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Taxability of conversion of Stock-in-trade into investment

April 21, 2017[2017] 80 taxmann.com 211 (Article)
267 Views

Introduction

1. It is indeed a pleasure for assessees as also for representatives such as Advocates and Chartered Accountants when a higher judicial authority like a High Court decides an important issue through a well-reasoned judgment after listing out full facts of the case, explaining lucidly law on the subject and after also referring to precedents on the issue. The pleasure gets trebled when the order passed by such authority ultimately goes in favour of assessees. One such moment arose when the Calcutta High Court, after analysing the issue in the background of facts obtaining in the case, held that where assessee converts its stock-in-trade of shares into investments and sells the same at a later stage, profit arising from sale of such shares shall be deemed to be capital gains and not business income. In the instant case decided by the Calcutta High Court Deeplok Financial Services Ltd. v. CIT [2017] 80 taxmann.com 51 (Calcutta) on 4th April, 2017 it was held that as the shares were held as long-term capital asset, profit arising from sale of shares would be exempt from tax under section 10(38) of the Income-tax Act(the Act).

Since period of holding of capital asset in such converted situations is also important, the same is also covered.

Facts of the case and decision of lower authorities including the Tribunal

2. The assessment year concerned in this case was 2006-07 and the assessee in this case was a company engaged in the business of leasing, finance and investment and certain shares held as on 1st April, 2004, i.e., during the previous assessment year 2005-06 as its trading stock was converted by the assessee into investments on that date and sold a portion of the shares. The stand of the assessee-company, that the profit earned out of such sales was capital gain, was denied by the Assessing Officer as well as the Commissioner of Income-tax (Appeals)(FAA). On further appeal to the Tribunal in ITA No.1475/Kol/2008-Assessment Year 2005-06- Order dated 13th May, 2011-the Tribunal extensively extracted from the order of FAA at para. 8 of its order which was to the following effect-

"The Hon'ble Supreme Court in the case of Sarder Indra Singh & Sons Ltd. v. CIT [1953] 24 ITR 415 also held that the surplus resulting from sale of shares and securities constituted business income. The object clause, inter alia, provided that the company was incorporated with the object of carrying on business of financiers and was also empowered to invest and deal with the monies of the company not immediately required for its business upon such securities and in such manner as might from time to time be determined. It was held in that case to constitute business income, it was not necessary that surplus should have resulted from such a course of dealing in securities as by itself would amount to the carrying on of business or if the realization of securities is a normal step of carrying on the assessee's business. The Supreme Court observed that the principle applicable in all such cases was well-settled and the question always was whether the sales which produced the surplus were so connected with the carrying on of the assessee's business that it could fairly be said that the surplus was the profits and gains of such business. In view of the aforesaid facts, and as per CBDT"s circular No.4/2007 dated 15.06.2007 and decisions of Hon'ble Supreme Court it is very clear that the assessee-company was engaged in the business of dealing in shares and, accordingly, profit earned by the assessee-company in share transaction constituted business income and, accordingly, would be assessed under the head business and the claim of the assessee-company to treat the same as capital gain denied. The action of Assessing Officer is sustained."

The Tribunal then observed that there is no provision in the Act in respect of conversion of stock-in-trade into investment and its treatment and, thus, upheld the decision of lower authorities whereby some addition was made on account of under statement of income by analysing the assessee's trading and investment account in shares. Of course, some marginal relief was provided by the Tribunal on account of wrong calculations made in working out figures.

The assessee filed an appeal before the Calcutta High Court and the same was not admitted as there was enormous delay in preferring the appeal. So the assessee lost right of appeal to agitate the matter decided against it by the Tribunal for the assessment year 2005-06 on account of delay (refer to para.3 of the judgment dated 4th April, 2017 Calcutta High Court in this case)

Be that as it may, the assessee sold the balance of shares held in investment portfolio during the assessment year 2006-07, i.e., Out of the shares held as on 1st April,2004- and the profit arising from the said sale was claimed to be exempt as the shares were long-term capital assets. The Assessing Officer did not agree with the claim of the assessee with regard to conversion of shares from stock-in-trade into investment based on the decision taken by him for the earlier assessment year [i.e., 2005-06] wherein he had not accepted the claim of the assessee on conversion from stock-in-trade to investment. The profit arising from the said shares was brought to tax as business profit. The FAA, however, allowed the appeal of the assessee following the decision of the Mumbai Bench of ITAT in the case of Asstt. CIT v. Bright Star Investment (P.) Ltd. [2008] 24 SOT 288 (Mum.) wherein it was held by the Tribunal that where the assessee converted shares as on 01-04-1998 at their book value from stock-in-trade to investments and sold them during the assessment years 2000-01 and 2001-02 then the whole profit had to be treated as long-term capital gain. The Mumbai Bench of ITAT also observed that "While incorporating the sub-section (2) to section 45, the legislature has not visualized the situations in the other way round, where, the stock-in-trade is to be converted into the investments and later on, the investment was sold on profit. In the absence of a specific provision to deal with this type of situations, a rational formula should be worked out to determine the profits and gains on transfer of the asset. We are also conscious about the judgment in cases of Sir Kikabhai Premchand v. CIT [1952] 24 ITR 506 (SC) and CIT v. Dhanuka & Sons [1980]124 ITR 24 (Cal)/[1979] 1 Taxman 417 wherein it has been held that there cannot be an actual profit or loss on such transfer when no third party is involved and the items are kept in a different account of the assessee by himself. The gain or loss would arise only in future when, the stock 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. In the absence of a specific provision to deal with the present situation, two formulae can be evolved to work out the profits and gains on transfer of the assets. One formula which has been adopted by the Assessing Officer, i.e., difference between the book value of the shares and the market value of the shares on the date of conversion should be taken as business income and the difference between the sale price of the shares and the market value of the shares on the date of conversion, be taken as capital gain. The other formula which is adopted by the assessee, i.e., the difference between the sale price of the shares and this 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. In the absence of specific provision, out of these two formulae, the formula which is favourable to the assessee should be accepted".

The FAA distinguished the decision of his predecessor passed for the assessment year 2005-06 as his predecessor relying on the Circular No.1827 dated 31-08-1969 had decided the issue of treating the surplus as business income based on the volume of transactions and did not decide the issue regarding the validity of conversion of shares from Trading Account to Investment Account. The FAA also observed that "as seen from Income Tax Act, the IT Act does not contain any provisions prohibiting the conversion of shares from Trading Account to Investment Account."

The Revenue filed an appeal before the Tribunal.

The Tribunal held against the assessee as in its own case, the earlier Bench of ITAT had not accepted conversion of business asset (stock-in-trade) to personal asset (investment) for the earlier assessment year, i.e., 2005-06, though the stand of the assessee was supported by various judicial pronouncements.

The assessee filed an appeal before the Calcutta High Court.

Decision of the High Court and its basis

3. The High Court admitted the following substantial question of law-

"Whether the Tribunal was correct in holding that the profit arising from the sale of the said shares is chargeable to tax in the hands of the assessee as its business income and not long term capital gain since in the assessee's own case in the previous assessment year the conversion of the shares was not accepted by the Tribunal?"

The High Court narrated the facts of the case starting from sale of shares from the previous assessment year 2005-06.

It was argued on behalf of the assessee based on the decision of the Supreme Court in the case of Sir Kikabhai Premchand (supra) that a person cannot transact with himself and only when he deals with a third party there can be profit or loss and in the case of shares there can be either capital gain or capital loss. Reliance was also placed on the decision of the Calcutta High Court in the case of Dhanuka & Sons (supra) for the proposition that profit or loss arising out of sale of shares can be ascertained only when these shares which were transferred from business stock account were sold on a later date.

It was also argued on behalf of the assessee that stock-in-trade could be converted into investment and there was no bar stipulated in the Act with regard to such conversion.

With regard to res judicata reliance was placed on behalf of the assessee on the decision of the Calcutta High Court in the case of Snow White Food Products Co. Ltd. v. CIT [1983] 141 ITR 861/[1982] 10 Taxman 37 (Cal.) wherein at para.10 of the judgment it was observed that "In any event, it is well-settled that the principles of res judicata are not applicable in revenue matters and findings of fact in an earlier year are not binding in the assessments in subsequent years and can be resisted on new evidence."

It was argued on behalf of the Revenue that no substantial question of law arose which required Court's attention as the earlier delayed appeal for the earlier year, i.e., assessment year 2005-06 preferred by the assessee was dismissed by the High Court on 5th May, 2015 by holding" that when the assessee chose not to file an appeal against the order of the Tribunal at the appropriate time then he could not be allowed to file one with an inordinate delay of 1500 days"

Reliance was also placed on behalf of Revenue on Circular no.6/2016 dated 29th February, 2016 to submit that once the shares of the assessee were treated as part of the stock-in-trade, the same shall remain applicable in subsequent assessment years. The assessee should not be allowed to adopt a different and contrary stand in subsequent years.

The High Court after listing out the arguments of both sides referred to section 45(2) of the Act and observed that "the Act does not provide for the conversion of the stock-in-trade into capital asset" and concurred with the view expressed by the Learned Single Judge in the case of Maniruddin Bepari v. Chairman of the Municipal Commissioners, DACCA decided on 16th April, 1935 and reported in 40 Calcutta Weekly Notes (CWN) 17 which was to the following effect-

"It is a fundamental principle of law that a natural person has the capacity to do all lawful things unless his capacity has been curtailed by some rule of law. It is equally a fundamental principle that in the case of a statutory corporation it is just the other way. The corporation has no power to do anything unless those powers are conferred on it by the statute which creates it."

With regard to res judicata the High Court extracted observations from the decision of the Supreme Court in the case of Amalgamated Coalfields Ltd. v. Janapada Sabha Chhindwara AIR 1964 SC 1013 at para.14 which were to the following effect-

"……..Where the liability of a tax for a particular year is considered and decided does the decision for that particular year operate as res judicata in respect of the liability for a subsequent year? In a sense, the liability to pay tax from year to year is a separate and distinct liability; it is based on a different cause of action from year to year, and if any points of fact or law are considered in determining the liability for a given year, they can generally be deemed to have been considered and decided in a collateral and incidental way. The trend of the recent English decisions on the whole appears to be, in the words of Lord Radcliffe, "that it is more in the public interest that tax and rate assessments should not be artificially encumbered with estoppels (I am not speaking, of course, of the effect of legal decisions establishing the law, which is quite a different matter), even though in the result, some expectations may be frustrated and some time wasted."(vide Society of Medical Officers of Health v. Hope Valuation Officer [1960] 2 W.L.R. 404, 563.]. The basis for this view is that generally, questions of liability to pay tax are determined by Tribunals with limited jurisdiction and so, it would not be inappropriate to assume that if they decide any other questions incidental to the determination of the liability for the specific period, the decisions of those incidental questions need not create a bar of res judicata while similar questions of liability for subsequent years are being examined……."

The High Court also referred to the fact that there was no adjudication on merits in respect of conversion for the previous assessment year 2005-06 and the High Court ultimately held that there was no impediment for the assessee to seek adjudication on the following points,-

"Whether the Tribunal was correct in holding that the profit arising from the sale of the said shares is chargeable to tax in the hands of the assessee as its business income and not long-term capital gain since in the assessee's own case in the previous assessment year the conversion of the shares was not accepted by the Tribunal?"

The High Court, thus, finally answered the question admitted by it in favour of the assessee and ultimately the assessee was able to enjoy the benefit of exemption as provided under section 10(38) of the Act as the shares were held as long-term investments,

Since period of holding of capital asset in such converted situations is also important, the same is also covered in the ensuing paragraphs

Period of holding starts from date of conversion of Business Asset

4. The period of holding of the capital asset is important in determining whether transfer of converted capital asset results in long-term capital gain or short-term capital gain.

An answer to the issue (question) raised is directly provided by the ITAT Delhi Bench in the case of Splendor Constructions (P.) Ltd. v. Income-tax Officer,[2009]-27-SOT-39 (Delhi)

Catchwords from that decision-

4.1 Section 45, read with sections 2(29A) and 2(42A) of the Income-tax Act, 1961 - Capital gains - chargeable as - Assessment year 2003-04 - Whether for ascertaining as to whether a capital asset is a 'short-term capital asset' or a 'long-term capital asset', period for which said asset is held by assessee as capital asset alone has to be reckoned - Held, yes - Assessee company was engaged in business of developing and selling freehold immovable properties - In financial year 1998-99, assessee company acquired a property i.e. land for a certain consideration and same was subjected to development in financial years 2000-01 and 2001-02 incurring certain expenditure - Cost of acquisition of said property along with development expenditure incurred in respect thereof was shown by assessee company as its stock in trade in balance sheet upto 31-3-2002 - As on 1-4-2002 said property was converted by assessee company into investment and same was sold on 12-12-2002 - Authorities below, taxed profits arising from said sale as short-term capital gain - Whether since assessee sold property in question within 36 months from date it was converted into capital asset, i.e., investment, authorities below rightly brought to tax profit arising from sale of said property as short term capital gain - Held, yes

Reasoning adopted in this case-

4.2 The definition of capital asset as given in section 2(14) of the Act does not include stock-in-trade held by the assessee for the purpose of his business or profession. The property in question which was held by the assessee as stock-in-trade could not be regarded as a capital asset up to 31-03-2002. It became a capital asset only on 01-04-2002 when the same was converted from stock-in-trade into investment. The Assessing Officer relied on the decision of the Bombay High Court in the case of CIT v. Santosh L. Chowgule [1998] 234 ITR 0787/[1999] 105 Taxman 372 wherein it was held that it is only "the life of the converted asset (being share in this case) has to be (re)considered in reckoning whether it is a short-term or long term capital asset. Reliance was also placed by the Assessing Officer on CIT v. Chunilal Khushaldas [1974] 093 ITR 0369 (Guj) and Manecklal Premchand (Decd.) v. CIT [1990] 186 ITR 0554(Bom)/[1990] 48 TAXMAN 310 wherein it was held that bonus shares are acquired by a shareholder when they are issued and they must be taken to be held by the shareholder from the date of their issue and not from the date when the original shares in respect of which they are issued were acquired by the assessee The Tribunal endorsed the views of the Assessing Officer. In the case before the Gujarat High Court in Chunilal Khushaldas (supra) bonus shares which were issued on 5th September, 1961 were sold on 12th September, 1961 and it was held by the High Court that the bonus shares were short-term capital assets within the meaning of section 2(42A) as they were not held by the assessee for more than twelve months.

Observations from the decision of the Gujarat High Court in the case of Commissioner of Income-tax v. Nirmal Textiles [1997] 224 ITR 0378

5. Capital gain is not income which accrues from day-to-day for a spell of period but arises at a fixed point of time, namely, the date of transfer. This is unlike the income arising or accruing as profits and gains of a business to be computed in terms of section 28 of the Income-tax Act, 1961, where the profits and gains can only be said to accrue at the end of the previous year when the result of the working of business for the entire period is known. Section 48 of the Income-tax Act, 1961, which prescribes the mode of computation and deduction in respect of income chargeable under the head "Capital gains", divides types of capital gains into two categories, namely, capital gains general and capital gains arising from transfer of a long-term capital asset. The period for the holding relates to the date of transfer and the transfer of such long-term asset on the date of transfer falls into the category of long-term capital gains. The question whether the capital asset which was transferred was a long-term capital asset or a short-term capital asset has direct relevance and nexus to the date of transfer, whether on that date it was a long-term capital asset or a short-term capital asset.

Conclusion

6. From the above detailed discussion the following 2 important points emerge-

(a)   There is no bar in converting stock-in-trade into investments, though it is not specifically provided for under the Income-tax Act
(b)   It is also quite clear that the date of conversion from business asset to capital asset is alone relevant for determining the period of holding of the capital asset. For example, if the initial date of holding of the asset as business asset is (say) 01-04-2000 and date of conversion into a capital asset is (say) 01-04-2016 and if the asset was sold on 20-08-2016 the asset would be treated as only a short-term capital asset resulting in short-term capital gain and the period of reckoning (holding) would start from 01-04-2016 only; the initial date of 01-04-2000 in this case is irrelevant. However, the period of holding of various capital assets such as shares and securities, immovable assets, etc., varies for determining whether the capital asset qualifies as a long-term asset -refer, section 2(29A) to read with 2(42A) of the Act.

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