Source: http://aiftponline.org/journal/2018/february-2018/finance-bill-2018-conversion-of-stock-in-trade/
Timestamp: 2019-04-23 14:58:16+00:00

Document:
1. An assessee may withdraw/convert/treat his stock in trade and hold it as a capital asset if there are changes in facts and circumstances necessitating such conversion.
taxpayer and consequently on sale of such investment, taxes as applicable to capital gains were paid.
3. However, the Income tax department disputed the veracity of such conversion in the year of sale and taxed the income arising on sale of investment as a business income. For example, in many cases it was seen that a share trader converted his stock of shares as on 31-3-2004 into investment as from AY 05-06, LTCG was tax free and STCG was taxed at a lower rate. Thus when the shares were sold after one year of conversion, assessee would claim income on sale as income arising on sale of investment and consequently claim LTCG as exempt. However, the A.O. would treat such gains as business income.
(i) Whether conversion of inventory into a capital asset is permitted by law?
(ii) Whether AO can dispute such conversion?
(iii) Whether such conversion gives rise to a taxable event?
(iv) If there is a taxable event upon conversion, then what is the sale consideration and when is the tax to be paid i.e., in the year in which there is sale of capital asset or in the year of conversion itself?
(v) What should be taken as the cost of acquisition of the capital asset post conversion and what will be the period of holding of the capital asset?
5. The above issues on conversion have arisen from a very long time and different assessees have given different treatments upon such conversion. However, unlike Section 45(2) which provides for taxability in the case of conversion of a capital asset into stock-in-trade, there were no specific provisions dealing with a reverse situation i.e taxability arising on conversion of Inventory into Capital Assets.
(i) Section 28, by inserting clause (via) so as to provide that 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 charged to tax as business income.
(iv) Clause (42A) of section 2, by inserting clause (ba) in Explanation 1 clause(i), so as to provide that the period of holding of such capital asset shall be reckoned from the date of conversion or treatment.
(i) To provide symmetrical treatment like treatment provided for conversion of capital asset into stock-in-trade u/s. 45(2).
(ii) To discourage the practice of deferring the tax payment by converting the inventory into capital asset.
8. These amendments will take effect from 1st April, 2019 and will, accordingly, apply in relation to the assessment year 2019-20 and subsequent assessment years.
9. It is important to analyse the pre-amended law to know the difference between the pre-amended law and post-amended law. Further, the conversions which have taken place prior to the proposed amendments would be governed by the pre-amended law.
Sir Kikabhai Premchand v CIT (1953) 24 ITR 506 (SC).
(i) A man cannot be compelled to make a profit out of any particular transaction.
(ii) It is wholly unreal and artificial to separate the business from its owner and treat them as if they were separate entities trading with each other and then by means of a fictional sale introduce a fictional profit which in truth and in fact is non-existent.
(iii) The position that the man is supposed to be selling to himself and thereby making a profit out of himself which on the face of it is not only absurd but against all canons of mercantile and income-tax law.
(iv) Under the Income-tax Act the State has no power to tax a potential future advantage. All it can tax is income, profits and gains made in the relevant accounting year.
Thus, as per this decision there is no taxable event arising on conversion of inventory into Capital Asset.
(i) So far as the business is concerned the asset ceases to be a part of the stock-in-trade whether it is realised or is withdrawn from the stock-in-trade. It makes not the slightest difference whether an asset is realised in the course of the business or is withdrawn from the stock-in-trade of the business.
(ii) So far as the business is concerned it is entitled to credit in its goods account the price of that asset as has been realised by the sale thereof or the market value of that asset as at the date of its withdrawal.
Thus, as per the dissenting view there is a taxable event arising on conversion of inventory into capital asset and market value of the stock-in-trade shall be the sale consideration.
Interestingly one can see that the minority view is now the proposed amended law and the majority view is set at naught by the Parliament.
Thus, conversion did not result into any taxable event and taxable event takes place only upon subsequent sale of capital asset giving rise to capital gains tax only.
(i) While incorporating sub-section (2) to section 45, the Legislature has not visualised the situation in other way round, where the 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 determine the profits and gains on transfer of the asset.
(ii) The formula which was adopted by the assessees i.e., the difference between the sale price of the shares and the cost of acquisition of share, which is the book value on the date of conversion with indexation from the date of conversion, should be computed as a capital gain was to be accepted.
ACIT v. Bright Star Investment (P.) Ltd. (supra). The Department appeal was dismissed by the High Court.
(i) There can be only one acquisition of an asset and that when the assessee acquires it for the first time, irrespective of its character at that point of time. It was therefore, held that what is relevant for the purpose of capital gains is the cost of acquisition and not the date at which the asset became a capital asset. Thus, FMV as on 1-4-1981 was to be taken as cost as acquisition.
(ii) Indexation has to be taken from the Base Year 1981-82.
In Splendor Constructions (P.) Ltd. v. ITO  27 SOT 39 (Del.)(Trib.) and Deensons Trading Pvt. Co. Ltd. v. ITO  81 taxmann.com 71 (Chennai – Trib.) it was held that holding period was to be counted from the date of conversion and not from the date of acquisition. The decisions also held that the Third Member decision of ITAT in the case of Jahannvi Investment Pvt. Ltd. (supra) related to cost of acquisition and not period of holding.
(i) The exercise of conversion was seen as sham to reduce tax incidence and consequently the conversion was not recognised.
(iii) The Court gave a prima facie view that on sale of investment/converted stock-in-trade, cost of acquisition could be the market value as on the date of conversion. Further, in the year of sale of investment, difference between market value and book value as on date of conversion should be assessed as business income and balance as capital gains. However, it is to be noted that the Court did not finally decide the issue and left the question open to be decided in an appropriate case.
also did not uphold the validity of conversion of stock-in-trade of shares into investments on the ground that Assessee had not shown any material change in facts justifying such conversion. The decision of ITAT was confirmed by the Bombay High Court in Kenneth D’Souza v. Addln CIT ITA No 770/M/15 dtd 24-1-2018(Bom.)(HC).
(i) Section 45(2) of the Act provides for 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 as chargeable to income-tax . The Act however does not provide for the conversion of stock-in-trade into capital asset.
(ii) Conversion of stock-in-trade into Investment is permissible even though the Income-tax Act does not provide for the same.
It appears that the above decision has acted as a trigger for the proposed amendment.
a) Though conversion is permissible in law, veracity of such conversion can be disputed by the AO.
b) Conversion does not give rise to any taxable event.
Delhi HC in CIT-Delhi v. Abhinandan Investment Ltd. (supra) was only a prima facie view and not a conclusive decision.
ACIT v. Bright Star Investment (P.) Ltd. (supra) the ITAT accepted the Book Value of stock- in-trade as on the date of conversion as cost of acquisition.
e) For classifying gains as short term capital gains or Long Term capital gains, period of holding is to be computed from date of conversion.
By virtue of amending Section 28 by inserting clause (via) it is provided that the fair market value of inventory as on the date on which it is converted into, or treated as a capital asset shall be charged to tax as business income. Consequently Section 2(24) is amended by inserting clause (xiia) so as to include such fair market value in the definition of income. Thus, FMV as on the date of conversion will be taken as income u/s. 28.
(i) The amendment is in accordance with the principle laid down by the minority view in Sir Kikabhai Premchand v. CIT (Supra) according to which there is a taxable event upon conversion. The minority view did not consider the principle of trading with oneself as applicable to the situation of conversion of stock-in-trade into capital asset. Hence, there is no merit in the argument that the business income arising on conversion is to taxed in the year of sale of capital asset.
(ii) Section 45(2) specifically provides that gain on conversion is to be taxed the year of sale of stock-in-trade. No such provision is incorporated w.r.t. conversion of stock-in- trade into investment.
by converting the inventory into capital asset.
(iv) The FMV as on date of conversion is itself income as per Section 2(24). Hence, there is no reason for deferring the incidence of tax to the year of sale of Capital Asset.
The FMV as on the date of conversion/treatment as capital asset shall be taken into consideration. Definition of FMV in relation to ‘capital asset’ has been provided in clause (22B) of Section 2 to be a value which it can fetch in the open market. However the same will not apply in this case as this clause requires FMV in relation to ‘Inventory’ and further in this clause it is provided that FMV of inventory shall be determined in the prescribed manner. It is to be noted that under the Income- tax Act FMV is not always the value which an asset can fetch in the open market. For instance under Rules 11U and UA, FMV is not always the value which can be fetched in the open market. Thus, one will have to wait for the CBDT to prescribe the valuation rules.
The amount to be taken as income is the entire FMV. This is because the difference between the FMV and the Book Value of opening stock will be adjusted in the trading account itself. For example, In AY 19-20 stock in trade being one share is purchased for ₹ 100. The closing stock is valued at ₹ 90. Hence, a loss of ₹ 10 will be booked in AY 2019-20. The share is converted to investment in the middle of AY 20-21. The FMV as on date of conversion was ₹ 200. For computation of income under Section 28(via) ₹ 200 will have to be taken and not ₹ 200-90. This is because the difference of ₹ 110 will be adjusted in the trading and P/L A/C itself.
Section 49(9) provides that for the purposes of computation of capital gains arising on transfer of such capital assets, the fair market value on the date of conversion shall be the cost of acquisition.
Clause (42A) of section 2, by inserting clause (ba) in Explanation 1 clause (i), provides that the period of holding of such capital asset shall be reckoned from the date of conversion or treatment.
(i) The conversion of stock-in-trade into investment has now been given a statutory mandate. Suppose, there is a claim of loss on account of conversion of certain stock- in-trade which is adjusted against business profits and according to AO the conversion is done for the purpose of reducing profits. Though ultimately the amount of profit which will be brought to tax may not change but there is a deference. Can the AO dispute the conversion? According to me, AO can no longer dispute the conversions which take place after the proposed amendments are brought into effect as conversion of stock-in-trade into investment is statutorily recognised and there is no provision putting any pre-conditions for conversion.
(ii) A situation may arise where no tax is paid upon conversion. The converted stock-in-trade is sold after 10 years. There is no way the gain of conversion can be taxed after 10 years. The issue will arise regarding adoption of cost of acquisition i.e., whether FMV as on date of conversion can be adopted. The proposed provision of Section 49(9) states that FMV as on the date of conversion will be the cost of acquisition. It does not state that FMV will be cost of acquisition only if gains on conversion are offered to tax.
deemed/ notional income instead of taxing real income.
14 From the analysis of the pre-amended law, it can be seen that almost all issues arising on conversion were no longer res-integra and were perhaps settled after years of litigation. The situation is similar to introducing penalty provisions u/s. 270A though the law on penalty u/s. 271(1)(c) was almost settled after several years of litigation.

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