Limited Liability Partnership - Taxation issues

[Dr. Sanjiv Agarwal]

A Limited Liability Partnership can most appropriately be described as a hybrid between a company and a partnership. that provides the benefits of limited liability but allows its members the flexibility of organizing their internal structure as a partnership based on a mutual arrived agreement.

A Limited Liability Partnership is a body corporate with a distinct legal entity separate from that of its partners. It has perpetual succession and a common seal. A limited liability partnership which is a separate legal person will be liable to the third parties independent of the other partners. Any change in its partners will not effect the existence rights or liabilities of the limited liability partnership

Most western economies have provisions for hybrid business entities like the LLPs. The United States legislation provides for six independent business forms, including the Limited Liability Partnership and also the Limited Liability Company (LLC) However, LLP form of business in US can be setup only by professional outfits. The LLP in US is governed by state laws, and in general, each partner in the LLP is fully liable for the debts of the partnership, but not for the acts of professional negligence of other partners. The LLC structure, on the other hand, is predominantly a corporate entity, which has the flexibility of choosing its tax classification (either as a corporate entity or as a partnership) for the purpose of federal taxes.

LLP form of business structure has been prevalent in many countries including USA, UK, Japan, and Singapore. While retaining this basic structure, different countries have framed their laws with suitable changes.

A limited liability partnership (LLP) is a hybrid legal vehicle that combines the limited liability attribute of a company and a small number of people operating through it to carry on business or professions. The essential feature of the LLP is that it combines the organizational flexibility and tax status of a partnership with limited liability for its partners. Although a hybrid, it is much closer to a company than to a partnership as it is a body corporate having perpetual succession and separate legal entity. The LLP form exists in many countries. In India, several times a debate has taken place and a few expert groups recommended codification of a law for LLP.

Taxation of LLPs

LLP Act 2008 does not contain any provision governing taxation of LLPs.

For the purpose of income tax, all activities carried on by LLPs should be treated as being carried on by its partners and not by LLP. The property of LLP should be treated as property of partners and taxed accordingly, i.e, any asset held by LLP should be treated as assets held by its partners. For taxation, the status of LLP as a corporate entity should be ignored and it should be treated as partnership and partners taxed on then share of profit. For capital gain arising out of assets of LLPs, it should be considered as if assets are held by partners and the resultant gain arising out of transfer of assets be taxed in the hands of partners. In this way, LLP would enjoy the pass through status of for income tax purposes.

UK and US have similar tax provisions for LLPs. In UK, profits of LLP are charged in the hands of partners and not the LLPs (Section 10 of UK's LLP Act).

In UK, the profits of the business of an LLP will be taxed as if the business were carried on by partners in partnership, rather than by a body corporate. This ensures that the commercial choice between using an LLP or a partnership is a tax neutral one. The taxation clauses in the Act are expressed in broad terms so that the existing rules for partnerships and partners will, in general, simply apply to LLPs, "and members of LLPs, which are carrying on businesses, as if these were partnerships and partners respectively. The transfer of an existing business to an LLP will only be treated for tax purposes as giving rise to a cessation of the business of the partnership which is making the transfer if in otherwise identical circumstances a transfer between one partnership and another would do so. The transfer of assets between a partnership and an LLP will only give rise to chargeable gain or capital allowance consequences if, in otherwise identical circumstances, a transfer of assets between one partnership and another would so do. Similarly, Inland Revenue Statements of Practice and Extra Statutory Concessions will apply to LLPs and members of LLPs as they apply to partnerships and to partners.

In US, LLPs enjoy the pass through status for the purpose of taxation. The profits or losses of the LLP pass through the business and are reported in each partner's individual returns. Thus LLPs are generally treated for tax purposes as a business carried on by the partners in a partnership, rather than as a body corporate.

Naresh Chandra committee had recommended the same pass through status for taxation of Indian LLPs.

It is expected that Income Tax Act, 1961 shall provide for tax treatment of LLP's in the Union Budget 2009-10 announcement and when next Finance Act, 2009 is enacted thereafter, the following issues shall have to be addressed -

(1) Whether LLP should be taxed as a separate entity or partners of LLP should be taxed as individuals?

(2) Whether partners of LLP should bear the capital gains tax in respect of transfer or disposal of assets of LLP?

(3) What will be the tax treatment on receiving the share capital by the partners or receiving accumulated profits on transfer of shares?

(4) How will the valuation of transferable interests of partners be done for the purpose of capital gains tax?

(5) Whether LLLPs will suffer the capital gains tax?

The provisions in relation to capital gains tax on conversion from company or firm to LLP, applicability of benefits under double taxation Avoidance agreements (DJAAs) to LLPs, tax benefits available to firms to be allowed to LLPs or not etc will also have to be addressed.

The likelbord of taxing profits in the hands of LLP partners get strength from the clause '6' of First Schedule of the LLP Act, which states that "no partner shall be entitled to remuneration for acting in the business or management of the LLP" . It appears that since LLP partners have been prohibited from accepting any remuneration from LLP, it implies that partners may be subject to income tax in respect of their share of profits in LLP.

According to reports (The Economic Times dated 16th Februray, 2009), an LLP would be taxed for its income while the individual partners would be taxed free. This benefit is not available to companies. The LLP format protects the partners from double taxation. The details of LLP tax regime would be unveiled in the Finance Bill, 2009 to be presented by new Government later in 2009, by way of amendment to Income Tax Act 1961. Also, under the new tax code, it has been reported that Ministry of Finance may not agree with the recommendations of the Parliamentary panel that LLPs should be given the freedom to choose between taxation at the organizational level or at partner's level, depending on the internal structure.

It may be noted that Minister for corporate Affairs had assured the Parliament that Indian LLP's will in no way be put to any disadvantage and LLPs will have a level playing filed with other similar entities outside India.