Exemption from capital gains tax on SUCCESSION OF SOLE PROPRIETARY BUSINESS BY COMPANY- 3rd article in view of a recent Tribunal judgment- a case for learning.

[CA DEV KUMAR KOTHARI]

Earlier articles written by author and found on this website:

Exemption from capital gains tax SUCCESSION OF SOLE PROPRIETARY BUSINESS BY COMPANY. September 22, 2011 

Succession /conversion of proprietary concern into a company- exemption from capital gains- November 28, 2009.

In the above articles author had analyzed provisions and made suggestions about process for succession of proprietary concern by a company and care to be taken during such process and thereafter. The readers are requested to refer to the same.

Recent judgment of ITAT:

In the case of Kantilal Gopalji Kotecha Versus ITO-8 (2) (4), Mumbai , in appeal no. ITA No. 6903/Mum/2012  decided on  06 June 2014   and reported on this website as 2014 (6) TMI 772 - ITAT MUMBAI, a case on exemption under said provision came for consideration.

Unfortunately in this case, the AO, The CIT(A) and the Tribunal has denied exemption. It appears that there has been some lacking in representation of the facts and circumstances of the case. In the earlier articles author had suggested that each and every assets and liabilities of the proprietary concern must be properly verified, valued and accounted for, for the purpose of ascertaining valuation of proprietary concern and determination of consideration payable by way of issue of shares by the successor company to the proprietor of the concern. It seems that some of suggestions had not been followed by assessee and that had led to dismissal of claim of assessee. However, inspite of that the assessee could have won the case if it was established that the amount accounted for as goodwill , is represented by various  business assets of the proprietary concern which have been transferred to the company, and the same are business assets of company and being used for business succeeded by the company.

 It also appears that honorable Tribunal has read into some conditions, which are not found in the relevant provision. Therefore, the judgment of Tribunal deserves to be contested before High Court. Before that an attempt can be made by assessee by way of a Miscellaneous application to bring on record correct and complete facts to establish that there was no violation of conditions of S. 47(xiv).

Form the Judgment / Order:

Quote (relevant portion):

   The portion relevant to issue of exemption of capital gains on succession of proprietary concern by company is reproduced below:

2. In this appeal the Assessee has raised the following grounds:-

“On the facts and circumstances of the case and law the learned Commissioner of Income Tax-Appeal (CIT-A) erred in treating Goodwill generated on conversion of Proprietary concern into a Limited Company as Short Term Capitals Gains without appreciation the provisions of Sec.47(xiv) of the I.T. Act, 1961, without appreciating that the Goodwill was self generated and also without considering and distinguishing the case laws relied upon by the Appellant.

3. Apropos Ground No. 1, the relevant facts are that the assessee, an individual who was the proprietor of M/s. Overseas Plastic Moulders (OPM), during the year under consideration converted the said proprietary concern into a private limited company namely Overseas Plastic Moulders India Private Ltd. (OPML) and in the process of succession, the assessee was issued equity shares of the company. During the assessment proceeding, from the details filed by the assessee, the AO noticed that the total of the balance sheet of OPM as on 31.03.2008, just before the take over was Rs.4,63,95,814/- and the assessee’s capital account in the capacity of the proprietor had the credit balance of Rs.1,16,05,939/-. The AO further found that the OPML allotted the assessee 33,59,064 equity shares of Rs.10 each representing share capital of Rs.3,35,90,640/-. According to the AO, since the assessee’s capital account had credit balance of Rs.1,16,05,939/- only, in order to comply the accounting entries, a good will of Rs.2,29,89,701/- was created in the books of OPMIL and the equal amount was credited to the capital account of the assessee in his personal balance sheet. According to the assessee, the excess credit namely the difference between the agreed consideration and the capital balance was accounted as good will in the books of M/s. OPMIL and such good will arising on succession is a fictitious and notional entry which has no impact on the income computation of any assessee hence its creation is neither treated as income nor allotted as expenses. Therefore, the transfer of the good will is covered by the exemption u/s 47(xiv) of the Act as the assessee did not receive any direct benefit other than the allotment of shares in lieu of transfer of good will which is fictitious and notional asset. However, the said contention was not accepted by the AO on the reason that the good will was never created in the books of propriety concern of the assessee and therefore, it never became the asset of OPM. Also, the good will was not the part of the assets of the propriety concern, M/s. OPM and therefore, the transfer cannot be exempted u/s 47(xiv) of the Act. Accordingly, the AO held that the assessee was liable to pay capital gain tax on the short term capital gain of Rs.2,29,84,701/- arising on the transfer of alleged good will to OPMIL. On appeal, the Ld.CIT(A) confirmed the action of the AO as the conditions of section 47(xiv) was not complied by the assessee as the good will generated was not in the books of OPM and was not a part of asset and liabilities of the sole proprietary concern which were succeeded by OPMIL. Aggrieved by the impugned decision, the assessee has raised this ground in the appeal before us.

3.1 Having heard both the sides and perused the material on record it is not disputed that the assessee was a proprietor of OPM and then he converted the same into a private limited company. Also it is not disputed that the good will generated has no mention in the books of OPM and is not a part of the assets and liabilities of the sole proprietary concern which has been succeeded by OPMIL. With the given factual background, it is relevant to mention that in para 9 at page 5 of the deed of assignment dated 17th September 2008 between M/s. OPM Ltd and OPMIL, it is stated that:-

“Negotiations were held between the assignor and assignees for the assignment of the assignor’s right title interest, claim and demand in the said business including its business assets and liabilities written and business rights quota allotments rights registration and intangibles including good will technical know how drawing designs etc. by the assignee and peruse terms and conditions in the said assignment were mutually agreed upon.”

However, the perusal of the first & second schedules at pages 14-15 of the said agreement which specifically deals with the particulars of immovable and movable assets to which the assignor is entitled does not contain any detail as to the valuation of the good will possessed by the assignor while arriving at a total value of Rs.3,35,90,640/- for which the allotment of 3,35,90,64/- shares of Rs.10 each paid in share capital of the assignee. Though the general wordings contained in the recitals of the said agreement in para 5 as reproduced above covers ‘good will’ for the transfer of which negotiation has taken place between the assignor and assignee, the assignment deed does not evidence that a good will, valued at Rs.2,29,89,701/- is transferred to the assignee. Moreover, it is not disputed that the alleged good will has never been created in the books of the propriety concern of the assessee. Therefore, the allotment of shares worth exceeding Rs.1,16,05,939/- is in the form of excess assets over the assets and liabilities of the assignor. In the light of the aforementioned discussions, after considering that the assessee’s capital account in the OPM had the credit balance of Rs.1,16,05,939/- only and the assessee has been allotted fully paid up share capital worth Rs.3,35,90,640/-, we are of the considered opinion that the assessee has got the additional share capital allotment of Rs.2,29,84,701/- without bringing anything to the assignee. Therefore, the pre-requisite laid down in section 47(xiv) has not been complied with. It is also pertinent to mention that the cases laws relied on by the Ld.AR to justify the case of the assessee are distinguishable on facts as in the cases relied by the Ld.AR, a proper valuation of good will has been done prior to the transfer of assets. In view of that matter, we do not find any justifiable reason to interfere with the order of the Ld.CIT(A) confirming the addition/disallowance made by the AO on this count.

Ground No 1 is dismissed.

Unquote

The weak points of assessee:

On behalf of the assessee it was contended that 

1.  the excess credit namely the difference between the agreed consideration and the capital balance was accounted as good will in the books of M/s. OPMIL
2.  and such good will arising on succession is a fictitious and notional entry which has no impact on the income computation of any assessee hence its creation is neither treated as income nor allotted (sic.allowed)as expenses.
3. Therefore, the transfer of the good will is covered by the exemption u/s 47(xiv) of the Act as the assessee did not receive any direct benefit other than the allotment of shares in lieu of transfer of good will which is fictitious and notional.

Therefore, in a way assessee has submitted that the amount represented was a differential amount without allocation against any asset and generally described as goodwill. It appears that the assets have been transferred at book value, and as a result the excess of consideration was considered as goodwill. Instead of that all assets of proprietary concern should have been valued properly.

In the accounts of proprietary concern assets including intangible assets, goodwill etc.  should have been revalued, and  accounted . This could be done at any time and at least  immediately before succession of business, for the purpose of valuation of business to be succeeded. But this was not done.

In the agreement, complete list of assets and valuation should have been given including for intangible assets and privileges accounted for as ‘goodwill’.  But this was not done.

Even before authorities (AO, CIT(A) and Tribunal) the list of business assets succeeded were not given.

4. The admission that such asset or entry is a fictitious asset and its creation is neither treated as income nor allowed as expenses was wrong. This goes against the basic purpose of exemption vide this provision. The purpose of provision is that the assets are transferred, there may be gains but these gains are not taxed because the proprietor of erstwhile proprietary concern remains to be major shareholder of company. Therefore, assets need to be valued at reasonable price for transfer. 

What has been missed by authorities and Tribunal?:

It seems that honorable Tribunal has missed some aspects of the provisions and read into some conditions which are not found in the relevant provision.

The relevant provision:

Quote:

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;

Unquote:

From reading of the above provision, it is clear that all assets and liabilities of proprietary concern immediately before succession must be transferred to the successor company. There is no condition that all such assets should have been reflected in the balance sheet of proprietary concern.

 It is general practice that self generated assets like  technical knowhow, technical and manufacturing information about manufacturing processes, trade names, trade brands,  trade names, trade logos, dealers network, suppliers and service providers network, contractual rights, benefits and privileges, licenses, registration, permissions, approvals, and human resources are important capital assets of any established business. In usual course of a proprietary concern such assets are not reflected in books of account. That does not mean that such assets do not exist.

Therefore, merely because the assets represented and accounted for as ‘goodwill’ were not accounted for in the balance sheet of assessee is not a sufficient ground to hold that conditions of S. 47(xiv) were not complied with. The finding recorded by the Tribunal are analyzed below with comments of the author in tabular manner:

From order of Tribunal	Observation of author
“ we are of the considered opinion that the assessee has got the additional share capital allotment of Rs.2,29,84,701/- without bringing anything to the assignee.	With due respect the author feels that this finding is wrong and suffers from perversity. Every established business has some intangible assets.  The agreement says about goodwill and intangible assets. Mere lack of proper description, valuation and documentation for transfer of such assets, cannot be a ground to deny the benefit. Unfortunately, the counsels of assessee has also not been able to bring the facts in a proper manner to establish transfer of intangible assets.
Cases laws relied on by the Ld.AR to justify the case of the assessee are distinguishable on facts as in the cases relied by the Ld.AR, a proper valuation of good will has been done prior to the transfer of assets.	As discussed earlier, there is no such specific condition to evaluate and account for intangible assets and goodwill. Though before transfer of any business this exercise is suggested to properly evaluate all assets, liabilities to ascertain valuation of business concern.
The pre-requisite laid down in section 47(xiv) has not been complied with.	This finding appears to be wrong. Even if there are no such assets, the excess consideration will be consideration of other assets admitted  received on succession. Therefore, when other conditions are fulfilled, conditions of S. 47(xiv) must be considered as complied with.

In view of above discussion the assessee can also take a plea that there is mistake apparent from records in the order of Tribunal. Even if there was no transfer of any other assets, the consideration by way of issue of shares can be considered as consideration of other assets transferred to company by way of succession of business. Since all conditions of provision are full filled, the assessee is entitled to exemption.