DISSOLUTION OF LLP & TAXABILITY

DISSOLUTION OF LLP & TAXABILITY

BY SASHI KANTA PANDA

Winding up is different from dissolution. Winding up is a process
which culminates into dissolution. During the period, when winding up commences
till the dissolution takes place, the legal entity of LLP remains and so, such
LLP can be sued. But on dissolution, the LLP loses its existence because its
name is struck off from the register of LLPs and therefore, it is not possible
to sue the LLP.

Procedure:

Declaring the LLP as Defunct

In case the LLP wants to close down its business or where it is
not carrying on any business operations, it can make an application to the Registrar
of Companies for declaring the company as defunct and removing the name of the
LLP from its register of LLP’s.

The procedure is given below
1. An application is required to be made in eForm 24 to the Registrar of
Companies for Striking off the name of the LLP under clause (b) of sub rule 1
of Rule 37 of LLP Rules 2008 with the consent of all partners.

2. The Registrar shall publish a notice on its website as to the content of the
application for a period of one month for the notice of the general public.

3. Application submitted to be supported by Indemnity Bonds to indemnify any
person legally claiming after the LLP to be striked off and duly sworn
Affidavits declaring all the information provided and statements given to be
true, from all partners.

4. Application filed also to be supported by approvals or No Objection
Certificates from concerned Regulatory Authorities with which the LLP is
registered. For eg. LLP engaged in or registered with RBI for Banking Business
has to obtain NOC from RBI before winding up of its affairs.

5. The Registrar, where he has sufficient cause to believe that the limited
liability partnership has any asset or liability, satisfy himself that
sufficient provision has been made for the realization of all amount due to the
limited liability partnership and for the payment or discharge of its
liabilities and obligations by the limited liability partnership within a
reasonable time and, if necessary, obtain necessary undertakings from the
designated partner or partner or other persons in charge of the management of
the limited liability partnership.

6. On the expiry of period of one month, the Registrar may, by an order, unless
cause to the contrary is shown by the limited liability partnership, strike its
name off the register, and shall publish notice thereof in the Official
Gazette, and on the publication in the Official Gazette of this notice, the
limited liability partnership shall stand dissolved.

Guidelines:
a. There should have been no liability existing or obligation subsisted on part
of LLP and its partners.

b. There should be no litigation pending for or against LLP.

c. The assets of the limited liability partnership shall be made available for
the payment or discharge of all its liabilities and obligations even after the
date of the order removing the name of the limited liability partnership from
the register.

d. Liability of the Designated Partners
subsists even after dissolution of LLP for payment of any legal dues to its
creditors and other persons as if the LLP has not been dissolved.

Declaring the LLP as defunct is much easier process to close down
the LLP as compared to wounding up because it does not involves high
formalities and due to simplified procedure, the time consumed is comparatively
very less.

Winding UP

As per section 63 of the LLP Act, the winding up of the Limited
Liability Partnership could be either of the following-

Voluntary Winding up

Here the partners of the LLP, after consenting among them, agree
to wind up its affairs and activities. And adopt the following procedure to
windup the limited liability partnership. If the firm is not solvent the
partners cannot start the process of winding up the firm. They also need to
have creditors’ consent/approval for winding up the firm. And many more
formalities have to be complied with for winding up the business.

i) Passing of Resolution-

An LLP can be wound up voluntarily only if at least three fourth
of total numbers of partners pass such a resolution and file a copy of it with
the Registrar within the next 30 days. It shall be deemed that the winding up
has commenced from the time of the passing of such resolution.

ii) Declaration of solvency by designated partners-

The designated partners are required to make a declaration, which
shall be verified by an affidavit, that their LLP is solvent and will be able
to fully settle the debts out of proceeds realized from the sale of assets
within a time period of one year starting from the date when winding up
commenced. This declaration along with the Statement of Assets and Liabilities
and Assets Valuation Report prepared by an independent valuer shall be
submitted with the Registrar of Companies (ROC) within 15 days of passing of
the winding up resolution.

iii) Approval of Creditors-

No winding up can take place voluntarily unless the approval of
creditors is sought. The LLP shall intimate to its creditors, the estimated
amount that it owes to each of these parties and shall give them an offer to
approve and accept the claims. They shall be given a 30days time to accord
their approval in respect of voluntary winding up or acceptance of the offer
made to them. Consent of at least 2/3 in value of creditors is required for
winding up. The LLP shall file the decision of the creditors with the ROC
within 15 days of receipt of their consent.

iv) Publication of Resolution-

Once the resolution demanding voluntary winding is passed and
approval of the creditors is obtained, then the LLP shall within 14 days of
receipts of creditors consent give a public notice about its resolution. For
this purpose, it shall place an advertisement concerning this matter in the
local newspaper of the district where the principal office or registered office
of the LLP is situated.

v) Appointment of Liquidator-

To administer the proceedings of winding up, an official known as
LLP liquidator is appointed from the panel maintained by the Central Government
within 30 days of filing of consent of creditors. Once the LLP liquidator gets
appointed, all the powers of the designated partners as well as that of other
partners shall cease. Further notice of such appointment of the LLP Liquidators
shall also be given to the Registrar.

Duties of LLP Liquidator :

The LLP Liquidator is supposed to discharge the following duties
with regard to the winding up–

1. Perform such functions and duties as may be prescribed under the Act or
Rules,

2. Maintain books of accounts in the proper manner,

3. Settle the list of creditors and partners,

4. Pay off the liabilities of the LLP and adjust the rights of the partners
among themselves,

5. Observe due care and diligence while discharging his duties,

6. Give a quarterly report on the progress of winding up of the LLP to the
partners and creditors in the prescribed form & manner,

7. Get the accounts of the LLP audited.

Preparation of Final Report by the
Liquidator-

Once the affairs of the LLP get fully wound up, then the
liquidator shall prepare a final report concerning the winding up accounts and
explanations in the prescribed format. Thereafter, he/she shall seek the
approval of the partners and the creditors, as the case may be, with regard to
the said report and accounts in the meeting with the partners and creditors.

Further, all the above mentioned documents shall be filed with the ROC within
15 days of the approval by the partners /creditors.

vi) Passing of Dissolution Order-

If the tribunal is satisfied that the process of winding up has
been duly followed, it shall pass the dissolution order within 60 days of the
receipt of the application. The liquidator is required to file a final copy of
the dissolution order of LLP with the Registrar of Companies (ROC), who shall
then get this fact notified in the Official Gazette.

Compulsory Winding up

The firm may also wound up by the order of the Tribune/court. And
this kind of winding up is known as Compulsory Winding up. The Tribune may
order an LLP firm to wind up in the following circumstances as provided under
section 64.

a) Petition by LLP – If the LLP firm has resolved to be wound up by the Tribunal, then
it may file a petition to the Tribune under section 64 subsection (a).

b) Number of the partners below
statutory minimum – If the number of partners in
an LLP falls below two, and still it keeps carrying on for more than 6 months,
then the Tribunal is bound to issue a winding up order under the provisions of
Section 64 sub section (b).

c)
Inability to Pay Debts – If the LLP is in a severe
financial crunch and is unable to honour its obligations towards the creditors,
the Tribunal may make a winding up order. The power of the Tribunal is,
however, discretionary and it may desist from making a winding up order, if the
majority of creditors in value oppose the petition in the hope that the LLP
would be able to regain its financial position and must therefore continue to
trade as referred under Section 64 subsection (c).

d) LLP
acts against the National Interest – If
the activities of the LLP put at risk the sovereignty, integrity and security
of India, then the tribune may make a winding up order under section 64 sub
section (d).

e) Default
in submitting the prescribed financial disclosures and other documents with the
Registrar – If the LLP has, for any reason
defaulted in filing with the Registrar its Statement of Account and Solvency or
Annual Return for five consecutive financial years, then the Tribune is bound
to make a winding up order as per the provisions of Section 64 subsection (e).

f) Just and
Equitable to wind up – If in the opinion of the
Tribunal, it is just and equitable to wind up the LLP; it may order it’s
winding up. The Tribunal has wide discretionary powers under this clause and on
the basis of judicial decisions; the following circumstances may be made a
ground for winding up under Section 64 subsection (f).

i) If there is a complete deadlock in management.

ii) If there is a Bubble LLP i.e. LLP exists only for the name sake without any
real business or property.

iii) If there is a loss of substratum i.e. whole of the capital of the LLP has
eroded or the main object of the LLP has failed.

iv) If the LLP firm carries business which is illegal.

v) The business of LLP cannot be carried on further except at a loss.

The following points should also be noted
and understood along with the conditions laid in section 64. These provisions
relate to the details of winding up procedure.

i) The petition or an application for
winding up of an LLP could be filed with the tribunal by the LLP itself or by
any of its partner(s) or creditor(s) or by the Registrar or by Central
Government or by a person authorized by Central Government.

ii) It shall be deemed that winding up of the LLP has commenced
from the time of the presentation of its petition to the tribunal.

iii) The tribunal is empowered with the special powers that can be
exercised by the Tribunal as per his discretion on presentation of petition.
Once the petition for winding up of the LLP, has been received by the Tribunal,
it fixes a date for its hearing and issues notice to the LLP to appear and
justify its position. The Tribunal shall also give a public notice in order to
inform everybody, particularly, the creditors and the partners, about winding
up so that their concerns or objections could also be considered. Then, on the
specified date, after taking into consideration the concerns of all the parties
and circumstances of the case, the Tribunal (within ninety days from the date
on which petition was presented), may – dismiss the petition or make an interim
order or direct to revive or rehabilitate the LLP or appoint a liquidator as
provisional liquidator till the final order or pass an order to windup the LLP.

iv) Once the Tribunal passes and communicates the Winding up order
to the firm, the following consequences will follow.

a) The petitioner and the LLP shall
ensure that a certified copy of the winding up order has been filed with the
ROC so that the Registrar could notify the fact in the Official Gazette.

b) The winding up order serves as a notice of discharge to all the
employees and officers of the concerned Limited Liability Partnership.

c) No suit or legal proceedings can be commenced against the LLP without the
leave of the court. Even a suit, which is pending against the LLP at the date
of winding up order, cannot be preceded unless the permission of Tribunal is
obtained.

Taxability:

Up to the assessment year 1987-88
distribution of assets on dissolution of firm was not subjected to capital
gains taxation. As a matter of fact Sec.47(ii) specifically provided that it
will not be considered to be a transfer. In Malabar Fisheries Co. vs. CIT
(1979) 120-ITR-49(SC), the Supreme Court held that distribution of assets among
partners on dissolution does not involve transfer as it is only because of
pre-existing rights. This settled position was upset by introduction of Sec.
45(4) and deletion of Sec. 47(ii) with effect from 1-4-1988 i.e., A.Y. 1988-89
onwards. The reasons for the introduction of the new Section and for disturbing
the settled position is explained by Circular No. 495, dated 22-9-1987, vide
para 24.3. It was felt that the route of dissolution was used in a scheme of
tax avoidance, which enabled the participants of the scheme to transfer assets
from one hand to another hand without payment of legitimate tax.

The profits or gains are deemed to
have arisen in the previous year in which the transfer takes place. The
identification of the year of transfer becomes an issue in cases where the year
of distribution happens to be different than the year of dissolution. The term
‘distribution’ is a legal and accounting concept which has given rise to a
debate as to whether the Section will apply in a case where all the assets are
taken away by one of the partners. An issue also has arisen as to whether the
sale of capital assets to a partner could be treated as distribution of assets
or not. A doubt has arisen about the entity in whose hands the deemed capital
gain could be taxable, i.e., whether the gain would be taxed in the hands of
the firm or in the hands of the group of partners as the firm has been
dissolved and ceases to continue.

Relevant Sections:

Sec. 45(4) of the Income-tax Act
provides for taxation of the deemed capital gains arising on distribution of
capital assets in the course of dissolution. The essential requirement for
attracting this provision is that there is a dissolution, and that in the course
of such dissolution, capital assets are distributed.

The said Sec. 45(4) reads as under:
“The profits or gains arising from the transfer of a capital asset by way of
distribution of capital assets on the dissolution of a firm or other
association of persons or body of individuals (not being a company or a
co-operative society) or otherwise, shall be chargeable to tax as the income of
the firm, association or body, of the previous year in which the said transfer
takes place, and for the purposes of S. 48, the fair market value of the asset
on the date of such transfer shall be deemed to be the full value of the
consideration received or accruing as result of the transfer.”

Ordinarily, capital gains arise on
transfer of a capital asset. ‘Transfer is considered to be ‘sine qua non’ of
capital gains. The term ‘transfer’ is defined by Sec. 2(47) of the Act, which
reads as under :

“ ‘transfer’, in relation to a
capital asset, includes: the sale, exchange or relinquishment of the asset; or
the extinguishments of any rights therein; or the compulsory acquisition
thereof under any law; or in a case where the asset is converted by the owner
thereof into, or is treated by him as, stock-in-trade of a business carried on
by him, such conversion or treatment; or any transaction involving the allowing
of the possession of any immovable property to be taken or retained in part
performance of a contract of the nature referred to in Sec. 53A of the Transfer
of Property Act, 1882 (4 of 1882); or any transaction (whether by way of
becoming a member of, or acquiring shares in, a co-operative society, company
or other association of persons or by way of any agreement or any arrangement
or in any other manner whatsoever) which has the effect of transferring or
enabling the enjoyment of, any immovable property;

Explanation : For the purposes of
sub-clauses (v) and (vi), ‘immovable property’ shall have the same meaning as
in clause (Id) of the Sec. 269UA”.

From a bare reading of the above
provisions, it is seen that the distribution of capital asset in the course of
dissolution is not specifically included in the definition of the term
‘transfer’. Instead, a direct charge is sought to be created by introducing a
deeming fiction in the form of Sec. 45(4) for bringing to tax the deemed
capital gains on such distribution. It is this act of by passing the provision
of Sec. 2(47) by the Legislature that has become the subject matter of an
interesting controversy where under a possibility of rendering Sec. 45(4)
nugatory is being debated.

One view of the matter is that Sec. 45(4) is a charging Section
that brings in an effective charge in the circumstances provided therein,
independent of Sec. 2(47). This view is supported by the decisions of the
Karnataka and the Goa Bench of the Bombay High Court. The other view of the
matter holds that without a specific amendment in Sec. 2(47) amending the
definition of ‘transfer’, Sec. 45(4) has no independent application. This view
is supported by a decision of the Madhya Pradesh High Court.

Case Studies:-

CIT v. Moped and Machines [ (2005) 281- ITR- 52 (MP)]

The High Court observed that the admitted facts revealed a
dissolution of the firm; that the dissolution deed showed that the retiring
partner had no objection whatsoever in continuation of business in the same
name, either as a sole proprietary or in any other manner as the other partner
thought fit; that the other partner in terms of the materials placed on record
had taken over the entire assets and liabilities of the partnership firm.

The Court further observed that a reading of Sec. 45(4) showed that the profits
or gains arising from the transfer of capital assets by way of distribution of
capital assets on the dissolution of a firm was chargeable to tax as the income
of the firm, in the light of the fact that a transfer had taken place. The
Court also took notice of the assessee’s contention that the term ‘transfer’
had been defined u/s.2(47) of the Act and that if Sec. 2(47) was read with Sec.
45(4), there was no transfer at all, and in any case if there was any transfer,
it was not by the assessee, but by the retiring partner.

For considering the issue on hand,
the Court was inclined to notice Sec. 47 of the Act. It noted that Sec. 47 was
a special provision which would define the transactions not regarded as
transfer and a reading of the said Sec. 47 of the Act showed that several
transactions were considered as ‘no-transfer’ for the purpose of Sec. 45 of the
Act.

It noted Sec. 47(ii), prior to its deletion read as : “any distribution
of capital assets on the dissolution of a firm, body of individuals or other
association of persons.”; that the said provision was omitted by the Finance
Act, 1987 with effect from April 1, 1988; that therefore, any transaction
resulting in distribution on dissolution of a firm had to be considered as
‘transfer’ in terms of Sec. 47; that on omission of clause (ii) of Sec. 47, it
could not be said that Sec. 45 was inapplicable to the facts in the case on
hand.

The Karnataka High Court further distinguished the judgement of the Madhya
Pradesh High Court in CIT v. Moped and Machines, 281 ITR 52 relied upon by the
assessee by observing that in the said judgement, there was no reference to
omission of clause (ii) of Sec. 47 as it stood prior to April 1, 1988; that in
the said judgement, what was considered was the provisions of Sec. 45(4) and
Sec. 2(47), as it stood then; that therefore, the said judgement would not be
applicable to the issue involved in the case on hand; that on the other hand,
the decision of the Bombay High Court in the case of CIT v. A.N. Naik
Associates, 265 ITR 346 was found to be applicable, as in the said decision,
the Bombay High Court had noticed the effect of the omission of the said clause
(ii) of Sec. 47 by the Act of 1987.

The Karnataka High Court, in respectful agreement with the judgement of the
Bombay High Court, noted that when the Parliament in its wisdom had chosen to
remove a provision which provided for the cases of ‘no transfer’, there was no
need for any further amendment to Sec. 2(47) of the Act. The Court accordingly
held that despite no amendment to Sec. 2(47), in the light of removal of clause
(ii) to Sec. 47, the transaction was liable to capital gains tax at the hands
of the authorities.

Conclusion :
Normally, in cases of firms consisting of more than two partners, the death or
insolvency of a partner would result in dissolution of the firm as per the
provisions of the said Act. However, there would be no dissolution in a case
where the partners have agreed to continue the partnership and the business
even after death or insolvency, on certain terms and conditions. On compliance
of such terms, the firm will be said to have continued. In such cases, there is
a consensus of opinion that the provisions of Sec. 45(4) will not apply.

Cases which create real difficulty are the cases of partnership consisting of
two partners only. It is in such cases that a difficulty arises, where one of
the partners dies or is declared insolvent or retires. In such cases, the firm shall
stand automatically dissolved on death or insolvency or on retirement by
operation of the law. In such cases of severe hardships, the recent decision of
the Madras High Court in the case of CIT v. Vijaya Metal Industries, 256 ITR
540, provides a major breakthrough. In that case, the assessee partnership
consisted of two partners, which was dissolved on death of one of the partners.
The business of the partnership firm was continued by the surviving partner
with the assets of the partnership firm. The Income-tax Department applied the
provisions of Sec. 45(4) and brought to tax the deemed capital gain by holding
that the transfer took place on dissolution of the firm. The Tribunal held that
though the dissolution of firm took place by operation of law, it was not
followed by transfer of capital assets by way of distribution of such assets.
The Madras High Court confirmed the decision of the Tribunal.

The decision in the case of Vijaya Metal Industries provides a
much needed relief. With this, one thing is certain that the dissolution by
itself will not result in distribution of assets of the firm. The distribution
will take place only on taking of a positive action by the parties concerned
for distributing the assets. Till such time, the assets may be treated as
jointly held by the parties. This by itself is a big relief for the assessees
who are caught unaware. It is also certain that it is possible to defer
the year of taxation to the year in which the distribution takes place. This
will enable an assessee to comprehend the impact of Sec. 45(4) and plan for the
same. In view of the above, a new possibility has emerged where under the
surviving partner can successfully join hands with the legal heirs of the
deceased partner, in partnership and continue the business with the assets of
the erstwhile firm. In such a case, the above-referred decision will help in
contending that the assets of the erstwhile firm are not distributed amongst
the parties entitled to it and till such time no liability to tax by virtue of
Sec. 45(4) will arise.

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