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Rajiv Bajoria, Shivali Valecha & Anisha Sekhri*

Capital assets and inventory are treated differently for the purpose of taxation and are governed by distinct provisions. As a result, classification of assets has often been a subject matter of challenge by the tax authorities. So also, a change in this classification by the taxpayer.

The income-tax law provides a definitive treatment to be applied where an asset originally bought as an investment is converted into stock-in-trade. However, the reverse scenario has not been specifically addressed.

Perhaps, the legislature did not visualize a situation of stock-in-trade being converted into a capital asset, and sold subsequently. In the absence of specific provisions to deal with these type of situations, tax payers generally made such conversion at book value and adopted a view that no tax implications arose at the time of conversion. Upon sale of such asset, the gains, computed with reference to the book value of the asset as on the date of conversion, were offered to tax as capital gains.

However, drawing analogy from the provisions applicable for conversion of capital asset into stock-in-trade, the tax authorities sought to tax gains till the date of conversion of stock to asset as business income, and only the residual, if any, as capital gains.

The controversies also led to other related issues such as the value to be adopted for determining business income, cost of acquisition of the capital asset and its period of holding, etc.

That apart, questions were raised with respect to the bona fides of the conversion, especially in cases where the capital asset being shares, were sold in quick succession to the conversion.

The Finance Bill 2018 proposes to introduce provisions (with effect from Assessment Year 2019-20) to put these controversies to rest and provide a symmetrical treatment vis-à-vis the already existing provisions for taxation on conversion of a capital asset into stock.

Key proposals

Nature and extent of gain

Under the proposed provisions, conversion of stock-in-trade into capital asset would attract taxability as business income with reference to the fair market value of inventory on the date of conversion; fair market value would have to be determined in the manner to be prescribed.

The said value would then form the cost of acquisition of the capital asset, for the purpose of computing capital gains on sale of the asset.

In the past, some courts had held in favour of the taxpayer on the basis that in the absence of specific provisions, the view beneficial to the taxpayer should be adopted.

However, the proposals seem to have taken cue from the possibility indicated recently by the Delhi High Court in the case of Abhinandan Investment Ltd.

Period of holding of the capital asset

As per the proposed provisions, the period of holding the capital asset is to be reckoned from the date of conversion of stock-in-trade to capital asset i.e. excluding the period for which the asset was held as stock-in-trade prior to conversion.

The proposals are in line with the approach adopted by the tax authorities which also found support of the courts[1].

A re-look needed?

While the Finance Bill 2018 does tackle the situation of conversion of stock into capital asset and its related aspects, and provide clarity of tax treatment for such conversions, it appears to leave some aspects unanswered.

The provisions intend to tax the gains on conversion of inventory as ‘business income’. However, unlike the provisions relating to taxability of capital asset converted to stock-in-trade, it does not defer the incidence of tax to actual sale.

This appears contrary to the principles held by the courts, including the Apex Court[2], that there cannot be an actual profit or loss when no third party is involved and the items are kept in a different account of the tax payer himself; since a person cannot make profits out of himself, the question of gain would arise only in future when the stock transferred to the capital asset account is disposed.

The provisions, in their current form, may result into taxing income at a time when it does not in fact exist.

In cases of genuine conversions on account of business requirements, the purpose of converting a stock into a capital asset is not to earn profits from the conversion, but to hold the asset as an investment i.e. not for sale in the normal course of business. In such cases, taxation in the year of conversion could amount to taxing a notional income which is against the principles of taxation. It is fairly settled that what can be taxed is real income.

As there would generally be a time lag between conversion to capital asset and its sale, there would be added difficulty. Further, it is worthwhile to note that while the intent was to introduce symmetrical provisions for taxing conversion, the year of taxability has not been duly aligned with the existing provisions on conversion of capital asset into stock (i.e. not deferred to the year of sale of asset).

Even otherwise, it is questionable whether at the stage of conversion into capital asset, the income proposed to be taxed can be said to meet the threshold of reasonable certainty for revenue recognition being applied in other cases. One would wonder whether such divergence is justified, particularly where the intention is not to avoid tax or defer payment thereof.

A re-consideration of this aspect, such that the tax payout is triggered only in the year of sale, would prove greatly helpful to the tax payers.

 [1] CIT v. Abhinandan Investment Ltd. [2016] 282 CTR 466 (Del.)

 Splendor Constructions (P.) Ltd. v. ITO [2009] 27 SOT 39 (Del. Trib.)

 Deensons Trading Co. (P.) Ltd. v. ITO [2017] 81 71 (Cal. Trib.)

[2] Sir Kikabhai Premchand c. CIT [1953] 24 ITR 506 (SC)

 CIT v. Dhanuka & Sons [1980] 124 ITR 24 (Cal.)

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June 2024