1.

Tax implication for converting firm to LLP:

Sections involved- section 55 of LLP Act, Section 45 of IT Act.

Section 55 provides that a partnership firm may convert into LLP as per the Second
Schedule of the Act

Section 45 of Income Tax Act, 1961 provides that any profits or gains arising from the
transfer of a capital asset effected in the previous year will be chargeable to income-
tax under the head 'Capital Gains'. Such capital gains will be deemed to be the income of the
previous year in which the transfer took place.

CIT v. Texspin Engg. & Mfg. Works, [2003] 263 ITR 345 (Bom.)-MANU/MH/0197/2003 -
where it was held that conversion of a partnership firm into private limited company would
not amount to ‘transfer’ and further that such a conversion also did not involve
‘consideration’ for the purpose of taxation under Section 45 of the IT Act.

2. Tax implication on dissolution of partnership firm

A doubt has arisen about the entity in whose hands the deemed capital gain could be taxable,
i.e., whether the gain would be taxed in the hands of the firm or in the hands of the group of
partners as the firm has been dissolved and ceases to continue.

Relevant Provision - Sec. 45(4) of the Income-tax Act provides for taxation of the deemed
capital gains arising on distribution of capital assets in the course of dissolution. The essential
requirement for attracting this provision is that there is a dissolution, and that in the course of
such dissolution, capital assets are distributed.

Madras High Court in the case of CIT v. Vijaya Metal Industries, 256 ITR 540, provides a
major breakthrough. In that case, the assessee partnership consisted of two partners, which
was dissolved on death of one of the partners. The business of the partnership firm was
continued by the surviving partner with the assets of the partnership firm. The Income-tax
Department applied the provisions of Sec. 45(4) and brought to tax the deemed capital gain
by holding that the transfer took place on dissolution of the firm. The Tribunal held that
though the dissolution of firm took place by operation of law, it was not followed by transfer
of capital assets by way of distribution of such assets. The Madras High Court confirmed the
decision of the Tribunal.
Observation-
one thing is certain that the dissolution by itself will not result in distribution of assets of the
firm. The distribution will take place only on taking of a positive action by the parties
concerned for distributing the assets. Till such time, the assets may be treated as jointly held
by the parties. This by itself is a big relief for the assessees who are caught unaware. It is also
certain that it is possible to defer the year of taxation to the year in which the distribution
takes place. This will enable an assessee to comprehend the impact of Sec. 45(4) and plan for
the same. In view of the above, a new possibility has emerged where under the surviving
partner can successfully join hands with the legal heirs of the deceased partner, in partnership
and continue the business with the assets of the erstwhile firm. In such a case, the above-
referred decision will help in contending that the assets of the erstwhile firm are not
distributed amongst the parties entitled to it and till such time no liability to tax by virtue
of Sec. 45(4) will arise.

3. Gifts of Partnership Interests

So when a partner relinquishes his rights so as to bring in his legal heir as a partner, that
would result in reconstitution of partnership. This attracts the provision of Section 45 (any
profits or gains arising from the transfer of a capital asset effected in the previous year will be
chargeable to income-tax under the head 'Capital Gains').Thus if a partner gifts/transfers his
rights to his legal heir, the legal heir should pay tax under the scope of section 45.