Tax Insights
from India Tax & Regulatory Services
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Conversion of firm into a company does not amount to distribution of assets – firm not liable to capital gains tax
July 3, 2019
In brief
In a recent ruling,1 the Ahmedabad Bench of the Income-tax Appellate Tribunal (Tribunal), held as follows:
Revaluation of assets could not be treated as transfer within the meaning of section 2(47) of the Income-tax Act, 1961 (the Act).
When converted into a company, the properties of the erstwhile firm vest into the company. Such vesting could not be equated to the distribution of assets as stipulated under section 45(4) of the Act.
No justification found to hold that there was any transfer of asset and thus, the question of liability to pay tax on capital gains by the firm does not and cannot arise at all.
In detail
Facts
The taxpayer was a partnership firm, engaged in the business of
manufacturing
transmission towers and undertaking job work of engineering fabrication and galvanising.
During the said financial year (FY), the taxpayer revalued one of its assets, i.e., land. The difference on account of revaluation was credited to the partners’
1 ITA No. 2316/ Ahd/ 2014
2 Section 45(4) of the Act stipulates that the profits or gains arising from the transfer of a capital asset by way of distribution of capital assets on the dissolution of a firm or otherwise, shall be chargeable to tax as the income of the firm of the year in which the said transfer takes place.
3 Some more issues were discussed in the ruling, which have not been covered in this news alert.
capital accounts in their profit sharing ratio.
During subsequent FY, the firm was converted into a company under Part IX of the Companies Act, 1956.
Upon conversion, the shares of the company were allotted to the partners of the erstwhile firm.
For the said FY, the tax officer (TO) held that the allotment of shares upon conversion into a
company, corresponding to the amount of enhanced
value of land tantamount to distribution of capital assets under section 45(4)2 of the Act, and thus, was chargeable to capital gains tax.
Issue before the Tribunal3 Whether the revaluation of land and subsequent allotment of shares on conversion of the firm into company could be treated as distribution of asset to partners on dissolution of the firm, and thus, is exigible to capital gains tax under section 45(4) of the Act?
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Taxpayer’s contentions
To invoke the provisions of section 45(4) of the Act, it is necessary to satisfy two conditions. First, there should be a transfer by way of distribution of capital asset.
Second, such transfer should be effected on dissolution of the firm or otherwise.
Under Part IX of the
Companies Act, 1956, when a partnership firm is converted into a company, all the assets and liabilities of the erstwhile firm vest with the company.
Such vesting of properties could not be equated with distribution, since
distribution on dissolution presupposes division, realisation, encashment of assets and appropriation of the realised amount as per the priority, such as the payment of taxes to the Government, payment to unsecured creditors, etc.
In the present case, there was no dissolution of the firm or transfer of any asset by distribution. Therefore, it did not attract section 45(4) of the Act.
Revenue’s contentions
Before the Tribunal, the Revenue relied on the order of the TO, who opined as follows:
o The value of the land was enhanced, and thereafter,
the taxpayer distributed the increased value to the partners, thereby, increasing their capital accounts.
o Upon conversion of the firm into a company, shares of enhanced value were allotted to the partners, and thus, there was an increase in the value of capital in the hands of the partners.
o Accordingly, capital gain arose on distribution of assets, by the taxpayer to the partners as a result of revaluation and
subsequent allotment of shares.
o Therefore, the revaluation gain was chargeable to capital gains tax.
Tribunal’s ruling
The only event in the said FY was the revaluation of land.
The conversion of the firm into a company occurred in the subsequent FY.
Revaluation of assets cannot be treated as transfer within the meaning of section 2(47) of the Act. Thus, the TO’s action of taxing the
revaluation gain in the said FY was incorrect.
Allotment of shares upon conversion into a company, corresponding to the amount of enhanced value of land
would not tantamount to the distribution of capital assets under section 45(4) of the Act.
When the firm was converted into company, the properties of the erstwhile firm vested in the company. Such ‘vesting of property’ is different from
‘distribution of assets’, as stipulated under section 45(4) of the Act.
In the present case, there was no sale or conveyance from the firm to the company. The partners’ capital increased only due to revaluation of asset. Thus, there was no transfer of asset to attract capital gains tax.
The takeaways
The decision reaffirms the position that for invoking section 45(4) of the Act, a distribution of capital asset of the firm on dissolution thereof is necessary, which is missing in the
conversion of a firm into a company. It impliedly confirms that the conversion of a firm into a company only results in vesting of property and may not
tantamount to transfer, and thus, is not liable for capital gains tax.
Let’s talk
For a deeper discussion of how this issue might affect your business, please contact your local PwC advisor
Tax Insights
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