Tax Implications on Conversion of Partnership firm in Private Limited Company

A partnership firm and a limited company are two different entities, in terms of legal liability. The company holds its independent legal entity and shareholders. But the partnership firm does not have such independent existence, like partners. Tax Implications on Conversion of Partnership firm in Private Limited Company is one of the major areas to look into along with other implications on the overall business.

In this article, the tax implication in case if a partnership firm converts into a limited company is discussed under the provisions of Part IX of the Companies Act, 1956.

Tax Implications on Conversion of Partnership firm in Private Limited Company

Tax Implications on Conversion of Partnership firm in Private Limited Company

Tax rule on capital gain measures an important . A recent decision of the Bombay High Court concluded that such conversion of a firm into a company which follows the route under Part-IX of the Companies Act, 1956, and no capital gains are there as there is no actual transfer of assets.

As per the rules specified under Part IX of the Companies Act, no capital gain arises when a partnership firm is registered as a limited company. When a partnership firm is converted into a limited company, the assets of the former bestows in the limited company. In this case, there is no dissolution happening for the firm. Hence section 45 (1) of the Income Tax Act is not applicable in this case.

Tax on the profit arising from Capital Gain on transfer of assets from Partnership firm to Limited Company

As per the Section 45(1) of the Income tax Act, 1961 states that any profits arising from the capital asset transfer from the previous year mentioned in sections of 54, it will be chargeable to income-tax under the head “Capital gains”. It shall be deemed to be the income of the previous year in which the transfer took place.

Before applying tax on the capital gain, it must be checked that, such gain has arisen from the ‘transfer’ by any mode as mentioned in Section 2(47)  of the Income Tax Act, 1961 (‘Act’ for short) including –

  1. Any sale, exchange of the asset
  2. By extinguishment of any rights
  3. Any acquisition under any law
  4. in a scenario where the asset is converted by the owner as stock-in-trade of a business
  5. the maturity or of redemption of a zero coupon bond
  6. any transaction like involving or allowing of the possession of any immovable property of the nature referred to in section 53A of the Transfer of Property Act, 1882 (4 of 1882)
  7. Any transaction which may have the effect of transferring of any immovable property

Implication under Section 45(4) for transfer of assets from Partnership firm to Limited Company

The Section provides that the profits or gains arising due to the transfer of a capital asset on the dissolution of a firm shall be chargeable to tax as the income of the firm. This also could be the association of persons or body of individuals which is not being a company or a co-operative society.

Under Section 45(4) of the Act, the below two conditions are required to be satisfied before applying tax on capital gains-

  • a transfer by means of distribution of capital assets;
  • The transfer must be on dissolution of the firm.

Related Read- No Capital Gains in case of transfer of assets from Partnership firm to Limited Company