Shantanu Shastri
Abstract–
The idea of income tax has an in-principle foundational premise; if there is an income, there would be charged an income tax, or conversely put, there can be no income tax without any income, provided that the income falls under one of the five heads. Among the five heads of income, income from capital gains and income from profits and gains of business or profession face a peculiar problem, the cases of self-dealing where conversion of stock-in-trade into capital asset takes place or vice-versa is deemed to be ‘transfer’ for the purpose of creating a charge of tax on the ‘transaction’. This paper discusses the three schools of thought regarding ‘income’ in such cases, the first one that says there must be entry of cost price in the revenue column thereby leading to cancellation in accounts, the second that says there might be no entry of a receipt at all which can further be divided into ‘zero’ as an entry and ‘nil’ as an entry, both of which have respective consequences, and the third that talks about the entry of FMV or the fair market value, whose origin lie in the idea of ‘imputed income’. Each school of thought either benefits the assesse or the revenue department. The scope of this paper is jurisprudential in nature and does not limit itself to the settled position of law on self-dealing in India but rather examines how the churn of perspectives regarding the subject has led to controversies and cases in the field of taxation.
Keywords– Imputed income, Fair Market Value, Dichotomy, Cost-price, Accounting.
I. Introduction
Tax is famously defined as a compulsory extraction of money by a public authority, for public purposes and is not a payment for services rendered.[1] Article 265 of the constitution of India directs that no income tax shall be levied or collected without the authority of law.[2] The income tax act, 1961 is the primary and substantive law for taxation in India. Section 4 of the income tax act talks about basis and authorizes the charge of income tax.[3] There are five heads of income, namely, income from salaries, income from house property, income from capital gains, income from profits and gains of business or profession (hereafter referred to as PGBP), and income from other sources. Section 28 is the charging section for income earned from PGBP.
Section 28(via) of the act says, ‘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’ shall be chargeable to income tax under the head “Profits and gains of business or profession”.[4] As per section 2(22B), the fair market value or the FMV is defined as ‘the price that the capital asset would ordinarily fetch on sale in the open market on the relevant date’.[5]
FMV is of substitutive nature. It aims at filling the vacuum created in accounts as a result of legal fiction of a deemed transaction where there has been no real transaction. Thus, the position of Indian law to calculate ‘income’ in case of conversion of stock-in-trade into capital asset is to calculate monetary value of the benefit received and then calculate the profit to tax it. But this should not be accepted without scrutiny and taken as the undebatable position of the law.
In India and abroad, there have been many cases where this question has come up and answered in different ways.
II. The Problem of Ownership
A. The entry of cost price
Let’s take the case of Sharkey v. Wernher.[6] In this case a woman named Zia Wernher owned a stud farm that generated profits to be taxed under the income tax act, 1918. She also owned a racing stable for a recreational purpose that did not generate any taxable liability. From stud farm, she transferred five horses to the racing stable. The issue that arose was as to what value should be entered into the accounts of the stud farm in respect of the transfer.
In the case of Sharkey v. Wernher, Lord Oaksey gave a dissenting opinion. When a person is the owner of two entities and a transfer takes place from one to another, there might be an entry made in the books for accounting purposes but this is not a taxable event. This conclusion, flows from a basic premise and principle that ‘a person cannot trade with himself’ because, ‘Ownership’ is a bouquet of rights. A ‘legal person’, i.e., something that has a right or a duty can be an owner. As Salmond among various other jurists, has suggested that an owner has the right to possess, transfer, use, or even destroy a property (subject to the context and laws of the land).[7] A ‘property’ is something against which a title of ownership lies.
He held that Zia Wernher is not liable and hasn’t made any profit or gain under section 10 of the finance act,1941. It’s a both logical fallacy and absurdity that a person trades with himself and even generates taxable profit from the ‘trade’ over and above it. The fact that the same person is the owner of the two entities can’t be looked over and ignored. It is a settled principle of law, he argued, that the notional profit or gain or simple benefit cannot be taxed and it has to be a demonstrable monetary profit as held in the cases of Tennant v smith (7) (1892) (3 tax cas.158)[8], Gresham life assurance company v styles[9] (4) (1892) (3 tax cas.185). Palles C.B., in the case of Dublin Corporation v. M’ Adam said that “if these two parties are identical, in my opinion there can be no trading”. [10]
Therefore, a person is free to withdraw any stock from his stock-in-trade unless the intent is to sell it out of the accounts of the business. To the argument that such a line of thought would compromise the value of assets to be shown in the accounts, Lord Oaksey dismissed the proposition saying if the assets are disposed of by means other than the way of sale, the amount to be entered in the revenue/credit side would be the same as the cost of production so that it does not impact the profit figures in the accounts or the deduction of expenses. Because, if a reverse scenario were to be assumed where the transfer happens from racing establishment to stud farm and if no value were to appear in the accounts of stud farm, the subsequent sale of horse from the stud farm couldn’t be taxed as it would result in taxation of fictitious profit without the cost of acquiring the horse by the farm.
Similarly in India, in the case of Commissioner of Income Tax v. kikabhai Premchand[11], the appellant was a businessman dealing in silver and shares. In 1942, the appellant withdrew silver bars and shares from his stock-in-trade and transferred them to three trusts in which he was one of the beneficiaries. Now, coming to accounts as it forms the basis of taxation, the appellant entered the cost price of the assets withdrawn in the revenue section.
In this case too, like Lord Oaksey’s dissent in Sharkey, the majority opinion held that in the absence of real, tangible and demonstrable profit, no tax liability would arise solely on the basis of simple benefit provided that the withdrawal is Bonafide. To the argument of the respondent that the state may lose out on revenue as the fair market value might be higher than the cost price, and that it would encourage the practice of withdrawing unsold assests at the end of the year, it is to be noted that the idea of taxing profits that might have happened isn’t something envisaged in the income tax act, 1961 and would amount to opening a pandora’s box. Also, the situation might reverse when the asset has depreciated and the assesse might withdraw it from the stock at the end of the year to show the current fair market value which is less than the cost price. The real hard fact that the owner of the two entities is the same does not warrant the conception of a fictional transaction with notional profit at par with a case when there are actually two parties involved who have engaged in trade with each other.
The cost price practice of accounting was also corroborated by the appellant’s method of book-keeping of unsold stock-in-trade. At the end of the financial year, he used to enter the ‘at cost’ value of the unsold stock in the relevant side of the accounts thereby cancelling the entries and giving the clear picture of the actual profits. Unthreading the whole trade and treating transaction in each stock separately couldn’t be an option because ‘businesses factorize as continuity, profit and profit motive when bought and the scale and magnitude of the activity.
On the basis of majority opinion in the Sharkey case, the kikabhai case’s reasoning was argued to be worth reconsideration in the case of CIT v. Shirinbai Kooka[12], a case of conversion of capital asset into stock-in-trade. The facts of the case were that the assesse purchased some shares as an investment but later converted the same into her stock-in-trade, 1st of April 1945 to be precise. Some of the shares were sold from the stock in the financial year 1947-1948.
The issue in the case was, whether the assessable profits from the sale of shares should be calculated as the difference between the sale price and the original cost price, or as the difference between the sale price and the market value as of 1st April 1945.[13]
The Income Tax Department preferred not to recognize the same ownership in Kikabhai Premchand case, while in Shirinbai Kooka, it sought to acknowledge the same ownership to ensure the taxability of gains when a capital asset was converted to stock-in-trade and later sold. Ironically, it lost in both the cases. The assesse tried to highlight perceived significant differences in the two cases that justify arriving at a different conclusion as discussed below.
Justice A.K. Sarkar gave a dissenting opinion in the Shirinbai Kooka case, following the reasoning in the Kikabhai case. So, to sum up till now, what started from Lord Oaksey’s dissent in the Sharkey case, later in India became the majority opinion in the Kikabhai case with Justice Bhagwati dissenting, and further became the dissenting opinion in Shirinbai’s case.[14] Justice Sarkar did not accept the argument of the respondent that kikabhai case was a case of potential sale and profit while in the present case there were actual realised gains on the sale of shares. The difference highlighted was said to be irrelevant as in either of the two cases, the owner was the same person and both were essentially cases of self-dealing. Even if the claim of the respondent that the two cases are different were to be accepted, the bone of contention would remain the same and the relevant similarity of a person ‘trading’ with their self would outweigh relevant differences. While calculating profits, the respondent wants the value of acquisition of the stock to be the fair market value which is only possible if the fiction that Kikabhai’s case rejected were to be accepted. Justice Sarkar did not agree with the proposition that as a general rule dichotomy between business and the owner should be recognised. More on this will be discussed in the later part of the article. The fact that this would create disparity in liability with another seller who has disposed the stock not by way other than sale was said to be immaterial for this reason: assuming that two businesses in the same sector who sold the same product in same quantity in the same financial year might show different profits because let’s say one acquired goods or stock at a much cheaper rate. If this scenario of disparity is not problematic in the eyes of the law, there is no reason why the one of disparity because of self-dealing should be. Moreover, the ideal of equitable distribution of burden of tax should not take precedence over right to liberty and property, especially in this case.
B. No entry at all
It is obvious by now that that in cases of self-dealing, the assesse can’t be allowed to credit the value ‘zero’ in accounts as this would tantamount to giving license to show less profits and would impact the revenue of the state where set-off and carry-forward rules are applicable and would also go against the matching concept of accounting while calculating profits and it would be unfair in comparison for the one who has disposed of an asset in stock by way of trade, unlike the case if cost price were entered because that is aimed at cancelling the cost and as far as the contention that it can be a way of escaping potential profits is concerned, it has remained answered as above. It was also thought that an entry can be made of fair market value for accounting purposes but definitely not for the purpose of taxation.
It is important to note that ‘no entry at all’ might mean both ‘zero’ as an entry and ‘nil’ (-) as an entry. In some places ‘nil’ may automatically become ‘zero’ like in cases of set-off and carry-forward while in others such as where the cost of acquisition is ‘nil’ like the scenario discussed above of ‘where the transfer happens from racing establishment to stud farm and if no value were to appear in the accounts of stud farm’ because the owner is same, judicial interpretation would decide whether it could be taken to mean zero for the capital gains tax to be applied. Such one case in India is B.C. Srinivasa Setty v. C.I.T (1981)[15]
III. Recognising the Dichotomy
What makes sense and is reasonable is different to different people and what is rational depends upon the perspective of the observer. The second school or the line of thought on the subject of self- dealing recognizes and considers the fact that business and owner are two separate legal entities as a valid reason to refute the premise of a person trading with ‘himself’ by giving a new interpretation with regards to this ‘himself’ and that whether and how far can this principle be extended to the subject at hand.
Let’s go back to the case of Sharkey v. Wernher and throw some light on the majority opinion. Lord Viscount Simonds, Lord Porter, Lord Radcliff and Lord Tucker were of the opinion that when an asset is taken out of the stock-in-trade by the owner, the value that should appear in account books is the fair market value (FMV). Lord Viscount Simonds refuses to accept the universality of the ‘trading principle’ and basically says that genesis and application of principles lied embedded in particular contexts. Just like the definition of a same thing may be different for the purposes of different acts, what is true of a principle in contract law may not hold water in case of taxation law. Therefore, it’s the businessman me trading with the individual me that paves the way for the logic that the entry on the credit side should be of fair market value and not of cost price. The tax code already achieves this fictitious separation in various ways. Differentiating it with just another trade is not an intelligible differentia and has no nexus with the objective of taxation sought to be achieved.
Another important point raised against the entry of cost price on the credit side is that this method assumes that cancellation is possible because finding out the ‘cost price’ is possible every time, but this is not the case when the expenses are a part of a whole continuous activity. In this case, “The trade of which the receipts and expenses are in question is the whole activity of farming and the disposal of the produce is only one, though a very important, incident of that activity”[16]. This allegation has broadly remained unanswered.
Similarly, in the case of Commissioners of Inland Revenue v. William Ransom & Son, Ltd[17], when the two departments were owned by the same person and the produce of one department was transferred to another for processing, the internal account of the former department was held to must be credited by the fair market value of the produce transferred.
The best way to criticise one position is to think from the perspective of another position. The fair market value school of thought launches a staunch attack on the cost price school of thought questioning as to why opt for a path where the cancellation of cost price should take place in the first place. “The fact that an item of stock is disposed of not by way of sale does not mean that it was any the less part of the trading stock at the moment of disposal”[18] Thus, creating a legal fiction of an actual legal transaction with respect to the asset withdrawn from the stock must be the preferred way of moving ahead. The court gave two reasons for this. First that this ensures equitable distribution of tax and takes care of the equality principle with respect to some other corresponding taxpayer engaging in the same business and second is more of a subjective reason that this seems to be better economics.
It must be noted that this school of thought expands the scope of tax to include notional benefit under its ambit. Some other cases cited in the Sharkey case on the same lines are Watson Bros v. Hornby[19] and Back v. Daniels[20] where it was held that for the purpose of proper assessment of profits it is necessary to treat a man engaging in self-dealing as trading with himself on usual commercial terms.
Similarly, in the case of kikabhai Premchand, justice Bhagwati dissented and was primarily concerned about the fact that the cost price method does not reflect the appreciation and depreciation in the asset and hence is inappropriate. The fact that the owner is one does not snatch away from the business its entitlement to credit in the books of accounts the real fluctuated figure as per the market conditions just because the assets was parted ways with by way of unconventional method of trade. Similarly, in the case of Shirinbai Kooka, the court took the path of fair market value approach.
A. Tossing by the Legislature
As it usually happens in the field of taxation, the parliament is infamous to overturn the judgments of supreme court as and when it finds suitable. Both in the case of kikabhai Premchand and Shirinbai Kooka, the income tax department could not get what it wanted, so the government took the next prudential step. To overrule Kikabhai case, the legislature introduced section 28(vi)(a) that mandates the ‘income’ in cases of self-dealing to be taxed to the extent of difference between fair market value at the time of ‘transfer’ and the cost price. Kooka was taken care off by introduction of section 45(2) which states that profits or gains arising from the conversion of a capital asset into stock-in-trade, or its treatment as such by the owner in a business they carry on, shall be taxable as income in the previous year when the stock-in-trade is sold or otherwise transferred. For the purposes of Section 48, the fair market value of the asset on the date of its conversion or treatment as stock-in-trade shall be considered the full value of the consideration received or accruing from the transfer of the capital asset.[21]
IV. Critical Analysis
The question that has been faced by the courts be in India or outside has been the question of taxation of ‘Imputed income’. This is one of the controversial topics in the tax jurisprudence for it questions the very idea of income beyond its traditional definitions and argues for a broader scope and ambit of the same. The basic premise of imputed income is that one generates ‘deemed’ income when one engages in self-supply of goods and services which would otherwise have been required to be bought from the marketplace.[22]
Imputed income can be classified in two types for our purposes. First when a taxpayer supplies himself out of his own business and second, when a taxpayer does not avail a particular service from the marketplace and rather does the work himself. For example, when a person does not avail the services of a gardener and cuts his lawn himself, the benefit he has enjoyed is equivalent to the unrealized wage of the gardener.[23]
The idea of fair market value is a consequence of imputed income as also seen in the case of J. Bert Mac Donald and Sons Limited v. M.N.R.[24] Here, the assesse company had a father and his children as the shareholders. The father transferred land to the company at a price much lower than the fair market value and later, the company sold the land. The issue in this case was as to what should be the taxable profit of the company for the purpose of capital gains tax, either the difference between sale price and the fair market value or the sale price and the actual cost at which land was transferred to the company by the father. The court extended the principle laid down in the Sharkey’s case because relevant similarities overshadowed the relevant differences between the two cases and held that the fair market value ought to be considered while calculating profit to be taxed. Here, one can notice that the concept of imputed income may or may not be stretched to cases of undervaluation and the ‘potential profit’ argument is being raised. Similarly, in the case of Petrotim Securities Ltd. v. Ayres[25], a company engaged in trading activities purchased the same in the course of business and sold it to them to associate and subsidiary companies at a price lower than the fair market value to show loss in the books of accounts. It was held that since the transaction is not construed to be in the course of ‘business’, the actual price of sale will not be considered for calculation of profit and fair market value shall take the spotlight.
The key point in any legal study is by and how far can a principle established in one case be extended to ‘similar’ cases the jurisdiction encounters and what the criteria of similarity should be. Should the principle laid down in the Sharkey case be applicable to cases of sale at undervalue as well? Considering the argument against ‘potential profits’ that the income tax act does not have the power to tax what could have been a gain, certainly not. But contrary was held in the case of Skinner. v. Berry Head Lands, Ltd.[26], the assesse company engaged in the business of real estate, sold a piece of land to its holding company not at loss but at a small profit less than the market rate, nevertheless a profit. The holding company, then, sells it to a third party at a substantial profit. Looking at the facts and circumstances of the case, Goff J. opined that it is a fit case for the precedent set in Sharkey’s case to be applied.
When a trader who used to hold assets from his stock-in-trade as investments instead of selling them, he could be said to have converted the asset from the stock-in-trade to his own capital asset, the ‘transfer’ ought to be recognised and the value assigned to it must be the fair market value. “I see no difference where a trader removes trading inventories to use them as capital assets of a producing business or as consideration for the acquisition of such assets” [27]. This was said in the case of Allarco Developments Ltd. v. M.N.R., thus cementing the fair market value view of taxation. From a perspective of the revenue departments across the world, who want to generate as much revenue as feasible, this seems to be by far the most popular position.
However, the supreme court of Canada reversed the decision as it interpreted the facts as not a withdrawal of assets from the trade but rather exchange of trading asset for a permanent investment in the course of trade.
The valuation of imputed income also may be a problematic exercise. Also, it may not go down well with the proponents of equity and distributive justice that a financially well-off person and a lower income person are both charged for imputed income. It may be seen as regressive form of taxation on the same lines as indirect taxation. The idea of imputed income risks viewing societal activities only from the standpoint of monetary valuation and overlooking the fact that some people might want to engage in doing the work themselves instead of hiring a service for reasons other than only monetary in nature.
Various jurists have raised their opinion against such broadened idea of taxation. For instance, Rowlatt J. said that it is wrong to say a person earned something by engaging in self-supply, at the very best one can be said to be saving their own money.[28] But in no circumstance, he can be said to have made taxable profit.[29] Similarly in the case of Tenant v. Smith, Lord Macnaghten said that there is no reason why a person shall be taxed for what he saves in his pocket apart from what he has earned.[30]
V. Suggestions and Conclusions
On the basis of above analysis, I find arguments in favour of fair-market value and imputed income unconvincing. In my opinion, the idea of imputed income goes against the minimum threshold of socio-cultural liberalism. The idea of imputed income is authoritative and tending towards totalitarianism in nature. Liberty, tolerance and minimal state is the growing acceptable norm in the contemporary societies and imputed income tries to nudge the society using soft paternalism, assuming an objective basis for the functioning of things that undermines the very premise of liberalism, only to achieve the end of higher revenue collection. The idea of taxation has existed since ancient period and suggestions like imputed income have been made earlier too and have been rejected by the ancient societies. For instance, ancient scholars like Chanakya have been very clear in their works like ‘Arthshastra’ that farmers have first right on their produce and must be allowed to extract the stock for personal use before paying taxes to the authorities.[31] Therefore, to conclude, the fair market value approach and imputing income seems to be logically incomprehensible to the general public at large and ideally must be done away with.
Notes:
[1] Rahul Hemrajani and Nigam Nuggehalli, Taxation and the Indian Constitution (National Law School of India University, Bengaluru, no date).
[2] Constitution of India, art 265.
[3] Income Tax Act 1961, s 4 (India).
[4] Income Tax Act 1961, s 28(via) (India).
[5]Income Tax Act 1961, s 2(22B) (India).
[6] Sharkey v. Wernher, [1955] AC 584 (HL).
[7] P J Fitzgerald (ed), Salmond on Jurisprudence (12th edn, Sweet & Maxwell 1966).
[8] Tennant v Smith (1892) 3 TC 158 (HL).
[9] Gresham Life Assurance Co v Styles (1892) 3 TC 185 (HL).
[10] Dublin Corporation v M’Adam (1887) 2 TC 387 (HL).
[11] Commissioner of Income Tax v Kikabhai Premchand (1953) 24 ITR 506 (SC).
[12]Commissioner of Income Tax v Shirinbai Kooka (1962) 46 ITR 86 (SC).
[13] Ibid.
[14] Nigam Nuggehalli, Fundamentals of Taxation (unpublished manuscript 2025) p 20.
[15] B C Srinivasa Setty v CIT (1981) 128 ITR 294 (SC) (India).
[16] Supra n 11.
[17] Comm’rs of Inland Revenue v William Ransom & Son Ltd [1918] 2 KB 709 (Eng).
[18] Supra note 6.
[19]Watson Bros v Hornby [1942] 1 KB 74 (Eng).
[20] Back v Daniels (1924) 2 KB 746 (Eng).
[21] Income Tax Act 1961, s 45(2) (India).
[22] A. F. Shefford, The Taxation of Computed Income and the Rule in Sharkey v. Werner, 28 Can. B. Rev. 55 (1950).
[23] ibid
[24] [19701 1 Ex.C.R. 230, [19701 C.T.C. 17, 70 D.T.C. 6032 (Ex.Cty).
[25] Petrotim Secs. Ltd. v. Ayres, [1970] 1 Ex. C.R. 230, [1970] C.T.C. 17, 70 D.T.C. 6032 (Ex. Ct.).
[26] [19711 1 All E.R. 222, [19701 1 W.L.R. 1441 (Ch.D.).
[27] (19701 C.T.C. 390, 70 D.T.C. 6274 (Ex.Ct) reversed, [l972] C.T.C. 172, 72 D.T.C. 6154 (S.C.C.) .
[28] Supra note 20.
[29] Thomas v. Richard Evans & Co. Ltd., [1927] 1 K.B. 33, at p. 46, (1926), 11 Tax Cas. 790, at p. 822 (Eng. K.B.).
[30] Tennant v. Smith, [1892] A.C. 150, at p. 164, 3 Tax Cas. 158, at p. 171 (H.L.).
[31] Chanakya, Arthashastra (translated by R Shamasastry, 6th edn, Mysore Printing and Publishing House 1956).
nice information