Kolkata Tribunal denies capital gains exemption on conversion of a private limited company into an LLP for violation of exemption condition

This Tax Alert summarizes a recent ruling of the Kolkata Tribunal (Tribunal) in the case of Aravali Polymers LLP (Taxpayer) on the issue of taxability of gains upon conversion of a private limited company (company) into a Limited Liability Partnership (LLP) which is exempt from capital gains under the provisions of the Indian Tax Laws (ITL) subject to compliance of certain conditions.

The Taxpayer, an LLP, was formed on conversion of the company into LLP under Limited Liability Partnership Act, 2008 (LLP Act). Post conversion but in the same year, the Taxpayer gave its partners interest-free loan in the profit sharing ratio partially out of the accumulated profits standing in the accounts of the company on the date of conversion. The Tribunal held that grant of such loan resulted in breach of one of the exemption conditions viz. the condition which requires that no amount is paid, either directly or indirectly, to any partner out of accumulated profit standing in the company’s accounts on the date of conversion for a period of three years from the date of conversion. The Tribunal held that since the violation of condition occurred in the same tax year as that of conversion, the Taxpayer never qualified to secure the exemption. Consequently, the general provision relating to taxation of capital gains was applicable and not the special provision which provides for forfeiture of exemption and taxation of capital gains in the hands of successor LLP in the year of violation.

The Tribunal further held that the capital gains on conversion cannot be computed on the basis of market value of assets transferred but should be computed on the basis of actual value at which assets are acquired by successor LLP.

The present Tribunal ruling deals with certain important issues arising on conversion of company into LLP. The Tribunal appears to have proceeded on the basis that the event of conversion necessarily triggers capital gains taxation upon conversion of company into LLP and the non-chargeability of capital gains was not tested on general principles. The Tribunal’s conclusion that the capital gains, if at all, should be computed on the basis of actual transfer value and not on the basis of market value as on date of conversion will be welcomed by the taxpayers. It should be noted that the Tribunal was not concerned with tax implications in the hands of the erstwhile shareholders of predecessor-company who become partners in successor-LLP which may need independent evaluation.