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Assessment of firms/LLPs and their partners under Assessment of Other Entities – Income Tax

Assessment of firms/LLPs and their partners under Assessment of Other Entities :

A firm is to be assessed as a unit and the share income from the firm in the hands of the partners is exempt. There is no need for registration.

1. General: Under section 2(23) of the Income-tax Act, 1961, the terms ‘firm‘, ‘partner‘ and ‘partnership‘ have the same meanings respectively as have been assigned to them under the Indian Partnership Act, 1932, but the expression ‘partner‘ also includes any other person who being a minor, has been admitted to the benefits of an existing partnership. A firm though not a legal person or juridical entity, is chargeable to tax as a separate entity distant from the partners and the partners are assessable as individuals and not as an association persons or body of individuals. The term ‘firm‘ as used in the Act covers both registered and unregistered firms.

Consequent to the Limited Liability Partnership Act, 2008 coming into effect in 2009 and notification of the Limited Liability Partnership Rules w.e.f. 1st April, 2009, the Finance (No.2) Act, 2009 has incorporated the taxation scheme of LLPs in the Income-tax Act, 1961, on the same lines as applicable for general partnerships, i.e. tax liability would be attracted in the hands of the LLP and tax exemption would be available to the partners. Therefore, the same tax treatment would be applicable for both general partnerships and LLPs.

Consequently, the following definitions in section 2(23) have been amended –

(1) The definition of ‘partner‘ to include within its meaning, a partner of a limited liability partnership;

(2) The definition of ‘firm‘ to include within its meaning, a limited liability par tnership; and

(3) The definition of ‘partnership‘ to include within its meaning, a limited liability partnership.

The definition of these terms under the Income-tax Act, 1961 would, in effect, also include the terms as they have been defined in the Limited Liability Partnership Act, 2008. Section 2(q) of the LLP Act, 2008 defines a ‘partner‘ as any person who becomes a partner in the LLP in accordance with the LLP agreement. An LLP agreement has been defined under section 2(o) to mean any written agreement between the partners of the LLP or between the LLP and its partners which determines the mutual rights and duties of the partners and their rights and duties in relation to the LLP.

The residential status of a firm to be determined depending upon the fac t whether or not the control and management of its affairs is exercised from within India. Even if the negligible part of the control and management is exercised from within India the firm would be resident in India for all the purposes. For determining the residential status of a firm, it is immaterial to ascertain the residential status of partners thereof because a firm may be resident even in cases where all the partners are not resident in India and they control or manage the affairs from outside India. Every firm is liable to pay tax flat rate of 30% on its total income of the previous year computed in accordance with the provisions of the Act , plus surcharge@12% if its total income exceeds Rs.1 crore, plus education cess@2% plus secondary and higher education cess@ 1%.

The following are the salient features of assessment of partnership firms:

(i) The firm will be taxed as a separate entity. There will be no distinction between registered and unregistered firm.

(ii) The share of the partner in the income of the firm will not be included in the hands of the partner. It will be exempt under section 10(2A).

(iii) Any salary, bonus commission or remuneration, by whatever name called, which is due to or received by a partner will be allowed as a deduction subject to certain restrictions.

(iv) Where a firm pays interest to any partner the firm can claim deduction of such interest from its total income. However, the maximum rate at which interest can be allowed to a partner will be 12% per annum.

(v) The income of the firm will be taxed at a flat rate of 30%. Surcharge@12% is attracted if its total income exceeds Rs.1 crore. Education cess @ 2% and secondary and higher education cess@1% will be levied on income-tax plus surcharge, if applicable.

For the purpose of our discussion we can divide the partnership firms assessable under this Act into two types.

(a) Partnership firms assessed as such (PFAS)

(b) Partnership firms assessed as association of persons (PFAOP)

2. Partnership Firm Assessed As Such (PFAS) [Section 184]

Conditions to be fulfilled: To get the status of PFAS the firm should be evidenced by an “instrument”. The word “instrument” means a document of legal nature by which any right or liability is created, limited, extended, or extinguished. Instrument does not necessarily mean a regular partnership deed, but it may constitute any other relevant document. If the terms of a partnership are contained in a number of documents or in the correspondence between the parties, the documents or letters would constitute
“instrument” for the purposes of section 184(1)(i).

The next condition is that the individual shares of partners must be specified in the instrument. A firm cannot get the status of PFAS unless the instrument of partnership specifies the individual shares of partners in the profits of the partnership. Evidence regarding the shares of partners should be available within the framework of the instrument. It should not involve searching of a number of documents.

The next condition is that a certified copy of the instrument should accompany the first return of income of a firm. As already noted “instrument” in this sense refers not only to the partnership deed but also other documents from which the existence of partnership can be proved. Accordingly, certified copies of all documents will have to be submitted. Section 184 requires that the copy of the instrument shall be certified in writing by all partners other than minors. If, however, the return is made after the dissolution of the firm, it should be certified by all partners other than minors who were partners in the firm immediately before dissolution and by the legal representative of any such partner who is deceased. The certified copy of the instrument of partnership shall accompany the return of income of the firm of the previous year relevant to the assessment year.

If there is any change in the constitution of the firm or profit -sharing ratio during any previous year, a certified copy of the revised instrument of partnership should be filed along with the return of income of the relevant assessment year. Even if there is a change in remuneration/payment of interest to partners but there is no change in profit sharing ratio, a copy of the revised instrument of partnership should be submitted along with return to comply with the provisions of section 40(b).

Section 184(5) provides that where the firm commits any default as mentioned in section 144 the firm shall be assessed as a firm and not as an AOP, which was the case earlier. However, no deduction for payment of interest, salary, bonus, commission or remuneration, by whatever name called, made by the firm to any partner shall be allowed in computing the income chargeable under the head “Profits and gains of business or profession”. However, the interest, salary, bonus, commission or remuneration so disallowed shall not be charged to tax in the hands of the partners under clause (v) of section 28.

Computation of income of partnership firm: While computing the income of a firm assessed as such, we have to keep in mind the following points:

(1) Remuneration is to be allowed

(2) Interest is to be allowed

(3) Unabsorbed depreciation and other losses should be provided for.

Remuneration paid to partners: First let us discuss the question of deduction of remuneration to the partners. In this context we have to remember the conditions prescribed by section 37 as regards the allowability of residuary expenses. Accordingly, no capital expenditure or personal expenses will be allowed. Further the remuneration paid must be only and exclusively for the purposes of the business of the firm. Apart from the general conditions prescribed in section 37 there are certain specific conditions prescribed by section 40(b).

They are as follows: –

(1) Such remuneration should be paid only to the working partner

(2) It should be authorised by the partnership deed

(3) It should not pertain to a period prior to partnership deed

(4) It should not exceed the permissible limit.

(1) Payment should be to a working partner: Explanation 4 to section 40(b) defines working partner as one who is actively engaged in conducting the affairs of the business or profession of the firm of which he is a partner. This definition is very general. It seems that a partner can be a working partner in more than one firm. If a partner is employed somewhere else too, he can still be a working partner in the firm. However, in all such situations the partner must infact be a working partner in the firm. In other words, merely because a person is working somewhere else too, such a fact does not by itself debar him from being a working partner in a firm in which he is a partner. As stated before, to be a working partner, the partner has to be actively engaged in conducting the affairs of the business or profession of the firm. Now in order to be actively engaged in conducting the affairs of the business or profession does not require either expressly or by implication that the concerned partner should be so actively engaged in conducting the business affairs on a full time basis. A partner can be said to be actively engaged in conducting the affairs of the firm even if he devotes a part and not the whole of his working hours.

Further, in order to be actively engaged in the affairs, a partner is not expected to be engaged in the whole of the affairs of the business of the firm, nor is he expected to know everything about the affairs of the business of the firm. For example, in a firm with many partners one partner may be looking after purchases, another after sales and another after production and still another after administration, finance and accounts. It cannot be contended that just because they are not over all incharge, they cannot be considered as working partner. Another significant point to be noted here is that the definition of “working partner” in Explanation 4 contemplates an individual. Therefore a partner other than an individual (example a company) cannot be working partner. An interesting situation may be considered here. When a company is a partner in a firm, a director or shareholder of the company can very well be an employee of the firm in which the company is a partner. Any salary/remuneration paid by the firm to such an employee would be totally outside the ambit of disallowance under section 40(b). This would be so because the individual who is an employee of the firm is not a partner in the firm. It is the company in which he is the director which is the partner and, section 40(b) contemplates allowance of remuneration paid by a firm to its partners and not to other employees.

(2) It should be authorised by the Partnership Deed: Any payment of salary, bonus, commission or remuneration by whatever name called to a working partner is not allowed as a deduction if the payment is not authorised by partnership deed or it is not in accordance with the terms of partnership deed. As a result, a mere general authority in the partnership deed that such and such working partners would be paid remuneration as may be agreed upon between the partners from time to lime will not be sufficient. The partnership deed will have to contain clear direction as to the quantum of remuneration to be paid to the working partners. For example such remuneration may be specified by way of annual fixed payment or as a certain specified percentage of the firm‘s book profit at the year end. It may be noted that such remuneration need not be paid on a monthly basis. An item like commission can be paid even as a percentage of sales. Remuneration also can be an yearly payment.

Now, a question arises whether the names of individual working partners should be specified in the partnership deed or whether it is sufficient if the total remuneration payable to the working partners as a whole is indicated. One opinion is that it is not necessary that the individual partners should be identified or designated. It will be sufficient to lay down an authorisation in the deed to the effect that remuneration will be payable to the class of working partners up to so and so percentage of the book profit. And further that, within such limits the working partners shall share such remuneration in any ratio as may be agreed upon. In other words this concept gives recognition to the working partners as a class and authorising remuneration for the class rather than identifying or designating individual working partners and authorising remuneration for each individual working partner. There is nothing in the section 40(b) which prohibits this type of interpretation. However in order to avoid litigation it is better that the deed identifies and designates the working partners as well as the remuneration payable to them.

As a result of this stipulation, every firm constituted on or after April 1, 1992 will have to provide for an appropriate clause in its partnership deed satisfying this requirement. However, so far as the existing firms are concerned, they will have to execute a supplementary deed or a deed of change in the constitution so as to incorporate a clause within the deed of partnership relating to payment of remuneration to its working partners.

(3) It should not pertain to period prior to partnership deed: By virtue of a further restriction contained in 40(b)(iii), such remuneration paid to the working partners will be allowed as deduction to the firm from the date of such partnership deed and not from any period prior thereto. Consequently, if for instance a firm incorporates the clause relating to payment of remuneration to the working partners by executing an appropriate deed as on July 1st, but effective from April 1st, the firm would get deduction for the remuneration paid to its working partners from July 1st onwards but not for the period from April 1st to June 30th. In other words, it will not be possible to give retrospective effect to oral agreements entered into vis-avis such remuneration prior to putting the same in a written partnership deed.

Example: A and B entered into partnership agreement on April 1, 2015. As per the deed, each of them will be entitled to salary of Rs 2,000 per month apart from profit. On August 1, 2015, they executed a supplementary deed by which they increased the remuneration to Rs 3,000 each effective from 1st April 2015. Discuss the validity of the supplementary deed.

Remuneration will be payable effective from the date of the deed which provides for the payment of such remuneration. In the given case, the original deed provides for remuneration at the rate of Rs 2,000 for each partner from April 1, 2015 onwards. The supplementary deed is executed on August 1, 2015 increasing the limit of remuneration. Such increase in the limit of remuneration will be allowable only from 1st August 2015, being the date of supplementary deed. Hence, for the period from 1st April 2015 to 31st July 2015, the partners will be allowed remuneration only at the rate of Rs 2,000 per month.

(4) It should not exceed the permissible limit: As we have seen earlier, salary, bonus, commission or other remuneration may be paid to any working partner in accordance with and as authorised by the terms of the partnership deed and in relation to any period falling after the partnership deed. However, the maximum amount of such payment to all the partners during the previous year should not exceed the limits given below:-

On the first Rs 3 lakh of book profit or in case of loss, the limit would be the higher of Rs 1,50,000 or 90% of book profit and on the balance of book profit, the limit would be 60%.

Book Profit: The permissible remuneration is to be computed as a percentage of book profit. For this purpose we have to draw up the profit and loss account and find the net profit. This profit and loss account is to be prepared in the manner laid down in Chapter IVD. It may be noted that Chapter IV-D contains the provisions relating to computation of income under the head ‘Profits and gains of business or profession‘. Further, Explanation 3 also lays down that if while arriving at the above net profit, the remuneration paid/payable by a firm to its partners is debited to such a profit and loss account, the aggregate of such remuneration paid/payable to the partners shall be added to the net profit in order to arrive at the book profit.

When the Act says that the profit and loss account should be prepared in the manner laid down in Chapter IV-D, it means that only those items which are chargeable under section 28 as income will be taken into account and only deductions permissible thereunder will be allowed. For example, rent from house property, dividend, interest on bank deposit or government securities are not chargeable as income from business or profession under section 28. Therefore, if the profit and loss account of a firm contains these above receipts, they have to be excluded while calculating the net profit. In the same way, items which are to be disallowed under the various provisions from sections 28 to 44D will have to be eliminated. It naturally follows, therefore, that brought forward business losses will not be deducted while calculating book profit.

The above table shows the upper limits up to which deduction is allowed to firm in respect of the remuneration paid to its working partners. It does not mean that a firm is prohibited from paying remuneration beyond these limits. A f irm can pay remuneration to working partners beyond these limits but it will suffer disallowance in respect of such excess under section 40(b) and consequently pay tax on it at the maximum marginal rate as per section 167A. If a firm pays remuneration to non-working partners, the same will be the result. However the above limits apply to the remuneration paid to the group of all working partners in a firm taken together and not to each individual partner. Finally, it may be noted that section 40(b) does not compel a firm to pay remuneration to its working partners. It is purely at the discretion of the firm. However, once a firm pays remuneration to its working partners it will be subject to the restrictive provisions of section 40(b). It is also open to a firm to pay salary only to a few working partners and not all the working partners.

  •  Interest payable to partners: So far as allowability of interest paid by a firms to its partners under section 40(b) is concerned, the following conditions have been prescribed by section 40(b):

(1) The interest payable by a firm to its partners should be authorised by and in accordance with the partnership deed.

(2) The interest payable by a firm to its partners should not be for a period falling prior to the date of such partnership deed authorizing the payment of such interest.

(3) The rate of interest payable to the partners shall not exceed 12% simple interes t per annum.

Apart from the above conditions the conditions prescribed by section 36(1)(iii) and section 40(a)(i) should also be satisfied. Section 36(1)(iii) provides that the amount of interest paid in respect of capital borrowed must be for the purposes of the business or profession. Section 40(a)(i) provides that any interest which is payable outside India will not be allowed as a deduction unless tax has been deducted therefrom.

An important question could be regarding the amount with reference to which this interest @12% will have to be calculated. For example, a partner may have contributed capital to the firm and in addition may also advance loan to the firm. The question would be whether the interest paid by the firm on capital would be allowable or that on the loan would be allowable. Moreover, some firms have an accounting system of maintaining
current accounts of partners in addition to the capital accounts. When some balance is standing to the credit of a partner in such current account as well the question arises whether the interest paid on the balance in the current account will be allowable within the meaning of section 40(b).

In this regard, it may be noted that section 40(b) does not refer to nor does it make any distinction between the capital contributed by a partner to the firm, the loan advanced by a partner to the firm or the balance in the current account of a partner. Therefore, the interest paid by a firm to its partners on the credit balance standing in all the accounts/whether in capital account, loan account or current account, shall be allowed as deduction to the firm under section 40(b). The idea seems to be to allow interest on the funds employed in the firm by a partner.

As it happens, many a time, a partner may have debit balance in his current account and credit balance in his capital account or loan account. The question which would arise in such a situation could be whether the interest payable to such a partner at the rate of interest authorised by and in accordance with partnership deed will be reckoned with reference to the aggregate of the credit balance in the capital account and the loan account including the debit balance in the current account or whether it should be calculated on the net balance that is the aggregate of the credit balance in the capital account and in the loan account as reduced by the debit balance in the current account. It appears that in such a situation the equitable principle would be to allow interest reckoned with reference to the net balance. Alternatively, if interest is recovered from a partner on the debit balance in his account and interest is paid to the same partner on the credit balance in his account, the net amount paid to that partner would be subjected to the provisions of section 40. However, interest received from one partner cannot be set-off against interest paid to another partner under this proviso.

The next issue which is to be considered here is the point of time at which interest should be credited to the partners‘ accounts. For example, a firm may adopt a policy of crediting interest quarterly to the credit of the partners‘ accounts. In such a case, the firm would be paying in effect interest on interest at the year end. This would amount to compounding interest quarterly. This is not permitted under section 40(b) because what that section contemplates is simple interest and simple interest here would mean interest which is calculated yearly or annually. Paying the interest on interest credited periodically during a year would be contrary to the concept of simple interest per annum.

  •  Partner in a representative capacity: If an individual is a partner in a firm in a representative capacity (that is on behalf and for the benefit of another

person) and not in his personal capacity then interest paid by the firm to such individual in his personal capacity and not as a representative partner wil l not be subject to the conditions and ceiling as prescribed for disallowance. But interest paid by the firm to such individual as representative partner or person represented shall be subject to the conditions and ceiling as prescribed (Explanation 1).

Example: X is a partner in a firm in a representative capacity for and on behalf of his HUF. Supposing the firm pays interest of ` 6,000 to X in his personal capacity and not in his capacity as the representative of HUF, it will be allowed as deduction and the prescribed ceiling will not apply. However, if such payment is made to X as a representative and partner or if the firm has paid the interest directly to the HUF, then the payment will be subject to the conditions and ceiling as prescribed.

  •  Interest received by a non-representative partner: If interest is paid to an individual partner who is not the representative partner and the interest

received by him is on behalf of or for the benefit of another person, then such interest payment shall be allowed without applying the ceiling limits.

Example: X is a partner of a firm in his individual capacity and is not a representative partner. Interest is paid by the firm to him in respect of a deposit made by his wife. This will be allowed as a deduction because such interest in not received by him any representative capacity but purely on behalf of another person.

  •  Computation of income of partner of a firm (PFAS): While computing the income of a partner including a minor partner of a firm, the following points

have to taken into consideration.

Share income exempt under section 10(2A): The partner‘s share in the total income of firm (PFAS) will be exempt in his hands and will not be included in his total income. His share in the total income of the firm will be calculated as follows:-

Total income of firm * Partner’s share in profits of firm as per partnership deed / Total profit of the firm

By virtue of this exemption a partner of PFAS will not be taxed in respect of his share in the firm‘s income since the firm itself will be taxed as a separate entity at the maximum marginal rate. There will be no allocation of income among the partners. On account of this exemption, he will not be entitled to set-off his share in the firm‘s loss against his other personal income.

  •  Chargeability of remuneration and interest: Remuneration and interest received by a partner of a PFAS in accordance with the conditions prescribed

under section 40(b) will be taxable in his hands as income from profits and gains of business or profession.

If remuneration or interest paid to a partner is disallowed in the assessment of the firm due to the fact that they are not in accordance with the conditions prescribed under section 40(b) then the partner will not be taxed in respect of the amount because in such a case the firm itself will be liable to pay tax on the amount which has been disallowed in its assessment. In other words, if the firm is given the benefit of deduction of remuneration and interest paid to a partner then the liability to tax in respect of such amount will be that of a partner. If the firm is not given the benefit of deduction because of the non-compliance with the provisions of section 40(b) then the firm itself will be liable in respect of the amount and the partner will not be taxed in respect of it in his personal assessment. It is obvious that such remuneration or interest which has been disallowed in the hands of the firm but actually received by a partner will be assumed to be his share in the income of such firm and exemption under section 10(2A) will operate.

Suppose a portion of the remuneration and interest in the assessment of the firm is dis – allowed since they exceed the overall ceiling limit prescribed under section 40(b), the question arises as to how to allocate such disallowance in the hands of the partner. One reasonable basis is to assume that the remuneration and interest paid to the partners concerned has been disallowed in proportion to the gross remuneration and interest paid to them and the exemption of the disallowed sum should be available to the partners in the same proportion.

  •  Rates of tax: A PFAS will be chargeable in respect of its total income at the maximum marginal rate of 30% plus surcharge@12%, if its total income

exceeds Rs.1 crore, plus education cess@2% plus secondary and higher education cess@1% thereon.

  •  Treatment of losses: If PFAS incurs any loss the firm alone can set off and forward such losses to be set off against income of the subsequent years. The

firm will not be allowed to apportion its unabsorbed losses among its partners.

  •  Set off of carry forward loss in case of change in the constitution of the firm [Section 78]: If there is a change in the constitution of the firm the loss of

a retired/deceased partner can be carried forward by the firm only to the extent that it does not exceed such partner‘s share in the profits of the firm of the relevant previous year. It does not matter whether it is a PFAS firm or PFAOP firm. However, it is to be carefully noted that section 78 is applicable only in case there is a change in the constitution of the firm as result of retirement or death of a partner in the previous year. In other words , it does not apply when there is a change in the profit sharing ratio or change in the constitution because of induction of a new partner. Similarly, section 78 will not apply to set off and carry forward of unabsorbed depreciation etc.

Section 167A: In the case of a firm which is assessable as a firm, tax shall be charged at the rate as specified in the Finance Act of the relevant year.

Section 167C: This section provides for the liability of partners of LLP in liquidation. In case of liquidation of an LLP, where tax due from the LLP cannot be recovered, every person who was a partner of the LLP at any time during the relevant previous year will be jointly and severally liable for payment of tax unless he proves that non-recovery cannot be attributed to any gross neglect, misfeasance or breach of duty on his part in relation to the affairs of the LLP. This provision would also apply where tax is due from any other person in respect of any income of any previous year during which such other person was a LLP.  “Tax due”, for the purpose of this section, includes penalty, interest or any other sum payable under the Income-tax Act, 1961.

  •  Conversion of company into a LLP

(i) Consequent to the Limited Liability Partnership Act, 2008 coming into effect in 2009 and notification of the Limited Liability Partnership Rules w.e.f. 1st April, 2009, the Finance (No.2) Act, 2009 had incorporated the taxation scheme of LLPs in the Income-tax Act, 1961 on the same lines as applicable for general partnerships, i.e. tax liability would be attracted in the hands of the LLP and tax exemption would be available to the partners. Therefore, the same tax treatment would be applicable for both general partnerships and LLPs.

(ii) Under section 56 and section 57 of the Limited Liability Partnership Act, 2008, conversion of a private company or an unlisted public company into an LLP is permitted. However, under the Income-tax Act, no exemption is available on conversion of a company into an LLP. As a result, transfer of assets on conversion would attract capital gains tax. Further, there is no specific provision enabling the LLP to carry forward the unabsorbed losses and unabsorbed depreciation of the predecessor company.

(iii) Therefore, section 47(xiiib) provides that –

(1) any transfer of a capital asset or intangible asset by a private company or unlisted public company to a LLP; or

(2) any transfer of a share or shares held in a company by a shareholder

on conversion of a company into a LLP in accordance with section 56 and section 57 of the Limited Liability Partnership Act, 2008, shall not be regarded as a transfer for the purposes of levy of capital gains tax under section 45, subject to fulfillment of certain conditions. This clause has been introduced to facilitate conversion of small private and unlisted public companies into LLPs. These conditions are as follows:

(1) the total sales, turnover or gross receipts in business of the company should not exceed Rs 60 lakh in any of the three preceding previous years;

(2) the shareholders of the company become partners of the LLP in the same proportion as their shareholding in the company;

(3) no consideration other than share in profit and capital contribution in the LLP arises to the shareholders;

(4) the erstwhile shareholders of the company continue to be entitled to receive at least 50% of the profits of the LLP for a period of 5 years from the date of conversion;

(5) all assets and liabilities of the company become the assets and liabilities of the LLP; and

(6) no amount is paid, either directly or indirectly, to any partner out of the accumulated profit of the company for a period of 3 years from the date of conversion.

(iv) However, if subsequent to the transfer, any of the above conditions are not complied with, the capital gains not charged under section 45 would be deemed to be chargeable to tax in the previous year in which the conditions are not complied with, in the hands of the LLP or the shareholder of the predecessor company, as the case may be [Section 47A(4)].

(v) Further, the successor LLP would be allowed to carry forward and set-off the business loss and unabsorbed depreciation of the predecessor company [Section 72A(6A)].

(vi) However, if the entity fails to fulfill any of the conditions mentioned in (iii) above, the benefit of set-off of business loss/unabsorbed depreciation availed by the LLP would be deemed to be the profits and gains of the LLP chargeable to tax in the previous year in which the LLP fails to fulfill any of the conditions listed above.

(vii) The tax credit under section 115JAA for MAT paid by the company under section 115JB would not be allowed to the successor LLP [Sub-section (7) of section 115JAA].

(viii) The actual cost of the block of assets in the case of the successor LLP shall be the written down value of the block of assets as in the case of the predecessor company on the date of conversion [Explanation 2C to section 43(6)].

(ix) The aggregate depreciation allowable to the predecessor company and successor LLP shall not exceed, in any previous year, the depreciation calculated at the prescribed rates as if the conversion had not taken place. Such depreciation shall be apportioned between the predecessor company and the successor LLP in the ratio of the number of days for which the assets were used by them [Section 32(1)].

(x) The cost of acquisition of the capital asset for the successor LLP shall be deemed to be the cost for which the predecessor company acquired it. It would be further increased by the cost of improvement of the asset incurred by the predecessor company or the successor LLP [Section 49(1)].

(xi) If the capital asset became the property of the LLP as a result of conversion of a company into an LLP, and deduction has been allowed or is allowable in respect of such asset under section 35AD, the actual cost would be taken as Nil [Explanation 13 to section 43(1)].

(xii) If a company eligible for deduction under section 35DDA in respect of expenditure incurred under Voluntary Retirement Scheme (one-fifth of such expenditure allowable over a period of five years) is converted into a LLP and such conversion satisfies the conditions laid down in section 47(xiiib), then, the LLP would be eligible for such deduction from the year in which the transfer took place.

(xiii) If a shareholder of a company receives rights in a partnership firm as consideration for transfer of shares on conversion of a company into a LLP, then the cost of acquisition of the capital asset being rights of a partner referred to in section 42 of the LLP Act, 2008 shall be deemed to be the cost of acquisition to him of the shares in the predecessor company, immediately before its conversion [Section 49(2AAA)].

Illustration
A Pvt. Ltd. has converted into a LLP on 1.4.2015. The following are the particulars of A Pvt. Ltd. as on 31.3.2015 –

(1) Unabsorbed depreciationRs 13.32 lakh
       Business lossRs 27.05 lakh
(2) Unadjusted MAT credit under section 115JAARs 8 lakh
(3) WDV of assets 
Plant & Machinery (15%)Rs 60 lakh
Building (10%)Rs 90 lakh
Furniture (10%)Rs 10 lakh
(4) Cost of land (acquired in the year 2000)Rs 50 lakh

(5) VRS expenditure incurred by the company during the previous year 2013-14 is Rs 50 lakh. The company has been allowed deduction of Rs 10 lakh each for the P.Y.2013-14 and P.Y.2014-15 under section 35DDA.

Assuming that the conversion fulfills all the conditions specified in section 47(xiiib), explain the tax treatment of the above in the hands of the LLP.

Solution
(1) As per section 72A(6A), the LLP would be able to carry forward and set-off the unabsorbed depreciation and business loss of A Pvt. Ltd. as on 31.3.2015. However, if in any subsequent year, say previous year 2016-17, the LLP fails to fulfill any of the conditions mentioned in section 47(xiiib), the set-off of loss or depreciation so made in the previous year 2014-15 would be deemed to be the income chargeable to tax of P.Y.2016-17.

(2) As per section 115JAA(7), the credit for MAT paid by A Pvt. Ltd. cannot be availed by the successor LLP.

(3) The aggregate depreciation for the P.Y.2015-16 would be –

Plant & MachineryRs 9 lakh (15% of Rs 60 lakh)
BuildingRs 9 lakh (10% of Rs 90 lakh)
FurnitureRs 1 lakh (10% of Rs 10 lakh)

In this case, since the conversion took place on 1.4.2015, the entire depreciation is allowable in the hands of the LLP. Had the conversion taken place on any other date, say 1.7.2015, the depreciation shall be apportioned between the company and the LLP in proportion to the number of days the assets were used by them. In such a case, the depreciation allowable in the hands of A Pvt. Ltd. and the LLP would be calculated as given below –

In the hands of A Ltd. (for 91 days)

Plant & Machinery91 / 366 * 9000002,23,770
Building91 / 366 * 9000002,23,770
Furniture91 / 366 * 10000024,863

In the hands of the LLP ( 275 days)

Plant & Machinery275 / 366 * 9000006,76,230
Building275 / 366 * 9000006,76,230
Furniture275 / 366 * 10000075,137

(4) The cost of acquisition of land in the hands of the LLP would be the cost for which A Pvt. Ltd. acquired it, i.e., Rs 50 lakh.

(5) The LLP would be eligible for deduction of ` 10 lakh each for the P.Y.2015-16, P.Y.2016-17 and P.Y.2017-18 under section 35DDA.

3. Association of persons (AOP) including partnership firms assessed as AOP (PFAOP): Section 2(31) defines “person” as including “association of persons” or a body of individuals. The expression association of persons is to be understood in its ordinary sense meaning there by a group or congregation of persons. The expression association of persons is of a wider connotation and scope than that of a body of individuals. An association of persons may have as its members not only individuals (including minors) but also companies, firms, joint families and other associations. When there is a group of persons formed for the promotion of an enterprise or when co-adventures join together in a common action they are assessable as an association of persons provided they did not in law constitute a partnership. Ordinarily, there can be no association of persons in business unless the members of the group join together out of their own volition or will.

In order to constitute an association of persons the members thereof must join any common purpose or common action and the object of the association must be to produce income. Mere receipt of income by a group of members in common will not make it an association unless income is earned by its own effort in common. For this reason appointing of a common agent, manager or lessee will not make the owners assessable as an association of persons. Thus, where the income does not arise to the group of members from any joint venture or joint activities the group of persons cannot be assessed as an association of persons. The most important features of an association of persons are that –

(i) the number of members is not restricted and

(ii) the shares of each member or group of members is not definite and ascertainable.

The co-owners, co-legatees and joint receivers joining for a common purpose or action would be assessable as an association of persons. For example, if the funds of a number of beneficiaries are put together and one business is carried on with the combined resources by the trustee, guardian or administrator, the business must be regarded as a single business assessable in the hands of an association of persons. However, section 26 specifically provides an exception to the assessment of co-owners as an association of persons. According to that section, where the shares of the co-owners in respect of income from house property are defined and ascertainable the co-owners must be assessed not as an association of persons but individually even if the property may be owned and managed and developed jointly by the co-owners. Thus, in all cases where the share of each member in group of members is definite and precisely ascertainable, the assessment cannot be made as an association of persons.

For the purpose of assessment, it is not necessary that the association should be legally constituted. In other words, it is not necessary that there must be mutual rights and obligations amongst the members enforceable in law. The illegality, invalidity or incorrectness in the constitution of an association does not in any way affect its liability to tax or its chargeability as a unit of assessment. A partnership which is illegal or otherwise void will have to be assessed as an association of persons. The question whether there is an association of persons or not depends upon the facts and circumstances of each case.

Section 185 provides that where a firm does not comply with the provisions of section 184 for any assessment year, the firm shall be assessed as a firm and not as an AOP, which was the case earlier. However, no deduction for payment of interest, salary, bonus, commission or remuneration, by whatever name called, made by the firm to any partner shall be allowed in computing the income chargeable under the head “Profits and gains of business or profession”. However, the interest, salary, bonus, commission or remuneration so disallowed shall not be charged to tax in the hands of the partners under section 28(v).

Computation of total income of AOP/BOI and PFAOP [Section 67A]

1. Computation of total income in the case of an association of persons or body of individuals will be done in the same manner as in the case of any other assessee.

2. In computing the total income, salary, bonus, commission, remuneration or interest paid to partners/members will not be allowed.

However in the case of payment of interest the following provisions will apply:

Explanation 1: If interest is paid by an AOP/BOI to any member who was also paid interest to the AOP/BOI then only that amount of interest paid by the AOP/BOI will be disallowed in its assessment which is in excess of the interest paid by the member to the AOP/BOI.

Explanation 2: If an individual is a member of an AOP/BOI in a representative capacity, on behalf of or for the benefit of another person, then interest paid by the AOP/BOI to such individual in his personal capacity will not be taken into account for the purpose of disallowance. But interest paid by the AOP/BOI to such individual or vice-versa or representative member or interest paid by the AOP/BOI directly to the beneficiary will be taken into account for the purpose of disallowance.

Explanation 3: If interest is paid to a member who is not a member in a representative capacity but such interest is received by him on behalf of or for the benefit of another person the interest payment will be allowed.

  •  Computation of tax where shares of members in AOP/BOI are unknown [Section 167B]: Tax on the total income would be computed as follows:

– If individual share of any partner is not known, tax will be levied at the maximum marginal rate, or at a higher rate.

– If individual share of a partner is known but total income of any member/partner exceeds the basic exemption limit, then the firm will pay tax at the maximum marginal rate.

– If individual share of a partner is known and no member/partner has total income exceeding the basic exemption limit, the firm will pay tax at the rates applicable to an individual.

  •  Computation of member‟s/partner‟s share in the total income of association of persons/AOP firm [Section 67A] : A member‘s share in the income of an

association of persons/AOP firm (wherein the shares of members are determinate/known) will be computed as follows:

(a) Any interest, salary, bonus, commission, remuneration, etc. paid to a member/ partner during the previous year will be deducted from the total income of the association, and the balance will be apportioned among the members in proportion to their respective shares.

(b) If the amount apportioned to a member/partner as per (a) is a profit, any interest, salary, etc. paid to him by the association or AOP firm during the previous year will be added to that amount and the aggregate sum will be such member‘s/partner‘s share in the income of the AOP/AOP firm.

(c) If the amount apportioned to a member/partner as per (a) is a loss, any interest, salary, etc, paid to him by the association or AOP firm will be deducted from the amount of loss and the balance sum will be such member‘s/partner‘s share in the income of the AOP/AOP firm.

The share of a member in the income/loss of the AOP/AOP firm will, for the purposes of assessment, be apportioned under the various heads of income in the same manner in which income/loss of the association has been determined under each head.

Any interest paid by a member on capital borrowed by him for the purpose of investment in the AOP/AOP firm will be allowed as deduction from share while computing his income under “Profits and gains of business or profession.”

  •  Assessment of share in the hands of member/partner [Section 86]:

– A member‘s/partner‘s share in the total income of an association of persons/AOP firm will be treated as follows:

– If an AOP/AOP firm has paid tax at the maximum marginal rate, or a higher rate, the partner‘s share in the total income of the firm will not be included in his total income and will be exempt.

– If the AOP/AOP firm has paid tax at regular rates applicable to an individual, the member‘s/partner‘s share in the income of the association/AOP firm will be included in his total income for rate purposes only. In other words, the member/partner will be allowed rebate at the average rate in respect of such share.

If the AOP/AOP firm has not paid tax on its total income, the member‘s/partner‘s share in the total income of the association/AOP firm will be included in his total income and taxed at regular rates.

Share of member of an AOP/BOI in the income of the AOP/BOI to be reduced from net profit for computing book profit for levy of MAT [Section 115JB]

(i) Under section 115JB, in the case of a company, if the tax payable on the total income computed as per the normal provisions of the Income-tax Act, 1961 is less than 18.5% of its book profit, such book profit shall be deemed to be the total income of the company and the tax payable for the relevant previous year shall be 18.5% of its book profit.

(ii) Explanation 1 below sub-section (2) of section 115JB provides that the expression “book profit” means net profit as shown in the profit and loss account prepared in accordance with the provisions of the Companies Act or in accordance with the provisions of the relevant statute governing a company, as increased or reduced by certain adjustments, as specified thereunder.

(iii) Under section 86, no income-tax is payable on the share of a member of an AOP/BOI in the income of the AOP/BOI in certain circumstances. A company which is a member of an AOP is also not required to pay tax in respect of its share in the income of the AOP in such cases. However, under section 115JB, a company which is a member of an AOP is liable to MAT on such share also, since such income is not excluded from the book profit while computing the MAT liability of the member. It may be noted that in a similar situation, in the case of a partner of a firm, the share in the profits of the firm is exempt in the hands of the partner as per section 10(2A) and no MAT is payable by the partner on such profits, since income to which any provision of section 10 [other than section 10(38)] applies, has to be reduced for computing book profit.

(iv) In order to ensure equity, clause (iic) has been inserted in Explanation 1 to section 115JB to provide that the share of a member of an AOP or BOI, in the income of the AOP or BOI, on which no income-tax is payable in accordance with the provisions of section 86, should be reduced while computing book profit for levy of MAT under 115JB, if any such amount is credited to profit and loss account. Consequently, clause (fa) has been inserted in Explanation 1 to add back the expenditures, if any, debited to the profit and loss account, corresponding to such income, while computing book profit for levy of MAT.

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