Conversion of Stock in Trade Into Capital Asset

Conversion of stock in trade into asset to be used for business purposes: [Explanation-1 to Section 43(1)]

Section-45 of the Income Tax Act already provides for chargeability of capital gain in the cases where a capital asset is converted into stock in trade. But the Income Tax Act had no provision in the opposite situation i.e. where stock in trade is converted into capital asset.

To deal with this situation, an amendment has been made in the Act as below:-

Newly inserted Clause-(via) of Section-28(1) provides that where stock in trade is converted into a capital asset, such transaction shall be subject to taxability under the head “Profits and Gains of Business or Profession”.
In this case, Fair Market Value of the stock in trade as on the date of conversion shall be treated as business income.
Fair Market Value shall be determined in the manner as may be prescribed.
This amendment has taken effect from 1^st April 2019 and will apply in relation to the assessment year 2019-20 and subsequent years.

We will understand the above provision with the help of an example:

A builder who is engaged in the construction business is having an inventory of commercial offices constructed by him. Such inventory has been held by him since 01-10-2017. Cost of construction of each office is Rs. 5 Lakhs and NRV as on 01-04-2019 is Rs. 5.50 Lakhs. Since, the commercial offices could not be sold, he decides to use one of the office for his own business purposes with effect from 1-11-2019 when fair market value is ascertained at Rs. 6 Lakhs. Ascertain implication for income tax purposes.

Answer:

Opening Book Value of Inventory as on 01-04-2019 shall be at cost or NRV whichever is lower. Since, cost Rs. 5 Lakh is lower than NRV Rs. 5.50 Lakhs, Therefore, Opening value of the office in the books of the builder is Rs. 5 Lakhs.
On 01-11-2019, when commercial office held as stock is converted into asset, the fair market value is Rs. 6 lakhs.
Therefore, Business Income shall be computed as below:-

Fair Market Value as on conversion date: Rs. 6 Lakhs

Less: Opening value of stock: Rs. 5 Lakhs

Rs. 1 Lakhs

Now, the next question arises as to what will be the “Actual Cost” of such converted stock as asset for the purpose of determining WDV of the block. For this purpose, we will refer “Explanation-1A to Section-43(1) which states as below:-

“Where a capital asset referred to in clause (via) of section 28 is used for the purposes of business or profession, the actual cost of such asset to the assessee shall be the fair market value which has been taken into account for the purposes of the said clause.”

Thus, in the above example, we will have the following implication:-

Actual cost to be added to block of building = Rs. 6 Lakhs (i.e. FMV on date of conversion)
Since, the asset is converted into asset on 01-11-2019, it has been used for less than 180 days in the business, therefore depreciation shall be charged @ 5% [1/2 of prescribed rate of 10%]
Depreciation on the asset (assuming only asset in the block) = 6 Lakhs * 5% = Rs. 30,000

Again, a question arises regarding capital gain implication on sale of such asset which has been converted as per clause- (via) of Section-28 of the Act as discussed above. So, we will now discuss Section-49(9) and Section-2(42A) for decoding the manner of calculation capital gain implication on sale of asset after conversion.

Section-49(9):-

Section 49(9) states as below:-

“Where the capital gain arises from the transfer of a capital asset referred to in section 28(via), the cost of acquisition of such asset shall be deemed to be the fair market value which has been taken into account for the purposes of the said clause.”

Section-2(42A)(ba):- Period of holding

“In case of a capital asset referred to in section 28(via), the period shall be reckoned from the date of its conversion or treatment.”

In our example as above, Fair Market Value as on the date of conversion is Rs. 6 lakhs. Therefore, if such asset is sold later on, Cost of acquisition for the purpose of capital gain shall be taken as Rs. 6 Lakhs. However, in our example, the office so converted into asset is a depreciable asset so it will be subject to provisions of Section-50 of the Income Tax Act.

Continuing our example, suppose, the asset is the only asset in the block of building and is sold on 04-04-2020 at Rs. 5, 90,000.

In this case, following points are noteworthy:-

Since, the asset sold is a depreciable asset, calculation of capital gain shall be subject to Section-50.
In case of depreciable asset, the capital gain as calculated will always be a short term capital gain.
Period of holding is not of relevance in case of a depreciable asset.
Cost of acquisition will be taken at Rs. 6 Lakhs (i.e. FMV on date of conversion).
Short Term Capital gain will be as follows:-

Sales Price: Rs. 5,90,000

Less: WDV of block Rs. 5,70,000 (6,00,000 – 30,000) [Cost- Depreciation]

Short Term Capital Gain Rs. 20,000

Now, we will take another example to understand capital gain implication if the asset so sold is a non depreciable asset:

An assessee acquired shares in a company as stock in trade on 01-04-2015 for Rs. 10 Lakhs. On 01-02-2019, he converts stock in trade into capital assets when fair market value is Rs. 12 Lakhs. On 01-06-2020, he sold these shares at Rs. 13.50 Lakhs.

Answer:

Profits from Business & Profession in F.Y. 2018-19:-

Business Income shall be Rs. 2 Lakhs [12-10]

Shares sold on 01-06-2020 are non depreciable capital assets.
Period of holding [01-02-2019 to 31-05-2020]:- More than 12 months so Long term capital asset
Long term capital gain:-

Sales Price:- Rs. 13.50 Lakhs

(-) Cost of acquisition:- Rs. 12.00 Lakhs

Rs. 1.50 Lakhs

Rule-11UAB

Clause-(via) of Section-28 of the Act states that fair market value shall be determined in the prescribed manner.
Rule-11UAB has been inserted by the Income Tax (Ninth Amendment) Rules, 2018 with prospective effect from 01-04-2019 to prescribe the manner of determining the fair market value.
Rule-11UAB shall be applicable for assessment year 2019-20 and subsequent years.

Rule-11UAB states that:

“Fair market value of the inventory shall be:-

		being an immovable property, being land or building or both, shall be the value adopted or assessed or assessable by any authority of the Central Government or a State Government for the purpose of stamp duty in respect of such immovable property on the date on which the inventory is converted into, or treated, as a capital asset;
		being jewellery, archaeological collections, drawings, paintings, sculptures, any work of art, shares or securities referred to in rule 11UA, shall be the value determined in the manner provided in sub-rule (1) of rule 11UA and for this purpose the reference to the valuation date in the rule 11U and rule 11UA shall be the date on which the inventory is converted into, or treated, as a capital asset;
		being the property, other than those specified in clause (i) and clause (ii), the price that such property would ordinarily fetch on sale in the open market on the date on which the inventory is converted into, or treated, as a capital asset.”

Quick Links