Income tax implications as capital assets , for treating constructed flats and offices: The Budget for 2018-19 has proposed to levy a tax on the conversion of a stock in trade into a capital asset.
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INCOME TAX
11 March 2019 - 5:52, by , in NRI, No comments

The income tax rules give various heads of income, for taxation, depending on the nature of activities carried out by you. A particular income may be taxed under the head ‘Profits and Gains of Business or Profession’ or the head ‘Capital Gains,’ depending on whether you are regularly dealing in the asset, or you are an investor of the asset.

At times, you may decide to convert your capital asset into a business asset and vice-versa. Conversion of one asset, from one category to another, has income tax implications. The Budget 2018 has proposed some significant provisions, which will apply when you convert your business asset into the capital asset. Let us discuss the impact of such regulations and the existing rules, applicable for conversion of a capital asset in a business asset.

Existing provision for conversion of capital asset into the business asset

As per the current income tax provisions, when one converts a capital asset into a business asset, the fair market value of the capital asset on the date of such conversion is taken as the value for computation of capital gains on such conversions. However, the law does not require you to pay the tax on such conversion, in the year in which such transformation has taken place. The taxation of profits on such conversion is delayed, till the time the capital asset so converted is sold. So, on the date of sale of such an asset, the profits shall be divided into two parts.

  • The difference of the cost and the fair market value on the date of conversion is treated as capital gains and is taxed as short-term gains or long-term gains, depending on the period for which the asset was held, as on the date of such conversion.
  • The difference between the sale price and the fair market value as on the date of conversion is treated like your business profit and taxed under the head ‘Profits and Gains of Business or Profession.’

This may happen, when a developer introduces and converts land, held as his personal asset or as investments in his business, into a business asset. The value of the land on the date of such conversion, will be the cost of the land for the purpose of computing business profits of the developer. When the building constructed by the developer is sold, the profits, as explained above, will become taxable under two heads.

Proposed regulations in Budget 2018, for conversion of stock in trade into capital asset

The present income tax laws do not have any provision, to deal with a situation where a stock in trade is converted into or treated as a capital asset. So, the Budget for 2018-19 has proposed that on the date on which a stock in trade is converted into or treated as a capital asset, the difference between the market value of such stock in trade and cost, will become taxable as business income in the year in which, such conversion takes place or is treated as a capital asset. So, even though you may not have received any money on such conversion, you still have to pay income tax on the difference between your cost of purchase/manufacture/construction and the fair market value on the date of its conversion into a capital asset. This provision, of making the tax payers pay the tax in the year of conversion, is in contrast with the existing provisions for conversion of capital asset into stock in trade.

This proposed provision will hit developers hard when they decide to let out the unsold flats and constructed offices that have remained unsold, as these may be treated as the conversion of stock in trade into the capital asset. At that moment the unsold flats are deemed to have been converted into or treated as the capital asset, will depend on the circumstances of each case. For example, if the developer lets out an unsold office/flat in the building for a fixed period of three years, without there being any clause for early termination of such tenancy, such an act or conduct of letting out of the office for a long tenure itself shows the intention to treat or convert the stock in trade (the unsold flats/offices) as capital asset. However, if the same is let out for a short period, with a clause in the agreement giving the builder a right to terminate the tenancy earlier by giving short notice, then, it may not be possible to infer that the stock in trade is treated or converted into a capital asset.

As the treatment of conversion of stock in trade into capital asset is to be judged by express decision or is to be inferred from the conduct, it is very important for the builders/developers not to let out the property for very long. The builder needs to ensure that the tenancy agreement gives him express power to terminate such tenancy with short notice. The same intention of converting his stock in trade into capital asset may strongly be inferred, when he furnishes and uses some of the offices as his office or furnishes any of the flat/s and stays in the building.

Moreover, when the developer sells the property which is treated as a capital asset, he will have to pay capital gains tax, on the appreciation between the date of such conversion and the time of actual sale. To compute the capital gains, the fair market value on the date of conversion will be taken as cost. If the developer holds the property for more than two years after such conversion, the profits made on such sale will be treated as long-term capital gains and will be become taxable at 20.80 percent. However, the developer will be entitled to the benefits of indexation, which will be available from the date on which the flat is converted into a capital asset.

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