Conversion of Stock in trade to Capital Asset

Karteek Konejeti

Article contains Examples of conversion of stock in trade to capital asset and its tax impact, Some important amendment introduced by Finance Act, 2018, Section 28 (Income which are chargeable to Income tax under the head ‘Profits and gains of business or profession’, Section 2(24) (Definition of Income), Section 49 (Cost with reference to certain modes of acquisition), Section 2(42A) (Definition of Short term capital asset), Final Conclusion in case of conversion of stock in trade to capital asset, Income which is chargeable under the head ‘Profits and gains of business or profession’ and Income which is chargeable under the head ‘Capital Gains’.

I) Background:

As per the section 45(2) of Income Tax Act, conversion of the capital asset by the owner of a capital asset into 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. For the purposes of computing the capital gains in such a case, the fair market value of the capital asset on the date on which it was converted or traded as stock-in-trade is to be deemed to be the full value of consideration received or accruing because of the transfer of the capital asset.

However, there was no such provision which is chargeable to the income-tax when there is a conversion of stock in trade to capital asset and it was used as a tax planning. Let’s go through in detail:

II) Examples of conversion of stock in trade to capital asset and its tax impact:

Example 1:  An assessee who is trading in shares transfers some of his stock in trade into capital asset by deciding to hold it as an investment. There is no business income at the time of conversion. It will be sold at the later stage and pay tax on the profit as capital gain instead of business profit. As we know that long term capital gain from equity shares sold in stock exchange and on which Security Transaction Tax has been paid will be eligible for the concessional rate of 10% on gains without providing the benefits of indexation, if the gains in excess of Rs. 1 lakh as per section 112A. Thus, in case of conversion of shares held as stock in trade into capital asset, the benefit of section 112A will be available if such converted capital asset is sold later and long-term capital gain arises from it.

Example 2: If an assessee who is in the business of real estate, retains part of the existing stock in trade of immovable properties of the business with him and holds it as investment then it will become his capital asset. On the date of conversion of stock-in-trade to capital asset, there will be no business income. In such case if he later sells the same capital asset then the gain arising therefrom might be a long-term capital gain and the benefit of indexation and paying of tax @ 20% instead of normal rate can be planned.

Hence stock-in-trade is converted into investments to claim benefit of lower or nil tax on capital gains.

III) Some important amendment introduced by Finance Act, 2018:

Government wants to put a check point for this and hence a provision has inserted to tax when there is a conversion of stock in trade to capital asset.

Section 28 (Income which are chargeable to Income tax under the head “Profits and gains of business or profession”)

Insertion of clause (via) i.e. the fair market value of inventory as on the date on which it is converted into, or treated as, a capital asset determined in the prescribed manner will be treated as “Income” under the head “Profits and gains of business or profession”.

If you observe the new clause (via), it mentions that fair market value of inventory as income instead of profits arising out of conversion. This needs to be corrected.

Section 2(24) (Definition of Income)

Insertion of clause (xiia) i.e. Income includes fair market value of the stock-in-trade referred to in Clause (via) of section 28 also. Here also it should have been “profits or gains arising out of conversion” instead of “fair market value of the inventory”.

Section 49 (Cost with reference to certain modes of acquisition)

Insertion of subsection (9) i.e. for calculating capital gain from transfer of capital asset referred to in section 28 (via), cost of acquisition shall be fair market value of the capital asset on the date of conversion.

Section 2(42A) (Definition of Short term capital asset)

Insertion of Sub-clause (ba) in Clause (i) in the Explanation 1 to the section i.e. For computing capital gain on transfer of capital asset referred to in section 28(via), the period of holding should be from the date of conversion of stock in trade to capital asset.

IV) Final Conclusion in case of conversion of stock in trade to capital asset

Income which is chargeable under the head “Profits and gains of business or profession”:

Fair market value of stock in trade on date of such conversion or treatment (-) Cost of acquiring stock in trade.

Here fair market value needs to be calculated in a prescribed manner. However, the prescribed manner for determination of fair market value is not yet specified.

It is proposed that tax must be paid in the year of conversion of stock in trade or its treatment as capital asset.

Income which is chargeable under the head “Capital Gains”:

Sale price of the capital asset (-) Fair market value of stock in trade on date of such conversion or treatment.

For calculate Long term / Short term capital gain, period of holding should be from the date of conversion of stock in trade to capital asset. Indexation must be allowed only from the date of conversion.

(The author can be reached at karteekcacma@gmail.com)

(Republished with Amendment)