Quest

Opinion

SUBJECT – SUCCESSION OF FIRM BY A COMPANY
QUERISTS – PIF INDUSTRIES & PIF INDUSTRIES LTD.

BRIEF FACTS

One of the querists, PIF Industries, is a partnership firm constituted under a deed of partnership consisting of 8 partners. It is engaged in the business of manufacturing ready-made garments mainly on jobwork basis from its factory premises at MIDC, Mumbai. The firm is engaged in the said business since the year 2004. As a part of the said business, the firm owned different assets including plant and machinery for manufacture of garments. The partners are sharing profits and losses in the ratios specified in the said deed of partnership.

The firm assigned the said business of manufacturing together with its assets and liabilities under a deed of assignment of business dated 1-1-2006 to the other querist, PIF Industries Ltd. (PIFIL) an existing company registered under the Companies Act, 1956, with its shares listed on a recognized stock exchange. Under the said deed of assignment, the firm sold, assigned, and transferred the said business to the said company PIFIL as a going concern together with all its assets and liabilities for an agreed lump sum consideration.

The said company PIFIL discharged its obligation to pay the said lump sum consideration by way of issue of agreed numbers of 5% cumulative preference shares of Rs. 100 each redeemable at the end of 10 yrs from the date of allotment. The said shares are allotted to the partners of the firm.

The firm has computed the net worth of the said business as per the books of account the firm, representing the difference between the book value of assets and liabilities. The querists further inform that the firm had over the period developed the manufacturing know how which was properly documented and had also acquired significant business and commercial rights and that the difference between the said net worth of the business as per the books and the said lump sum consideration represented the value of consideration received for assignment of the said know how and the rights as a part of assignment of business.

The firm has computed the capital gains on transfer of the said business. The querists further inform that the partners of the firm were already the shareholders of the said company PIFIL and were holding more than 51% equity shares carrying voting rights in the total capital of the company, PIFIL before assignment of the said business. The querists inform that this position has remained unchanged even after assignment of the said business.

The firm has claimed an exemption u/s 47(xiii) of the Income-tax Act in respect of Capital Gains arising on transfer of the said business for A.Y. 2006-07.

The querists further inform that in the books of the said company PIFIL, the assets and stock of the said business are accounted at the book value and the difference has been accounted as an amount paid for acquisition of the said know how and the business rights by debiting the same under the head intangible assets.

The querists further inform that the company has not paid the dividend on the cumulative preference shares issued as a consideration for assignment for a period of two consecutive years.

It is further informed that the partners of the querist firm intend to sell their equity holdings in the said company PIFIL to an outside group in an offer for sale in a manner that the aggregate equity share holdings and the voting power of the said partners will stand reduced to less than 50% in the total capital of the company.

On the above facts, the querists have raised the following queries for our consideration:

1. Whether issue of preference shares to meet the payment of consideration for assignment of business was in compliance of clause (c) of the proviso to sec. 47(xiii).

2. Whether the fact that the partners of the firm were holding not less than 51% of the total voting power of the company before assignment of the business ensure compliance of clause (d) of the said proviso to sec. 47(xiii) or that it was necessary for the partners of the firm to have acquired such voting power as a result of assignment of business.

3. Whether it was necessary to take into consideration the equity as well as the preference share holding of the partners in the said company PIFIL to determine whether they were the shareholders in the same proportion in which their capital accounts stood in the books of the firm for the purpose of compliance of sub-clause (c) of the said proviso to sec. 47(xiii).

4. Whether on transfer of the equity shares of the said company PIFIL by the partners of the firm within a period of five years from the date of assignment will result in withdrawal of the said exemption granted to the querist u/s 47(xiii) of the Act. If yes, what are the consequences.

REPLIES AND OPINION

1. The partners of M/s PIF Industries have received consideration for assignment by allotment and issue of preference shares. Clause (c) of the proviso to sec. 47(xiii) provides that the partners of the firm should not receive any consideration other than by way of allotment of shares. The said clause (c) reads as under:

“the partners of the firm do not receive any consideration or benefit, directly or indirectly, in any form or manner, other than by way of allotment of shares in the company”

From a bare reading of the clause, it is apparent that the condition of the clause stands complied with the allotment of shares. No distinction is made therein between a preference share and any other share including an equity share. The requirement is that the partners are allotted shares in the company. A “share” is not defined under the Income-tax Act. The Companies Act defines a share vide sec. 2 (46) of the said Act which reads as:

“share” means share in the share capital of a company, and includes stock except where a distinction between stock and shares is expressed or implied”

From the reading of the definition of share, again it is clear that no distinction is made between a preference share and any other share. The Companies Act, in fact provides for issue of preference shares and contains specific provisions for issue and allotment and regulation of preference share. From a combined reading of the provisions of the Income-tax Act and the Companies Act, it is clear that the allotment of preference shares to the partners is not in violation of the condition of the said clause (c).

2. The partners of M/s PIF Industries were holding 50% or more of the total voting power of the company PIFIL before the assignment of business by the firm to the company. No additional voting power has been acquired on account of allotment of preference shares on assignment. The partners continue to hold the same voting power. Clause (d) of the said proviso to sec. 47(xiii) prescribes that the aggregate of share holding of the partners in the company shall not be less than 50% of the total voting power in the company. What it really means is that the shares held by the partners shall carry the total voting power of 50% or more in the company. Such share- holding carrying such voting power shall continue for a period of 5 years from the date of succession. The said clause (d) reads as under:

“the aggregate of the share holding in the company of the partners of the firm is not less than fifty per cent of the total voting power in the company and their share holding continues to be as such for a period of five years from the date of succession”

From a plain reading of the provision, it is clear that the requirement of the section is that the partners shall hold the prescribed percentage of voting power and such share holding shall continue for a specified period. The requirement does not specify the acquisition of voting right as a result of assignment or succession. In our opinion, the condition stands complied with as long as the prescribed percentage of voting power is held by the partners on the date of succession and for a period of 5 years thereafter.

3. The partners of the firm M/s PIF Industries hold not less than 50% in the total voting power of the company. The said is in accordance with the condition of clause (d) of the proviso to sec. 47(xiii). The said clause further provides that such shareholding of the partners continues to be so held for a period of 5 years from the date of the succession. Not holding the required voting power will result into withdrawal of benefit of tax exemption conferred u/s 47(xiii). The querist has informed that the partners are likely to transfer their equity shares to an outsider or a group of outsiders. The partners however will continue to hold preference shares in the company PIFIL.

4. Attention of the querist is invited to the provisions of sec. 47A of the Income-tax Act which provide for withdrawal of exemption in certain cases. Sec. 47A(3) provides that on non-compliance of the condition laid down in the proviso to clause (xiii) of section 47, the amount of profits or gains (capital gains) arising from transfer of capital asset or intangible asset which enjoyed the tax benefit will be chargeable to tax in the year in which the condition stands violated. Such capital gains shall be deemed to be the gains of the successor company and will be chargeable in the hands of such company in the years of violation of the said condition.

5. Accordingly the capital gains that has not been taxed in the hands of the firm in A.Y. 2006-07 on account of tax exemption u/s 47(xiii) shall become taxable in the hands of the company PIFIL in the year in which partners cease to hold the prescribed percentage of voting power. Thus if the equity shares of the partners are transferred in the F.Y. 2008-09 and as a result the partners cease to hold the said voting power then in such an event the withdrawal provision contained in s. 47A(3) will be triggered and the capital gains since then exempted from tax in the hand in the hands of the firm will become taxable in the hands of the company in A.Y. 2009-10.

6. It is intriguing to note that the firm M/s. PIF Industries continues to enjoy the benefit of tax exemption even where the violation of the conditions of the section is by the firm and the punishment or injury for such violation is inflicted on the successor company which has no role to play in such violations. The transaction of succession between the firm and the company is carried out at the arm’s length and the successor and the successee are independent persons and separate taxable entities. The successor has no interest in the taxation or non taxation of the successee. The share holders of the successor company are independent persons who are not prevented but are authorized to transfer their holdings at any point of time of their choice by the Articles of Association of the company. The company and its body of share holders have never undertaken to ensure the compliance of the conditions of s. 47(xiii) by the partners. The partners of the said firm are not the only share holders of the company. The punishment is grievous and more so in the case of the company PIFIL, wherein the public is participating in the shares of the company and the company is a listed company. To prohibit a share holder or a set of shareholders to transfer his holding is not only against the Articles of Association but also the provisions of Companies Act, SEBI Act, SCRA and the listing agreements.

7. In the circumstances, it is seriously debatable whether the successor company can be punished for the acts of the partners of the successee firm especially where it has not enjoyed any benefit or the tax advantage. It is ordinary and prudent to withdraw the benefit only in the hands of the persons who have enjoyed the benefit; for example, as provided in s. 54 to 54F. Similar is the case where assets are transferred from holding company to subsidiary company and vice-versa as per ss. 47A(1) and so is the case where a tax benefit is conferred where a membership at Stock Exchange is transferred to company as per s.47(xi) of the Act and is withdrawn u/s 47A(2) for non compliance. Attention is also invited to the provisions of s. 72A(3) which provide for withdrawal of the tax benefit enjoyed by the amalgamated company in the hands of such company only.

8. It’s important to note that the company PIFIL has not enjoyed any tax benefit nor it has agreed to be responsible for the acts of the firm or its partners. In the circumstances, it is debatable whether the Income tax Act can inflict an injury on a person for acts of other persons without the consent of the first person. Such an act in our considered opinion is in violation of the fundamental rights under the Constitution of India and more particularly of Article 19 which provides for the right to property. The provisions of s. 47A(3), it implemented has the effect of depriving a person of his right to property and has the effect of infringing such a right.

9. 9. If at all the tax benefit is sought to be withdrawn the same should be in the hands of the firm or its partners who alone are the beneficiaries. At this stage it is pertinent to note that the company PIFIL has not derived any benefit of set-off of unabsorbed depreciation or loss of the firm M/s. PIF Industries as is otherwise permitted by s. 72A(6). It may be perhaps rational to apply provisions of s. 47A(3) in the hands of the company in such a situation where it has enjoyed the benefit of such set-off.

10. Attention is also invited to the decision of the ITAT in the case of DCIT vs. Oscar Investments Ltd., 98 ITD 339 p. (Mumbai) and in the case of NCK Sons Exports (P) Ltd. vs. ITO, 102 ITD 311 p. (Mumbai) wherein the Tribunal was required to consider the effect of provision of s. 2(22)(e) of the Act. The said provision required for taxing loans of advances by a closely held company to the extent of unaccumulated profits of the company. It is provided in s. 2(22)(e) that any payment by a company to any concern in which the specified shareholder holds a substantial interest will be deemed to be a deemed dividend. The question that had arisen for consideration of the Tribunal was whether in such circumstances, the said deemed dividend would be taxed in the hands of specified share holder or in the hands of the beneficiary concern who had received the said payment. The Tribunal on consideration of various aspects including the aspect of third party punishment held that it was the concern who was liable to be taxed for such deemed dividend.

11. The facts of the case of the querist however have taken a weird twist in the years subsequent to the succession. The partners of the firm as noted, have been paid consideration by allotment of preference shares. These preference shares carry a right to dividend and such a right is cumulative in nature. It is informed by the querist that the company has failed to pay dividend on such shares for a consecutive period of 2 years. The querists have drawn our attention to the provisions of sec. 87(2)(b) of the Companies Act which provide that on default by the company, for a consecutive period of two years, in payment of dividend to preference share holders, the said share holders obtain voting rights in the company. The said section reads as under:
    “Subject as aforesaid, every member of a company limited by its shares and holding any preference share capital, be entitled to vote on every resolution placed before the company at any meeting, if the dividend due on such capital or any part of such dividend has remained unpaid –

1. in the case of cumulative preference shares, in respect of an aggregate period of not less than two years preceding the date of commencement of the meeting; and

2. in the case of non-cumulative preference shares, either in respect of a period of not less than two years ending with the expiry of the financial year immediately preceding the commencement of the meeting or in respect of an aggregate period of not less than three years comprised in the six years ending with the expiry of financial year aforesaid.”

On a reading of the said provision, it is clear that the failure of the company PIFIL to pay dividend for 2 consecutive years has empowered the preference share holders with voting rights which voting right constitute more than 50% of the total voting rights of the company. Accordingly any transfer of equity shares by the said partners subsequent to acquiring more than 50% of the voting rights on account of default of the company MIL will not be in violation of condition of clause (d) of the said proviso. And the provisions of sec. 47A(3) shall not apply in such case.

We hope the above meets the queries raised by the querist. We will be pleased to provide any further clarification in respect of the opinion.