 In India businesses mainly operate as incorporated companies, sole proprietorships and general partnerships. Each of these organisation structures has its own advantages and shortcomings, and is subject to different regulatory and tax regimes. The Limited Liability Partnership (LLP) Act 2008 has created a new form of organisation, namely the limited liability partnership (LLP), which is a corporate organisation that seeks to provide an alternative to traditional partnership. LLPs provide the statute-based governance structure of the limited liability company. This allows firms to organise and operate in a flexible, innovative and efficient manner.
In certain professional sectors a firm or a professional cannot function in a corporate structure. This often hinders its growth because a partnership firm cannot have more than 20 partners.1 Besides, in today’s dynamic world, changes at partnership level are also frequent.
The LLP Act 2008 received the assent of the Honourable President of India on 20 January 2009.
However, despite numerous beneficial aspects of converting to an LLP, what still remains uncertain is the scheme of taxation of an LLP. Until this problem is clarified the use of an LLP as a form of organisation would not find favour and would defeat the entire objective of introducing this law.
The challenges associated with the taxation of LLPs can be broadly categorised as the following:
- whether, if taxed under the provisions of the Income Tax Act 1961 (the 1961 Act) the LLP would qualify as:
- a person, as per the definition of ‘person’ under s2(31) of the 1961 Act; or
- a person under the United Nations/Organisation for Economic Co-operation and Development (OECD) Model of Double Taxation Avoidance Agreements (DTAA);
- whether partners would be taxed in their individual capacity or the LLP would be taxed as a firm;
- assessment procedure to be followed for an LLP; and
- tax implications in case of conversion of a partnership/company into an LLP.
Can an LLP be classified as a ‘person’?
Domestic law
Section 2(31) of the 1961 Act provides that a ‘person’ includes:
- an individual;
- a Hindu undivided family;
- a company;
- a firm;
- an association of persons (AOP) or a body of individuals (BOI), whether incorporated or not;
- a local authority; and
- every artificial juridical person, not falling within any of the preceding sub-clauses.
Explanation
For the purposes of this clause an AOP, a BOI, a local authority or an artificial juridical person shall be deemed to be a person, whether or not such person, body, authority or juridical person was formed, established or incorporated with the object of deriving income, profits or gains.
The imperative question to be addressed here is whether an LLP would fall within any of the above mentioned clauses of s2(31) and hence qualify as a ‘person’.
The definition of a person inter alia includes a company also. As per s2(17) of the 1961 Act, ‘company’ means:
i) any Indian company;
ii) any corporate body incorporated by or under the laws of a country outside India;
iii) any institution, association or body that is or was assessable, or was assessed as a company for any assessment year under the Indian Income Tax Act 1922 (the 1922 Act), or that is or was assessable or was assessed under the 1922 Act as a company for any assessment year commencing on or before 1 April 1970; or
iv) any institution, association or body, whether incorporated or not and whether Indian or non-Indian, which is declared by general or special order of the board to be a company.
Provided that such institution, association or body shall be deemed to be a company only for such assessment year or assessment years (whether commencing before 1 April 1971, or on or after that date) as may be specified in the declaration.
Therefore, on an analysis of the above section, an LLP would not classify as an Indian company as per clause (i) of this section, because according to s2(26) of the 1922 Act, an Indian company means a company formed and registered under the Companies Act 1956. An LLP normally does not fall within this.
Clause (ii) deals with any corporate body incorporated outside India and clause (iii) deals with certain bodies recognised as companies under the 1922 Act. The LLP is clearly not a corporate body incorporated by or under the laws of a country outside India. In light of the above, it can therefore be concluded that an LLP would not fall within the ambit of the above-mentioned clauses.
Clause (iv) of s2(17) envisages a situation where the Central Board of Direct Taxes (CBDT) may notify certain forms of organisation to be taxed as companies for the purpose of the 1961 Act. Considering the fact that CBDT has so far not notified an LLP to be covered under this particular clause, an ambiguity related to the taxation of an LLP being a company is still persisting.
The government must act fast and CBDT must come up with a clarification if it is intended to be taxed as a company.
This is despite the fact that, as per s3(1) of the LLP Act 2008, an LLP is defined as a body formed and incorporated under the LLP Act 2008. For the LLP to be classified as a company under this Act, it would become mandatory for the CBDT to officially notify or publish a circular that duly recognised an LLP as a company, for income tax purposes.
- Furthermore, clause (iv) of s2(31) includes a firm as person for the LLP Act 2008. However, it is imperative to note that as per s2(23) of the LLP Act 2008, ‘firm’ has the meaning assigned to it in the Indian Partnership Act 1932 (the 1932 Act). Since an LLP is not governed by the 1932 Act, it cannot be referred to as a firm for income tax purposes.
In addition to the above, the term ‘person’ also includes an AOP. The term has not been defined in the LLP Act 2008; therefore, an AOP may have as its members companies, firms, joint families and associations.
There are no decisive tests laid down by the courts to determine the issue as to what constitutes an AOP. However, the moot concept that emerges from the analysis of various judgments is that, where persons join together for a common objective for the purposes of producing income, and there is joint execution of work, the same would constitute an AOP. In CIT v Indira Balakrishna [1960] the Honourable Supreme Court held that a combination of persons getting together for income producing activities would constitute an AOP.
- From the above it can be inferred that in the case of an LLP:
- two or more persons are joined together or associated together;
- the association is for a common purpose or common action;
- the objective is to come together for income generating activity – ie to produce income – and profits and gains for the benefit of all; and
- there is joint execution of work out of the own free will of the persons.
Therefore, at this juncture, it would be safe to conclude that an LLP can be classified as an AOP.
Section 2(31) has a residual category of persons, namely, ‘artificial juridical person’. By virtue of this clause, the LLP Act 2008 envisages to cover any other form of organisation that is not covered in the preceding sub-clauses and states that any such form of organisation falling within the residual category should be taxed under this heading.
Historically, the idols of Hindu deities and Bar Councils have been held to be covered under this residual category. Therefore, one can take the view that if an LLP is not covered within the definition of ‘company’ or within the definition of AOP, then it can be covered under this sub-clause.
Tax Treatment under Tax Treaty Conventions
Generally, Article 3 of any tax treaty defines the term ‘person’ as someone to whom the provisions of the relevant treaty may apply. As per the OECD Model Tax Convention, the term ‘person’ includes an individual, a company and any other body of persons. In light of this definition it needs to be examined as to whether an LLP would fall within the definition of company or any other body of person.
If, under the domestic tax law, an LLP is held to be a separate legal entity for tax purposes, it would be able to enjoy tax benefits under the respective tax treaty unless a specific exclusion, similar to one that is contained in Article 3 of the Indo-UK Tax Treaty, is inserted in any tax treaty.
Other Aspects
In case an LLP is held to be a company it would be interesting to examine whether provisions relating to minimum alternate tax (s115JB of the 1961 Act) or provisions relating to distribution of profits, or deemed dividend (s115O, s10(34), and s2(22) of the 1961 Act) would come into play.
Similarly, in this example, an LLP is held to be an AOP, whether or not tax rebates available to partners of an AOP under s86 of the 1961 Act would be available to the partners of an LLP. Further, it would also be interesting to observe whether tax exemption available to partners of a partnership firm on receipt of a share of profit would similarly be available to the partners of an LLP.
Another key issue that merits consideration is whether the exemption from capital gains tax on conversion of proprietorship/ partnership firm into an LLP would be available on the laws of exemptions available for conversion into a company.
Besides, the term ‘employer’, for the purposes of fringe-benefit tax, has also been defined as:
- a company;
- a firm;
- an AOP or BOI;
- a local authority; and
- every artificial juridical person in s115W of the 1961 Act.
It would be interesting to see, based on the above discussion with respect to the definition of ‘person’, whether an LLP could be considered as an employer for the purpose of levy of fringe-benefit tax.
The full budget took place in the first week of July. Passing an LLP Bill without clearing the air with regards to its tax implication therefore seems to be a futile exercise.
By Aseem Chawla, partner and Gagan Kumar, principal consultant, tax practice, Amarchand Mangaldas. E-mail: aseem.chawla@amarchand.com; gagan.kumar@amarchand.com.
Note
1)In terms of the Partnership Act 1932, there is no stipulation as to the maximum number of partners in a firm. However, s11 of the Companies Act 1956 indirectly restricts the number of partners to 20 per firm.
