Conversion of firm into company held taxable since revaluation profit recorded as loanConversion of firm into company held taxable since revaluation profit recorded as loan

 

In a recent decision in the case of KTC Automobiles Private Limited (“KTC” or “the taxpayer”), the Cochin Income Tax Appellate Tribunal (“ITAT” or “the Tribunal”), has denied capital gain exemption upon conversion of partnership firm into private limited company under section 47(xiii) of the Income‑tax Act, 1961 (“the Act”). The taxpayer-firm had converted into a company and treated the balance in the partners’ current account as loans in the books of the company in this case and hence, the Tribunal ruled that the exemption conditions listed down under section 47(xiii) of the Act for non-taxability of the capital gains were violated.

 

We have summarized the key aspects of the decision in relation to the above issue. 

 

Facts of the case

 

·          The taxpayer was a partnership firm and had an automobile dealership. The firm owned a land parcel having a book value of Rs 18.1 million which was revalued to Rs 77.2 million and the revaluation profits were credited to the partners’ current accounts as per their profit sharing ratio.

 

·                The firm was converted into a private limited company during the Assessment Year (“AY”) 2005- 06.  The credit balance in the partners’ current accounts after revaluation was treated as loan in the hands of the company and not as share capital.

 

·          The taxpayer contended that it had complied with the provisions of section 47(xiii) of the Act and hence, there was no liability for capital gain tax on transfer of asset to the company on its conversion from the partnership firm.  However, during the course of assessment, the Revenue Authorities (“RA”) held that the profit accrued on revaluation of the assets was indirectly transferred to the partners and hence, the taxpayer had not fulfilled the conditions laid down in section 47(xiii) of the Act.  Basis this, the AO treated the conversion as ‘transfer’ under section 45 of the Act and taxed the revaluation profit as capital gains in the hands of the taxpayer.

 

·          The action of the RA was upheld by the first appellate authority who relied on the Supreme Courts’ landmark ruling in the case of McDowell & Co vs CTO [154 ITR 148] and noted that the partnership firm was converted into a company only with an intention to avoid tax on capital gain.

 

 

Taxpayer’s contentions before the Tribunal

 

·          The taxpayer contended that the conversion of partnership firm into a private limited company was on account of the larger business objectives and there was no motive to avoid any tax liability.  The taxpayer further contended that it had followed a legal procedure prescribed under Companies Act, 1956 under Chapter IX and there was no conversion of the assets of the firm into loans.  Therefore, there was no transfer of property when the partnership firm was converted into a private limited company and as such there was no question of any capital gain.  In this regard, the taxpayer placed its reliance on the decision of the Ahmedabad ITAT in ITO vs Alta InterChem Industries [20 ITR (Trib) 103].

 

RA’s contentions before the Tribunal

 

·                By recording the credit balance in the partners’ current account as loan in the books of the company, a liability has been created by the company towards the partners’ of the firm.  Moreover, the shareholders who were erstwhile partners are now given a right to withdraw the profit on revaluation or receive interest as the same is recorded as a loan in the books of the company.

 

·                The above treatment of current account balances as loans in the company’s books on succession resulted in consideration other than by way of shares.  Further, this also violated the condition which requires that all assets and liabilities of the firm become assets and liabilities of the company on succession.

 

·                The RA contended that all conditions under section 47(xiii) of the Act for exempting the transfer of assets on succession of the firm into a company had not been fulfilled and hence the conversion would be regarded as transfer and chargeable to tax under the head ‘Capital Gains’.

 

Decision of the Tribunal

 

The Tribunal ruled against the taxpayer mainly on the basis that the conditions as laid down in the section 47(xiii) of the Act were not fulfilled.  The said section lays down the following conditions for exempting the transfer of capital assets to a company on succession from capital gains tax:

 

a)             All the assets and liabilities of the firm relating to the business immediately before succession became the assets and liabilities of the company;

 

b)         All the partners of the firm immediately before the succession become the shareholders of the company in the same proportion; and

 

c)         The partners of the firm did not receive any consideration or benefit directly or indirectly in any form or manner other than by way of shareholders of the company

 

d)            The aggregate shareholding in the company of the partners of the firm is not less than 50 percent of the total voting power in the company and their shareholding continues to remain as such for a period of 5 years from the date of succession.

 

The Tribunal observed that all the assets and liabilities of the firm did not become the assets and liabilities of the company in the given case since the land was shown as asset of the company, while its revaluation amount was shown as loan in the balance-sheet of the company.  Further, the Tribunal held that by converting the partnership firm into a private limited company, the taxpayer made an attempt to create a liability in the hands of the private limited company.  As a consequence, the first condition under section 47(xiii) of the Act for exemption of the capital gain is not complied with. 

 

The Tribunal further observed that, apart from allotment of shares, the erstwhile partners were also given the right to receive the other benefit in the form of interest on the amount which was treated as loan.  In this regard, the Tribunal noted that this condition as per clause (c) of section 47(xiii) of the Act was also being violated by the taxpayer.

 

The Tribunal concluded that that the revaluation and conversion was only an accounting technique which was adopted by the taxpayer for the indirect transfer of property with an objective to evade tax and the consequential capital gain.