Non-resident shareholder liable to capital gains tax on transfer of Indian company shares pursuant to conversion of the Indian company into an LLP under the LLP Act – The value of partnership interest as represented by capital as well as reserves and surplus is the full value of consideration for computation of capital gains on transfer of shares — Value of partnership interest is not same as cost of investment in shares

Non-resident shareholder liable to capital gains tax on transfer of
Indian company shares pursuant to conversion of the Indian company into an LLP
under the LLP Act – The value of partnership interest as represented by capital
as well as reserves and surplus is the full value of consideration for
computation of capital gains on transfer of shares — Value of partnership
interest is not same as cost of investment in shares

FACTS

The applicant, a tax resident of the UK, was 100% shareholder of an
Indian company ICo. During the relevant year and in accordance with the LLP
Act, ICo was converted into an LLP. Consequently, the shareholding of the
applicant in ICo was transformed into a partnership interest in the LLP.

The Applicant filed an application before the Authority for Advance
Ruling (AAR) with respect to the aforesaid conversion and raised the following
questions:

(i) Whether conversion of equity shares held by the applicant in ICo
into partnership interest in the LLP, consequent to the conversion of the ICo
into an LLP, would be regarded as a ‘transfer’ under the Act?

(ii) Whether the computation provisions of the Act are capable of being
applied to such transfer?

(iii) Whether the transaction can give rise to any taxable capital gains
in the hands of the applicant when the value for the partnership interest in
the LLP was the same as the value of the applicant’s interest in ICo?

HELD

On whether conversion would be regarded as a ‘transfer’ of a capital
asset:

(a) The definition of transfer u/s 2(47) of the Act is inclusive and,
therefore, extends to events and transactions which may not otherwise be
‘transfer’ according to the ordinary, popular and natural sense of the term. The
Act also clarifies that transfer includes parting of any asset or any interest
therein;

(b) As per the LLP Act, conversion results in dissolution and vesting of
all the assets of the company into the LLP. On such vesting, the share capital
of the company along with the interest of shareholders in the shares of the
company gets extinguished. Alternatively, conversion involves exchange of
shares in the company with partnership interest;

(c) The argument that charge of capital gains triggers only when there
is a transfer between two existing parties at a time is not correct. This is
evident by the fact that even conversion of capital asset into stock-in-trade
is considered as transfer under the Act;

(d) The Supreme Court in the case of Grace Collis²  concluded that the extinguishment of a
right includes extinguishment of a right in a capital asset independent of and
otherwise than on account of transfer. This also supports that extinguishment
of rights in the shares on conversion results in transfer;

____________________________________________________________

2. ITAT seems to be of the view
that since the income qualifies as a business income u/s 28(va), the assessee
creates a business connection in India

(e) Existence of a specific provision under the Act which exempts the
transaction of conversion of company into LLP from capital gains tax also
indicates that such transaction results in transfer, such conversion will be
subject to capital gains tax under the Act.

On computation mechanism of capital gains arising on transfer as a
result of conversion:

(f) On conversion, shareholders
relinquish their shareholding in the company to acquire capital in the LLP in
the same proportion in which shares were held in the company. Thus, the value
of the partnership interest in the LLP is to be considered as the Full Value of
Consideration (FVC) received / accrued to each shareholder for computation of
capital gains;

(g) FVC can be computed on the
basis of the accounts of the LLP considering the reserves and surplus
transferred. If such FVC is not ascertainable, the deeming provision u/s 50D of
the Act can be adopted to deem the fair market value as the FVC.

(h)        The
assessee’s contention that the value of partnership interest was the same as
the cost of acquisition of the shares in the company, is incorrect for the
following reasons:

(I)  Cost of shares is the price at
which shares are acquired. Such cost of acquisition varies from one shareholder
to another shareholder;

(II)       The value of partnership
interest is inclusive of the share capital as well as the reserves and surplus
(i.e., shareholders fund) which is different from the cost of acquisition of
shares;

(III)      Thus,
the value of partnership interest as reduced by cost of acquisition of shares
is subject to capital
gains tax.