Section 45(2) of Income Tax Act deals with the cases where a capital asset is converted into stock in trade. Whenever a capital asset is converted into stock in trade by an assessee it is deemed as transfer of capital asset and attracts capital gain provisions, in spite of the fact that the ownership of such capital asset doesn’t change by such conversion.
Section 2(47)(iv) while defining the term “Transfer” in relation to a capital asset provides for that it includes “in a case where the asset is converted by the owner thereof into, or is treated by him as, stock-in-trade of a business carried on by him, such conversion or treatment”
Section 45(2): “Notwithstanding anything contained in sub-section (1), the profits or gains arising from the transfer by way of conversion by the owner of a capital asset into, or its treatment by him as stock-in-trade of a business carried on by him shall be chargeable to income-tax as his income of the previous year in which such stock-in-trade is sold or otherwise transferred by him and, for the purposes of section 48, the fair market value of the asset on the date of such conversion or treatment shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of the capital asset.”
From the plain reading of section 45(2) and 2(47)(iv) above it is clear that if a capital asset is converted into stock in trade of a business carried on by the assessee then it is considered as a transfer of such capital asset and capital gain or loss as the case may be shall be computed in the year of sale of such converted capital asset. The consideration in such case for the purpose of computing capital gain/loss shall be equivalent to the fair market value of such asset as existing on the date of such conversation.
Section 2(22B) defines the Fair Market value in relation to a capital asset as follows:
(i) the price that the capital asset would ordinarily fetch on sale in the open market on the relevant date ; and
(ii) where the price referred to in sub-clause (i) is not ascertainable, such price as may be determined in accordance with the rules made under this Act
From the above relevant provisions the following points can be summed up:
There must be a capital asset: The first thing for application of section 45(2) is that there must be a capital asset. If an asset does not fall in the definition of capital asset u/s 2(14) then even if such asset is converted into stock in trade by an assessee in his business, there will be no applicability of section 45(2) and no capital gain/loss there from will arise.
For example if a person is having rural agricultural land which is outside the definition of a capital asset u/s 2(14) and such land is treated as stock in trade by the assessee in his business of real estate, then there wont be any application of section 45(2).
Capital Gain shall be computed in the year when such converted asset is sold: Although conversion of a capital asset into stock in trade is treated as transfer in relation to a capital asset but section 45(2) provides that capital gain/loss shall be calculated on such converted asset in the year in which such asset is actually sold.
For example if a person converts his personal jewelery into stock in trade of his business of Jewelery in the year 2009-10 and sell such jewelery in the year 2010-11 then though conversion has taken place in the year 2009-10 but capital gain/loss shall be computed in the year of sale i.e. 2010-11.
Cost indexation shall be done till the year of conversion: Although the transfer of capital asset in case of its conversion into stock in trade, is deemed to have taken place in the year of conversion but the capital gain/loss is computed in the year of sale of such asset.
Hence the indexation of cost of acquisition and improvement will be done (in case of long term capital asset) by considering the C.I.I of the year of conversion. In the above example the C.I.I of year 2009-10 will be considered (since it’s the year of conversion) while calculating capital gain/loss in the year 2010-11.
F.M.V to be the sale consideration in case of conversion while calculating capital gains: As per above discussion transfer of capital asset into stock in trade is treated as transfer in relation to capital asset and capital gain/loss is computed in the year of sale of such asset. The question arises in mind that in such case what shall be the sale consideration which is to be used while calculating capital gain/loss. As per section 45(2) the sale consideration will be equivalent to the Fair Market Value of such asset as existing on the date of conversion. F.M.V has been defined u/s 2(22B) as provided above.
Business Income also to be calculated in the year of sale: After the conversion of capital asset into stock in trade of business of assessee, where the Fair Market Value on the date of conversion is considered as full sale consideration of such capital asset for the purpose of capital gain/loss computation, such fair market value is considered as cost of such asset as converted into stock in trade in the books of accounts and at the time of sale of such stock in trade the sale price (as realized from sale of such stock in trade asset) will be deducted from the fair market value of such asset as existing on the date of conversion(Since it’s the cost price of stock in trade) and the profit arising therefrom, if any shall be treated as Income U/H business and profession.
An example will make it clear more: Suppose X purchased a plot in the year 1981 for Rs 1 Lakh and converted it into stock in trade of his business of Real Estate in the year 2009-10. The Fair Market Value of such plot on the date of conversion is Rs 10 lakhs. Such Plot after conversion is sold for Rs 12 lakhs in the year 2010-11. The capital Gain and business Income shall be computed in the following manner:
Capital Gain computation:
|Less Indexed cost of acquisition(100000*632/100)
(CII for year 2009-10 is taken)
Business Income Calculation:
|Sales consideration of converted plot||1200000-00|
|Less cost of such plot(treatedas stock after conversion)
Conversion of stock in trade into capital Asset: While incorporating sub-section 2 to section 45, the legislature has not visualized the situation in other way round, where stock-in-trade is to be converted into the investment and later on the investment is sold on profit. In the absence of a specific provision to deal with this type of situation, a rational formula should be worked out to deal with this type of situation, two formulas can be evolved to work out the profits and gains on transfer of assets. One Formula which had been adopted by the assessing officer, i.e., difference between the book value of the shares and the market value of the shares on the date of conversion, be taken as a business income and the difference between the sale price of the shares and the market value of the shares on the date of conversion, be taken as capital gain. The other formula which was adopted by the assessee, i.e., the difference between the sale price of the shares and the cost of acquisition of share, which was the book value on the date of conversion with indexation from the date of conversion, should be computed as a capital gain. In the absence of a specific provision, out of these two formulas, the formula which was favorable to the assessee, should be accepted. Therefore, the Commissioner (Appeals) had properly examined this issue in the present situation and directed the Assessing officer to accept the capital gain offered by assessee. Hence, the order passed by the Commissioner (Appeals) deserved to be upheld [ACIT v Brisght Star Investment (P.) Ltd. (2008) 24 SOT 288 (Mum)]
Amit Bajaj Advocate
Bajaj & Bajaj Advocates
128, Sangam complex, Milap Chowk, Jalandhar city