By Anup P. Shah | Chartered Accountant
Laws and Business
1. Introduction :
1.1 Partnership firms and sole proprietary concerns have been
and continue to be one of the most popular business entities in India. However,
concerns of growth, limited liability, expansion, private equity funding,
foreign investment, etc., have forced even the staunchest supporters of these
business entities to consider a company structure. Some of the biggest benefits
of a corporate structure are limited liability, perpetual existence, a body
corporate, etc.
1.2 In the light of this background, let us examine how a
firm can be converted into a company. Further, what are the issues in this
connection.
1.3 Two routes :
There are two alternative options by which a firm can be
converted into a company :
(a) Conversion under Part IX of the Companies Act, 1956
(b) Sale of the business by the firm to a company and
claiming of exemption u/s.47(xiii) of the Income-tax Act.
2. Conversion under Part IX of Companies Act :
2.1 Steps to be
taken :
(a) One of the options available for converting a firm
into a company, is a conversion under Part IX of the Companies Act. Here the
firm is converted into a limited company by registering it under Part IX of
the Companies Act, 1956.
(b) Some of the important steps to be taken in this
respect, include :
(i) Increasing the number of partners from 3 to a
minimum of 7, since the company to be registered should have a minimum of
7 members
(ii) Restructuring the Partnership Deed keeping in mind
the requirements of Part IX of the Companies Act, 1956
(iii) Applying to the ROC for Registration under Part
IX along with the applicable fees
(iv) Obtaining the Certificate of Registration as a
company from the ROC
(v) Issuing the equity shares to the erstwhile partners
(vi) Intimating the Registrar of Firms
(c) Upon conversion of the firm into a limited company,
the partners of the firm at the time of conversion will become the
shareholders of the company.
2.2 No Stamp Duty :
A conversion under Part IX of the Companies Act, 1956 would
not attract any incidence of Stamp Duty, as under Part IX, there is a
statutory vesting of the assets of the firm in the company and there is no
transfer. This view is supported by the decisions in the case of Vali
Pattabhirama Rao, 60 Comp. Cases 568 (AP) and Rama Sundari Ray v. Syamendra Lal
Ray, ILR (1947) 2 Cal. 1, which state that under Part IX, there is a statutory
vesting of the assets of the firm in the company and there is no transfer.
Therefore, there is no conveyance and hence, no incidence of Stamp Duty.
2.3 No Capital Gains Tax :
A conversion under Part IX of the Companies Act, 1956 would
not attract any incidence of Capital Gains Tax, as under Part IX, there is a
statutory vesting of the assets of the firm in the company and there is no
transfer or distribution of capital asset as envisaged by S. 45(1) or S. 45(4).
This view is supported by the decision in the case of Texspin Engineering and
Manufacturing Works, 263 ITR 345 (Bom.), which states that under Part IX, there
is a statutory vesting of the assets of the firm in the company and there is no
transfer. As per
S. 45(4), transfer should be on account of dissolution of the firm which is not
the case here. Hence, the liability to pay Capital Gains Tax would not arise.
2.4 Sale of shares :
Once the firm is converted into a limited company under Part
IX, the shareholders of that company can sell their shares at any time to anyone
without holding it for a certain minimum period. The condition u/s.47A of the
Income-tax Act, 1961 that 50% of the shareholders must continue to hold the
shares for a minimum period of five years does not apply to a conversion under
Part IX of the Companies Act. This condition only applies to the second mode of
conversion, i.e., a sale of the business by the firm to a company and the
partners claiming exemption u/s.47(xiii) of the Income-tax Act. This proposition
has also been laid down by the AAR’s recent decision in the case of Unicore
Finance Luxembourg, 189 Taxman 250(AAR).
2.5 Tenancies :
An interesting issue arises in the case of conversion of a
partnership firm which is a tenant into a company under Part IX of the Companies
Act, 1956. Various High Court decisions mentioned earlier have held that under
Part IX, there is a statutory vesting of the assets of the firm in the company
and there is no transfer. Thus, a conversion under Part IX of the Companies Act,
1956 would not be treated as a transfer, since there is a statutory vesting of
the assets of the firm in the company. Hence, there is a good case for holding
that there would not be a transfer of tenancy or an illegal subletting of
tenancy.
3. Sale of
business :
3.1
Steps :
The firm would make a slump sale of its business as a going
concern or a lock, stock and barrel sale to the company. In return for the same,
the company would issue shares to the partners of the firm.
3.2 Capital Gains Tax :
The sale by the firm would be taxable u/s.50B of the
Income-tax Act as capital gains. However, S. 47(xiii) of the Income-tax Act
exempts the gains arising from the transfer of any capital asset by a firm to a
company as a result of the succession of the firm by a company in the business
carried on by the firm. The conditions to be satisfied for availing this
exemption are as follows :
(a) all the partners of the firm must become shareholders
in the company in the same proportion as their capital;
(b) the aggregate shareholding of the partners in the
company must be at least 50% and it must so continue for 5 years from the
date of the succession;
(c) the partners do not receive any other consideration
for the sale from the company; and
(d) all the assets and liabilities of the firm become the
assets and liabilities of the company.
If these conditions are satisfied, then the gain on sale would be exempt. However, if any of these conditions are violated, then S. 47A of the Income-tax Act provides that gains which were exempt would become taxable in the company’s hands in the year of violation of conditions.
3.2 Stamp Duty :
Stamp duty as on a conveyance would be levied on the slump sale on the net value of the undertaking after reducing the liabilities from the total assets. For this purpose, it would be necessary to bifurcate the assets into movable and immovable assets. The immovable assets would require an instrument of transfer and would have to be registered. However, the movable assets may be transferred by delivery and possession without an instrument of transfer. If no instrument is executed for the movable assets, then there would not be any Stamp Duty incidence on their transfer.
3.3 Other :
One of the more contentious issues would be under the Rent Act in regard to the change in the tenancies of the firm. On a slump sale, the landlord can contend that there is an illegal subletting or assignment and hence, he can terminate the tenancy. It may be noted that the earlier Bombay Rent Act contained a provision that if the tenancies were transferred along with the sale of the business as a going concern and the goodwill and stock-in-trade of the business, then the transfer was not illegal. However, such a provision is not found under the current Maharashtra Rent Control Act, 1999.
