Upgrad LLM

proprietory firm to be made a 100% subsidiary of pvt ltd co?

Senior Management

Hi,

My client has a proprietorship firm (owns 100% of it) and at the same time has a private limited company in which he holds 99% of the shares.

Am in the process of consolidation/restructuring all my client's businesses and plan to recommend that he makes this proprietory firm a 100% subsidiary of his private limited company (coz the business models/lines are very similar).

  1. Could you please let me know the different options through which a proprietory firm can be made a 100% subsidiary of a private limited company?
  2. If the proprietorship firm is "sold" and made a 100% subisidiary of the pvt ltd company then my client will have to pay a long term capital gains tax - how can i minimise his tax liability to the lowest possible level?
  3. Can "slump sale" method be adopted for making the proprietory firm a 100% subsidiary of the pvt ltd company?

Thanks

 
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Advocate

Mr Sharma
What do you mean by 100% holding of your client in his proprietary business, a proprietary is so called only if it has a sole owner and coming to the next point that you want to make the proprietary 100% subsidary of the private limited company which will lead to the proprietary lose its character.
Section 47 (xiv) provide that in specified circumstances succession of a proprietary concern by a company will not be regarded as transfer for the purpose of S.45. Thus capital gains accruing on such transfer shall not be taxable. This provision has now attained importance because business re-organization is required when business expand and more resources are required. This provision can be effectively used to reorganize proprietary businesses into companies to attract more resources. The proprietor can also capitalize against various intangible assets like  copy rights and advantages of various trade names, trade brands, logos, technical and commercial information base, distribution channels, base of loyal customers etc. Partnership firms can also first be converted into proprietary concerns and then proprietary concerns can be succeeded by company.  
When a proprietary business expand or situation changes a re-organization  of business and its legal form  may be needed. A business which is owned by one person may require to associate with others to bring in more manpower, financial, technical, organizational  and other resources. A business unit owned by one person is called  ‘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.
 

A transaction involving transfer of business to other person,  will generally attract  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 of capital asset like a proprietary concern  , 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.
We are concentrating  on issue of succession of a proprietary business into a company and exemption from capital gains tax. The provision is found in clause (xiv) of S. 47 which is reproduced with underlining of crucial words:
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;
A sole proprietary concern should be succeeded by a company- there should be succession of concern. To avoid any doubts it is advisable to form a new company with main object to succeed business of particular proprietary concern with all assets and liabilities.
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. For example stock-in-trade or rural agricultural land or some other items excluded from ambit of ‘capital gains’, may be part of assets of proprietary concern. All such assets whether be a capital asset or not  which are part of such concern  immediately before succession, need to be transferred. 
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 can be transferred to the proprietor. 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.
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.
In memorandum and articles of association also the proprietor should subscribe shares to hold at least 50% voting power immediately on incorporation of company which also lead to succession of business.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 taking into account further issue of shares also. Issue of nonvoting shares or preference shares having no voting rights can also be considered.
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.
Care should be taken that there should not be either express 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. Excess cash and bank balances or surplus assets can be transferred to proprietor much  before the succession date to reduce overall consideration.
 

Therefore, in context of the Income-tax Act, we find that the full owner is considered as sole proprietor. The general notion that a proprietary concern is a small concern owned by one person is not applicable in this context. In context of S. 47 (xiv) it is natural that a proprietary concern intended to be covered by this clause is a concern owned by one person and which has reasonably large size of operations to justify corporatization.

 

In any case of business re-organization its benefits for business should be paramount. Therefore, there should be justification to corporatize a proprietary concern into a company. This can be justified as a measure of meeting future challenges for more finance, attracting more manpower, requirement of bankers, principals and customers etc. The tax advantage should be a natural consequence and it should not appear that tax planning was sole consideration or reason to corporatize a proprietary concern. There are many other advantage which can be availed by corporatization of proprietary concern, and those advantages should be the reason for corporatization.

 
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Director

Hi Ankur,

under companies Act a proprietory business cannot become a company/subsidiary

only way is he bring this business in as his contribution other then cash { i presume your concern is transfer of some property]

 

best regards

sunita

 
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Thanks for your valuable information, I really appreciate it.

I need your help further :

in my clients case
- the company is an existing closely held company (with son and daughter-in-law as directors), a trading entity of products manufactured by proprietary concern,
which wants to take over the proprietary concern owned by the father, which is a manufacturing entity.
and they are planning to take manufacturing license in the Company as succession

So, in this case, can this be termed as succession under IT Act and Can they enjoy the Capital Gains exemption.

Please reply at the earliest as they wish to acquire on 31st March and also would appreciate if you can check and advise over the following process / steps as to whether they are in order or needs some amendments:

Steps for Acquiring:

1. Hold a Board meeting for moving proposal for takeover of business and to do the needful activities 

2. Execute an MOU between the parties for acquiring / takeover. ALso obtain an affidavit on stamp paper from the prop. that the firm will shut down after this incorporation.
3. The first clause of the Moa will be amended to indicate the takeover of firm by the company.
4. File revised F-2 (allotment of shares), 18, 32 in addition to take over the business of Proprietorship firm and proceed to allot shares.
 

Regards,

 
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