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08 February 2019
Conversion of company into LLP at book value not taxable as capital gain
Resale price method most appropriate for localisation expenses
Entity-level benchmarking permitted for interrelated transactions
Redeemable preference shares are not loans
In accordance with Section 47(xiiib) of the Income Tax (IT) Act, the transfer of assets while converting a private company into a limited liability partnership (LLP) – in accordance with the LLP Act and subject to the prescribed conditions – is not considered a transfer and thus not taxable as a capital gain.
The Mumbai Tax Tribunal recently dealt with a case in which the conversion of a company into an LLP involved the transfer of the entire business, including all of its assets and liabilities.(1) However, one of the conditions in Section 47(xiiib) had not been satisfied.
When considering whether the conversion could be considered a transfer even though it had failed to meet all of the conditions set out in Section 47(xiiib), the tax tribunal ruled as follows:
In this case, the taxpayer assembled automated electrical components, which were resold to original equipment manufacturers and automobile manufacturers in India.(2) The taxpayer had selected the transactional net margin method as the most appropriate method for determining the arm's-length price of the transactions. The taxpayer also debited localised expenses and claimed these as reimbursement on a cost-to-cost basis from its associated enterprise for the localisation support provided.
The lower tax authority believed that the resale price method was the most appropriate method. It also held that since the taxpayer had already entered into a royalty agreement with its associated enterprise and was paying royalty, there was no need to pay any localisation expenses to its associated enterprise.
The tax tribunal agreed, holding that the resale price method was best suited for determining the arm's-length price of the international transaction (ie, the purchase of goods from an associated enterprise and the resale to unrelated parties). Further, the tax tribunal concluded that no separate compensation was required for the receipt of the associated enterprise's localisation support, as royalty covers such benefits and services.
In the case at hand, the taxpayer manufactured automobiles and had completed entity-level benchmarking for all of its transactions.(3) However, the lower tax authority believed that distinct transaction categories should be benchmarked separately. The taxpayer claimed that the transactions were interlinked to its main activity of manufacturing and selling passenger cars; hence, they need not be benchmarked separately.
The lower tax authority rejected the taxpayer's contention and issued a show cause notice and proposed adjustments for the import and sale of finished built units and royalty payments. Aggrieved, the taxpayer appealed to the tax tribunal.
The tax tribunal upheld the taxpayer's contention that the transactions were interrelated and thus permitted the entity-level benchmarking of all of the taxpayer's transactions.
In this case, the taxpayer was engaged in the exploration and production of oil and gas.(4) The taxpayer had invested in its subsidiary in the form of redeemable preference shares.
The lower tax authority recharacterised the taxpayer's investment as unsecured loans and imputed interest. This resulted in a significant transfer pricing adjustment. Aggrieved, the taxpayer appealed to the tax tribunal.
The tribunal referred to the Delhi High Court's ruling in Globe United Engineering and Foundry Co Ltd and stated that preference shares are part of a company's share capital and cannot be considered as a loan. The tax tribunal thus rejected the lower tax authority's finding that the redeemable preference shares were a loan and stressed that real income is subject to tax, unlike notional income.
For further information on this topic please contact Pranay Bhatia at BDO in India by telephone (+91 22 3332 1600) or email (firstname.lastname@example.org). The BDO in India website can be accessed at www.bdo.in.
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