In Pursuit of Knowledge

Capital Gains – Five Burning Issues

CA. Ashish Goyal

Direct Taxes

1. Introduction

A tax according to Latham CJ of the High Court of Australia ‘is a compulsory exaction of money by public authority for public purposes enforceable by law and is not payment for services rendered.’ Mathews vs. Chicory Marketing Board 60 CLR 263, 276.

Capital gain is an artificial income created by a fiction of law. The lawmakers always argue the morality of capital gains on the ground of Horizontal Equity i.e. equal treatment of taxpayers of the same taxable capacity; and also Vertical Equity i.e. to reduce large inequalities in the distribution of income and wealth.

In this article, I shall discuss some burning issues in capital gains.

2. Capital asset to stock-in-trade and vice versa

The taxation of conversion of capital asset to stock-in-trade has been always been a matter of interest concerning some tax-planning that may be available on such conversion. In case, Capital asset is converted into stock-in-trade, the following tax implications arise: -

  1. The conversion of capital asset to stock-in-trade is treated as transfer u/s. 2(47). Thus, capital gain arises on the date of conversion itself.

  2. The full value of consideration is taken as the Fair Market Value (FMV) on the date of conversion.

  3. Holding period will end on the date of conversion and indexation shall also be done till the date of conversion, being "date of transfer’.

  4. Since on the date of conversion, no income as such arises, the taxation on capital gain is deferred till the date of actual transfer of asset by assessee. Thus on actual transfer of asset by assessee, there shall be income under two heads: –

Capital gain = FMV on date of conversion

Less Cost of Acquisition

Business Income = Sale Consideration on Actual transfer

Less FMV on date of Conversion

In recent past, there has been some controversy on what shall be the tax treatment of conversion of stock-in-trade to capital asset. In my view, the following shall be the tax implications: –

  1. On the date of conversion of stock-in-trade to capital asset, there shall be no business income. Generally, no one can earn income from oneself. [Kikabhai Premchand (Sir) vs. CIT (1953) 24 ITR 523 (SC)1. Unlike capital gains, there is no such provision under the provisions of "Income under the Business/Profession" creating a deeming fiction and charging the same as Business income.

  2. When, after being converted from stock-in-trade to capital asset the capital asset is sold, the same shall be chargeable under the head Capital Gains. The question which becomes important is what shall be the Cost of Acquisition and holding period of the same: -

(i) Cost of Acquisition: - As per section 49, cost of acquisition is the cost of the acquisition of the "property". The word "property" becomes important. The word "property" is wider than the word "capital asset". The word suggests that the cost of acquisition of "capital asset" shall not be taken but of the "property" shall be taken; whether it was acquired as a "capital asset’ or not

In CIT vs. Jannahavi Investments P Ltd. 304 ITR 276 (Bom.), assessee acquired bonus shares as stock- in-trade prior to 01.04.1981. The same were converted into capital asset after 01.04.1981. Department contended that the cost of acquisition shall be taken on date of conversion. Assessee contended that the same shall be taken on date of acquisition. Since the asset was acquired prior to 01.04.1981, the cost of acquisition (NIL) shall be replaced by the market value of 01.04.1981. It was held that the cost shall be so replaced by market value of 01.04.1981.

(ii) Holding Period:- Interestingly u/s. 2(42A), which defines "short-term capital asset", it is stated that the "short-term capital asset means a capital asset held by an assessee for not more than 36 months. Section 2(42A) uses the words, "capital asset". Therefore. It seems that the holding period of an asset as a "capital asset" becomes important.

In Lohia Metals P Ltd. 131 TTJ 472 (Trib. Chennai), it was held that holding period of only capital asset shall be taken and period as stock-in-trade shall be ignored. In this case, assessee purchased shares before 31.03.2004. Assessee converted the shares from stock-in-trade to Capital Asset on 01.04.2004. Assessee sold the shares and claimed exemption u/s. 10(38). It was denied by AD holding that the holding period shall begin only from date of conversion of stock-in-trade to capital asset and not for earlier period. The Hon’ble ITAT confirmed the order of AD holding that u/s. 2(42A) holding period of capital asset has only to be considered.

One may however, note that a contrary decision was taken in Kalyani Exports & Investments Pvt Ltd 78 lTD 95 (Pune), where it was held that holding period from date of acquisition of stock-in-trade shall be considered.

In DCIT vs. Dwarkaprasad Anilkumar Investment P. Ltd. 304 ITR (AT) 182 (Mum.) pg 213, it was held that where the company converted its stock-in-trade into capital asset for tax planning purposes, it was perfectly legal.

3. Capital gain exemption on shares

The exemption in respect to capital gains on shares and securities has always been looked at with suspicion by the Department. The department generally, denies the exemption u/s. 10(38) in respect to long-term capital gains on shares and securities on other of the two footings: -

(a) Treating capital gains alleged as Business Income.

(b) Treating capital gains as undisclosed income u/s. 68 (Entry Business)

(a) Capital Gains vs Business Income

So far as whether the income from trading in shares shall be treated as Business Income or Capital Gains is concerned, there has been a long-drawn debate between the assessee and the department. Courts has always held that it would depend on the facts and circumstances of the case, whether the income shall be business income or capital gains.

CBDT has also issued Circulars on this aspect. Instruction No. 1827 dated 31.08.1989 was further supplemented by Circular No. 4/2007. These circular provide the tests to be applied for determining the head, whether Business Income or Capital Gains. The Circulars state that all the tests shall be applied in totality and one cannot pick and choose some tests. The Circulars also clarify that an assessee can have both business head and capital gains. In such cases, it is advisable to maintain separate books of accounts and separate Demat accounts for both.

I hereby quote some decisions in this regard: -

Rewashanker A. Kothari 283 ITR 388 (Gui.)

Mrs. Amita A. Kapadia Al FTP Times Apr. 09. Pg. 4

CIT vs. N.S.S. Investments P Ltd. 277 ITR 149

Ramnarain Sons P. Ltd. 41 ITR 534

CIT vs. Karam Chand Thapar & Sons 115 ITR 250

Juggilal Kamlapat 75 ITR 186

CIT vs. Gopal Purohit 14 ITJ 282 (Bom.)

Bharat Kunverji Kenia 130 TTJ 86 (UO) (Mum.)

Management Structure & Systems (itatonline.org)

Sadhana Nabera (itatonline.org)

Kunvarji Nanji Kenia 131 TTJ 87 (Mum.)(UO)

DCIT vs. SMK Shares (itatonline.org.)

(b) Capital Gains vs Cash credits u/s. 68

Another aspect, which the department is pressing hard in the modern times is to hold the capital gains as cash credits u/s. 68 and treating the same as undisclosed income. The Department becomes more suspicious when there is buy-back in subsequent period, or when there is share-forfeiture for non-payment of a part of call money, or when the shares are purchased off-market, or when the prices have exorbitantly increased, or when the broker or buyer does not appear before AO.

It is a settled law in respect to cash credits that the initial burden is on assessee to prove the identity, genuineness and credit-worthiness of the creditor. Once assessee gives evidences to prove the same, the burden shifts on the department, to show by tan9ible material or by surrounding circumstances (showing that the transaction is humanly improbable [Courtesy: Sumati Dayal 214 ITR 801 (SC) and Durga Prasad More 82 ITR 540 (SC)] that the transaction was not real.

One may note that suspicion, howsoever, strong cannot take form of evidence. In recent past, in most of the cases, the efforts of the department to prove the

In recent past, there have been decisions from ITAT Benches, which provide that without discharging the burden, the department cannot tax the capital gain offered by assessee as undisclosed income of assessee. Some of the decisions are as reported under: -

Arzoo Anand vs. JCIT 14 ITJ 604 (Trib. Indore)

Baijnath Agrawal 15 ITJ 693 (Agra)(TM) : 133 TTJ 129 Smt. Sunita Oberoi 126 TTJ 745 (Agra)(TM)

ITO vs. Smt. Bibi Rani Bansal 133 TTJ 394 (Agra)(TM)

CIT vs. Anupam Kapoor 299 ITR 179 (P & H)

ITO vs. Smt. Kusumlata (2006) 105 TTJ 265 (Id) 133 TTJ 201 (Del)

One may further note that buy-back of shares has been made taxable this year by Finance Act, 2010 at the time of Buy-back in the hands of Closely-held company u/s. 56(2)(viia). The provision seems to be faulty as the buy-back has been made taxable at difference of book value as reduced by amount paid for buy-back. The provision should have taxed the difference in the issue price and redemption price.

4. Capital Gains on Immovable property (Section 50C)

Black money has been one of the prime problems in the country. To tackle the problem of black money in real estate sector which has been regarded as the best destination for black money, in the original I-T Act section 52 was inserted under the head capital gains. This provision was quite similar to section 50C as existing today. Section 52 provided that the sale consideration shall be treated as the market value of the immovable property transferred. However, this section was read down in K.P Verghese 131 ITR 597 (SC), where it was held that unless there is evidence with the department that black money is invested, no addition can be made u/s. 52, as there was no mechanism for the assessee to rebut the contention that the transaction was done at lower price than the market price.

After K.P Verghese 131 ITR 597 (SC), section 52 was deleted and a new Chapter XXA was introduced, which was further modified as Chapter XXC. These provisions empowered the Central Government to initiate Certificate proceedings for acquiring/ auctioning the property in case the property was sold below market price. Again the practical difficulties faced by government in acquisition of the properties and the long-drawn procedure in the acquisition and auctioning of properties lead to repeal of those provisions.

Thereafter from 01.04.2003 i.e. A.Y. 2003-04, section 50C was introduced under the provisions of Capital Gains. This provision, after its introduction by A.Y. 2003-04 has been subjected amendment by a recent amendment by Finance (No. 2) Act, 2009. This amendment provided that even if the stamp duty is not "assessed" or "adopted", but is assessable or adoptable, still section 50C will be attracted.

The provision is still premature as not much of research has been done by the judiciary on this provision. One can say that only 7 A.Ys. have gone by since the provision was inserted.

In this segment I have tried to compile some of the decisions on this most controversial provision. To make the discussion simple, I have compiled this section in question-answer format.

4.1 Whether section 50C is constitutionally valid?

The rigours of constitutional validity of section 50C have been upheld by various High Courts. The High Courts have held that section 50C provides a mechanism for assessee to rebut the presumption raised therein, therefore, the provision is constitutionally valid. If assessee wants to challenge the stamp valuation, assessee has got the remedy u/s. 5OC(2). [Palaniswamy, K.R. & Ors, vs. UOI 219 CTR 323 (Mad.); Bhatia Nagar Premises Co-operative Society Ltd. 234 CTR 175 (Bom.)]

4.2 Whether section 50C applies to the head Capital Gains or does it apply even to the head "Income under the head Business or Profession"?

Section SOC is provided under the head Capital Gains only, it does not apply to the head "Income under the head Business or Profession". Therefore, even if the builder sells the property below guideline value, his sale consideration shall be actual consideration and not guideline value. [Inderlok Hotels P Ltd. 122 TTJ 145: 32 SOT 419 (Trib., Mum.); CIT vs. Thi ruvengadam Investments P Ltd. 320 ITR 345 (Mad.); ACIT vs. Excellent Land Developers P Ltd. (2010)1 ITR (Trib.) 563 (Del.)]

At this juncture, I may quote from McGee, Robert W., The Philosophy of Taxation and Public Finance, page 246 where he has said that it cannot be said that our representatives act in our own interest, since it has been proved conclusively that they act in their own interest, often to the detriment of the general public.

4.3 Whether addition u/s. 50C in hands of seller, means that the buyer has paid "on-money" and addition u/s. 69 for unexplained investment shall be made in hands of buyer?

Section 50C creates a deeming fiction and provides that the guideline value shall be treated as the lull value of consideration in the hands of the seller. It is a settled principle of law that a deeming fiction cannot be stretched beyond its context. No presumption can be made against the buyer that he paid "on-money". Unless the AO has evidences against the buyer that he paid "on-money", no addition can be made in his hands. [ClT vs. Chandani Bhuchar 229 CTR 190 (P & H); CIT vs Smt. Shweta Bhuchar 192 Taxman 67 (P & H); Sangam Tower 130 TTJ 104 (Jp.); ITO vs Fitwell Logic System P Ltd. (2010)1 ITR (Trib.) 286 (Del.); ITO vs Harley Street Pharmaceuticals Ltd. 38 SOT 486 (Ahd.); ITO vs Smt. Anshu Jain 36 SOT 263 (Jp.); .Optic Disc Mfg. 11 DTR 264 (Chd.)]

4.4. Why the new clause "assessable" or "adoptable" was introduced u/s. 50C by the Finance (No.2) Act, 2009 and what is the impact of this new clause?

Priorto the amendment by Finance (No.2) Act, 2009, it was argued in one of the cases that section 50C does not apply to a case where the transfer of property is not registered. Section 50C used the words "adopted or assessed". Value is adopted or assessed at the time the documents are presented for registration. Thus, section 50C applies only where sale deed is registered. [Navneet Kumar Thakkar 110 lTD 525 (Jodh.)(SMC); Carlton Hotel P Ltd. (2009) 122 TTJ 515:35 SOT 26 (Luck)].

Thereafter by Finance (No. 2) Act, 2009, section 50C was modified. The amended clause provides that even if the value is "assessable", section 50C would apply. The word "assessable" has been defined as under:

"Explanation 2.—For the purposes of this section, the expression "assessable" means the price which the stamp valuation authority would have, notwithstanding anything to the contrary contained in any other law for the time being in force, adopted or assessed, if it were referred to such authority for the purposes of the payment of stamp duty."

The notes to clauses explained the provision as under: -

"Clause 25 of the Bill seeks to amend section SOC of the Income-tax Act relating to special provision for full value of consideration in certain cases.

Under the existing provisions contained in the said section where the consideration received or accruing as a result of the transfer by an assessee of acapital asset, being land or building or both, is less than the value adopted or assessed by any authority of a State Government for the purpose of payment of stamp duty in respect of such transfer, the value so adopted or assessed shall, for the purposes of section 48, be deemed to be the full value of the consideration received or accruing as a result of such transfer.

It is proposed to amend the said section so as to substitute the words "or assessed" wherever they occur in the said section by the words "or assessed or assessable". It is also proposed to insert an Explanation after the existing Explanation so as to define the expression "assessable" as the price which the stamp valuation authority would have adopted or assessed, if it were referred to such authority for the payment of stamp duty notwithstanding anything to the contrary contained in any other law for the time being in force.

This amendment will take effect from the 1st October, 2009."

The amendment was made effective from 01.10.2009. The amendment was explained by CBDT Circularas follows: -

23. Provisions for deemed valuation in certain cases of transfer

23.1 The existing provisions of section 50C provide that where the consideration received or accruing as a result of the transfer of a capital asset, being land or building or both, is less than the value adopted or assessed by an authority of a State Government (stamp valuation authority) for the purpose of payment of stamp duty in respect of such transfer, the value so adopted or assessed shall be deemed to be the full value of consideration received or accruing as a result of such transfer for computing capital gain. However, the present scope of the provisions does not include transactions which are not registered with stamp duty valuation authority, and executed through agreement to sell or power of attorney.

23.2 With a view to preventing the leakage of revenue, section 50C is amended, so as to provide that where the consideration received or accruing as a result of transfer of a capital asset, being land or building or both is less than the value adopted or assessed or assessable by an authority of State Government for the purpose of payment of stamp duty in respect of such transfer, the value so adopted or assessed or assessable shall be deemed to be the full value of consideration received or accruing as a result of such transfer for computing capital gain.

23.3 Further, Explanation 2 has been inserted in the sub-section (2) of the section 50C, so as to clarify the meaning of the term "assessable".

23.4 Applicability - These amendments have been made applicable with effect from 1st October, 2009 and will accordingly, apply in relation to transactions undertaken on or after such date."

The following things become important here: -

  1. The provision applies only to transfers on or after 01.10.2009. Therefore for transactions prior to this date, this amendment is not applicable.

  2. The amendment was introduced to over-rule Navneet Kumar Thakkar (supra) and Carlton Hotel P. Ltd. (supra). This amendment provides that even if the value is assessable, section 50C would apply.

  3. Although the amendment and its objective make it clear that it will apply to transactions where sale deed is not registered. However, some people argue that this amendment will not apply to power of attorney sales, but to cases where sale deed is presented for registration.

4.5 Whether section 50C is mandatory? How can assessee prevent himself trom the rigours of section 50C?

Assessee may sell his property below the guideline value for various reasons, some of which are: -

1. Title is disputed.

2. Land has inherent problems like it is on slope or inner side of colon,y etc.

3. Surroundings are not palatable; there is a nearby railway line or high-tension line or hospital or a factory etc.

4. Urgent need of funds.

In such a case, the question becomes important whether section 50C would be still applicable.

U/s. 50C(2), assessee has two defences against the application of section 50C: -

(a) Assessee can challenge the stamp valuation before the Stamp valuation authority;

or in alternative,

(b) Assessee can apply to the AO for making a reference to the District Valuation Officer (DVO). On such application by assessee, the AO may make a reference to DVO.

In determining the Fair Market Value (FMV), the DVO shall follow the provisions of sections 16A(2) to (6), 23A(1 )(i), 23A(6) and 23A(7), 24(5), 34AA, 35 and 37 of Wealth-tax Act, 1957.

It has been held in N. Meenakshi 226 CTR 625 (Mad.) that once the assessee applies to AO for making reference to DVO u/s. 50C, "may" becomes "shall". Therefore, if assessee applies, AO shall make reference to DVO. It is not optional for AO to make reference to DVO. It was held that right to assessee u/s. 50C is a valuable statutory right available to protect his interest against arbitrariness which may creep in while fixing the value of capital gain and it is the safeguard given to the assessee. The said right is more effective in cases where the parties to the document have not taken any steps to defend or to initiate proceedings under Stamp law. [Jitendra Mohan Saxena 117 TTJ 974 (Tnib. Luck.)]

Further, in Jitendra Mohan Saxena 117 TTJ 974 (Trib. Luck.), it was held that both the remedies u/s. 50C are alternative. If guideline value has been challenged before the stamp valuation authority, same cannot be again challenged before the AO. In other words, assessee can challenge the guideline value before AO only if he has not challenged the same before stamp valuation authority. [Mohd. Shoib 127 TTJ 459 (Luck.)]

4.6 Assessee sold his property below the guideline value. Assessee asked the AO make valuation ot property. DVO valued the property at a figure more-or-less similar to what was the guideline value. Whether still section 50C wouId be attracted?

Although not much research has been done on this aspect, I may submit that in an array of decisions in respect to sections 55A and 142A, it has been held that Report of the DVO is not sacrosanct. It is only estimation.

It has been held in Santosh Kumar Dalmia 208 ITR 337 (Cal.) that valuation is only a matter of opinion and valuation differs from valuer to valuer, depending on the facts and circumstances of each case. The valuer’s report is after all a statistical hypothesis that leaves wide room for error on either side. [Bhola Nath Majumdar (1996) 221 ITR 608 (Gau.); Kamalam Rajendran 129 Taxman 840 (Mad.); Abdul Mazid 178 1TR 616 (MP)]

Therefore assessee can give report of AVO and can also challenge the valuation on merit. This view further finds support by a direct decision in Waqf Alal Aulad (2010) 37 SOT 58 (Del.) the DVO had given deduction of 33% on account of encumbrances in tenancy while computing Market Value u/s. 50C. Matter was remanded back to AO to allow proper time to assessee to rebut the DVO’s report. See also Ravi Kant (2007) 110 TTJ 297 (Del.), where the DVO made the valuation at Circle rates, which are not indicative of market rates. It was held that such an approach will render exercise u/s. 50C(2) a meaningless ritual and an empty formality. In such a case, the DVO’s report should be based on consideration stated in the registration documents for comparable transactions, as also factors such as inputs from other sources about the market rates.

Further, one can argue that if there is an acceptable margin, say up to 15% in the actual consideration and valuation of DVO, same shall be ignored and no addition shall be made. [Rahul Construction 38 DTR 19 (Pune)]. Reliance is further placed on C.B. Gautham 199 ITR 530 (SC).

4.7 Assessee sold a land for Rs. 10 lakhs. However, u/s. 50C, the Full Value ol consideration was treated as Rs. 19 lakhs. Whether, for claiming exemption u/s. 50F, assessee should invest Rs. 10 lakhs or Rs. 19 lakhs?

As per the latest decision in Gyan Chand Batra 133 TTJ 482 (Jp.), the "full value of consideration" for section 50C shall be the guideline value. Section 50C creates a fiction and replaces the "full value of consideration" u/s. 48 with the guideline value. Such fiction cannot be extended to section 54F. Reinvestment u/s. S4F shall be done only of actual consideration. In given example, assessee shall only invest Rs. 10 lakhs. The decision needs to be highly appreciated, as the assessee may not be in a position to reinvest Rs. 19 lakhs since he received only Rs. 10 lakhs.

4.8 Compare the provisions of section 50C with section 56(2)(vii)

As on date, section 50C and section 56(2)(vii) operate in a totally different fields:

a. Section 50C will apply to seller, if he transfers an immovable properly (being capital asset) without adequate consideration. This transfer may be to a relative or to a non-relative. For the buyer, the cost is actual cost of acquisition.

b. Section 56(2)(vii) apply to a buyer, if he receives an immovable property (being capital asset) without consideration. This is taxable only if it is received from a non-relative. For the buyer, the cost is the guideline value considered for the purpose of section S6(2)(vii).

[One may note that this is in contradiction to section 49, whereby in case of asset received under a gift, the cost is cost of previous owner]

4.9 Assessee becomes a partner of the firm. He gives his house as a capital contribution to firm. Value recorded in books of firm is Rs. 30 lakhs. Guideline value is Rs. 45 lakhs. Section 45(3) states that full value of consideration for the partner shall be the value recorded in the books. However, section 50C states that the lull value of consideration shall be guideline value. Whether section 45(3) or section 50C would be attracted?

This issue came for consideration in a latest decision in Carlton Hotel P Ltd. (2009) 122 TTJ 515 : 35 SOT 26 (Luck). In that case, it was held that in such situation, section 50C would override section 45(3). Section 45(3) is a general provision and section 50C is a special provision which would override section 45(3) if the sale deed is sought to be registered by paying stamp duty.

4.10 Assessee sold a building which was depreciable asset. Can section 50C be applied.

As held in ACIT vs. Roger Pereira Communications P Ltd. 34 SOT 64 (Mum.), section 50C cannot be applied as section 50 is a special provision for computation of depreciable assets which are covered by block of assets concept. [see also Panchiram Nahata 127 TTJ 128 (Kol.)]

4.11 Assessee sold lhe immovable property by way of transfer u/s. 53A of Transfer of Property Act, 1882, on 10.03.2010. At that time the guideline value was Rs. 40 lakhs. Subsequently, the property was registered on 12.05.2013. On that date, the guideline value was Rs. 150 lakhs. Whether sale consideration shall be Rs. 40 lakhs or Rs. 150 lakhs?

One may note that transfer of a capital asset is taxable under the head Capital Gains on the date of transfer. Section 50C is merely a computation provision. Section 50C shall apply to compute the income underthe head capital gains. Section 50C therefore applies at the time of transter. Therefore, in my view, therefore, guideline value on the date of transfer shall be applicable. Registry is a post- transaction event. The same should not have value for computation of capital gains u/s. 50C.

One may note that such an issue was for consideration in one of the cases in Smt. Meera Somasekaran (2010) 4 ITR (Trib) 271 (Chennai). In this case, it was held that assessee should bring evidence on record to show that all the conditions of section 53A of Transfer of Property Act are satisfied at time of agreement.

Further, in Kaushik Sureshbhai Reshamwala 39 SOT 357 (Ahd.), assessee transferred agricultural land in March 2006 u/s. 53A of Transfer of Property Act, but the registration could be done only in F.Y. 2007-08. AO adopted the market value instead of stamp value u/s. 50C. It was held that section 50C applies only to computation of capital gains in real estate transaction. Therefore, even on the date of transfer u/s. 53A, section 50C would apply and AO cannot adopt a higher figure on the plea that registry was done belatedly. It was further held that AO had no evidence otherwise to adopt a higher value than the guideline value.

In M. Siva Parvathi 129 TTJ 463 (Visakha), the issue was whether section 50C would apply to transfers which were entered into prior to insertion of section 50C, but registry was done after the insertion of section 50C. It was held that section 50C shall not be applicable. This decision can be taken as a help for argument that the transfer is different from section 50C, which is merely computation provision; and the computation is done at the time of transfer.

4.12 Whether addition u/s. 50C would necessarily mean that assessee has "concealed" the income or "furnished inaccurate particulars thereof" and therefore penalty u/s. 271(1)(c) should be levied?

As held in ACIT vs N. Meenakshi (2009) 125 TTJ 856 (Chennai), penalty cannot be levied in such a case, as there is no ‘concealment or furnishing of inaccurate particulars’. Also see Prakash Chand Nahar 110 TTJ 886 (Jodh.); Balkrishna Waghere & Others, July/Aug, 2010, BCAJ, 3 (Pune).

5. Conversion of firm to company and company to LIP

Under the provisions of I-T Act, the conversion of Firm to Company has been made exempt from Capital Gains. Similarly, the conversion of proprietary concern to Company has been made exempt from capital gains. Further, the conversion of Company to LLP has been made exempt from capital gains by Finance Act, 2010 by A.Y. 2011- 12. One may further note that Firm includes LIP. Therefore, after the Finance Act, 2010, the following conversions are made exempt from capital gains: -

From

To

Exempt/Taxable

Firm

LLP

Exempt (as both firm and LLP are same assessee)

Firm

Company

Exempt (u/s. 47)

Company

Firm

Taxable **

Company 

LLP

Exempt (u/s. 47)

LLP

Company

Exempt (u/s. 47, as it amounts to conversion of Firm to Company)

LLP

Firm

Exempt (as both firm and LLP are same assessee)

* May be covered by ciause relating to liquidation of company, if the conditions thereof are fulfilled.

The procedure for such conversions has been dealt in great detail by the learned Author in ‘The Chartered Accountant Nov. 2010, pg 768.

In case of conversion of Firm to Company, the following conditions are prescribed; -

(a) All assets and liability immediately before succession are transferred to company

(b) All partners of firm become immediately before succession become shareholders of company.

(c) The partners become shareholders in same proportion in which their capital accounts stood on date of succession.

(d) Partners do not receive any consideration or benefit, directly or indirectly, in any form, other than allotment of shares.

(e) Aggregate of shareholding of partners in company is not less than 50% (of voting powers), and their shareholding continues for 5 years.

One may note that even if the aforesaid conditions are not complied, the firm can claim exemption provided the conversion is in terms of Part IX of the Companies Act.

The tax treatment of conversion of firm to company under the provisions of section 47 of the Income-tax Act, 1961 is as follows:

(a) At time of conversion, the capital gain arising to firm shall be made exempt, as discussed above.

(b) Cost of Acquisition:- In case of conversion of Firm to Company, the cost of acquisition of company shall be cost for which the capital asset was acquired by company. Thus, transfer of assets from firm to company can be done at revalued figure and the cost of the company shall be such revalued figure. The company can claim depreciation at higher figure and at time of sale by company, the company would be liable only for sale consideration over and above the acquisition cost of company.

(c) It seems that the holding period only of company shall be considered for transfer of asset subsequently by company.

In case of conversion of company to LLP, following additional conditions have been introduced, apart from the aforesaid conditions: -

Conditions Possible reasoning
Total sales/ turnover/ gross receipts in any of the 3 years preceding the year of conversion do not exceed Rs. 60 Iakhs. Only small companies shall get converted into LLR
For a period of 3 years from date of conversion, the accumulated profits of the company on the date of conversion are not paid to any partner of the LIP, whether directly or indirectly The conversion of company to LIP shall not be done merely to avoid Dividend Distribution Tax (DDT).

The tax treatment of conversion of Companyto LLP is as follows: -

(a) At time of conversion, the capital gains arising to Company shall be made exempt, as discussed above.

(b) Cost of Acquisition :- After conversion, when the LLP transfers the asset subsequently, the Cost of Acquisition for LLP shall be the Cost of company. Thus, the scope of planning which was available in the case of conversion of Firm to Company is not available in case of conversion of Company to LLP The transfer between Company to LLP at revalued figure will not make any difference.

(c) Holding period :- The holding period of only LLP shall be considered as no amendment has been made u/s. 2(42A). Therefore, the long-term assets of Company would become short-term assets.

Apart from the above planning aspects, following planning aspects are further available.

1. When firms want to sell off the assets, and dissolve the firm, good amount of tax planning can be done in order to save capital gains and stamp duty, which wants to transf er capital assets: -

(a) The partners may retire and new partners may join. The new firm may be dissolved and assets distributed to partners. Although as per section 45(4), full value of consideration at the time of distribution of assets to partners at time of dissolution shall be the market value on the date of distribution; however, only may contend that the definition of transfer u/s. 2(47) has not been amended and therefore, capital gains shall not be levied. Reliance may also be placed on decision of CIT vs. Moped and Machines 281 ITR 52 (MP)

(b) The firm, instead of selling the capital assets, may prefer to change the partners by retiring the existing partners and introducing new partners. The new partners may convert and merge the firm into an existing company. The assets would thus be transferred from firm to company without any capital gains and stamp duty.

2. When the Company wants to liquidate its business, it may convert the Company into LLP Although for a period of 3 years the profit cannot be distributed, but thereafter, the profits can be freely distributed. Thus, subject to lock-in period of 3 years, the company may distribute the profits freely.

6. Tax treatment of Development Agreements

Development agreements have been a very popular form of transactions in the real estate industry. In Development agreements, the land owner agrees into an agreement with the builder, landowner hands over the possession of property to builder. The builder does the construction of property, and the constructed property is distributed between the land owner and the builder at an agreed ratio.

The question as to what shall be the tax treatment in hands of land owner and builder has been a part of judicial consideration in some cases.

To summarise, the following taxtreatment shall arise: -

(a) At the time when the land owner hands over the property to the builder, the question which arises is whether there is a transfer of property u/s. 53A of the Transfer of Property Act. Since the possession is given to the builder and the builder also pays part consideration in form of advance or deposit, the question becomes more controversial. The courts have held that in case the land owner gives the builder a specific power of attorney (to develop the property and to obtain permissions, etc.), there is no transfer. However, when the builder gives the builder, a general power of attorney, ensuing all rights in builder to sell, discard or dispose of the property; same results in a transfer of capital gains at the time of handing over of the land, by the land owner to builder. [Ref. CIT vs. Atam Prakash & Sons 219 CTR 164 (Del.); Jasbir Singh Sarkaria 212 CTR (AAR) 107; Chaturbhuj Dwarkadas Kapadia 260 ITR 491 (Bom.); Ms. Rubab M. Kazerani 97 TTJ 698 (TM)(Mum.); CIT vs. Jindas Panchand Gandhi 200 CTR 473 (Guj.); R. Gopinath (HIJF) 133 TTJ (Chennai) 595].

(b) When the builder completes the construction and hands over the part of construction to land-owner, again there shall be no capital gains in hands of Land-owner. As such, the land-owner does not transfer anything on this date, but receives part of property.

(c) When the flats/ constructed portion is sold by land owner and builder, the land-owner shall be liable for capital gains. The cost for the Land owner shall be the cost of land. In case of sale of only part of constructed property, the cost of land Owner shall be proportionate cost in relation to the cost of land.

(d) When the builder sells his part of flats/constructed portion, the builder shall be liable for business income. The cost of construction shall be proportionately allocated to each flat and the sale consideration shall be treated as income.

(e) At some places, the builder Transfers his Development Right (TDR). Such TDR is not liable for capital gains as held in Jethalal Mehta 2 SOT 422 (Mum.) as there is no cost in acquisition of such development rights. One may also refer unreported decision in case of Om Shanti Co-operative Society & Lolita Co-operative (Mum.) available at www.itatonline.org.

[Source : Paper presented at Two Day National Tax Conference held at Indore on 11th & 12th December, 2010]