Succession /conversion of proprietary concern into a company- exemption from capital gains.

[C.A. DEV KUMAR KOTHARI]

Business reorganization:

Sometimes due to change in circumstances a business organization and its legal form need to be changed to suit business need. A business which is owned by one person may require to associate with others to bring in more financial and other resources. A business which is owned by one person is called his own business or a proprietary concern of the owner. A proprietor of a business can be an individual, A HUF, a firm, a BOI, an AOP , a company or a co-operative society. For example:

Superior cloth Mills prop. Mr X . Mr. X is also owner of Coarse Yarn. Thus he has two proprietary concerns.

Superior cloth Mills prop. M/s. X and Y firm M/s. X  and Y Firm is also owner of Coarse Yarn. Thus the firm  have two proprietary concerns.

Superior Cloth  Mills, -  Prop. XYZ Ltd./   a unit of XYZ Ltd. M/s. XYZ Ltd is also owner of Coarse Yarn. Thus the company  have two proprietary concerns.

We find that in above example  "Superior cloth mills" as a unit  is a sole proprietary concern  of owners  as indicated above. The unit remain to be a sole proprietary concern irrespective of the owner being an Individual, HUF, Firm or a company or other legal form of it owner. Thus, a concern or unit owned by any person can be considered a sole proprietary concern of the owner.

Provision for exemption from capital gains:

A business is a capital asset, therefore, if a business is transferred to other person, then there will generally be tax on capital gains arising on such transfer. However, if a business is transferred in a situation which is not regarded as a 'transfer', as per general law  or  where there is no consideration accruing on such transfer or such consideration is not capable of determination then also it may not be taxable. However, all these issue may involve difference of opinions.

Specific exemptions: We find some specific exceptions under the Income-tax Act, 1961. Whereby, some transactions which involves transfer, are not regarded as transfer for the purpose of levy of capital gains tax u/s 45. Gift and inheritance are popular cases in this regard. Considering needs of business reorganization there are many other exceptions provided e.g. for mergers and demergers of companies, business reorganization of stock exchange and its members etc.

Scope of this write-up:

In this write-up we are mainly concerned with succession of a proprietary business into a company. The provision is found in S. 47 vide the following clause which is reproduced with highlights for analysis purposes:

Transactions not regarded as transfer

47.   Nothing contained in section 45 shall apply to the following transfers:—

XXXXXx

                (xiv) where a sole proprietary concern is succeeded by a company in the business carried on by it as a result of which the sole proprietary concern sells or otherwise transfers any capital asset or intangible asset to the company :

                Provided that—

      (a)  all the assets and liabilities of the sole proprietary concern relating to the business immediately before the succession become the assets and liabilities of the company;

      (b)  the shareholding of the sole proprietor in the company is not less than fifty per cent of the total voting power in the company and his shareholding continues to remain as such for a period of five years from the date of the succession; and

      (c)  the sole proprietor does 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;

Analysis and related suggestions:

A sole proprietary concern should be succeeded by a company- there should be succession of concern.

Whole concern:

All the assets and liabilities of the sole proprietary concern relating to the business immediately before the succession  should become the assets and liabilities of the company- here concern is with all assets and liabilities, immediately before succession. The assets may not even be capital asset.

Suggestion:

There should be succession of proprietary concern into a company (preferably a new company to avoid any doubt).

If any asset is not required by the company, the same can be transferred beforehand. It can be taken away from sole proprietary concern to the account of proprietor so that it does not attract capital gain tax. For example investments in land, building, securities etc. held in proprietary concern Superior Mills can be transferred to Mr. X. The timing should be proper. 

The above exemption is only in relation to 'capital asset', and therefore items which are not capital asset are not covered by this exemption. Therefore, profit or loss, if any on transfer of stock-in-trade is to be separately considered. This should properly be planned.

Shareholding-

The sole proprietor (Transferor) in the company should have minimum  fifty per cent of the total voting power in the company and he should maintain at least 50% of such stake  for a minimum  period of five years from the date of the succession.

Suggestions-

Shares to proprietor can be issued at par or at low premium. Thereafter, preferably on commencement of business by company, and improvement of the prospects of business more shares can be issued to others at premium or higher premium to meet capital requirements. Care should be taken that at least 50% stake in voting rights is maintained for at least five years. Issue of nonvoting shares or preference shares having no voting rights can also be considered.

Consideration:

The sole proprietor should receive entire consideration only by way of allotment of shares in the company and should not receive any other consideration or benefit, directly or indirectly, in any form or manner.

Suggestion:

Care should be taken that there should not be eitherexpress or implied, direct or indirect consideration being passed to proprietor or his nominees on his behalf or any benamidar etc. Any doubt raising situation should be avoided.

Sole proprietary concern:

There appears no definition of 'proprietary concern' in the Income-tax Act. However, we find that an individual, a HUF, BOI, AOP, Company etc. are regarded as person. A firm and its partners are considered separate persons for the purpose of the Act. Similarly members of HUF and HUF are separate persons. However, if a sole proprietary concern is owned by any assessee whether it be an individual, a HUF, a firm or a company, it is  not considered  as separate from the sole owner. For example in the illustration given above two units of the owner whether it be Mr. X, M/s X & Y Firm or M/s XYZ Ltd will be considered as income of the owner.

In the same example suppose owner starts another unit say PFY unit with Mr. P as a partner. Say PFY unit is owned by a firm known as XYZ & P Co.  In this case PFY unit is not sole proprietary concern of either XYZ Ltd or Mr. P but it is a sole proprietary concern of new firm  XYZ & P Co. This illustration makes the point clear that only the sole owner of a business unit can be considered its sole proprietor and concern which is owned by a single person can only be considered as a sole proprietary concern. This also find support from related dictionary meanings.

This also find support from commercial practices and expressions. For example we find trade name of a unit and in bracket it is written ( proprietor…… or a unit of ……) this shows that a unit has its trade name and its owner is another person. For example see the following imagianary names:

Taza Tea Estate        ( Prop. Taza plantations Ltd.)

Taza Coffee  Estate  ( Prop. Taza plantations Ltd.)

Soft Rubber  Estate   ( Prop. Taza plantations Ltd.)

Beauty care centre    (A unit of Taza Plantations Ltd.)

The above illustrations shows that all four units are sole proprietary concerns of Taza plantations Ltd. Income of all four units will be considered as income of Taza plantations Ltd.  

Therefore, in context of the Act, we find that the  full owner is considered as sole proprietor.

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