Advocate Rahul Hakani has analyzed the proposed amendments by the Finance Bill 2018 to sections 2(24), 2(42A), 28 and 49 to tax the notional gains arising on conversion of stock-in-trade into capital asset. He has explained precisely the nuances of the amendments and also identified the controversies that will arise therefrom
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.
2 Conversion of stock-in-trade to capital asset may also result into advantage of lower taxes since capital gains are taxed at a lower rate compared to business income and there is also an advantage of indexation. Therefore, many a times we see builders convert their stock-in-trade i.e. land into a capital asset or a share trader converts his stock-in-trade of shares into investment. Such conversion was usually not treated as taxable by the 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.
4 Thus, when an inventory is converted into a capital asset, several issues regarding taxability of said transaction arise. Some of the issues are as under:
(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.
6 The Finance Bill, 2018 proposes to make amendments to following provisions:
(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.
(ii) Section 2(24), by inserting clause (xiia) so as to include such fair market value in the definition of income;
(iii) Section 49, by inserting Sub-Section (9) so as to provide 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;
(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.
Reason for proposed amendments
7 As per the Memorandum explaining the provisions, the reason for proposed amendment are two fold as under :
(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.
Effective date of proposed amendments
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.
10 The pre-amended law is essentially derived from judicial precedents. Some of the important decisions and the legal principles laid down by them are as under:
A. NO TAXABLE EVENT ON CONVERSION OF INVENTORY INTO CAPITAL ASSET
Sir Kikabhai Premchand v CIT (1953) 24 ITR 506 (SC).
This a landmark decision which forms the fulcrum of various subsequent decisions on the issue of conversion of stock-in-trade into capital asset. This was a Judgment rendered by a Full Bench (5 Judges) and the verdict was a split in the ratio of 4:1. The judgment deals with the tax treatment in the year of conversion. In this case, assessee a trader in silver bars and shares was valuing the stock at cost. During the relevant previous year the assessee withdrew from the business certain shares and silver bars and settled then or certain trusts at cost. The AO assessed the profit at the difference between the cost price of the said shares and silver bars and the market value thereof at the date of their withdrawal from the business. The High Court confirmed the action of the AO. Reversing the decision of the High Court, the Supreme court held, speaking through Bose, J. for the majority view:
(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.
At this juncture, it will be very important to consider the dissenting view of Bhagwati, J who held as under :
(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.
In CIT v. Dhanuka & Sons  124 ITR 24 (Cal.)(HC) while dealing with the assessment in the year of conversion, on considering Sir Kikabhai Premchand’s case (supra) and several other judgments had expressed as under:—
"14. Further, in our view, there cannot be any actual profit or loss in such transfers where no third party is involved and the items are kept in a different account of the assessee himself. The question of gain or loss would arise in the facts of the instant case only in future when the stocks transferred to the investment account might be dealt with by the assessee. If such shares be disposed of at a value other than the value at which it was transferred from the business stock, the question of capital loss or capital gain would arise."
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.
In ACIT v. Bright Star Investment (P.) Ltd.  120 TTJ 498 (Mum)(Trib) assessee had converted some shares from stock-in-trade to investment as on 1-4-1998 at its book value. Thereafter, the assessee sold some of the shares out of the above shares and offered profit earned as long-term capital gain. The Assessing Officer opined that in view of the provisions laid down under section 45(2) the income of the assessee would be computed separately as business income till the date of conversion of the shares from the stock to investment and thereafter as long-term capital gain. The Assessing Officer, therefore, took the highest market rate of the said shares on date of conversion and computed the business income, being the difference in the value at which the said shares were converted into investment and the market value of the said shares on the date of conversion, i.e., 1-4-1998 and, further computed the long-term capital gain at ` 4,57,62,262 being the difference between the market value and the actual sale value of the shares. The Hon’ble ITAT held as under :
(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.
It is to be noted that no appeal against the above decision was filed by the Department. However the Income Tax Department filed an appeal before the Bombay High Court in the case of Synchem Chemicals (I) Ltd. reported in CIT-10 v. Synchem Chemicals (I) Ltd.  384 ITR 498 (Bom.)(HC) wherein the ITAT had followed the decision of ACIT v. Bright Star Investment (P.) Ltd. (supra). The Department appeal was dismissed by the High Court.
B. COST OF ACQUISITION AND INDEXATION
In the case of Kalyani Exports & Investment (P.) Ltd./Jannhavi Investment (P.) Ltd./Rajgad Trading (P.) Ltd. v. Dy. CIT  78 ITD 95 (Pune) (TM) assessee acquired certain shares in the year 1977. On the original holding they received bonus shares in the financial year 1981-82 and additional bonus shares in the financial year 1989-90. All the shares were held as stock-in-trade till 6-11-1987. On the sale of the shares, while working out capital gain, assessee computed fair market price as on
1-4-1981. Indexation was also claimed by taking base year as AY 1981-82. The Assessing Officer held that since the assessee was holding the shares as stock-in-trade up to 2-11-1987 and as the said shares were not capital assets as on 1-4-1981, the option adopted as fair market price as on 1-4-1981 was not available to the assessee and indexation should be allowed from the year of conversion. The Tribunal held as under :
(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.
The above decision of the ITAT has been confirmed by the Bombay High Court in CIT v. Jannhavi Investment Pvt. Ltd.  304 ITR 276 (Bom)(HC) The High Court held as under :
“In our view, there is no substance in the contention of the Revenue. The amendment of 1993 referred to hereinabove does not in any way nullify or dilute the ratio as laid down in the case of Keshavji Karsondas v. CIT reported in  207 ITR 737 (Bom.) The cost of acquisition can only be the cost on the date of the actual acquisition. In the present case, there was no acquisition of the shares on November 6, 1987, when the same were converted from stock-in-trade to a capital asset.”
C PERIOD OF HOLDING
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.
D DISPUTING THE VERACITY OF CONVERSION
In CIT-Delhi v. Abhinandan Investment Ltd.  282 CTR 466 (Delhi) the year of conversion of stock-in-trade into investment and the year of sale of investment was the same. The conversion was not accepted by the Court. It was held as under :
(i) The exercise of conversion was seen as sham to reduce tax incidence and consequently the conversion was not recognised.
(ii) The period of holding is to be computed from date of conversion
(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.
Similarly the Mumbai ITAT in Mr Kenneth D’Souza v. Addl. CIT ITA No 865/M/2012 A.Y. 2008-09
dtd. 6-2-2015 (Mum)(Trib.) 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).
However, in Deeplok Financial Services Ltd. v. CIT  393 ITR 395 (Cal)(HC) the claim of assessee regarding conversion of stock in trade into investment in earlier year and return of capital gains in year of sale of converted stock-in-trade was accepted. It was held as under :
(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.
11 Thus the pre-amended position can be summed up as under:
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.
c) Taxable event arises only upon subsequent sale of capital asset and the gains will be taxable as capital gains. It is to be noted that the observation of Delhi HC in CIT-Delhi v. Abhinandan Investment Ltd. (supra) was only a prima facie view and not a conclusive decision.
d) The cost of acquisition shall be the actual cost of acquiring the asset. However, in 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.
12 Having analysed the pre-amended law, I will now proceed to analyse the post-amended law as under :
A CONVERSION OF INVENTORY INTO STOCK IN TRADE RESULTS IN A TAXABLE EVENT
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.
B YEAR OF TAXABILITY SHALL BE THE YEAR OF CONVERSION
The year of taxability shall be the year of conversion itself. The reason for same is as under :
(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.
(iii) The memorandum explaining the provisions clearly state the one of the objectives of the proposed amendments is to discourage the practice of deferring the tax payment
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.
C FAIR MARKET VALUE
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 Rs 100. The closing stock is valued at Rs 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) Rs 200 will have to be taken and not Rs 200-90. This is because the difference of ` 110 will be adjusted in the trading and P/L A/C itself.
E COST OF ACQUISITION ON SUBSEQUENT SALE OF CAPITAL ASSET
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.
F PERIOD OF HOLDING
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.
G CERTAIN ISSUES
(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.
13 As pointed out above, the proposed amendments completely disregard the fundamental principles of Income Tax Act such as “no man can trade with himself” or that “no one can profit from oneself”. It was on these principles that the Supreme Court in Sir Kikabhai Premchand v CIT (Supra) held that there is no taxable event upon conversion. It further held that State has no power to tax potential profits. This amendment is a part and parcel of the recent trend 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.
15 The Supreme Court in Sir Kikabhai’s case also highlighted the freedom of businessman to deal with his business in the manner he likes by way of an illustration. It appears that such freedom now stands impinged. I would conclude by reproducing the said illustration which would aptly manifest the contrast between the pre-amended law and post-amended law :
“A man trades in rice and also uses rice for his family consumption. The bags are all stored in one godown and he draws upon his stock as and when he finds it necessary to do so, now for his business, now for his own use. What he keeps for his own personal use cannot be taxed however much the market rises; nor can he be taxed on what he gives away from his own personal stock, nor, so far as his shop is concerned, can he be compelled to sell at a profit. If he keeps two sets of books and enters in one all the bags which go into his personal godown and in the other the rice which is withdrawn from the godown into his shop, rice just sufficient to meet the day-to-day demands of his customers so that only a negligible quantity is left over in the shop after each day’s sales, his private and personal dealings with the bags in his personal godown could not be taxed unless he sells them at profit. What he chooses to do with the rice in his godown is no concern of the Income-tax department provided always that he does not sell it or otherwise make a profit out of it. He can consume it, or give it away, or just let it rot. Why should it make a difference if instead of keeping two sets of books he keeps only one? How can he be said to have made an income personally or his business a profit, because he uses ten bags out of his godown for a feast for the marriage of his daughter? How can it make any difference whether the bags are shifted directly from the godown to the kitchen or from the godown to the shop and from the shop to the kitchen, or from the shop back to the godown and from there to the kitchen? And yet, when the reasoning of the learned Attorney-General is pushed to its logical conclusion, the form of the transaction is of its essence and it is taxable or not according to the route the rice takes from the godown to the wedding feast. In our opinion, it would make no difference if the man instead of giving the feast himself hands over the rice to his daughter as a gift for the marriage festivities of her son.”
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