Simplifying Tax for C.A's and Taxpayers
Conversion of Capital Asset into Stock in trade: Understanding Section 45(2)

Conversion of Capital Asset into Stock in trade: Understanding Section 45(2)

Mr. Sameer (hereinafter referred to as SR) is engaged in business of sale of Jewellery. He wishes to bring some personal jewellery to his business. He approached Taxingtax (hereinafter referred to as TT), his tax consultant for advice. Check out their conversation.

SS: Sir, I wish to bring my personal jewellery into my business? Can I do it?

TT: Of course, you can do it.

SS: What will be the impact on my individual tax and business profits?

TT: Well, in this case, Section 45(2) of Income Tax Act, 1961 is attracted. Section 45(2) deals with computation of business profits and capital gains in case the capital asset is converted into stock in trade.

SS: How is it applicable to me?

TT: ‘Jewellery’ falls under the definition of “Capital asset” under Section 2(14) of Income Tax Act, 1961. Since you wish to convert this capital asset into stock, Section 45(2) is attracted.

SS: How does it affect my case?

TT: When you bring Jewellery to your business stock, the tax impact as per Section 45(2) is as under:

  • There will be a capital gain in your individual return but same will be computed in the year in which such converted Jewellery is sold.
  • The full value of consideration for computing capital gains will be determined as fair market value as on date of conversion.
  • Cost indexation shall be done till the year of conversion.

Let us assume an example. You convert the Jewellery into stock on September 15, 2016. The Jewellery was purchased by you on 1 May, 1981 for Rs 3,00,000. Fair market value as on 15.09.2016 is Rs 40,00,000. Also you sell the Jewellery in 1 June 2017 for 41,00,000.

  • Firstly, in year 2016-17, there is no tax impact. Tax impact will happen in year 2017-18 when Jewellery is sold.
  • Computation of business profit will be as under:
Previous year2017-18
Assessment year2018-19
Sale Consideration41,00,000
Less: Fair Market Value on Conversion 40,00,000
Business profits1,00,000
  • Computation of capital gain will be as under:
Period of holding1.5.1984-15.9.2016
Capital GainLong term
Full value of consideration40,00,000
Less: Indexed cost of acquisition (3,00,000*1125/100)33,75,000
Capital gain 6,25,000

Similar to Sameer, there are many individuals who wish to bring assets into their businesses. The reason is simple. Section 45(2) can be exploited very well.

In this article we have mainly brought provisions of Section 45(2) into picture. To reiterate:

Points to remember:

  • To attract Section 45(2), asset should be capital asset as defined under Section 2(14). Remember, motor cars, furniture are not capital assets.
  • Asset should be converted into stock in trade. If they are treated as business fixed assets, Section 45(2) not applicable.
  • Capital gain will be computed in the year in which such converted stock is sold.
  • The full value of consideration for computing capital gains will be determined as fair market value as on date of conversion
  • Cost indexation shall be done till the year of conversion
  • The period of six months for making investments in specified assets for the claiming capital gain exemption under sections 54EA, 54EB and 54EC, is to be reckoned from the date such stock-in-trade is sold or otherwise transferred, in terms of section 45(2). (CBDT Circular No791 dated 2.6.2000)

For the sake of ready reference, section 45(2) and section 2(14) are reproduced as follows:

Section 45(2)

Notwithstanding anything contained in sub-section (1), the profits or gains arising from the transfer by way of 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 shall be chargeable to income-tax as his income of the previous year in which such stock-in-trade is sold or otherwise transferred by him and, for the purposes of section 48, the fair market value of the asset on the date of such conversion or treatment shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of the capital asset.

Section 2(14)

Capital asset” means—

(a) Property of any kind held by an assessee, whether or not connected with his business or profession;

(b) any securities held by a Foreign Institutional Investor which has invested in such securities in accordance with the regulations made under the Securities and Exchange Board of India Act, 1992 (15 of 1992),

but does not include—

(i) any stock-in-trade [other than the securities referred to in sub-clause (b)]], consumable stores or raw materials held for the purposes of his business or profession ;

(ii) personal effects, that is to say, movable property (including wearing apparel and furniture) held for personal use by the assessee or any member of his family dependent on him, but excludes—

(a)  jewellery;

(b)  archaeological collections;

(c)  drawings;

(d)  paintings;

(e)  sculptures; or

(f)  any work of art.

6[Explanation 1].—For the purposes of this sub-clause, “jewellery” includes—

(a) ornaments made of gold, silver, platinum or any other precious metal or any alloy containing one or more of such precious metals, whether or not containing any precious or semi-precious stone, and whether or not worked or sewn into any wearing apparel;

(b) precious or semi-precious stones, whether or not set in any furniture, utensil or other article or worked or sewn into any wearing apparel.

7[Explanation 2.—For the purposes of this clause—

(a) the expression “Foreign Institutional Investor” shall have the meaning assigned to it in clause (a) of the Explanation to section 115AD;

(b) the expression “securities” shall have the meaning assigned to it in clause (h) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956);]

(iii) agricultural land in India, not being land situate—

(a) in any area which is comprised within the jurisdiction of a municipality (whether known as a municipality, municipal corporation, notified area committee, town area committee, town committee, or by any other name) or a cantonment board and which has a population of not less than ten thousand; or

(b) in any area within the distance, measured aerially,—

 (I)  not being more than two kilometres, from the local limits of any municipality or cantonment board referred to in item (a) and which has a population of more than ten thousand but not exceeding one lakh; or

(II) not being more than six kilometres, from the local limits of any municipality or cantonment board referred to in item (a) and which has a population of more than one lakh but not exceeding ten lakh; or

(III) not being more than eight kilometres, from the local limits of any municipality or cantonment board referred to in item (a) and which has a population of more than ten lakh.

Explanation.—For the purposes of this sub-clause, “population” means the population according to the last preceding census of which the relevant figures have been published before the first day of the previous year;

(iv) 6½ per cent Gold Bonds, 1977, or 7 per cent Gold Bonds, 1980, or National Defence Gold Bonds, 1980, issued by the Central Government;

(v) Special Bearer Bonds, 1991, issued by the Central Government ;

(vi) Gold Deposit Bonds issued under the Gold Deposit Scheme, 1999 8[or deposit certificates issued under the Gold Monetisation Scheme, 2015] notified by the Central Government.

Explanation.—For the removal of doubts, it is hereby clarified that “property” includes and shall be deemed to have always included any rights in or in relation to an Indian company, including rights of management or control or any other rights whatsoever;]

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