 23 Id 24 Id 25 Naresh Chandra Committee-II, Report of the Committee on Regulation of Private Companies and Partnership, 3.11, Recommendation 3.1 available at http://www.llponline.in/naresh_chander_committee.php (Last visited on August 21, 2013). 26 See Recommendations of the J.J.Irani Committee available at http://www.llponline.in/jj_irani_committee.php (Last visited on August 26, 2013). 27 Available at http://www.mca.gov.in/LLP/faq_introduction.html. (Last visited on August 24, 2013). 28 See Panel proposes key changes in limited liability partnership bill available at http://articles.economictimes.indiatimes.com/2007-12-06/news/27680499_1_llp-bill-limited-liability-partnershipllp-act 6 December 2007, Last visited on August 22, 2013. 29 Available at http://www.mca.gov.in/LLP/faq_introduction.html. (Last visited on August 24, 2013).

The Cabinet on 1 May 2008 approved the introduction of a Limited Liability Partnership (LLP) Bill, 2008 in Parliament by replacing the Limited Partnership Bill, 2006.30 On 21 October 2008, the Bill was introduced in the Rajya Sabha. This Bill was introduced first in the Rajya Sabha since the Union Minister of Corporate Affairs, Shri Prem Chand Gupta, is a member of the Rajya Sabha.31 After being passed in the Rajya Sabha on 24 October 2008, the Bill was tabled in the Lok Sabha, which also passed the Bill without any changes. The Bill received the assent of the President of India on 7th January, 2009. The Limited Liability Partnership Act, 2008 was thereafter notified in the Official Gazette of India dated 9th January 2009.32 III. TAXATION OF LLPS The method of taxation of companies or for that matter partnership firms has not been explained through the provisions of Indian Companies Act, 1956 or the Indian Partnership Act, 1932 but by the Income Tax Act. Therefore it is clear why the Indian LLP Act, 2008 is silent on the taxation system applicable on the LLPs. The Finance Act, 2010, which has come into effect from the assessment year 2010-2011, incorporates the mechanism for taxation of LLPs by amending the Income Tax Act, 1961. Subsequently the Ministry of Corporate Affairs has releases press notes on the taxation of LLP. The Explanatory Memorandum to the Finance (No. 2) Bill, 2009 clarifies the taxation of LLPs as follows: The Income tax Act has been amended to incorporate the taxation scheme of LLPs in the Income Tax Act on the same lines as the taxation scheme currently prevalent for general partnerships, i.e. taxation in the hands of the entity and exemption from tax in the hands of its partners. A limited liability partnership and a general partnership will be accorded the same tax treatment.33 There are two popular options for taxation used in various foreign jurisdictions that provide for LLPs. The first is the practice, as is seen in the French LLP model, of treating an LLP as a fiscally transparent entity and taxing merely the income of the partners and not of the

30

See Revised LLP Bill enters Rajya Sabha available at http://articles.economictimes.indiatimes.com/2008-1022/news/28439984_1_llp-format-limited-liability-partnership-chartered-accountants October 22, 2008 Last visited on 22 August, 2013. 31 See Revised LLP Bill enters Rajya Sabha available at http://articles.economictimes.indiatimes.com/2008-1022/news/28439984_1_llp-format-limited-liability-partnership-chartered-accountants 22 October, 2008 Last visited on 22 August, 2013. 32 See Govt introduces Limited Liability Partnership available at http://articles.economictimes.indiatimes.com/2009-04-01/news/28408183_1_limited-liability-partnership-llpshybrid-of-partnership-firms Last visited on 22 August, 2013. 33 Explanatory Circular for Finance (No.2) Act, 2009 Pg. 13 of 63 available at http://www.aadisol.in/aca/images/related_news/rn_747.pdf (Last visited on August 21, 2013).

transparent entity.34 The alternative to this, based on the UK and Singapore LLP models, is to accord similar treatment to an LLP as a partnership. India has adopted the latter practice. Under the amended 140 of the Income Tax Act, 1961, the designated partner has to sign the return of the income and due to some unavoidable reasons maybe signed by any other partner. Keeping this in mind the Finance (No. 2) Act, 200935 amended 2(23) of the Income Tax Act, 196136 by inserting (i) "firm" shall include a limited liability partnership as defined in the Limited Liability Partnership Act, 2008; (ii) "partner" shall include a partner of a limited liability partnership as defined in the Limited Liability Partnership Act, 2008; (iii) "partnership" shall include a limited liability partnership as defined in the Limited Liability Partnership Act, 2008. Thus it was declared that LLPs formed and registered under the LLP Act, 2008 in India shall be taxed as firms and those incorporated outside shall be taxed as companies.37 An LLP will be considered an equivalent of a general partnership for taxation purposes and will reap all the tax benefits that are available to a partnership.38 Income tax will be levied on the LLP itself and the profits from the LLP which the partners obtain will not be computed for their personal income as it will be considered as business income which is within the scope of a deduction for computing income.39 In the event of failure to comply with 184 of the LLP Act, the remuneration paid to the partners will not be allowed as deductions on their personal income.40 Further, any contribution of capital assets by a partner to his LLP or distribution of such assets by the LLP to any partner, will be considered to be income of the partner and LLP respectively, and will be subject to income tax. 41 40(b) of the Income Tax Act, which provides for restrictions on payment of interest and remuneration to partners, has been modified now to uniformly apply to professional and non-professional firms. LLPs are beneficiaries of the modification, thus making them an attractive business option for professionals forming an association.42 While an LLP is generally treated as an equivalent of a general partnership for taxation purposes, the Union Budget 2011-12 has announced the levy of Alternate Minimum Taxes
34

Mahajan, Yamini and Sachdeva, Amit M., Indian Limited Liability Partnership Law: Some Concepts and Concerns (February 22, 2010). Available at SSRN: http://ssrn.com/abstract=1557002 or http://dx.doi.org/10.2139/ssrn.1557002 (Last visited on August 26, 2013). 35 Finance (No. 2) Act, 2009, Bill No. 33-F of 2009. 36 Available at http://law.incometaxindia.gov.in/DIT/ . (Last visited on August 24, 2013). 37 Income Tax Act, 1961, 2(17)(ii), as amended by Finance Act, 2010. 38 Income Tax Act, 1961, 184, as amended by Finance Act, 2010. 39 Income Tax Act, 1961, 10(2A) and 28(v). 40 Paras Savla, LLP and Partnership, 35(4) Income Tax Rev. 38, 39 (2009). 41 Income Tax Act, 1961, 45(3) and (4). 42 Id.

(AMT) on LLPs similar to the Minimum Alternate Tax (MAT) imposed on companies. 43 In this regard, the Union budget has proposed to introduce a new Chapter XII-BA under the Income Tax Act, 1961 providing for the levy of AMT at 18.5 percent of the adjusted total income of LLPs.44 Thus the tax base for LLPs would be the adjusted total income and not book profits as in the case of companies. Although the introduction of the AMT on LLPs may be perceived as a disadvantage to the LLP business form, the LLP nevertheless remains an attractive business form due to its inherent flexible structure along with the exemption from dividend distribution tax. The taxation scheme for LLPs may, however, deter prospective foreign investors given that investment in LLPs may lead to double taxation- first, at the level of the LLP in India and second, at the level of profits for the investor in the foreign jurisdiction.45 It may, however, be of convenience to an Indian LLP doing business abroad depending on the legislation prevailing in the foreign jurisdiction, as the LLP may be treated as fiscally non-transparent and taxed as a separate entity. Hence, it will avail the benefits of tax credit. If the partners, and not the LLP, are treated as beneficiaries of income in the foreign state, the tax credit cannot be utilised.46 Even the double taxation avoidance agreements that India has signed with some States have not provided a suitable solution. At this point, it is interesting to note that in the US adopts a truly unique system that, in accordance with the internal structure of the LLP, gives the option of taxation either at the level of the LLP or at the level of the partners.47 This enables an LLP to decide its structure depending on the laws of the countries where the LLP is investing and doing business so as to avail of the tax credit advantage. Had India adopted such a mechanism, the problem of double taxation could have been effectively put to rest. The taxation system for an LLP can be explained according to the following table

Table 1: Taxation of LLP under various heads Tax Percentage Comment

43

Finance Bill 2011, Cl. 18, available at http://indiabudget.nic.in/ub2011-12/fb/bill31.pdf (Last visited on August 26, 2013). 44 Id 45 Sachdeva and Mahajan, supra note 34, 8; Anant Pai, LLP-Its Incidental Tax Considerations, 6 Income Tax Rev. Vol. XXXV 61 (September 2009). 46 See id. (for a detailed discussion on the contingencies which may arise in different jurisdiction). 47 See Uniform Limited Liability Partnership Amendments to the Revised Uniform Partnership Act 1996.

Income Tax

30%

Income 2012-13).48

Tax

Slabs

and

Rates

Assessment Year 2013-14 (Financial Year

Education Cess

3% of Income Tax, If income exceeds 1 crore the rate of tax i.e. 30.9% effectively (Income tax plus education cess is 33.99% otherwise it is 30.9%.

Minimum Alternate Not applicable Tax (MAT) Alternate Minimum 18.5% Tax (AMT)

Not applicable

In

order

to

save

revenue

on

account of companies converting to LLPs to take benefits of tax exemptions and to rationalize taxation of LLPs with

companies, this Union Budget has proposed to introduce a new Chapter XII-BA under the Income Tax Act 1961 which provides for levy of Alternate Minimum Tax @ 18.5% on the adjusted total income of LLPs.49 The effective rate of AMT after taking in account education cess will be 19.05%. Dividend Distribution (DDT) Deemed Dividends under 2(22)(e) Loan by LLP to partner not taxable as deemed dividend in his hands Wealth Tax Not Applicable Not applicable Tax Not Applicable Not applicable

IV. LOOP HOLES IN THE TAXATION STRUCTURE OF LLPS A. TAX EFFECT OF THE CONVERSION OF A PRIVATE COMPANY OR AN UNLISTED PUBLIC COMPANY INTO LLP

48 49

Available at http://incometaxindia.gov.in/download_all.asp. (Last visited on August 21, 2013). Introduced through Finance Bill 2011.

LLP Act, 2008 allows for the conversion of a private company or unlisted public company into an LLP.50 The Finance (No. 2) Act, 2009, however, does not clarify the tax effects of conversion of a private company or an unlisted public company into LLP on matters such as:51 i. Levy of capital gains tax on transfer of assets to LLP on conversion. ii. Availability of carry forward of losses and of unabsorbed depreciation to the LLP. iii. Availability of MAT credit to the successor LLP. iv. Carry forward of benefits under 35DDA to the successor LLP. Lack of clarity on these matters was a roadblock to conversion of a company into a LLP. To remove these hurdles Finance Act, 2010 was introduced. The Honble Finance Minister Pranab Mujkherjee while presenting the Budget 2010-11 clarified the objects to these amendments as "To facilitate the conversion of small companies to LLPs, I propose that this will not be subject to capital gains tax."52 The Finance Act, 2010 has inserted a new clause (xiiib) in 47 and a new sub-section (4) in 47A of the Act with effect from assessment year 2011-12. The said new clause (xiiib) provides that the transfer of capital asset or tangible asset to LLP or any transfer of share or shares held in the company by a shareholder on conversion of a private company or unlisted company into a LLP in accordance with 56 and 57 of the LLP Act, 2008 shall not be regarded as transfer for the purpose of capital gains tax, Subject to the following conditions: (i) All the assets and liabilities of the company immediately before the conversion become the assets and liabilities of the LLP;53 This condition is lop sided as it only provides that all the assets and liabilities of the company immediately before the conversion become the assets and liabilities of the limited liability partnership however there can be a situation where assets are transferred after conversion. The only condition that appears prima-facie seems to be that transfer should not be erstwhile shareholder who becomes partner of the LLP. (ii) All the shareholders of the company immediately before the conversion become the partners of the limited liability partnership and their capital contribution and profit successor

50 51

LLP Act, 2008, 56 & 57. CA Srinivasan Anand G., Taxmanns Taxation of LLPs, I-3(Taxmann Publications Private Ltd. 2010). 52 See Union Budget 2010: Govt exempts LLP firms from paying capital gains tax available at http://articles.economictimes.indiatimes.com/keyword/limited-liability-partnership/recent/2 (Last visited on August 22, 2013). 53 Income Tax Act, 1961, 47(xiiib)(a), as amended by Finance Act, 2010.

sharing ratio in the LLP are in the same proportion as their shareholding in the company on the date of conversion;54 It was held by the honble Supreme Court that the words all the shareholders mean all the registered shareholders. A beneficial owner of shares whose name does not appear in the register of shareholders cannot be said to be a shareholder.55 Here the question that arises is with respect to minor shareholders. It was held by the Punjab High Court in the case of Dewan Singh v. Minerva Films Ltd56 that minors can be members of a company. 57 However the Indian Partnership Act, 1932 expressly bars a minor from becoming a partner of a firm and instead allows a minor to be admitted to the benefits of partnership.58 This has given rise to a controversy whether minor can be a partner or can he be admitted to the benefits of partnership in LLP. It is desirable that the ministry of Corporate Affairs come out with suitable clarifications on this issue so that the wheels of commerce roll on smoothly and general partnership firms do not feel hesitant to convert to LLPs. (iii) 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 limited liability partnership;59 The words consideration or benefits is not in any way qualified by the words for the conversion or in connection with the conversion. The intention seems to be that the shareholders should not receive any consideration or benefit in connection with the conversion other than profit share and capital contribution in LLP.60 CBDT needs to clarify this too. (iv) The aggregate of profit sharing ratio of the shareholders of the company in the LLP shall not be less than fifty percent at any time during the period of five years from the date of conversion;61 If this condition is violated any time before the expiry of 5 years from the date of conversion, the capital gains on transfer of assets in conversion shall be charged to tax in the hands of the
54 55

Income Tax Act, 1961, 47(xiiib) (b), as amended by Finance Act, 2010. Rameshwarlal Sanwarmal v. CIT, Assam, [1980] 122 ITR 1. 56 Dewan Singh v. Minerva Films Ltd (1959) 29 Comp Cases 263 (P&H); See also Master Gautam R. Pandival v. Karnataka theatres Ltd. (C.P. No. 13/111/SRB/97, decision dated 16-2-1999); Diwan Jaffar v. Minerva Films Ltd. (1958) 28 Comp Cas 191 (Punj.). 57 The position with respect to a minor becoming a member of a company would be in terms of the following two circulars issued by the Department of Company Affairs in this regard: i) Government of India Publication, Clarifications and Circulars on Company Law, Circular No. 8/18/(41)/63-PR, dated November 2, 1963:1977 Edition, p. 23; and ii) Government of India Publication, Clarifications and Circulars on Company Law, 1977 Letter No. 8/18(41)/63-PR, dated March 31, 1964, Edition, page 23. 58 Indian Partnership Act, 1932, 30(1). 59 Income Tax Act, 1961, 47(xiiib)(c), as amended by Finance Act, 2010. 60 Supra note 51, I-10. 61 Income Tax Act, 1961, 47(xiiib)(d), as amended by Finance Act, 2010.

successor LLP under 47A(4) in the previous year in which this condition is violated. Also, capital gains not earlier taxed in the hands of erstwhile shareholders (who become partners) on account of exchange of shares in the company for interest in LLP shall be taxable. This raises a question as to what happens if due to death of one of the partners, the share of profits in the LLP of the erstwhile shareholders (who become partners in the LLP) falls below fifty percent before the expiry of five years from the date of conversion. CBDT need to clarify this issue.62 Further, this condition envisages that the holdings of the shareholders of the company in the LLP can be reduced to less than 50 percent of the profits of the LLP to even zero percent after a period of 5 years from the date of conversion. When (ii) and (iv) are read simultaneously it seems as if condition (ii) is also applicable only for 5 years after the conversion. CBDT should clarify this. It should be clearly stated in the LLP agreement that if any erstwhile shareholder who is a partner of LLP quits the LLP as partner anytime within 5 years from the date of conversion, he shall compensate the LLP for loss of tax-benefits- capital gains exemption, loss of carry forward of business loans etc. Further if any registered shareholder expresses inability to guarantee that he will remain a partner of the LLP for atleast five years, it seems better that, before conversion, the company buyback all his shares and transfers the same to some other person who is willing to remain a partner for atleast 5 years.63 (v) The total sale, turnover or gross receipts in business of the company in any of the three previous years preceding the previous year in which the conversion takes place does not exceed sixty lakh rupees and64 This has been done to ensure that tax benefit is available only for conversion of small companies into LLPs. If this condition is not fulfilled then, according to 47A(4), the amount of capital gains arising from the transfer of such capital asset or intangible asset or share or shares not charged under 45 by virtue of the said conditions shall be deemed to be taxable capital gains of the successor LLP or the shareholders of the predecessor company in the previous year in which such non compliance takes place. The terms total sales, turnover and gross receipts are not defined in 47(xiiib) nor in any other provision of the Act. However ICAI has provided guidance note in order to clarify the same.65 Further this condition is capable of peculiar interpretation in case a private company or an unlisted public company converts itself into LLP before it completes three previous years from the date of incorporation. The question that arises is whether this conversion will deny
62 63

Supra note 51, I-10. Supra note 51, I-9. 64 Income Tax Act, 1961, 47(xiiib)(e), as amended by Finance Act, 2010. 65 ICAIs guidance note on tax audit (revised 2005 edition).

them of tax benefits such as capital gains tax exemption, carry forward of unabsorbed loss/depreciation? CBDT must issue suitable clarifications to avoid unnecessary litigation. (vi) No amount is paid either directly or indirectly, to any partner out of balance of accumulated profit standing in the accounts of the company on the date of conversion for a period of three years from the date of conversion.66 This requirement creates a controversy in case accumulated profits are exhausted by way of issue of bonus shares before conversion. Further this requirement seems to serve no purpose. It is not clear what help will retention of identity of these accumulated profits will do. Further it might create unnecessary disputes with new partners who might be admitted by the LLP as to whether they also have a claim on these reserves of the erstwhile company. The issue of bonus shares before conversion would avoid cash outflow which dividend distribution entails. 67 Further it is interesting to note that if the above conditions are not fulfilled then the conversion shall not be treated as a transfer and shall attract capital gains. However a contrary view has been established which states that as 2(47) of the Act gives an inclusive definition of transfer. The conversion of a private/unlisted company as per the LLP Act, 2008 is not listed anywhere in the definition as amounting to transfer. Therefore the normal meaning of transfer needs to be examined to see whether such conversion amounts to transfer. It was held in Asstt. CIT v. Unity Care and Health Services68 that From the ....Scheme of Part IX of the companies Act, 1956, it is clear that the partners who were either to register as firm can register themselves under the Companies Act. On such registration what was earlier called a firm is now called a company. However both entities do not exist simultaneously. When firm comes to an end, the company takes birth. It is possible to take a view that conversion of company into LLP under the LLP Act, 2008 is similar to the conversion of a firm into a company under part IX of the Companies Act, 1956. Since the predecessor company and the successor LLP do not exist simultaneously, there is no transfer in the normal sense of the word. Thus it can be argued that since conversion of a company into firm under the LLP Act, 2008 does not involve transfer under 2(47), the question of invoking the exemption provision under 47(xiiib) does not arise and capital gains tax will be exempt even if the six conditions in 47(xiiib) are not complied with. Thus this controversy will persist unless the government includes expressly the conversion of company into LLP in the inclusive definition of transfer in 2(47).
66 67

Income Tax Act, 1961, 47(xiiib)(f), as amended by Finance Act, 2010. Supra note 51, I-11. 68 Asstt. CIT v. Unity Care and Health Services, [2006] 103 ITD 53 (Bang.).

B. TAX EFFECT OF THE CONVERSION OF A PARTNERSHIP FIRM INTO LLP One controversial issue in relation to conversion of a firm to a LLP is set off/ carry forward of losses. The Indian Partnership Act, 1932 states that when there is change in constitution of firm, nothing in this chapter shall entitle the firm to have set off/ carry forward....in respect of the previous year.69 However it is possible to take a view that firm in 78(1) refers only to general partnership firm and hence will not include LLP. Such a view is possible as all the definitions in 2 of the Act including that of firm are qualified by the phrase unless the context otherwise requires. However this contention was rejected by the Income Tax tribunal in the case of CIT v. Sant Lal Arvind Kumar70, where it was held that now 2(23) incorporates references to LLP and the LLP Act, 2008. Therefore drawing an analogy from the above ruling it is possible to take a view that, in the context of taxation of the LLP, the concepts of the LLP will have full application unless there is something in any particular provision which compels a contrary view. Hence there will be no set off/carry forward of losses to a LLP. However a clarification through Finance Act is required to make the matter crystal clear. Further 78(2) states that Where any person carrying on any business or profession has been succeeded in such capacity by another person otherwise than by inheritance, nothing in this chapter shall entitle any person other than the person incurring the loss to have it carried forward and set off against his income. However, according to Amin Machinery (P.) Limited v. Dy. CIT71 it seems that conversion of Firm to LLP in accordance with the Second Schedule to the LLP Act is succession (other than by inheritance) in accordance with 78(2). However it is submitted that the above decision of the tribunal needs reconsideration as it is based on the assumption that conversion involves succession, this has been done without going into the exact meaning of the word. As it was held in CIT v. KH Chambers72 that succession involves change of ownership; i.e. the transferor goes out and the transferee comes in. However such a change of ownership is not a pre requisite of a conversion. V. CONCLUSION Limited Liability Partnership (LLP) is an innovative initiative which came into existence as an alternative corporate business vehicle in order to provide a substitute to the traditional partnership, with unlimited personal liability on the one hand, and, the statute-based governance structure of the limited liability company on the other. It provides for a hybrid in which a partner is not personally liable, directly or indirectly for any obligation of another
69 70

Indian Partnership Act, 1932, 78(1). CIT v. Sant Lal Arvind Kumar, [1982] 136 ITR 379. 71 Amin Machinery (P.) Limited v. Dy. CIT, (2007) 111 TTJ Ahd. 892. 72 CIT v. KH Chambers , [1965]55 ITR 674 (SC).

partner solely by reason of being a partner of the LLP. This concept was first promulgated in the US which later spread to the UK, Singapore and so on. This concept was introduced in India during the process of revision of the Indian Partnership Act, 1932 in 1957 however it was rejected. It was later in 2006 pursuant to the recommendations of the J.J. Irani Committee, the Naresh Chandra Committee-II and the feedback received on the Ministry of Company Affairs Concept Paper on LLP that a draft LLP Bill was prepared. However due to the changing circumstances this bill was replaced by another bill which was approved by the Cabinet on 1 May 2008. The bill was finally notified in the Official Gazette of India on 9th January 2009. The LLP Act, 2008 however is silent on the taxation system applicable on the LLPs. The Finance Act, 2010, which has come into effect from the assessment year 2010-2011, incorporates the mechanism for taxation of LLPs by amending the Income Tax Act, 1961. LLPs are taxed on the same lines as general partnerships, i.e. taxation in the hands of the entity and exemption from tax in the hands of its partners. This is based on the UK and Singapore LLP models. A LLP is subject to Income Tax, education cess and also Alternate Minimum Taxes (AMT), which has recently been announces in the Union Budget 2011-12 through the introduction of a new Chapter XII-BA under the Income Tax Act, 1961. However unlike private/unlisted public companies, LLPs are not subject to MAT (minimum alternate tax), DDT (Dividend distribution tax), and Wealth tax. This makes LLPs an attractive alternative to companies. The taxation scheme for LLPs may, however, deter prospective foreign investors given that investment in LLPs may lead to double taxation- first, at the level of the LLP in India and second, at the level of profits for the investor in the foreign jurisdiction. Due to recent introduction of this statutory structure, payment of taxes by LLPs is complicated. Further there are various drawbacks in the taxation laws on LLPs. Especially the failure of Finance Act in providing for the smooth conversion of private/unlisted public companies or partnership firms to LLP. Also, The Finance (No. 2) Act, 2009 has failed in clarifying various issues which ought to have been clarified keeping in view the fast growing popularity of LLPs. Further there are various controversial provisions in 47(xiiib) of the Income Tax Act, 1961 as amended by Finance Act 2010 which need CBDTs clarification like the ones relating to the levy of capital gains tax on transfer of assets to LLP on conversion, availability of carry forward of losses and of unabsorbed depreciation to the successor LLP, availability of MAT credit to the successor LLP and carry forward of benefits under 35DDA to the successor LLP. By:Shruti Sethi, III year, BA.LLB. (Hons.), Hidayatullah National Law University, Raipur