Conversion of Company into LLP-Accounting & Tax implications

A business organisation structure is like our shoes; if too small, they pinch us; but if too large, they cause us to lose balance.

1. Introduction

Deciding the form of business organisation is among the first decisions that an entrepreneur has to make. The right choice of the form of the business is very crucial because it determines the flexibility, continuity, power, risk and responsibility, control as well as the division of profits and losses. Business organisations can take different forms which include sole proprietorship, partnership, joint Hindu family, private company, public company, etc. 

Limited liability Partnership is relatively a new arrival that has taken the centre stage. An LLP is a corporate business vehicle that combines the flexibility of a partnership with the advantages of a separate legal entity. It has rightly been called the ‘Hybrid’ of a company and partnership firm.

Essential features: 

2. Conversion of Company into LLP

Someone has rightly said, “You can suffer the pain of change or suffer remaining the way you are” and I assure you that the change we are talking about is not going to cause you pain in any way.

Section 56 and 57 of the LLP Act, 2008 allow existing private limited companies and unlisted companies to convert into an LLP.

A. Tax implications on conversion

The Income Tax Act has been suitably modified to include provisions for the taxation and other issues concerning LLP’s.

Capital Gain: Conversion involves transfer of assets from company to LLP and in the absence of any specific exceptions would have acted as a hindrance to the adoption of LLP’s.

Section 47 (xiiib) of the Income Tax Act comes to the rescue of the assessee, transfer of a capital asset or intangible asset by a private company or unlisted public company to a limited liability partnership as a result of conversion of the company into a limited liability partnership in accordance with the provisions of section 56 or section 57 of the Limited Liability Partnership Act, 2008 shall not be treated as transfer for the purposes of capital gains tax subject to certain conditions.

The section, going a step forward also exempts the transfer of shares by the shareholder in the course of such conversion. So, no capital gains in the hands of shareholder as well.

What are the conditions referred to in the above section?

Analysis

a. Capital assets: The above exemption is limited to capital assets and not other assets like inventory.

b. Turnover: The limit on turnover will render a big section of companies willing to convert as ineligible.

c. Reserves: It is a safeguard against misuse by a company to escape Dividend Distribution Tax since a LLP is not liable to DDT.

Sections 56 & 57: The conversion should be in accordance with the provisions of section 56 or section 57 of the Limited Liability Partnership Act, 2008.

Accumulated loss and unabsorbed depreciation allowance:

Under Section 72 of the Income Tax Act, the assessee has the right to carry forward the loss in cases where such loss cannot be set-off due to the absence or inadequacy of income. The loss so carried forward can be adjusted against the profits of subsequent years.

Section 32(2) of the Income Tax Act, provides for carry forward of unabsorbed depreciation. Unabsorbed depreciation is that part of current year depreciation which could not be allowed due to the absence or inadequacy of income. Such depreciation can then be carried forward and treated as part of depreciation expense for the next previous year.

In the course of conversion, the successor LLP would be allowed to carry forward and set-off the business loss and unabsorbed depreciation of the predecessor company, provided the conversion meets the conditions discussed above under section 47(xiiib). [Sec 72A(6A)]

III. Breach of conditions of Section 47(xiiib)

E.g. fall in the profit sharing ratio of shareholders of the predecessor company below 50 % in the successor LLP during the first 5 years of conversion.

Subsequent breach of conditions would render the LLP ineligible for the benefits and the benefits would be withdrawn.

Other issues:

Amortisation of expenditure incurred under voluntary retirement scheme: Benefit would be available to the succeeding LLP as if no conversion had taken place. [Sec. 35DDA]

MAT Credit: The succeeding LLP will not be allowed the credit of the MAT paid by the preceding company. [Sec 115JAA(7)]

Cost of acquisition: Cost of acquisition of asset transferred for the Succeeding LLP would be the cost for which the Predecessor Company had acquired the asset as increased by cost of any improvement. [Sec. 49(1)(iii)(e)]

Depreciation for the year of conversion:

The total deduction in respect of depreciation allowable to the Predecessor Company and the Succeeding LLP should not exceed the depreciation calculated as if no succession had taken place. The deduction should be apportioned between the two entities in the ratio of number of days for which the assets were used by them. [Sec 32(1) fifth proviso]

The cost of the block of assets in case of LLP would be the written down value of the block of assets for the company as on the date of conversion [Sec 43(6)]

B. Accounting for Conversion

Accounting is based on the substance of the transaction. It should be kept in mind that the transaction under consideration is not a commercial one. For accounting, the transaction can be resembled to  

Accounting in the books of Succeeding LLP:

To take advantage of benefits discussed under the Income Tax Act, it is necessary to follow the conditions specified. Thus, accounting will also be influenced by the tax impact of it.

AS-14 issued by ICAI on “Accounting for Amalgamations” though directed principally to companies is a source of guidance for accounting for other entities as well.

Under AS-14, all amalgamations are classified into:

a. Amalgamation in the nature of merger, and

b. Amalgamation in the nature of purchase

The conditions to be satisfied for amalgamation to be treated as a case of Genuine Merger have some clear resemblance with the conditions specified in Section 47(xiiib) of the Income Tax Act:

a. All the assets and liabilities of the transferor company become, after amalgamation, the assets and liabilities of the transferee company.

b. Shareholders holding not less than 90% of the face value of the equity shares of the transferor become equity shareholders of the transferee company by virtue of the amalgamation.

c. The consideration for the amalgamation receivable by equity shareholders of the transferee company is discharged by the transferee company wholly by the issue of equity shares in the transferee company.

d. The business of the transferor company is intended to be carried on, after the amalgamation, by the transferee company.

e. No adjustment is intended to be made to the book values of the assets and liabilities of the transferor company when they are incorporated in the financial statements of the transferee company.

- The essence of accounting under Genuine Merger is that there is a genuine transfer of not merely assets and liabilities but also of the shareholders’ interest and of the business.

- All assets and liabilities of the transferor company should be recorded at their book values.

- All reserves be transferred at their existing carrying amounts and in the same form, i.e. the reserves will maintain their identity. Capital Reserves of the company will become capital reserves in the books of LLP.

- Any amalgamation loss or profit (Difference between amount recorded as capital of partners and the amount of share capital of the predecessor company) should be adjusted in reserves.

The illustration below will explain why any amalgamation loss would breach conditions of section 47 (xiiib) and the consideration should be equal to the share capital of the company.

Accounting in the books of Predecessor Company:

Accounting for closing of books is not a difficult task. It is similar to the accounting treatment for dissolution of a partnership firm. It just involves giving the opposite effect.

1. An intermediary account may be opened by the name of Realisation A/c to effect to the closure.

2. Credit all assets to the Realisation A/c.

3. Debit all liabilities to the Realisation A/c.

4. Credit the consideration receivable to the Realisation A/c which would be in the form of capital in the new LLP.

5. Difference in the Realisation A/c (profit or loss) and the consideration received should be transferred to Shareholders’ A/c.

Illustration:

Accounting is a practical subject and an example can perform a task that several pages together can’t. Below is an over-simplified case of conversion of ABC Private Limited Into ABC LLP.

Books of ABC Private Limited

(the predecessor company)

Balance Sheet of ABC Private Limited (before conversion)

A.

B.

C.

D.

E.

Books of ABC LLP

(the succeeding LLP)

A.

B. Balance Sheet of ABC LLP (after conversion)

Analysis:

i. The consideration given to partners though proportionate, was in excess to their existing shareholding (double in our case).

ii. One of the conditions of section 47(xiiib) was that the accumulated profit cannot be distributed to the partners for a period of 3 years.

iii. The ultimate effect of our accounting treatment is that we have distributed Rs. 50,000 of reserves to the partners which is in breach of the above condition.

3. But why convert at all!

I. Internal Flexibility: The internal structure of LLP can be organized as per mutual agreement. Restrictive provisions like limit on managerial remuneration are not applicable to it.

II. Maximum number of partners: Unlike a private limited company which limits the number of members to 200 (as per Companies Act, 2013), there is no cap on the maximum number of partners in an LLP.

III. No minimum capital required: There is no provision in the LLP Act to bring a minimum capital contribution at the time of incorporation as against the Private Limited companies’ requirement of Rs. 1 Lakh.

IV. Lesser Compliances:

Statutory audit: Every company, irrespective of its turnover, liability or capital is required to get its accounted audited by a Chartered Accountant.

LLP’s are exempted from this requirement until the turnover in any financial year exceeds Rs. 40 lakhs or the capital contribution exceeds Rs. 25 lakhs.

a. Cost of administration:  The requirements as to Board Meetings, Resolutions, Annual meetings, etc. are not there in case of LLP.

b. Statutory filing fees: The filing fees of Annual return of an LLP (Form 11) costs Rs. 50 compared to Rs. 200 for filing of annual return of a company (form 20B) for the same amount of capital.

Tax benefits:

a. No DDT on distribution of profits among partners.

b. Deemed Dividend provisions describing specific transaction extension of loans to shareholders etc. as 'deemed dividend' are applicable to only companies.

c. Wealth Tax provisions are not applicable to LLP.

4. Conclusion:

India ranks 173rd in terms of starting business in a group of 185 economies as per the Doing Business in India 2013 report by The World Bank. The concept of Limited Liability Partnership is a step in the right direction and should be welcomed with open arms. The benefits that the structure provides are attracting a lot of attention. Permission to convert existing entities into LLP under the LLP Act coupled with necessary enabling provisions in the Income Tax Act makes it a viable proposal for existing companies.

5. Bibliography:

a. The Limited Liability Partnership Act, 2008 and rules made thereunder- http://www.mca.gov.in/MCA21/.

b. The Companies Act, 1956 and 2013 and rules made thereunder-http://www.mca.gov.in/MCA21/.

c. The Income Tax Act, 1961 - http://law.incometaxindia.gov.in/DIT/.

d. Conversion of Partnership Firms and Private Limited Companies to LLP’s- CA Chandrashekhar V. Chitale.

e. Limited Liability Partnership- A New Form of Business Organization-Manish B. Raval & Ashish B. Gorvadiya (CA Students’ journal, Nov. 2012).